I still had much to learn but I knew what to do. No more floundering, no more half-right methods. Tape reading was an important part of the game; so was beginning at the right time; so was sticking to your position. But my greatest discovery was that a man must study underlying conditions, to size them so as to be able to anticipate probabilities. – Jesse Livermore

Yesterday I was engaged in a discussion about subtle details of trading. The relative importance of entries; trailing stops vs. fixed stops; stop entries vs. limit entries and so fourth.  But I think that most people get caught up in these subtle details, missing the forest for the trees.

The reality is that asset selection is the most important component of your whole trading plan. You can be as technically refined as you like, but if you’re picking assets that aren’t moving, or that are unclear, all your prowess goes to waste. Like Jesse Livermore said: underlying conditions are the trump card.

Gauging Underlying Conditions

“The desire for constant action irrespective of underlying conditions is responsible for many losses in Wall Street even among the professionals, who feel that they must take home some money every day, as though they were working for regular wages.” – Jesse Livermore

It is simply incredible to see just how repetitive human behaviour is. One of the most common issues I confront during my coaching sessions is precisely the “need to trade” or “fear of missing out” or “overtrading syndrome” or something of that nature, where the trader is paying attention to setups but fails to size up underlying conditions first and foremost.

Opportunity cost is real: we have a limited amount of funds that need to be allocated in the most efficient (profitable) way possible. We need to try and select the asset/asset classes that are most likely to attract positive flow. For example, Jesse Livermore made a very good suggestion – that is used even today – for finding good stocks to trade:

  1. Start with the broader indices and determine their overall direction & influences. For example, currently the indices are rising given the lack of conflict in North Korea and the lower impact of Hurricane Irma.

2. Then go through sector-specific indices and find which one is leading the pack. For example, using ETFs is an efficient way to do this kind of filtering.

3. Pick the leaders of the leading sector

This kind of top-down filter is efficient and robust. Now we need to do the same thing within the FX universe.

Gauging Underlying Conditions in the FX Market

One of the main issues I see within novice FX traders is their “dollar-centric” view: they simply stick to the majors and ignore the cross rates. It’s true that most of the dealing is done through direct dollar buying/selling but in order to gauge a currency’s true strength/weakness you need to use the crosses.

For example, over the past couple of weeks Sterling has been gaining strength across the board, with the exception of GbpCad. Even without having any particular technical prowess, had you selected a GBP-pair, you would have been sitting pretty.

So the key in FX is to setup your watchlists/profiles for each major currency pair, and scan it’s crosses. Then ask yourself some questions:

  • Are they moving in sync? The market is probably focused on a common theme involving that currency.
  • Are they all over the place? The market is concentrated on something else.

One you find a common theme, select the best mover of the pack and deploy your preferred trigger.

It’s also not difficult to understand what fundamental influences are driving the markets. Nowadays retail traders have access to a wide range of low-cost squawk services, research pieces and the like, to stay in tune with the markets. For example, on Sterling recently we have had positive data surprizes, including CPI and that can directly affect monetary policy decisions.

In this light, we can understand why GBPCAD has not moved in lockstep with the other GBP crosses: the Bank of Canada raised rates last week after a plethora of good data output. Indeed, the Loonie has had quite a run and it’s quite inefficient to play strength vs strength. Always seek strength vs. weakness.

Over to You

Could it be that you’re too busy scanning dozens of charts, without actually focusing on value propositions? Are you paying attention to the fundamental influences that drive market movements? Are you trying to match strength & weakness?

These are the keys that can allow you to gauge the underlying conditions in any market and across asset classes. If you start your analysis with this top-down approach, I know your trading will never be the same, for the better!

About the Author

Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.