A new leading indicator: the strategy of forecasting with composite instruments
Experienced traders and programmers have developed a unique technology for creating Personal Composite Instruments (PCI) to visualize and improve trading on any of your strategies. In this article series we will look at whether a composite tool can be used as a leading indicator for analyzing traditional currency pairs.
Example of a Pairwise (Spread) Trading Strategy: Idea and Implementation
Let us assume, for example, that the trader trades the usual EUR/GBP pair. He has a hypothesis that by comparing the behavior of all the classical cross-courses EUR with the major currencies and all the classic crosses GBP with the major currencies (but excluding the pairs with the U.S. dollar from the analysis), you could get earlier trading signals or predict a trend change in advance.
One can easily test this hypothesis by creating a tool (Instructions. How to create a composite instrument in NetTradeX), in which the first currency of the pair is a portfolio of 5 crosses EUR: EUR/AUD, EUR/NZD, EUR/JPY, EUR/CAD, EUR/CHF, and the second - an instrument of 5 crosses GBP: GBP/AUD, GBP/NZD, GBP/JPY, GBP/CAD, GBP/CHF. We take each cross in equal shares (20% each).
Let's investigate the tool, the formula of which is as follows:
Tool = Part1 / Part2,
where
- Part1 = k*EURAUD + k*EURNZD + k*EURJPY + k*EURCAD + k*EURCHF;
- Part2 = GBPAUD + k*GBPNZD + k*GBPJPY + k*GBPCAD + k*GBPCHF;
- k = 0.2.
Using the proposed technology (within the dialog of the NetTradeX trading terminal), we create a composite instrument that implements this relation. After natural mutual reductions and a significant reduction in both parts of the currencies EUR and GBP (to exclude the influence of the EUR/GBP pair proper) we obtain the following composite instrument PCI:
&EURcurr/ GBPcurr_3 = Base / Quote,
where
- Base = b1*AUD + b2*NZD + b3*JPY + b4*CAD + b5*CHF + b6*EUR;
- Quote = q1*AUD + q2*NZD + q3*JPY + q4*CAD + q5*CHF + q6*GBP;
- bi, ki - coefficients calculated from the current exchange rates to USD for the translation of the studied ratio into the composite instrument.
Composite instrument as a leading indicator
Let's look at the behavior of the instrument &EURcurr/GBPcurr3 in the first few days of February 2016 compared to the EUR/GBP pair on the H1 chart. Let's build, for example, a moving average with a period of 21.
On the charts we will see that our composite instrument turned upwards (on the average reversal) noticeably earlier than the EUR/GBP pair itself, which would have allowed us to buy the pair earlier and add purchases around 0.7550 (on the apparent divergence with a composite instrument). This approach can be used to predict early entries and the beginning of trends.
It should also be noted that the movement of a composite instrument is smoother because it is less dependent on the behavior of individual currencies. Therefore, if desired, a trader can trade a composite instrument (buy, sell, place orders) if the volatility for his strategy should be lower. Each trade with this instrument means, in fact, a group operation with its constituent components, i.e. one command can make a series of trades in specified volumes and directions according to the trader's strategy.
Of course, we have only looked at one example of using composite assets for prediction. In order to apply our theory in practice, you should study it a bit more and test it on your own strategy. Nevertheless, the idea is quite real and economically explainable, which means it could be a good strategy for investment.
In my opinion, cross rates, not ahead, but a little behind.
Why exactly one-hour timeframe was used? Or was the period random?
The author was experimenting with the idea without going into much detail yet. So it's just a random choice.
It's the highest-rated pair, so it's a good thing you picked it.
Thank you! Glad you liked the idea.
So the signal in the left picture is almost at the close of 02.02. If you use it to BUY on EUR/GBP at that moment, you will get -70 points of drawdown! The arrow in the right picture shows another opening time...
Again, it is not written that it is necessary to enter by this signal. The idea of the article is an indicator with earlier reversal signals. Of course it would be strange to enter only by it, but it can be taken as one of the good filters indicating the general reversal in your TS. We should approach trading wisely. This is not the Grail!