By Edward Ponsi
In a world economy in which different markets become more and more deeply entwined, the relationship between seemingly disparate markets becomes apparent. As markets become more interconnected, traders will uncover and exploit relationships between these markets. For example, forex traders use the close relationship between certain commodities, such as oil and copper, to trade currencies like the Canadian dollar and the Australian dollar. These "commodity currencies" tend to rally when their corresponding products rise in value. The relationship between oil and the 'Loonie' has been well documented, as has been the correlation between copper and the Aussie. By monitoring one market, we can gain an advantage when trading another. This points out the clear advantage one can obtain by following or trading in multiple markets, and more traders appear to be practicing intermarket analysis to take advantage of these relationships.
There are less obvious intermarket correlations that are equally useful, and one in particular has come to the forefront in recent weeks. As the subprime debacle continues to unwind, a close relationship between the Euro/ Japanese Yen (symbol EUR/JPY) and the U.S. equity markets has captured the attention of many forex traders. If you look at last week's chart action for the EUR/JPY pair (see figure1) and compare it to last week's activity in the Dow Jones Industrial Average (see figure 2), you'll notice that the charts are not entirely dissimilar.
Figure 1: Hourly chart of last week's activity in the EUR/JPY pair. Source: Saxo Bank
Figure 2: Five-minute chart of the Dow Jones Industrial Average. Source: Yahoo.com
Both charts depict trading activity during of the week of August 6 through August 10, 2007. If you're wondering why I compared an hourly chart of EUR/JPY to a five-minute chart of the DJIA, consider this - the U.S. equity markets are open for trading only 6.5 hours per day, compared to the 24 hour per day trading available in the forex market. Therefore, we need to use different time frames in order to create a clearer picture of what really happened last week. The EUR/JPY currency pair has recently shown a tendency to fall when U.S. stocks are falling, and the pair tends to rise when equities rally. Since stocks tend to move more quickly than currency pairs, forex traders may have found a useful leading indicator in the U.S. stock market. Even though trading can be a tough and risky business, every once in a while Mr. Market is in a generous mood and gives us a nice gift.
To understand why the EUR/JPY pair is following along with U.S. stock markets, think of U.S. stocks as a proxy for risk. Traders buy stocks when they embrace risk, and when they are in risk avoidance mode they sell stocks. The same risk aversion mindset that has been roiling U.S. equities is also at work in the currency markets; the Japanese Yen carry trade pairs such as EUR/JPY, GBP/JPY, and AUD/JPY rallied to multi-year highs and continued to climb when traders were willing to assume the risk of holding on and adding to positions that had already skyrocketed. Tremendous profits were made in carry trades, but now that fear is back in a big way, the bulls are pulling in their horns and profit taking has ensued. This has led to some sharp pullbacks on the weekly charts of the carry trade pairs such as EUR/JPY and GBP/JPY (see figures 3 and 4).
Figure 3: Pullback within the trend on the EUR/JPY weekly chart. Source: Saxo Bank
Figure 4: Deep pullback on the GBP/JPY weekly chart. Source: Saxo Bank
The markets received a respite last week when central banks initiated a joint effort to pump additional cash into the system, to alleviate a credit crunch. Despite this recent injection of liquidity from the Fed, the ECB, and other central banks, the subprime mess is likely to be with us for a while. While we have seen tremendous volatility in U.S. stocks for the past few weeks, we have not seen any sign of panic selling or capitulation. Perhaps U.S. stocks need one truly frightening selloff in order to push prices down to a point where real buyers are willing to step into the market and establish positions to which they will remain committed. If such a day should come, keep an eye on the EUR/JPY pair to see if it has also reached a state of capitulation. If the current correlation holds true, and the currency pair falls along with the U.S. equity markets, we could see an opportunity for a huge reversal in both markets.
Question of the Week
Q) Dear Ed, is there an inner secret to trading the forex market successfully?
Ed Ponsi) The 'secret' of trading, if we can call it that, is cutting losses. Of course this is not a secret at all, everyone has heard the slogan, "Cut your losses short and let your winners run" but of course for many of us this is easier said than done. On my first day at work as a trader on Wall Street, I asked what I could do to improve my chances for success. My supervisor said, "Cut your losses and everything else will take care of itself". He was right! The desire to hold on to a losing trade in the hope that it will become a winning trade proves to be the Achilles heel of most novice traders, because the inability to cut a small loss eventually forces the trader to take a large loss. This desire is a part of human nature, since so many traders exhibit this type of behavior; in fact, almost every major trading disaster, from the Nick Leeson Barings Bank scandal to the Long Term Capital Management debacle, begins with the inability to take a loss.
How can we avoid a similar fate? My advice is to focus on risk management, because in my opinion that is the key to success at forex or at any type of trading. The diligent use of risk management will prevent you from falling into traps such as the one mentioned above. Practicing good risk management will keep you in the trading game long enough to gain valuable experience, and help you to survive the dreaded 'learning curve'. In fact, good trading strategies have risk management built right in to the trading plan. Once you have gained sufficient experience trading in the correct manner (cutting losses and protecting the account above all else), you've made an important step toward success in the world of trading.
Have a question about Forex trading? Send an email to eponsi(at)tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.
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