We’re well into the second half of the month of August and I’ve made a grand total of two trades to date.

It’s plain from looking at any of the main currency pair charts that it’s been a great month for US dollar bulls. During that time I’ve been sitting on my hands, studiously practicing my patience. It was a trading skill that I had to relearn earlier this year and it’s certainly come in mightily useful this summer.

Patience now ranks alongside consistency as a fundamental pillar needed in the mindset of a successful trader (or in my case aspiring trader).

I stood aside and watched as the markets interpreted Trichet’s words at the ECB rate meeting on 7 August to be incredibly bearish for the European market. EUR/USD got pummeled and broke to the downside out of the 1.53-1.60 range it had been stuck in since March.

My first trade of the month occurred on August 10th when price spiked down just after the Sunday opening after having dropping 500 pips on the Thursday and Friday of the week before. I doubted that the downtrend would be over that quickly but I did think there was a high probability of a least a slight pullback as the pros took advantage of all the Johnny Come Latelys who would enter shorts at the start of the week as a result of the big drop that had just occurred.

There was indeed a nice pullback that lasted into Monday’s London session before the downward momentum resumed. I extracted 75 pips from that trade.

The rest of last week saw a lot of consolidation between 1.4850 and 1.4950. This area represents the top of the range that EUR/USD was trapped in from the end of October last year until February 2008. It represented a significant support level and I entered a trade at 1.4850 on Thursday, as the low of the week had been at 1.4814 on Tuesday. While I obviously felt the probabilities were high of a bounce back up, price didn’t see it my way and I was stopped out at 1.4800.

I’ve stuck to having fixed 50 pip stop losses in place which forces me to be extra critical in deciding when to enter the market. I have contemplated having a slightly more elastic stop loss level, potentially related to the current ATR (Average True Range) but I’ve yet to decide if the benefits of this extra complexity (however minor it may be) is worth distilling the straight forward simplicity of what I’m currently using. Once I have a few more months of real trades under my belt I think I’ll be able to go back and examine what would have happened if I had used an ATR-based stop loss level instead of a fixed pip amount. Only then will I know if it is truly worth changing things.

Last Friday the Euro continued to break down and found itself at the 1.47 handle. It seems as if we’ve broken through the 1.48-1.49 support level, although the price drop over the past ten days has been so steep that it is hard to see it continuing with such ferocity for much longer.

There are understandably compelling arguments on both sides. The US economy seemingly has all the bad stuff out in the open. Everyone is well aware of the credit crunch and the problems it is causing, even if all of its consequences and writedowns have yet to become reality. The Eurozone is now beginning to experience its own slowdown in earnest. The US dollar bulls see the US economy bottoming out and beginning a slow rise while the European economies are about to go down the toilet, ergo the Euro gets sold.

The US dollar bears wonder what the bulls are smoking. None of the fundamental reasons that have been the main factors in the US dollar’s decline over the past seven years have been addressed or fixed. Issues such as the trade and current account deficits are still two sleeping elephants in a china shop. The US housing market is still a mess and US consumer saving abysmal. The official strong dollar policy is seen as a mirage and the seemingly miraculous resurrection of the US dollar in recent weeks is due more to the correlation with oil and central bank intervention. Neither of which is considered to be viable in the long term for providing a solid base for continued dollar strength.

I think the US dollar bulls have the momentum for now but I don’t see how the they’re going to overcome all the reasons that have seen the dollar weaken for years now. I still believe that the dollar bear trend is in place and this is a strong correction.

I can’t really see myself going actively long again until one of two things happens:
1/ We reach the support level at 1.4250.
2/ One or more pieces of US fundamental data come out so bad that all the wind is taken out of the dollar bulls sails.

I think there’s probably a very good chance that we’ll just end up range trading in the same price range from the start of this year: 1.43 to 1.49. If that range trading does materialise then I’ll be looking to position myself for breakouts to the upside again, for another retest of the 1.6 all-time high.

Now I have just one other decision to wrestle with: 1.4250 is almost 500 pips below where we currently are. Do I take short only positions to take advantage of the remaining vestiges of this dollar bull train, or continue to sit on my hands until it’s time to place a high probability long position?

I’m inclined to the later option. I’ve waited the move out this far and waiting a bit more only gives me extra time to practice on my patience! I’m also trying to take very seriously these days the Sage of Omaha’s number one rule: don’t lose any money!

I’m going to wait until tomorrow’s US housing data to make a definitive decision. In a sense I really am trading the medium term trend, so if the dollar is going to be strong for the weeks and months ahead then I need to trading in the direction of that trend. While I foresee that the long term trend of dollar weakness will resume that doesn’t mean that there aren’t tradeable corrections that I can take advantage of. The dollar bull move in 2005 is a prime example of this, although it is yet to be seen if this dollar move has the legs of the one from three years ago.

