Quick Notes From The FX Desk

I started this thread earlier this week - but someone at FF moved it to another forum. Not sure why that was, hopefully they will leave this one in place.

My intent is to share with you, when possible, some insights and analysis that I am doing during the course of a week. I will start this thread (again) with some of my perspective and pet peeves I have with the FX industry. I am hopeful that my 14 years of experience as a trader/money manager in both FX and equities will bring a common sense perspective to the table that will allow for good discussion. I will mainly focus on technical analysis as well as healthy doses of general insights and opinions.

For today, here are my thoughts not only on the current trading environment but also at attempt to cut through some of the noise that traders are bombarded with everyday.

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Perhaps 'Quick Notes...' is a bit of a misnomer for today's posting. Not only will it likely be longer than normal it will have elements of 'ranting' as well.

There can be no denying that the price action and circumstances recently are unprecedented. Huge intra-day ranges have provided ample opportunities for those who are able to intra-day trade. The fact is however, there are very few people who can do this consistently. With all due respect, newer traders have little to no chance of CONSISTENTLY short-term trading with any degree of success.

So, if we agree that 99% of traders are not in there 'scalping' that leaves only swing and position traders. Either camp has had to be extremely selective and only trade when all the planets came together so to speak. Personally, I have only made 2 (yes 2) trade alerts to my clients so far in September - both turned out to be solid winners and oddly enough September has been the best month since May. Bear in mind I am a swing trader so frequency is not terribly high to begin with. However, with only 2 trades for September, it is well below the historical average of 8-12 per month. Naturally with these trades have come wider stops - if not, price action would have taken you out.

Now the FX managed accounts are a different story. In there, I have included the 2 trades noted above, but also probably about 6 or so intra-day trades that were done on the fly so to speak. I have been at this game since 1994 though and as a result I can and do make 'scalps' when conditions permit. To have conveyed these trades to clients in a timely and effective manner would have been impossible.

So what am I driving at? Rid yourself of these erroneous thoughts that all this price action should result in massive gains. For most traders that is simply rear-view mirror analysis. Most traders have horrible discipline and these markets are the ideal 'drug' to exploit that shortcoming.

Remember, trading is not a game for entertainment; it is a game to create wealth. Too many traders feel they need to be in all the time and fret about not being in.

We have all heard these arguments before - unfortunately rarely are they observed. Too many people are seduced by the scumbags that prowl the internet touting large pip gains that are either fictitious or impossible to have executed in a timely manner. Risk adjusted gains are far more important that gains. Any investor with an ounce of common sense will be very shrewed about looking under the hood so to speak. Max draw-down, annualized standard deviation, Sharpe Ratio, Sortino Ratio etc.

Unless these numbers pencil out, your gains, regardless of how large, are irrelevant because the risk you took to achieve them is simply not worth the gains. Next time you here the idiot, I mean the polished presenter, from the 'Red Light; Green Light' seminar (or similar racket) tell you about how great their system is, ask them for their Sharpe and Sortino Ratio's - and even if you do not stump them, they will go pale as you have likely exposed them for the frauds they are.

So, you can either approach this like a business or a hobby. If you choose the business route, get ready to be bored to tears at times because you are sitting on your hands while putting in long hours of research while you perfect your craft.

Take the time to document your monthly gains/losses and make sure you calculate the ratios noted above. You will be surprised how much more effective and conscious you will become about the quality of the trades you are putting on.

Excellent post Dave

While markets and the economy may still experience a long period os sideways consolidation and perhaps another nasty surprise, by and large, I believe that most of the damage has been done. This is not to say that we are on our way back to good times. No, unfortunately, it will take time to unwind the excess of the last 20-years. My hope however, is that a solid foundation will be built and perhaps even some lessons learned.

Enough of the literary aspects and opinion though, let's look at the stats and charts behind where we stand currently.

I will focus today on both equities and FX since they are so closely related presently. My main focus will be over the next few days, but towards the end of the commentary I will provide you with some data points worth considering for those looking to re-position their investment portfolios.

With the S&P 500 having nearly tested the October low at 839.80 there is a very good chance that prices will sustain a rally that may last several days/weeks. My immediate upside target is seen at 1044/50 and a break
above that level could easily help sustain the rally into the tail end of 2008. For now however, my focus is 1044/50. Under that scenario, it is reasonable to assume that not only would DXC (Dollar Index) weaken but that would allow for EUR/USD to trade higher.

