From the May 01, 2011 issue of Futures Magazine • Subscribe!

Reading forex memory with five-day Markov chains

Practical results

"Tracking the euro" (below) contains the results of calculated sentiment indexes for the euro and the dollar. Such a comparative chart carries a great deal more information about the sentiment of the currency pair in question. Let’s note the main points from its analysis.

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The crossing of the indexes indicates a changing in currencies’ power balance and can be used most successfully as basis of a trading strategy. However, statistically, with the indexes’ differential being more than 0.65, the probability of a positive trading scenario rises to 80%. This is the main technique used with this method. In the period shown, this took place six times: long on Nov. 18, short on Nov. 24-30, long on Dec. 1-3, long on Dec. 24-30, short on Jan. 5-7 and long on Jan. 12-14.

The index ratio also allows us to understand the reasons of the present movement more deeply. For instance, the fall in the euro from Nov. 24 to Nov. 30 was caused not only by dollar strength but mostly euro weakness relative to other currencies. In other words, traders were selling the euro more than they were buying the dollar. The same situation happened Jan. 5 to Jan. 7. We saw the opposite scenario Dec. 1 to Dec. 3 when against a background of moderate euro sentiment, the dollar was exposed to pressure. The current strength of the euro also is supported by a strong buying interest.

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