The article is such a good rant here it is in full:

The Llama of Lame
by Johnny Debacle

To: The Fed
From: Long or Short Capital
Re: You suck

Dear the Fed,

You suck. You don’t have a backbone and as a result you are slowly and very surely making our country and our currency irrelevant. Usually the masses rebel and bring down great empires but luckily for us democracy fixed that problem. Unfortunately, democracy can’t fix how lame and fickle you are and so you will be our ruin.

A few things to tell you:

1) Inflation isn’t 2% like your pathetic CPI ex-Food & Energy says it is.

First of all, as far as I can tell food and energy are the only two items you should NEVER exclude from an inflation index. Tell your wife and kids they can have everything in the consumer basket except food and energy and you will quickly see that they are actually the two MOST important and indispensable factors in the CPI. You can find substitutes for, or go without, everything in the basket EXCEPT those two.

Secondly, stop using “Seasonally Adjusted Intervention Analysis” it’s as sketchy as the Seldom-Accepted-Accounting-Principles (SAAP) we use to cook the books here at LoS. I mean writing a computer program to automatically remove any items in the basket which deviate meaningfully from the previous year? Isn’t the point of the data to SHOW the change versus the previous year not hide it? Oh, I found the list of items that you’ve adjusted for and it’s embarrassing.

The majority of adjustments remove price increases with much less frequent adjustments for price declines. You’ve basically left dairy products out of the index for the last 5 years citing outrageous one-offs like “a generally tight cheese market” as justification for this. And as if reporting a separate ex-energy index wasn’t enough you’ve statistically intervened to remove the effect of higher energy prices even in the index that’s supposed to INCLUDE energy. In one outrageous case you removed the effect of fuel oil for three months in March 03 and the reason you cited for the “abnormal” move was the “end of winter,” yeah I was surprised as sh-t when winter ended in Spring 03, it was wild! For a real measure go back to the old method, you’ll see inflation is at least double what you’re reporting.

2) Grow a spine you slimy invertebrate

The market has a memory. Over the past 15 years you trained us to believe that no matter how much risk we take, and how much we lever that risk, if anything really scary comes down the pike then you will bail us out. Now we all run around like reckless, spoiled 16 year olds bidding up the price of anything we can get our hands on and not worrying about consequences because daddy (Greenspan) and mommy (Bernanke – that’s right you’re spineless AND a girl) will get us out of any trouble we get in. Well you’re only making the problem worse and we aren’t learning anything so we’ll continue taking stupid leveraged bets creating bubble after bubble so you can tip-toe around trying not to pop any of them.

3) You’re lying to yourself if you think we still have real GDP growth in this country.

I challenge you to find one measure of wealth OTHER THAN THE DOLLAR which shows the US economy as worth more now than in 2001. If I wanted to buy our country it would cost me 30% fewer euros today than it did in 2001, it would cost me less bars of gold, less barrels of oil, less ounces of copper, less btu’s of natural gas, less cubic feet of lumber, less of almost anything that has intrinsic value. Yet you keep reporting GDP growth, why? Because your quick fix is to effectively print more money so that in dollar units everything is getting more “valuable”. But guess what, to the 95% of the world that doesn’t use dollars the true value of the US economy has been shrinking, rapidly.

It’s like a company doing a 5 for 4 reverse stock split every year and claiming to have 20% eps growth, you haven’t changed the earnings just the units those earnings are measured in. The rest of the world is telling you our country is worth less by massively selling our currency and you still naively think we’re growing value – I feel like I’m at a gathering of the flat earth society or in Zimbabwenomics 101.

This will come back to bite you but not nearly as much as it bites us. The cheaper the dollar gets the more expensive all our imports get, inflation will rise faster than you can statistically manipulate it and when that happens expected inflation goes through the roof (which as you yourself have pointed out many times is by far the most serious threat to economic existence). Then the only way out will be interest rate increases as swift and severe as all the cuts have been. All the bubbles will pop at once and then we’re really in for it. Maybe it’s 10 years away but there’s a toll collector at the end of every free ride.

When will you learn that recession is ok? It’s actually healthy, it’s the cycle, it’s how things have worked for a thousand years. Trying to prevent every small recession is going to end in one huge recession (ie. depression) and no one will trust you anymore which is a much bigger problem. No economy in history has ever been able to successfully inflate its way to health, this won’t be any different.

Benny, I know you had to trade in your hypothalamus and spine to be fed chairman and now you biologically over-react to everything and are incapable of standing up straight when confronted by bully-morons like Kramer. But I’m hoping you at least still have your brain. Before you had this job all your published research showed that central banks should strictly target inflation and should be ignorant of asset prices. You had good reasons for this conclusion, don’t forget them.

Subprimely,

Long or Short Capital Management

I’m pretty sure that everyone with any pedigree in the financial markets knows that everything mentioned in this article is true. Yet everyone is happy to be force fed the baloney government statistics and never bothers to forcefully complain about it! Maybe each individual knows the truth and hopes to act on their knowledge while at the same time hoping everyone else falls for the government bull.

