How to Prepare for an Event Driven Trade
The retail trader is always at the mercy of the big banks and brokers who are busy executing trades for assorted fund managers the true drivers of FX trends. Whether these funds are hedging an equity or fixed income position or taking an FX position for their own account, fund managers are the ones whose sentiment we want to figure out. Since the FX market is essentially private, with each trade a confidential contract between the bank and the customer, we never get any usable information about volume or about any particular player taking a big position. In years past, we knew about the Soros bet against the pound and the Buffett bet against the dollar, but nobody today can tell you that on March 7 it was Fund X or Mr. Y buying the euro after the European Central Bank left rates on hold and Mr. Draghi walked around the question about whether the euro is too strong, for example.
But we can make a pretty good guess that this would be the outcome. In preparing for a trade ahead of a market-moving Event, you need to have an understanding of the ?deep bias? toward a currency as well as the ?current risk sentiment climate??before you even look at the chart.
First, we know that a central bank lowering interest rates is currency-negative and raising them is currency-positive, but we have to acknowledge that deciding not to cut rates is very nearly the same thing as raising them. Second, we know that Mr. Draghi has a bias toward keeping rates on the high side because he disapproves of spiking the punch bowl when what economies really need to recover is German-style reform of labor markets and government spending.
Third, despite efforts by France and some other eurozone countries, jawboning about how a too-strong euro harms exports was repudiated, and by none other than Mr. Draghi. Currency war rhetoric is a powerful tool?for example, see the Australian dollar but of limited application in the case of the euro, if the one guy with the tools to actually implement currency weakening explicitly refuses to use them for that purpose.
Overriding this all is the market?s deeper long-standing bias in favor of the euro, sovereign debt crises notwithstanding. That is because to the saver and long-term investor, the eurozone?s commitment to controlling inflation through monetary policy and contractual budget limits is the gold standard of fiscal excellence. No sovereign in the history of the world has ever done it before, and never mind that the eurozone is not actually a true sovereign in the old-fashioned definition of the word. The no-inflation promise imbues the euro with an allure no other currency enjoys. On the surface, the euro seems able to withstand economic and institutional setbacks that would crush another currency.
The euro has magic?but not a free pass. A rate cut in early March would have pushed it down, at least for a while, and as the next policy meeting in April comes closer, we will probably have the same wobbling lower on uncertainty over whether the ECB will cut.
Almost as strong as deep bias and sometime overriding it is current risk sentiment, which in the case of the euro in recent years arises from a single source?peripheral debt problems. When peripheral country spreads are narrowing vis-à-vis German Bunds, risk appetite for the euro is positive, whereas when peripheral spreads are widening versus Bunds, risk appetitive for the euro is negative. At the time of the ECB policy meeting on March 7, crisis conditions occasioned by the Spanish banking sector and by the Italian election were fading away. Peripheral yields had been falling back to normal levels and narrowing versus German Bunds, and a few hours ahead of the ECB rate decision, that Thursday Spain even issued over ?5 billion in new 10-year notes under 5%, the lowest level in two months. To lower eurozone interest rates would have been to rock the boat.
Adding up the deep bias and the risk sentiment at the time, the probability of an ECB rate cut was very low and from that, we deduce the euro was likely to rise off temporary new lows under 1.3000.
That doesn?t mean that fund managers and others wouldn?t reduce euro positions if certain developments on the chart caused them to doubt the big-picture analysis. In this instance, we had the euro falling from the February 1 high at 1.3711 to a new low of 1.2967 on March 1. If you can see a chart of the euro on a 240-minute basis you will see six waves. Forget how many waves a certain theory says there should be. This time, there were six distinct occasions when the euro bottomed, recovered partway but not to the previous high, only to fall again to a new lower low. Sometimes, we have three waves and sometimes we have ten, but six is a lot. The key point is that any corrective recovery will likely be limited by the previous intermediate high, and choosing the previous intermediate high depends on what timeframe you choose.
Also, the moves occurred over a one month period, or roughly 20 days. For short-term trends and at times larger directional changes, do not sneer at the 20-day moving average. It may be an old-fashioned indicator but it?s a rock-solid one and one that some central banks still watch (such as the Bank of Japan). This time, the euro fell under the 20-day moving average in the second wave down.
Now to the important point?near the US close the day before the ECB policy decision and Draghi press conference on March 7, the euro hit a low of 1.2983, or 17 points above the previous low from three days before. But the Asian session, taking over from the US, took the euro to 1.2966 early on March 7, or one point lower than the previous lowest low. And yet, that one point is all we got. Traders declined to take it any further. This is a failed test of a lower low and embodies the information that ahead of the ECB decision and Draghi speech, traders were feeling cowardly about betting against the euro.
At this point, a savvy day trader would set up a buy order at some ?prove it? level above that lowest low.
