From the January 01, 2007 issue of Futures Magazine • Subscribe!

Lessons in chaos and currencies

Trading activity during the recent Thanksgiving holiday was a classic example of the dynamics forex markets. While U.S. traders were taking holiday time off with the markets closed, global sentiment led to a significant decline in the value of the dollar against the world’s currencies.

Many traders were caught on the wrong side of the market during the multi-hundred pip moves against the dollar in the hours and days that followed. The GBP/USD cross moved from 1.8830 on Nov. 17 to 1.9830 by Dec 1. This is a 1,000 pip move! The question, however, is what lessons can we learn from the Thanksgiving holiday dollar massacre that can help traders move forward?

1. Holding positions for several days can be risky. Perhaps the first lesson is that any forex trader putting on positions for more than one day, and especially through a holiday or weekend, underestimates the risks associated with long duration trades. The events during Thanksgiving showed that there is no such thing as a forex holiday. The world economy doesn’t stop because U.S. traders are celebrating. The speech by an important finance official in China, Japan, or almost any central bank of Canada, Britain, Euro zone, Russia, can be a catalyst for a forex price reaction.

2. Concepts of overbought and oversold are misleading. In the post Thanksgiving period, the dollar moved to 14-year lows against the pound sterling, and 20-month lows against the Euro, which represented a 3% move. Those traders who thought that retracements would immediately follow forgot that the power of crowd behavior can prevail and extend the currency moves beyond expectations. Strategies of fading sharp parabolic moves will not work in these conditions.

3. Fundamentals cannot be ignored. The recent events can be considered a milestone in the battle between fundamental vs. technical traders. While the magnitude of the move was technically surprising, it was not a fundamental surprise. The handwriting has been on the wall. The key fundamental factor was the Federal Open Market Committee’s decision to stop raising rates after 17 increases in a row starting in June 2004. When U.S. interest rates are stable and not expected to rise, it is a weak fundamental sign for the dollar. Traders have had months advance notice in the form of negative U.S. economic moves that the dollar’s trend is down. Another indication of a weak dollar has been the decline in the housing sector.

4. Forex markets can be chaotic but not random. An enduring challenge to scientists has been to predict phenomenon such as hurricanes and floods. These are phenomenon that are mathematically chaotic in nature. They are not random, but sudden moves are embedded in their physical systems. What actually caused the dollar meltdown can not really be known. The currency moves resembled a sudden flood or unexpected hurricane. Once it formed, the price action was not linear but was similar to a chemical reaction-diffusion. The lesson for the forex trader is to respect the fact that forex markets have this chaotic nature and have in place risk controls for the worst case scenario.

If in the future similar forex sudden moves occur, allowing the behavior run its course by diffusing into tradable patterns is advisable. In other words, get out of the way.

5. Three-line break protection. The most dangerous of all trading errors is to be on the wrong side when sudden moves occur. A very useful tool to minimize this risk is to use three-line-break charts. Many charting platforms provide this tool. Three-line-break charts show only consecutive closes of highs or lows. In “Looking for a break” we see a three-line break, four-hour chart of the GBP/USD. The trader using three-line breaks would have seen that on Nov. 22 the GBP/USD reversed just above 1.90, a previous downtrend that started on Nov. 13 and ended on Nov. 16. The Nov. 22 price rose past three previous succeeding low closes, and after Nov. 22 the persistent sentiment direction for the GBP/USD was going long for a remarkable 23-consecutive-higher four-hour closes. The key point is that the origin of the big move was detectable before the Thanksgiving holiday surge. A trader following three-line break charts would have avoided trading counter to the prevailing trend.

Abe Cofnas is president of learn4x.com LLC and author of Understanding Forex: Trading to Win. E-mail: learn4x@earthlink.net.

About the Author
Abe Cofnas

Abe Cofnas is author of “Sentiment Indicators” and “Trading Binary Options: Strategies and Tactics” (Bloomberg Press). He is editor of binarydimensions.com newsletter and can be reached at abecofnas@gmail.com.

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