Thanks for your reply. I’m a little confused about guaging the fundamentals – what is the time frame for the fundamental outlook? Is it the long term fundamentals (like 5-10 years) or is it like what the monthly sentiment is after a slew of news events? Maybe if you could provide an example or your “routine” (if any) to approaching fundamentals.

Thanks for answering my questions – I really appreciate it. I’m trying to decide whether I should follow through with studying this method, and your answers are helping me decide.

The time frame I use for my fundamental outlook has a time horizon of three to six months. I’m generally trying to gauge what price might do in those next few months. Anything beyond that goes back into pure randomness for me; pure guesswork.

I don’t have a predefined routine for how I approach the fundamentals. Maybe if I was doing this fulltime I’d lock down a more definitive approach, but I seem to keep it pretty lose. I follow a basic set of daily reports (Daily Pfennig, etc, which I’ve previously mentioned in my blog a few times) and weekly news periodicals (The Economist). There’s no real secret to getting to grips with the fundamentals; it’s more a case of just getting into the flow of things. Once you see the same economic data reports cropping up month after month they become familiar and pedestrian. It becomes easier to see the ebb and flow in the strength of the two currencies that make up the pair you’re interested in.

Price can generally be said to be either trending or range bound, so it is possible to say that there is no trend at a particular point in time. It’s important to also keep in mind that time is the other axis when looking at any chart, and so changing the time scale of your chart will make a seemingly strong trend on the one hour chart turn into a range bound market on the daily chart. Any time you look to identify a trend you also need to be aware of what time frame you are looking at.

Using the 4×1 methodology you aim to extract profits from the market when it is going in your favour (trending in your one direction) as well as when it is range bound. If your one direction is generally right, then you only end up losing money during strong corrections.

Obviously when you’re trading on the hard right edge you have to continually question whether the supposed correction is just that or is it the beginning of a trend in the opposite direction. This is where your interpretation of the fundamentals comes into play. Your strength of conviction in how you see the fundamentals overlaid on your one direction will play an important part in how actively you trade and take new positions. For example, if a correction is unfolding and your analysis is still strongly in favour of your one direction then you should have no problems buying the dips. You are effectively on the look out for a base to form, ready to benefit from price resuming its long term trend. On the other hand if you see mixed data and your conviction about your one direction looks in question you might hold back more on your trading activity until either more data makes things clearer or price makes the trend or lack of it evident.

It’s important to remember that any currency pair is made up of two currencies; it’s the relative strength of the two currencies that results in the current price. Both currencies might have strong fundamentals. If so, what you need to determine is which one has the stronger fundies. Which one is stronger relative to the other? It’s generally easier if one currency is strong and the other is weak. Similarly, if both have weak fundies, it comes down to determining the relative difference between the levels of weakness.

When any data release comes out, you try to see how that piece of the jigsaw puzzle affects the strength or weakness of the affected currency. And then try and see if you can read how it will play out in the relative strength/weakness between your two currencies.

It is the relative nature between the two currencies that is key. In the same way that speed is something that can only be measured relative to something else. We generally measure the speed of a car relative to how fast it is moving compared to the Earth. Let’s equate the speed of our car to the strength of currency A. Now let’s introduce another car which is moving parallel to our first car, but at a different speed. I’ll equate this second car to currency B. The way to determine the relative strength between the two currencies A and B is just like determining the speed difference between the two cars.

I don’t think I’ve ever mentioned politics on this blog before; primarily because there is little day-to-day correlation between what goes on in the corridors of power and what plays out in the currency markets.

The reason for this quick interlude of politics is an article on currencytrading.net on one of the current presidential candidates. The article is titled How Ron Paul as President Would Affect the US Dollar.

Ron Paul is my favourite candidate at the moment, out of the field of both Democratic and Republican contenders. He has a very simple platform from which all his policies stem from: if a policy or program is laid out in the Constitution then he is for it. He wants to strip away all the excesses of government so that the American people can get on with their lives and make the most of their freedoms.

The Fed and IRS would be for the chopping block, as they are both inextricably linked. While a full return to the gold standard is all but impossible, Ron Paul would aim to back the US dollar with commodities such as gold and silver as much as possible.

If these changes came to pass it would certainly make for interesting times in the foreign exchange markets!

Researchers have found very old snail shells in various parts of Africa that seem to have been fashioned into beads. Very old, as in 82,000 years ago. The similarity in the beads in the disparate locations across the continent has led the researchers to postulate that “an ancient human society [...] may have developed a long-distance system of trade and cultural exchange”.

Fascinating stuff.

While you’re browsing The Economist website, you’ll also find a useful article on slightly more modern currency matters that looks at the waxing and waning of monetarism. It’s been out of vogue for quite a while now. Could it be due for a comeback?