In previous articles we have spoken about our preference for combining technical analysis with macro factors and the benefits of keeping up-to-date with economic data, central bank speak and interest rate decisions.
In our view this is one of the best ways to create winning trading strategies. But recently it is easy to get extremely frustrated with the wave of fundamental factors that have caused havoc in the financial markets and had the potential to wipe out positions in an instant.
That can be extremely frustrating to a technical trader. We will look at a few examples here and try and give some tips on how to dodge those macro curve balls.
The first example is the US dollar and the Federal Reserve’s quantitative easing policy. The downtrend in the dollar, which began in mid-2010, was interrupted when the Federal Reserve began their second round of quantitative easing last November. Prior to this, the dollar index looked like it may be heading towards the 2009 lows of 74.50.
The market’s reaction to QE2 was unexpected. If the Fed floods the market with dollars then surely the buck should go down right? No. The opposite happened. After the announcement of QE2 on November 3rd 2010 the dollar rose sharply. On a trade weighted basis it jumped 550 points in less than a month. In fact, the dollar only started to weaken again in mid-January when it looked like QE2 wasn’t benefiting the US economy and the unemployment rate started to deteriorate.
But after flirting with historic record lows at the start of May there was a sense that the dollar was oversold and both technical and fundamental factors were pointing to a reversal in the dollar downtrend. Indeed, the dollar even broke through its 50-day moving average. This leaves the next big resistance level at 76.90 – the 100-day moving average before 78.35 – the 200-day moving average, which would see us back to levels last reached in February. But dollar bulls need to be wary of the Fed.
QE2 is expected to end on schedule in June. Should we then expect the dollar to do the opposite of what it did in November and start to weaken? On a fundamental basis, once the Fed stops its extraordinary stimulus measures, it makes perfect sense for the dollar to weaken as investors start to fret about how the US economy will get on without the support of the Fed.
Due to this, the dollar may run into some stiff resistance at 76.00, as fundamental investors start to price in the downward effect on the buck from the end of QE2. But don’t bank on anything to go up for down in a straight line over the next few weeks and months.
Trading the single currency:
For those who look at Elliot Wave analysis then EURUSD looked well over-bought below 1.4900, after the pair had experienced five waves since the start of this year. There are plenty of technical and fundamental reasons to sell the euro; just on the fundamental side there is the sovereign debt crisis, weak growth in the peripheral nations and a cloudy outlook for the future of ECB policy. These are all compelling reasons to sell the single currency, and we may see the cross move back towards 1.4000, a whole 900 points below the 17-month high reached in early May.
But the big spanner in the works to this trading strategy is the Federal Reserve and the end of QE2. Stimulus of this length and scale is an untested tool of monetary policy. We don’t know who will buy Treasuries once the Fed stops and we don’t know how long it will be before US firms start hiring, again causing the unemployment rate to moderate. So even though EURUSD looks ripe for further declines, the single currency could essentially piggy-back on a weaker dollar and remain elevated for some time to come, even as the sovereign debt crisis rolls on.
So what can traders do? There are a couple of tips that make sense for traders of all sizes. Firstly, it pays not to have long-term strategies that you have laboured over for months. The FX market is too deep and liquid and can swallow up even the most thoroughly-researched trading strategy. The best traders are nimble and will trade on a short-term basis and move with the prevailing trend. In other words, don’t get yourself married to a certain stance. Even if you think the euro is headed for collapse, remember the Federal Reserve essentially control the dollar and the time may not be right for a reversal in the buck.
Another tip for retail traders is to start small. Don’t put all of your eggs in one basket. Enter a position small and then add to it if it moves to your advantage, that way you can avoid racking up losses. Also, use stop losses. I like to use a 50 pip minimum stop to give myself some lee-way without ruining my risk reward ratio. On that note my risk reward ratio rule is 2:1 – so I risk 50 but intend to make 100.
These are simple rules but it pays to stick with them, especially when we are in unchartered waters as we are now.
Kathleen Brooks can be contacted at Forex.com