The Federal Reserve Bank’s recent activism in the interest of promoting psychological stability makes one wonder about the qualifications of central bankers. Perhaps they need advanced degrees in mass psychology or more accurately, psychopharmacology. The Fed’s actions in facilitating the saving of Bear Stearns, and its “injection” of a great deal of money to dilute market pessimism, certainly underscores that trading the forex market requires an increased understanding of the psychology of the Fed. This should not be a surprise to forex traders. If there are any laws of price action, one of them is that markets do not tolerate extremes. We see this every day along multiple time frames. When currency pairs trace parabolic paths, there is a pullback. The price action of gold provided a classic case. If price action doesn’t tolerate extremes, why should central bankers? What are the lessons that we can derive from this recent period of price and policy turbulence?
The first lesson is that intervention in the currency markets is more likely than ever. While official doctrine is to let the market determine the price of the dollar in foreign exchange, central bankers are brushing off the dust on how to accomplish a massive intervention. One simply needs to see the increase in the frequency of “intervention” being cited in the world financial press. Stephen Hanke, a world-class currency economist and senior fellow at the Cato Institute, recently argued for intervention as a policy remedy to prevent a free-falling dollar.
No one knows what would precipitate an intervention scenario. It may be a sudden and massive drop in the Dow Jones Industrial Average leading foreign investors to sell dollars and move into safer havens. Investors should not count on gold because during sudden moves there is likely to be a liquidity crisis causing gold to sell off. Such a sell-off happened Aug. 16 when both gold and the Dow had massive drops.
A second lesson is the need to adapt trading tactics to this environment. Traders more than ever need to avoid longer- term trades. Even overnight trades should be avoided. Entries using 15- and 5-minute time intervals should be used. They provide the opportunity for high probability trades offering small pip moves. It doesn’t have to be complicated. For example, just by recognizing retracement failures, a trader can have repeated patterns and opportunities, as we can see in “Short-term profits.” In the current environment, sideways channels followed by breakdowns offering 20 pip ranges are increasing in frequency.
Current conditions have also served to increase the volatility of market reactions to economic data. These releases occur every day and provide the market a reason to react to any level of surprise. They provide in a concentrated period of time a great probability of large moves. An efficient forex platform is necessary to be able to play this trade. Skills in riding such explosive moves can be acquired.
A third lesson is to become more contrarian. Perhaps the most striking aspect of recent volatility is the uncertainty among institutions and experts about the underlying risk exposures. The forex trader needs to respect the fact that this uncertainty can cut both ways. While fundamentals do not point to dollar strength, risks to the euro and pound have emerged from their own sources of uncertainty. Britain’s housing boom is over, and UBS’s loss of nearly $19 billion has caught the euro bulls off guard. The contrarian case for a dollar bounce can be made on the basis that the other currencies may be caught in unexpected risk exposure. A further case for dollar bulls is that Canada, Britain, Europe and Australia are likely not to increase interest rates and are facing slowdowns in their GDP.
A fourth lesson is to become familiar with options strategies. Options on currencies through futures exchanges, options exchanges and OTC markets are more easily available and are a valuable tool given recent volatility. Traders can use options to reduce risk in longer-term trades while maintaining opportunity. In this environment the forex trader needs to be armed with all the tools that are available.
Abe Cofnas is president of learn4x.com LLC. E-mail him at learn4x@earthlink.net.
