A Reliable Framework for Trading Currencies?

Quotable

“Why, sometimes I’ve believed as many as six impossible things before breakfast”.

Lewis Carroll, Through the Looking Glass

Commentary & Analysis

“Six impossible” beliefs before breakfast are probably the norm for most currency traders. There seems a simple reason for this–it’s because there are incredible number of potential variables in the marketplace that seemingly move price. Our goal, as traders, is to develop a trading system that helps us sift through the potential reasons with some degree of clarity

The bottom line is: If something works for you, use it. It is not for me or any other trader to say what you are using is wrong. We all see the market differently and process information differently. So, keep in mind as you read this missive it is only an attempt at summarizing a “rational” framework to apply to an extremely “irrational” world.

One reason so many experts are consistently wrong when it comes to the world of currencies is because of all the asset markets available to trade, the movement of currency prices seems the most random, or irrational.

As a trader your goal is not to forecast real world events, but to monitor the expectations of the players who are trying to forecast real world events. George Soros, the man credited with “breaking the Bank of England” shorting the British pound had this to say about market prices:

“I believe that market prices are always wrong in the sense that they present a biased view of the future.”

We think, feel, and forecast for all kinds of different reasons; millions and millions of reasons. All of these reasons taken collectively are what we refer to as market sentiment.

It is a sentiment game

Currency trading can be boiled down to a sentiment game. It’s a game driven by a crowd mentality. And it’s a tough game. Irrational and seeming random short-term price action can shake us out of what proves ultimately to have been a very good position. Price action is the final arbiter, but do we react too quickly? Usually, the panic out of what otherwise was a good position usually is driven by the fact we are trading too large. We need a framework to help us remain in “good” positions; those based on solid rationales that have worked for us before:

To achieve this lofty goal I think the system must contain these three primary elements:

  1. Reasons for making a trade

    Sentiment analysis and technical: helps you determine the crowd’s expectations and helps you to exploit the seemingly irrational price action

  2. Risk in the trade

    Trading discipline: define your risk and set your stop-loss level

  3. Time-frame

    The choice of time frames will impact your reasons and risks. And the amount of risk you take on will help dictate your trading size (# of positions).

Going with flow

So our framework can be equivalent to “going with the flow.” Let the market do the talking. Each of the elements of our framework is grounded in the fundamentals of market price action and human behavior

This is a framework that can be used by either day traders or position traders. The only thing that changes is the time-frame. Keep in mind, the shorter the time frame the more your technical skill will come into play.

Now let’s examine the component parts of this framework.

Sentimental journey

It is exceedingly difficult to determine the underlying driver of currency prices, especially in the short run. Currency prices are affected by the fundamentals and the fundamentals are affected by the currency price. It is a continuous feedback loop.

Because the players are not sure what is really moving currency prices–trade, interest rates, inflation, deficits, geopolitics, economic growth, on into infinitum, any expectation that is validated by price action enhances the belief of the players that their current position is the “right” position. It emboldens the players to add positions. This price action and player reaction process is raw material of a self-reinforcing trend.

If you follow the news you have probably seen it many times before. What seems like an important piece of fundamental news that would move a currency in one direction results in a movement in price opposite of your expectations based on the news–the real world event. The “trend’ is established and that’s the key driver. And as this driver pushes prices, these new prices tend to influence the fundamentals. And the strategists create very plausible sounding rationales to further encourage this trend following behavior.

It this process that leads to two things we see in all markets, but even more so it seems in currency markets: 1) more consistent trending for longer periods of time that leads to 2) “overshooting,”–prices becoming extremely detached from the fundamentals.

Self-reinforcing cycles become the nature of our irrational beast–forex. So our goal is to ride this beast with the knowledge that at some stage the players will begin to realize the widening gap between expectations and reality. This is when we as traders need to start looking in the other direction than the crowd. We apply our sentiment analysis.

Measuring sentiment

Some relatively easy methods can help you judge market sentiment. These methods include both quantitative measures and qualitative judgments. They are: open interest and volume, consensus, and perception of the trend.

