Trading FX is the ultimate intellectual challenge. Contrary to what most books and ‘gurus’ tell you, there are no cookie cutter formulas to trading FX, or any other market for that matter. The FX market is simply too large and consists of too many players with different motives to apply a simple approach each and every time. The FX market is a living and breathing entity, it is a traders job to determine what is making it move today and more importantly, tomorrow. Hence, while my approach is firmly rooted in technical analysis, intermarket analysis is the most critical piece to gain an edge as a trader. Let’s explore a couple of recent examples.
In recent months, the correlation between the S&P 500 and the Dollar Index (DX) had been pretty tight - S&P’s would rally; DX would sell off and vice-versa.
In mid-March however, that correlation was cast aside and the correlation became positive.
The result was a situation where the dollar and the S&P 500 were both rallying as well as related currencies like EUR/USD, AUD/USD & NZD/USD. Normally if the DX is rallying, AUD/USD and NZD/USD would be selling off. It quickly became obvious that the driver of these two pairs was not the dollar but the S&P 500. Given that most traders rely upon the DX to gauge direction of the major FX pairs; this was now making the situation a bit more difficult. Sure AUD/USD and NZD/USD were being pulled higher by the S&P 500 but to some extent the strength in the DX counteracted that. What you were left with was a situation where dollar based pairs were simply not the cleanest trade. Many traders get frustrated by situations like this and continue to charge ahead. A trader, however, who took a step back and tried to understand the new dynamics was able to find more robust crosses to trade.
By April 15 it was becoming clear that the S&P 500 was likely nearing a top. An ending diagonal pattern was forming indicating the upside was limited.
Given that AUD had been extremely strong during this whole rally in the S&P 500, it was natural to assume that it would be sold-off if the forecast for a weak S&P 500 were to play out. A trader could have shorted the AUD/CHF or AUD/JPY at this point – they were very tightly correlated to the S&P 500 without the strength of DX adding a component that tainted the relationship.
The S&P 500 did eventually move into the target zone noted in the chart above and AUD/CHF followed tick for tick. However, what was pretty obvious was that once the S&P’s failed at the target area, shorts in AUD/CHF would fall too. What followed was a quick and decisive move lower of 330 pips.
In the end, it was the combination of Elliott Wave analysis, inter-market analysis, correlation studies and tape reading that brought this trade about. A week later opportunities using this relationship still exist. The S&P’s have recovered from that sharp sell-off at 880, but are likely to move back lower after this Wave B correction has completed. AUD/CHF and AUD/JPY are front and center as the best way to express a bearish S&P 500 opinion via the FX market.