Quantum Physics, Einstein and the Financial Markets!

Hello everyone!

We have a new trading week ahead of us andthere are going to be new information and economic data released in the marketsthat can significantly change the current regime and act as powerful catalyststhat will further drive prices.

Before we explain our view further, we believeit would be interesting to understand the nature of our universe and howquantic entities work! Yes, we will talk about quantum physics and you willsoon see the relevance with the world of financial markets.

Let’s talk about elementary particles and howwe can predict their trajectory and the way they move in space. In physicsthere is something called “wave-particle duality” and it is a theory thatexplains the properties of both particles and also waves. We cannot properlyaddress the properties and behavior of quantum entities, if we treat them onlyas particles or only as waves of energy. Einstein wrote about this:  "It seems as though we mustuse sometimes the one theory and sometimes the other, while at times we may useeither. We are faced with a new kind of difficulty. We have two contradictorypictures of reality; separately neither of them fully explains the phenomena oflight, but together they do".

Another famous physicist Niels Bohr treatedthis “duality paradox” as a fundamental or metaphysical fact of nature and henoted that a physical particle will sometimes exhibit wave character, while inother times it will behave like a particle, it would all depend on thepsychical settings.

Let’s try to bring this knowledge intofinancial markets and try to explain the behavior of asset prices and predictwhat happens next. Can we use exclusively technical tools like MAs, MACDs,RSIs, etc., or crunch economic data in Excel and predict relatively accuratewhat will prices do next?

Probably not.

A financial time series, such as the prices ofa currency pair, or an equity index or a bond and so on, are indeed astochastic time series, that is a set of numbers that changes through time andsince it is a number, it is governed by the laws of math’s, statistics andeconomics but at the same time it also expresses human behavior and sentiment.

Therefore, as in the world of quantum physics aphysical quantum entity is at the same time both a particle and a wave ofenergy, similarly in Finance, an asset price, at the same time, is both anumber and sentiment.

While it is easier to measure and analyze thebehavior of a number using technical or statistical analysis, the fact that italso expresses sentiment and intention, makes it more unpredictable anddifficult to forecast.

Hence, when we take a look at financialmarkets, we examine both the behavior of prices through technical analysis andwe also employ fundamentals to understand better the current regime and whichcatalysts are driving prices. We also pay great attention to the news flow andthe economic releases, since this also affects sentiment significantly.

So, we have a new trading thesis now that isgoing to affect our strategies and new trading ideas.

In the first couple of months of 2016, we werefocusing on two major fundamental catalysts that were seriously affectingprices, the monetary policies set by two major central banks, the ECB and BoJ.They both have important QE programs in place and further accommodative policyis expected since inflation in both nations is hovering around the zero leveland they are both away from reaching their inflation target. That is alsodriving yields further lower and in the case of Japan we even have negativeinterest rates. Both sentiment and news flow were strong and supportive of thattrading thesis.

Back then, our trading idea, was to Sell EUR atthe appropriate resistance, since we expected it to weaken and buy USD againstthe JPY.

The EUR positions rewarded us handsomely and wemade very good profits in taking short positions in EURUSD and EURAUD. InUSDJPY because of the price action, we only took a small speculative position usingcall options with a strike price of 113.50 that expires this week and theposition is around breakeven.

We will let the USDJPY call expire but all theother positions against the EUR are closed, since we shift our attention tosomething different.

As we have explained before, asset pricesexhibit properties of both numbers and sentiment, we must therefore focus inthe most probable outcome with the right risk/reward and there are noguaranteed events.

For this week, we see that the attentionreturns to China and whether it will avoid a hard landing in the economy ornot. George Soros predicts there will be a hard landing, while Chineseofficials strongly emphasize to the media that there is not such case. Therewas however the slowest growth in China for the last quarter of the century andthe deficit is expected to rise, in an effort by the government to stimulatethe economy. Further depreciation of the Yuan and capital flows away fromChina, will destabilize the global economy and increase deflationary forces. Sothis is an important macro catalysts to watch.

In order to evaluate if this scenario is inplay, we can track intermarket relationships and equity indices in particular.Since we do not know exactly how the sentiment will be affected next week, withall the news and economic data released in the markets but the impact will beshown in the major equity assets.

Take for example the S&P500 in the US.

It has moved higher in the short term forvarious reasons but right now, we are very close at important resistance levelsand it would take some very important catalysts to push it to the higher levelsof the range.  Sellers will definitelyappear at these levels but it would be the news and expectations about thefuture that determines whether they take full control over the buyers or not.The Chinese situation as well as a more dovish US FED will be supportive of thebearish scenario, since global growth concerns and the deflationary forces willbe in the spotlight.

This week it is expected that Mario Draghi ofthe ECB will deliver a very accommodative policy in order to stimulate theEurozone’s economy and help reach their inflation target.

Have you heard of the old saying “buy the rumorand sell the fact”? Because of that expectation regarding Mario Draghi and theECB, we were bearish on the EUR for quite some time now but now we approach theactual fact, we remain more cautious as the markets have driven expectationsabout the possible outcome to an extreme. Hence, there is even a smallprobability that the outcome of the ECBs policy can disappoint the markets,this is why we are “selling the fact” and have no positions in the EURcurrency.

So you can see from the chart below, I preferto do “business” and look for trades from the edges of the range between1.1300-1.1500 to 1.0700-1.0800.

Another catalyst that in my opinion is evenstronger than the potential ECB decision is the price of crude oil.

Recently, prices have moved higher, at least inthe short term but, is this likely to continue? You have probably witnessed inthe last few months, how lower levels of crude oil contributed to increaseddeflationary pressures and lower levels in commodity currencies like the AUD,NZD and the CAD, as well as in Equities.

The overall big trend is down and now we areapproaching an important resistance level around the $38-$39 area. It wouldtake a decision from OPEC members and Russia to cut production for Oil to getoutside that downward channel.

But deteriorating economic conditions in Chinaand a decision not to proceed with a production cut among OPEC members, willimpact commodity producing countries and I shift my focus to the USDCAD sinceit is approaching levels that offer a good risk reward.

Let’s not forget government decision and themonetary policy set by the Bank of Canada, since the government has alreadydecided to proceed with a deficit in their budget in the coming years and thereis still the possibility of a more dovish central bank policy to protect theeconomy from oil shocks and international conditions.

So please take into consideration the Chineseeconomic situation and the prospects of a slowdown, increased volatility in theEUR due to monetary policy decisions, an anemic growth in the US and theimportant impact of Oil prices in the global economy. I will be watchingclosely developments in that areas.

For this week only, because of the upcomingnews flow in the Eurozone, the higher probability trade for me would be theEurostoxx50.

A significant dovish statement by Draghi canpush prices in European stocks further higher in a trade that offers a nicerisk/reward but if he fails to deliver and markets turn negative, we are in anarea that offers decent risk/rewards also from the short side.

During this week, you might see many othermoves happening or an entirely different catalysts that is affecting themarkets but please keep in mind two things, the duality of asset prices, theparallels between quantum physics and Finance that we discussed at thebeginning. Also we are looking to take the highest probability trade, we try toidentify events that we understand as best as possible, since that offers us agreat edge. We will never get bored repeating what George Soros used to say,“It doesn’t matter how often you are right or wrong but how much you win whenyou win and how much you lose when you lose”!

Thank you!

Fotis Papatheofanous,MBA.