Market talk often describes the crowd as either bullish or bearish. Always keep in mind there are “talking” bulls and bears and there are “acting” bulls and bears. The “acting” bulls and bears show up in open interest and volume. Of course you can’t get volume and open interest numbers for forex, but they are reported for currency futures. And these measures (the non-commercial players) represent an excellent proxy for overall market sentiment.

Turning points in currency markets often coincide with extremes in open interest levels, i.e. one-way bets. Watch for both high levels of open interest and large changes accompanied by unusual volume to alert you that a turning point may be near. (These changes also show up during minor fluctuations within the major trend, i.e. the fractal stuff.) If you begin to record changes in open interest and volume for each of the currencies traded at the Chicago Mercantile Exchange (CME) on a daily basis, you probably will be surprised to learn how often changes in trend correspond with unusual fluctuations in these numbers.

Though open interest numbers are of little use intraday, knowledge of a change in trend or extreme speculation in a particular currency based on open interest and volume can be valuable information for any time frame.

Watching the consensus

Consensus, conversion flow, and perception of the trend are qualitative measures. How is the market acting? What is the tone? Is it moving in line with the background news events? Is the bullish or bearish talk among players actually showing up in the open interest and volume? Are longer-term fundamental traders who have been wrong starting to capitulate to the trend? Is price action confirming specific news events? Are important pundits and players getting behind the trend with a new rationale?

Here is how Bruce Kovner, a Market Wizard and major player in the currency markets, views consensus opinion:

“During major moves, [the consensus] will be right for a portion of it. What I am looking for is a consensus that the market is not confirming. I like to know that there are a lot of people who are going to be wrong.”

Kovner, in effect, validates several key items: currencies trend, the crowd will be right during the middle of the trend, and because of the overshoot quality in currency price behavior, there comes a time when consensus expectations are no longer reflected in prices. Here is where we begin to see conversion flow–traders changing positions based on the belief in a new rationale.

The new rationale eventually leads to a new trend. And as more and more traders switch direction, the crowd begins to articulate this new trend i.e. the perception of the trend.

Here is a roadmap of a typical currency cycle. It should help put the terms “conversion flow” and “perception of the trend” into better perspective for you.

  1. Extreme bearishness–this is the stage where “shoe shine boys” are shorting the currency and can articulate the rationale to anyone and everyone who will listen. This is when things seem the most bearish, but are in reality most bullish (as later can be seen with the elusive gift of hindsight). This is Tao of the market time!
  2. Conversion flow–this is the stage when bears (during a long downtrend) start to question their “so obvious” rationale for being short. It is the stage where the flaw in perception of the crowd begins to be recognized by members of the crowd. Conversion flow has an early stage and a more advanced stage. It is why we see increased volatility when the trend changes. The players begin to realize something has changed. But they realize it at different times.
  3. Perception of the trend–this is the stage where the crowd recognizes that a new trend may be underway. They have discarded the old rationale and are beginning to accept the new one.
  4. Capitulation to the trend–now the trend is fully underway. The crotchety old diehard bears can’t hold out hope any longer–they capitulate and buy into the new trend. Often this is a sign that the new trend is actually becoming a bit stale, for now even the diehards are along for the ride.
  5. Extreme bullishness–now the “shoe shine boys” are buying the currency and are articulating the rationale to anyone and everyone who will listen. This is when things seem the most bullish, but are in reality most bearish.

That is the typical pattern or five stages of the currency life cycle.

So the key is to understand consensus expectations while at the same time fighting the need to judge whether such expectations are right or wrong. The moment you start to judge the “rightness” or “wrongness” of market expectations, you have admitted that you are being guided by expectations of your own. Simply watch how consensus expectations play out relative to real world events and watch the way the market reacts to the that interplay.

Of course, it is never easy or we’d all be rich. But hopefully some of these insights may help you when trading currencies.

*A special thank you to John Percival for many of the ideas I shared in this piece.