Brexit lessons

Brexit will be talked about, written about and analyzed for many years.

Brexit will be talked about, written about and analyzed for many years. It also revives the age-old argument between fundamental and technical traders. Technical traders argue that price action is all you need to know to formulate direction, entry and exit targets. The charts indicate with reliability, the future direction of price. It is not that they don’t believe in fundamentals, but they believe the fundamentals are already reflected in price.

Fundamental traders, in contrast, assert that price and price patterns are caused by and reflect fundamental forces. Prices are simply a measure of the balance of expectations. For fundamental mind-sets, the Brexit event and its aftermath becomes a case study of the relevance of fundamental analysis.

For example, the large sell-off of the British pound, and its subsequent shallow rallies, supported the view that price patterns are by their nature expectation waves. The pre-Brexit period starting in April generated a range of 1.40 to 1.47 in the British pound/U.S. dollar (GBP/USD) currency pair. This range was no greater than the previous three months but a sell-off ensued following a June 10 poll in The Independent indicated Britain favored Brexit by 10%. The pound reversed, along with the polls, following the murder of pro-Remain Parliamentarian Jo Cox (see “Pounded” below).

The GBP/USD rally to 1.50 on the morning of the vote was not technical in nature, but reflected faulty expectations in the polls for a “Remain” outcome. Brexit demonstrated that a price pattern, without understanding why it is occurring risks misdiagnosing the direction. This is a lesson for technical traders in the post-Brexit period. Technical traders will likely be looking for a retracement of the GBP/USD to possibly the 50% of the high-low wave, emerging after Brexit (1.5023 to 1.2798), bringing the GBP/USD to a level of 1.3904. But fundamental analysis predicts the GBP will likely evolve into a range between 1.30 and 1.35 until there is a shift in expectations about the strength and stability of the GBP, as shown in “Pounded.” Technical targets such as Fibonacci retracement levels work in normal conditions. However, the Brexit event underscores what could be called the first law of fundamental trading:

A price will stay in a pattern until news moves it out of its pattern.

Another key lesson of Brexit is that currency cross-pairs forming a “basket” do not necessarily move in the same direction. Each cross-pair has its own dynamics. GBP weakness, in a cross-pair has to be assessed against the counter currency’s strength or weakness. Take the pound/yen currency pair. Both the pound and the yen are likely to experience weakening. Therefore the resulting pattern would be sideways and even bullish if the yen continues weakening. Choosing probable direction in a cross-pair requires a fundamental point of view regarding expectations about the economies that the currencies in the pair represent.

Another lesson for forex traders from the Brexit event is that fundamental analysis goes beyond traditional forecasts of economic performance, such as inflation, GDP and employment. Instead, contagion is a powerful, psychological and fundamental force. The UK generates about 4% of the Global GDP. At this level, the Brexit event should not have been that dramatic. However, market uncertainty cascading quickly, magnified the impact, generating herding behavior.

The lesson is that currency prices do not reflect fair value, are not efficient and cannot always be derived from price. Price, rather, reflects a combination of economic performance expectations, wrapped in fears, hopes and rumors. Effective trading, in the context of Brexit-like events, requires, not only honed trading strategies and tactics, but also the recognition, and understanding of the forces that cause the price patterns.

About the Author

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.