It was clear that the yen patterns, influenced by the titanic volume of the carry trade (estimated to be above $1 trillion), were getting ready to breakdown this summer.
The monthly chart of the key GBP/JPY pair showed an ominous parabolic pattern, which was an early sign of unsustainable buying. We know now that the subprime market worries were the catalyst for a shift in market tastes away from high yield/high leveraged instruments. The bloated carry trade currencies broke their patterns, the flow of cash hurried back to their debt based origins to buy back overextended investments, and a great deal of the carry trade still continues.
The resulting enormous moves of the last week of August was also a signature of mass emotional contagion. What can the forex trader learn from this that will improve his analytical and trading skills when currencies and markets break with feverish patterns the next time?
The first lesson is that knowledge of big picture price patterns and fundamentals gives you an edge in forex. Aug. 10 was a key milestone. The yen found support at 117 and had been in sideways action for several days. But notice on the four-hour chart that we had six four-hour candles crowded around the 117 area. There was plenty of time to be ready for a breakout (see “Saw it coming?” below). The pre-breakout period is best indicated by a sideways channel. The four-hour sideways channel is among the most reliable because it enables an instant view of where the “smart” large money flow has been able to push the price.
The second lesson is that there are embedded patterns even in the midst of the chaos of the moment. When a sudden breakout comes, many traders are caught off guard. But it is very useful to know that even in the apparent fury of the move there is an ebb and flow that is tradeable. In fact, the entire pattern has three phases, a pre-breakout period of susceptibility, a period of contagion and then a period of diffusion. These phases replicate themselves in multiple time frames.
A third lesson is the contagious nature of forex price movements. Contagion is an apt phrase because the forex patterns that arose in the wake of the subprime market emotional fever are quite similar to the patterns exhibited when influenza epidemics and pandemics arise. Both share the classic paths generated by parabolic equations.
When a parabolic curve emerges, in any time frame, it is a predictor of a topping pattern. This is true in markets as well as in nature.
A third lesson, perhaps paramount for the future, is that more than ever there are
inter-market connections between forex and equities. During the subprime market crisis we could see that the USD/JPY pair had become a very accurate predictor of market moves as the USD/JPY and the DJIA moved with a high degree of synchronicity (see “In sync,” below).
In the coming months, the markets will continue to be intertwined and the seemingly unpredictable black swan events will occur. Armed with pattern recognition skills and tools, the forex trader can be ready. These events should not be feared because they can be traded.
Abe Cofnas is president of Learn4x.com and author of the forthcoming book “The Forex Trading Course: A Self-Study Guide to Becoming a Successful Currency Trader,” (Wiley Trading). E-mail: Learn4x@earthlink.net.