You will recall that EUR/USD is inversely correlated to DXC and positively correlated to the S&P 500 - especially lately.

Inverse Correlation

The 60-min charts of both DXC and EUR/USD are poised for solid moves lower and higher respectively.

DXC

EUR/USD meanwhile has also retraced back to key support of the Oct 27 - Oct 30 move higher at 1.2698. Time retracements also come into play up until November 2nd.

My minimum upside target for EUR/USD is 1.3365 and possibly even 1.3736. Naturally these target(s) are completely dependent on moves in DXC and the S&P 500. As will continue to be the case, this will not be a market where you can just let the trade go, it will require you to check in periodically to see if the bullish scenario still makes sense.

Data Points Worth Considering

While sentiment, the magazine cover indicator (i.e. pictures of bread lines from the Great Depression), CNBC coverage (rear view mirror analysis at its finest)and a variety of other factors suggest a rally is more likely than further losses. Let's consider some hard data:

When looking at data where you isolate the percentage of NYSE stocks making 52-week lows on any given trading day, the results can often be quite compelling. Let's consider the daily data prior to October 2008 during periods where the markets were under tremendous selling pressure. I want to isolate days where more than 50% of the NYSE stocks were making new lows.

There were 9 trading days where this took place and on average the worst readings were in a range of 52.1% to 73.8%. One month later, the average gain was a modest 1.2% but the 3 and 6-month returns were 7.86% and 13.68% respectively.

In October 2008 the range of stocks making new 52-week lows was between 58.9% & 87.7% (yes, 87.7% of the NYSE stocks on Oct 10th made 52-week lows!). Will the outcomes be similar to those noted above? There is no way to know for sure, but the simple concept of mean reversion combined with the overall level of pessimism certainly favors those who look at this as a time to buy versus.

Naturally, this situation is also bullish for EUR/USD.

A Good Read

As always, the monthly commentary from Bill Gross of Pimco is insightful and thought provoking. I highly recommend you take a few minutes to read his comments.

Bill Gross comments

I couldn't get your Bill Gross comments link to work. Just me or ?

Edit: Found it inside their homepage here

sorry about that -

http://www.pimco.com/LeftNav/Feature...8+So+CQish.htm

The sell-off over the last 24-hours in EUR/USD was deep, but not one that violated any standard EW rules for pull-backs. Granted, if you were long you would have needed wide stops to test ones forecast for support at the 1.2735/05 level. We now know this level was quite valid.

Now the pattern is clear (either an ABC correction or the beginning of a 5 wave sequence higher) the immediate outlook is clear - higher prices.

This chart of EUR/USD illustrates my forecast.

Great analysis Dave, thankfully I'm in the same boat as you, long already

Reading your earlier post Dave I am wondering how standard deviation applies to forex since their is typically so much volatility in these instruements. Does not that form of analysis prove more useful in equity and bond trading?

Thanks - given the range intra-day lately however, scalpers/hit & run traders can look to be short as long as prices do not exceed 1.2850 as I believe the rally has run the course for now (wave 1 of 5 is in place) - support levels seen at 1.2647/1.2725 (i.e. Wave 2)

Just my general thoughts and forecast for the next 24-hours and slightly beyond.

Indeed Dave, if the bullish move from yesterday on EURUSD would have been a wave 3 of C I would have expected a greater momentum. I still have half my position on the long side just in case, the pattern is not invalidated, yet...

A second re-test of the October 10th low at 839.80 is appearing more likely. As was noted in this letter a couple of weeks back, the previous two data points historically that likely mimic the current situation suggest a re-test then either a gradual sideways recovery or a sharp move higher as we saw in 1987. Hence, a second re-test would put us back to merely looking at the charts rather than relying on historical data to forecast what may happen. Under this scenario, one would have to conclude that lower prices are in the cards.

http://www.aspentrading.com/uploaded_files/5057spx.png

While lower prices in the S&P 500 will certainly inflict more pain to the ‘long only’ equity crowd, it will continue to offer good insights on how to play the FX market as most major pairs are very correlated with the S&P 500 presently.

