Understanding Intermarket Analysis for Financial Traders
In financial trading, intermarket analysis is a method used to understand the relationships between different markets and how they influence one another. By examining the correlations and interactions between asset classes such as stocks, bonds, commodities, and currencies, traders can gain insights into market trends and potential opportunities. However, while intermarket analysis is a powerful tool, relying solely on it for trading decisions has its limitations. To gain a real edge, incorporating a news trading strategy offers a more robust and informed approach.
The Significance of Intermarket Analysis in Trading
Intermarket analysis examines how different markets influence each other. For example, a rise in bond prices might indicate falling interest rates, which can impact stock prices. Similarly, changes in commodity prices can affect currency values, especially for countries that are major exporters or importers of those commodities. By understanding these relationships, traders can anticipate market movements and make more informed trading decisions.
Historical Context and Insights
Intermarket analysis gained prominence in the late 20th century, with the work of analysts like John Murphy, who published books and articles on the subject. Murphy’s work highlighted the importance of understanding the connections between different markets to improve trading performance. The approach became particularly valuable during periods of economic uncertainty when traditional market indicators were less reliable.
One interesting insight from intermarket analysis is the concept of leading and lagging indicators. For instance, bond markets often lead the stock market, providing early signals of potential changes in economic conditions. By monitoring these relationships, traders can gain a better understanding of market dynamics and improve their timing for entering or exiting trades.
Trading with Intermarket Analysis
Traders use intermarket analysis for various reasons, including:
- Trend Identification: By examining the relationships between different markets, traders can identify trends and potential reversals.
- Risk Management: Understanding how different markets interact helps traders diversify their portfolios and manage risk more effectively.
- Market Confirmation: Intermarket analysis can provide confirmation of signals from other technical indicators, enhancing the reliability of trading strategies.
Intermarket Analysis in Action
To understand how intermarket analysis is used in practice, let’s consider a hypothetical scenario. Suppose a trader notices that bond prices are rising, which typically indicates falling interest rates. The trader might then anticipate a bullish trend in the stock market, as lower interest rates can lead to increased corporate earnings and higher stock prices. By monitoring these relationships, the trader can make more informed decisions about when to enter or exit stock positions.
Limitations of Relying Solely on Intermarket Analysis
While intermarket analysis is a useful tool, it has limitations that traders should be aware of:
- Complex Relationships: The relationships between different markets can be complex and influenced by numerous factors, making it challenging to draw definitive conclusions.
- Changing Correlations: Market correlations are not static and can change over time, reducing the reliability of intermarket analysis.
- Overreliance: Solely relying on intermarket analysis without considering other market factors or indicators can lead to suboptimal trading decisions.
A More Reliable Alternative: News Trading Strategy
Rather than relying solely on intermarket analysis, a more effective approach is to incorporate a news trading strategy. This strategy involves trading based on significant economic data releases, which can provide clearer and more immediate trading opportunities.
Clear Edge with News Trading
News trading strategies offer a significant advantage, particularly when the market reacts strongly to deviations in key economic data. When an important economic report, such as GDP growth or employment figures, deviates from market expectations, it can result in substantial market movements. Traders who are prepared to react quickly to this new information can benefit from the ensuing volatility.
Trading Strategy for Economic Data Releases
Step 1: Analyze Central Bank Priorities
Understanding the current focus of central banks is crucial. If a central bank is closely monitoring a specific economic indicator, that indicator’s report will have a heightened impact on market volatility. Use a professional economic calendar, which includes a fundamental guide, to stay updated on the central bank’s priorities.
Step 2: Use High-Low Expectation Forecasts
Professional traders use high-low forecasts to gauge market expectations accurately. Here’s a more detailed look at why these forecasts are essential:
- Institutional Forecasts: Professional economic calendars include high and low estimates from top institutions, providing a comprehensive picture of potential outcomes.
- Market Shocks: When a report exceeds the high estimate or falls below the low estimate, it often results in sharp market movements due to the unexpected nature of the data.
- Lightning Bolt Feature: This tool signals deviations above the high or below the low of analyst expectations. Quick reaction to unexpected data can differentiate between a profitable trade and a missed opportunity.
Understanding High-Low Forecasts
Economic forecasts are based on surveys from credible institutions, providing their best estimates on upcoming data points. Retail calendars typically present the median of these estimates, which can be misleading. The median forecast doesn’t reveal the full range of expectations and, therefore, doesn’t indicate how surprising an actual data release is compared to the extremes of analysts’ projections. In contrast, professional economic calendars include both high and low estimates. This additional information shows the analysts’ expectations at the extreme ends of their projections. Great trading opportunities arise when data releases fall outside these high and low estimates, creating market shocks that move prices significantly.
Step 3 - Choosing the Most Volatile Instrument to Trade
Using insights from institutional reports, traders can select the most responsive currency pairs or assets. For example, if the USD/JPY is particularly sensitive to economic data and a significant report shows a substantial deviation, this pair could be an ideal target for trading.
- City Economic Surprise Index: This report identifies currency pairs that react strongly to economic surprises, highlighting sensitive pairs.
- Risk-Reversal Report: Reveals market positioning and options build-up on certain currency pairs, helping traders choose responsive markets.
- CFTC Report: Details hedge funds' positions, indicating potential market movements based on fund activities.
Trade Execution Steps
- Confirm Central Bank Focus: Ensure the central bank is currently emphasizing the economic data in question. If the central bank is focused on a specific data point, it’s because they are using that data point to make a decision on rates, leading to potential market volatility. This is the reason data points that are focused on cause volatility. Sometimes, the central bank is focused on a data point inside a data point. For example, the Federal Reserve has often highlighted average hourly earnings as the key metric within the Non-Farm Payroll report.
- Check Forecast Ranges: Before the data release, review the high and low forecast expectations for the event. Plan to trade only if the actual data significantly exceeds the high estimate or falls below the low estimate. This strategy ensures you act on genuinely surprising data and there will most likely be a follow-through reaction.
- Monitor Revisions: Check for any conflicting revisions in the data, as these can alter the initial market reaction. Make sure the primary release and any revisions align to support your trade.
- Enter Trade Promptly: Once you confirm the deviation, act quickly to enter your trade. Enter within the first 30 seconds. Speed is crucial, as market reactions to significant data surprises happen rapidly.
- Set Stop and Take Profit:
- Stop-Loss: Place your stop-loss below the low of the initial spike candle to protect against adverse movements.
- Take Profit: Aim for 15-30 pips for tier 2 events, adjusting based on market conditions and volatility.
Managing the Trade
- After the Initial Run: Look for a shallow pullback around a 23% Fibonacci retracement or near support/resistance levels. This initial pullback can provide an opportunity to enter the trade again after taking a few points off the table from your first entry.
- Break Even: Move your stop-loss to break even as soon as possible to protect your gains. The stronger the release, the shallower the pullback. If the market doesn’t buy off your support/resistance level and continue to the highs of the one-minute candle, consider reassessing the trade.
- Reentries: If your initial position is stopped out at break even, consider reentering at deeper retracements, such as the 38% or 50% Fibonacci levels. Use nearby support and resistance levels to guide your reentry points.
Conclusion
While intermarket analysis is a valuable tool for understanding the relationships between different markets, its limitations make it less reliable for making standalone trading decisions. Instead, adopting a news trading strategy, such as the one detailed for economic data releases, can offer a more robust approach to trading in the Forex market. By following these steps, you’ll be well-prepared to trade economic data releases effectively, leveraging the same strategies that professional traders use to profit from these significant market events.
For more information, consider using our professional economic calendar to stay updated on the latest economic data and central bank priorities.