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Deadly Hurricanes and Dangerous Assumptions

Wed, Sep 3 2008, 06:05 GMT
by Online Trading Academy Team

Online Trading Academy

Yesterday, Hurricane Gustav made landfall. Thankfully, it appears this will not be a repeat of Hurricane Katrina. We all know what happened; on August 29th, 2005, Katrina slammed into the U.S. Gulf Coast, becoming the fifth deadliest hurricane in U.S. history.

This weekend, I received several emails from traders who were thinking of shorting the U.S. Dollar in anticipation of a major natural disaster. I can give you two good reasons why this might not be a good idea. First and foremost, you don't want to make money off of someone else's misery. It's bad karma, and besides, if you have good techniques and practice stringent risk management, you don't have to. If you believe in what you are doing, and are using good trading techniques, there is no need to stoop to such depths.

In addition to this, there is another reason - we can't assume that the USD will fall, even if there is a major disaster. Currency market reactions to events like Hurricane Katrina and September 11, 2001 are not always as predictable as you might think. For example, when Katrina hit on August 29, 2005, the Euro - U.S. Dollar currency pair (EUR/USD) was trading at around 1.2300, but hours later it closed at 1.2233, near its lows of the day, as the dollar gained against the Euro. The next day, August 30, 2005, the USD continued to gain slightly against the Euro, closing at 1.2219.

It wasn't until August 31 that the Dollar began to fall vs. the Euro, beginning a three-day slide that ended with the EUR/USD pair closing near 1.2550 on September 2nd. After pausing near that level, the buck began to regain its losses, starting on September 6th. At that point, the USD began a relentless rally that carried the EUR/USD pair all the way down to 1.1900 by October 3rd.

The point is this - not only is it wrong to try to make money off of a natural disaster, but market reactions to these types of events are unpredictable at best. You simply don't know how the greenback will react, because there are too many underlying factors at work, not just the one factor that holds everyone's focus. Sometimes you're better off just leaving things alone, and this is one of those times.

Question of the Week

Q) Hi Ed, hope you are well, and it certainly has been a long time since we last met. In the recent month, we have seen markets transitioning from solid uptrends to now downtrends. Typical examples include EURUSD, AUDUSD and GBPUSD. During the days of the uptrends, we looked for currencies that presented a strong vs. weak notion and if the fundamentals matched the technicals, we would look to get in at an optimal point.

Now that we are in a downtrend, all the major economies are suffering and as it's predicted more contractions are yet to come. So using a similar strategy to the uptrend, are we to select currencies that are neutral vs. weak or neutral vs. the very weak for establishing shorts? According to what I have seen, the Swiss currency is holding on better than its euro counterparts, and if my strategy of shorting a neutral currency vs. a weak currency is correct, then shorting something like GBP/JPY or GBP/CHF seems the best way to position for long term trades (for the next 6 months). Could I have your take on this?

Ed Ponsi) Thank you for your email, it's good to hear from you! You're right, it's time to look for weak currencies and short them vs. those that are relatively strong. For example, the USD/CHF (U.S. Dollar - Swiss Franc) currency pair sports a pretty bullish look right now, rallying over 1000 pips since the middle of July. In fact, there is a bullish ascending triangle forming on the pair, as it attempts to extend the current rally (see figure 1).

Figure 1: USD/CHF forms an ascending triangle, attempts to continue rally. Source: Saxo Bank

Adding to the general bullish attitude is the weekly chart of USD/CHF, which indicates that a successful double bottom has formed on the pair (see figure 2). But the question remains, does this currency pair present the best situation possible, or can we find a better one?

Figure 2: USD/CHF weekly chart shows a double bottom, a bullish technical formation. Source: Saxo Bank

Does this mean that we should go long the USD/CHF pair? Maybe, but it is not an automatic decision. The Swiss Franc is holding up well against the greenback compared to the Euro or the British Pound, which have been pummeled in recent weeks. It's always in our best interest to match up a strong currency vs. a weak currency, and this presents us with a problem - right now, everything, with the exception of the U.S. Dollar and the Japanese Yen, seems weak to a varying degree. You could even make the argument that the USD is only rising by default; the dollar was crushed earlier this year, and now it's everyone else's turn to be beaten with the ugly stick. So you could say that the Euro, the British Pound, and the rest are just playing "catch up", they are being punished for their weak economies, something that happened first to the USD because that is where the global slowdown first became evident.

So what to do? Well, weakness varies by degrees, and right now nothing seems to be weaker than the British Pound, which fell nearly 2000 pips vs. the greenback during the month of August. With Alistair Darling this weekend referring to the worst U.K. economy in 60 years, it's no wonder that the Pound is getting pounded.

Ok, but what to buy vs. the British Pound? You mentioned the Japanese Yen, and this might be a good choice. Just be aware that you'll have to pay interest on the trade, since the yield on the Pound is relatively high compared to the Yen. The GBP/JPY currency pair is at a critical support level, as we can see on the weekly chart (see figure 3).

Figure 3: GBP/JPY tests a critical support level on the weekly chart. Source: Saxo Bank

If this level breaks, we could see the door opened to 192.50, an area that was last tested in March.
What could cause the GBP/JPY pair to break lower? The Japanese Yen tends to perform well when equities markets perform poorly, so if recent stock market weakness persists, look out below.

Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.

Published on  Wed, Sep 3 2008, 11:02 GMT