What is a ?prove it? level? It?s the level at which uncertainty falls away and your confidence in the long position becomes compelling. One old standby is the most recent intermediate high, in this case 1.3075. But that?s pretty far away from 1.2966, over 100 points and it leaves too much on the table. We have the same complaint about the double-bottom pattern that generally points to a rally. A day-trader doesn?t have the time to wait for confirmation (price over the middle bar of the W at 1.3075.
Another idea is when the euro rises by some percentage of the Average True Range. On the daily chart, the 5-day ATR ranges from about 90 to 116 points over the past month. If we take 40% of the average (103), we think a rise off the low by 41 points is a prove-it level. As a happy coincidence, adding 40 points to the extreme low brings the prove-it level to 1.3007, just a little bit over the ?round number.? Again, don?t laugh. Some folks place stops and targets at round numbers and a research paper by the US Federal Reserve a few years ago showed that round numbers (and even numbers) occur far more often than chance would allow.
We now have a reasonable expectation of a successful euro long by entering into this position at 1.3007. What?s the stop? Well, we already know traders chickened out at 1.2966, so that?s a good stop, or maybe a little under the level. Traders often leave their stops five or ten points lower, and sometimes 20 points below, a prior low. But we have to be realistic about our take profit versus stop-loss ratio We always want our target to be a bigger number than the stop, since over time, even a 51% rate of profitable trades will be net profitable when losses are controlled. Here comes the hard part: if we set a target at (say) 60% of ATR, does it result in a price that is likely to be reached within our trading timeframe? In this case, 60% is 62 points, which we add to our entry at 1.3007 to get 1.3069. Note that this number is less than the previous intermediate high at 1.3075, and we like that, because we are not taking the risk of the previous intermediate high becoming resistance. Here too, traders often do not use a formula to ascertain their take profit levels, but merely do so ten or 20 points before the prior high or low.
In the end, the euro hit a high of $1.3118 after the Draghi press conference, so we have plenty of wiggle room in this trade. That?s an important consideration, because on a day without an event-trade, we can?t count on ATR being bigger than the usual average 103 points. By using the prove-it tactic, we need the ATR to be sizeable. This brings up the observation that ?trading the news? can be high-risk. However, the bigger the news, the higher the probability of a profitable trade if your entry level is correct. The problem with trading big news around the ECB decision is that you absolutely, positively need to have the right interpretation of both the deep bias (euro = gold standard) and the risk sentiment (good risk appetite in the absence of crisis). By getting those two things right, you are in sync with the big players and thus joining their table instead of seeking scraps from their table. See Figure 1. You may not see their flow advantage but having the right understanding of market conditions does level the playing field.
This little case study shows that in FX trading, your goal is to make a profit by reading the mind of the big players and copying their actions. The fundamentals come first, both the deep bias and the current risk sentiment reading. – A look at technical and a good chart comes second, but is no less important, because strategy depends on getting the entry, stop and target levels within the realm of positive expectancy of a gain. It wouldn?t do any good to set a stop likely to get hit on an ATR basis or to set a target far outside the likely ATR, i.e., wishful thinking.
Of course, you may decide to trade on a shorter timeframe or to use other, fancier indicators, but the lesson is that simple indicators can be and often are sufficient. That is not to say that combining deep bias with current risk sentiment cannot get tricky. Consider the Canadian and Australian dollars. We have a long-standing deep bias to buy these currencies because of their correlation with commodity prices. This seems to be fine as long as commodity prices are rising or falling in a non-volatile way, but is not actually the basis of deep bias. Instead, the correlation of the commodity currencies with commodity prices is a risk sentiment factor. Deep bias arises from factors internal to those countries, including capital investment, interest rate policy, and growth rates. Yes, the commodity sector is critical to the deep bias, but it?s only one of several factors. It?s an error to consider all of those other factors as somehow belonging to the risk sentiment barrel. For example, employment and job creation has an existence independent of commodity prices and commodity exports, and can influence the central bank, whose policy belongs to deep bias. Confusing matters recently has been currency war rhetoric, which sometimes overrides both deep bias and risk sentiment.
The mix of muddling deep bias with risk sentiment along with an overlay of currency war rhetoric results in a disorderly chart. See Figure 2. You can trade the AUD/USD, but not easily and not by trying to think like the big players. You can?t tell what big players are thinking from this chart. We can merely deduce that commodity prices alone are not driving the AUD/USD?see Figure 3. It is our observation that intermarket correlations are consistent and reliable only when overall financial market conditions are tense and uncertain. You should certainly not consider commodity prices alone as setting the deep bias tone, and over these few months, not consistently setting the risk tone, either.
It may seem too obvious to mention, but an orderly chart is easier to trade, especially when you understand the interaction between deep bias and risk sentiment and how it is playing out on the chart. A disorderly chart reflects confused thinking about what is fundamental deep bias and what is risk sentiment. Bottom line, if you can?t read the chart and imagine what the big players must be thinking, you shouldn?t try to trade it, even when the most sophisticated of indicators are giving you the go-ahead. Clear thinking leads to profitable trades.
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