It is interesting to note however, that the downside action in EUR/USD was muted today despite the strong dollar (DXC) and weak S&P 500. In discussing this with colleagues we are all a bit uneasy about EUR/USD’s current price action. The last 12-24 hours have essentially provided only a series of overlapping waves which are corrective, but do not fit into the normal sequence that one would expect at this juncture of the move.

http://www.aspentrading.com/uploaded_files/5386eur.png

Add to this the fact that implied volatility (IV) values for the major pairs and EUR/USD are becoming rather expensive and it may suggest that the market is now valuing quite highly hedges on their existing ‘short dollar’ positions. While IV values alone are not a stand-alone indicator, at this time they are merely confirming some general gut feels regarding EUR/USD and perhaps the limited downside for the time being.

While I rarely will attempt to pick bottoms, I have been short EUR/USD since 1.2790 and have now lowered my stops to account for the potential rebound in EUR/USD. Traders who have been looking to get short EUR/USD may wish to re-evaluate that idea – the move lower has been generous and with the points noted above, shorts may be a lower probability play presently. Nonetheless, the market may continue lower and today will have been nothing more than a blip on the radar screen. A decisive break below 1.2470 exposes 1.2374/50.

Weak S&P 500 will keep pressure on EUR/USD despite overnight bounce.

http://www.aspentrading.com/uploaded_files/7157spx.png

However, it is possible that short-term bottom is in place for S&P's - frankly though, I am flat and happy to be so as this market is getting a bit too dicey for me.

Good morning folks. Equity markets worldwide remain under pressure and that is likely to keep our markets under pressure as we head towards the NY opening. It will be pretty key today to watch the S&P 500 as that action will dictate in which direction the major pairs trade.

As we all know, weak equities has equaled weak prices in EUR/USD, GBP/USD and of course AUD/USD and NZD/USD - I do not expect that relationship to change but what is becoming less clear is if the S&P 500 has put in a short-term bottom as of yesterday's close (807.12). While the larger trend is of course down, even a modest rally in the S&P's towards 861/883 which is simply the basic Fib retracements that corrections trade towards would put a great deal of pressure on EUR/USD to the upside.

So, while I am not trying to call a bottom in the S&P's I am trying to avoid playing EUR/USD from the short side at a time when a rally is possible. The 2 charts below illustrate where we are and where we might be heading over the next several hours. This is 'scenario analysis' to the core as bulls and bears can both make decent cases.

S&P 500 60-min chart

EUR/USD 60-min chart

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Aspen Trading Ranks #8

I agree with you Dave, watching the S&P and the Dow like a hawk. I'm pretty sure we have the same fib level which has been tested a few times already, we may see a rally (short lived) if it fails to break this support but I have a feeling we will see another bottom before the end of the year. This is an interesting level of support though.

The daily close today is critical. Already below support.

While I do not do too much intra-day trading, when the conditions permit (as they have lately) I will not be too shy about making a scalp here and there.

Regardless, even if you are doing some longer-term trades, the support/resistance zones below can be helpful at identifying short-term overbought/oversold areas.

This video link provides some simple guidelines on how to use them. Bear in mind, these are not stand alone indicators, use them in conjunction with other analysis techniques.

Levels are valid through 21:00 GMT on Nov 25th

This is a bigger picture thought to be sure, but certainly well worth considering as we head towards 2009. The recent run up in DXC both in price and implied volatility (IV) leaves DXC bulls potentially having seen the lions share of the move higher. While in the short-run prices are still likely to push higher based on my read of the charts (see chart below), higher IV values typically precede a reversal of some sort in the future.

If you look at IV values of the U.S. dollar vs. a basket of G10 currencies over the last 18 years you will see that the average IV value was between 9 and 11 - presently that value is at 19, far exceeding the last peak seen back in 1996. As noted in previous postings over the years, high IV's typically indicate a market that is growing ever less comfortable with the current trend - hence lots of hedging of positions take place and drives up IV values.

Naturally IV values are merely the canary in the coal mine to use a familiar analogy, but rarely do they provide a useful timing purpose. Timing of course is left to the price action and ones interpretation of the charts. I for one fully expect to see a lower DXC in 2009 and will certainly be looking to establish long-term positions in EUR/USD and GBP/USD to take advantage of that. Stay tuned.

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A little back patting here: Aspen Trading gets ranked for the 2nd time in 2008 for Sharpe Ratio by Barclay Hedge - click link below.

http://www.aspentrading.com/uploaded...nRankNOV08.png

Looks like yesterday's forecast has been temporarily blown out of the water, or has it?

I can see merit in both a bullish and bearish interpretation of the Dollar Index as noted in the chart below.

Dollar Rally: Sustainable or Doomed To Fail?

Like most questions in trading, you must consider the time frame. Is your forecast for the next few days or next few months? In this case, short and long-term forecasts are bearish in my view.

Over the next few days it is hard to imagine that Friday’s rally in the Dollar Index (DXC) will amount to nothing more than a correction with the 82.60/83.41 area creating a solid resistance zone where Wave 2 is likely to terminate before another leg lower begins.

http://www.aspentrading.com/uploaded.../2148dxcW2.png

Taking a longer-term view, technically and fundamentally, DXC will remain on the defensive. Consider some of the bullet points below:

- U.S. employment fell another 524K and the unemployment rate rose to 7.2% in December. For the first time since the early 1990s, when USD/DEM was plunging to record lows, the U.S. unemployment rate has risen above that of Germany. It may even rise above pan-euro area unemployment in the coming months.

- U.S. dollar interest rates are expected to remain well below other major currencies. The dollar tends to be weak when the level of U.S. rates falls below other economies. Today, the U.S.’s expected interest rate disadvantage is even larger than the 2002-2004 period when the dollar was in a steady bear trend

-As noted in this column last week, with U.S. interest rates the lowest among the major world economies and a massive budget deficit, the U.S. dollar will become the next funding currency for carry trades.

1980 Redux

I have heard many comparisons lately to 1980, a period where there was a very aggressive fiscal stimulus plan in place during the Reagan administration which set off a powerful dollar rally. The massive stimulus we are seeing today is now ushering in the belief that a similar 1980’s style dollar rally will soon be underway. However, these comparisons are misplaced.

A mix of easy fiscal and tight monetary policy is bullish for a currency, i.e. 1980’s. This was clearly seen as Fed Chairman Volcker kept monetary policy tight to offset the stimulative/inflationary impacts of Reagan’s fiscal policies. Presently we have a very loose monetary policy and rates are not heading higher anytime soon. Easy fiscal policy and loose monetary policy results in de facto debt monetization. Large budget deficits financed by the printing presses is not a recipe for currency strength.

Bottom Line

Shorter-term traders will inevitably be playing the dollar from both the long and short side in 2009 as there will of course be periods where DXC will rally – I too will be happy to take advantage of those periods. However, if you are long-term oriented, you must view the dollar form the bearish perspective. The ‘anti-dollar’ trade of course is long EUR/USD and that is the most straight forward play.

However, the loose fiscal policies already in place via Bush and soon to be expanded upon by Obama simply cannot be dollar supportive in the months to come. Given that all this fiscal stimulus is not being offset by tight monetary policy it is inevitable that inflation will come roaring back. Granted ‘massaged’ government statistics will never suggest there will be or is inflation, but the bond and currency markets know better. Long gold and AUD/USD will be another way to play a weak dollar while also taking advantage of rising inflation. For those bold enough, shorting 10-Year Treasury Notes is also quite compelling.

I have yet to establish longer-term FX plays in my FX managed accounts but will likely do so shortly. I have however begun to build a short position in Treasuries via ETF’s and have also picked up some high-yield (i.e. ‘junk’) bonds as spreads have begun to narrow from very wide margins seen in the last quarter of 2008.

2009 will be an unconventional year for traders and investors as the landscape will be quite different from what has been seen over the last 10-years. Given that the large majority of investors/money managers do not think outside the box, it will likely prove to be another disappointing year for them after having suffered dramatically in 2008.

Model Portfolio

When I kicked off my FX managed account program in September 2007 I also decided to start a portfolio (my personal capital) that not only incorporated FX but other asset classes as well. Outside of the FX managed accounts my intention was to be strategic and long-term oriented, making adjustments or additions perhaps a few times a year, if that.

I am a staunch believer in market timing, both short and long-term, and believe that that is the only way to achieve superior returns over time. Thus far with 16 months under my belt, that belief is evident as the performance has been solid relative to simply the buy and hold (buy and hope) approach implemented across nearly all portfolios such as 401k's and IRA's.

At this point I have no intentions of managing money outside of FX, however, I will soon launch an advisory service that is published monthly that will assist clients in properly allocating their portfolio with the intention of not only beating the averages but more importantly, avoiding the inevitable pitfalls that seriously impair performance.

If you would like to be informed when this advisory service goes live, simply drop me a private message with Advisory Letter in the subject field.