A Framework for Trading Currencies; Plus Feedback Loops and Symmetrical Boom-Bust in FX

Quotable

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

Lewis Carroll, Through the Looking Glass

Commentary & Analysis
A framework for trading currencies; plus feedback loops and symmetrical boom-bust in FX

“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 an 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 right or wrong. We all see the market differently because we 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—currency trading.

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, forecast, and move real money in markets 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

The currency game, boiled to its essence is a sentiment game. It’s a game driven by a crowd mentality; no different from any other actively traded asset market. But because the seeming number variables are so vast that could potentially move a currency’s price, the currency game seems much more irrational than stock or bond trading, for example.

Often this irrational and seeming random short-term price action can shake us out of what proves ultimately to have been a very good initial position. Therefore it is most important to develop 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
    1. Sentiment and technical analysis: helps you determine the crowd’s expectations and helps you to exploit the seemingly irrational price action
  2. Risk in the tradea.
    1. Trading discipline: define your risk and set your stop-loss level before entering a trade3)
  3. Time-frame
    1. 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, size of contracts, etc.).

Going with flow

Our objective should be to develop a framework grounded in market price action and human behavior. As the great Richard Wyckoff said:

“Listen to what the market is saying about others, not what others are saying about the market.”

This isn’t easy. We are all swayed in some form or fashion by our opinion leaders. And we each have our own set of leaders; thus multiplying the rationales for price action amongst the crowd. It is not that this technique is any Holy Grail, but at the margin I think it has helped me; it is this:

Every morning I view charts and determine my levels before I read the news. Of course this won’t apply to fundamental traders. But for technical traders in some small way it helps us apply what Mr. Wyckoff’s maxim of “listening to the market,” as Mr. Market is the final arbiter.

So, I think this simple framework 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 you decide to trade, the more your technical skill will come into play. Intra-day trading means playing against the bank traders, the robots, and of course yourself. I think the ability to extend our time frames, aka positional advantage, is one of the few advantages punters such as us really have.

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, as I’ve indicated. Currency prices are affected by the fundamentals and the fundamentals are affected by the currency price. It is a continuous feedback loop. And let us not forget, there are lots of things going on beneath the surface we don’t see; and that stuff can be as much or even more important as the stuff we do.

Because the players are not sure what is really moving currency prices—trade, interest rates, inflation, deficits, geopolitics, economic growth, on into infinitum, rationales validated by price action enhance the belief by players their current position is the “right” position. It emboldens those who are “right” to add positions. This process is a feedback loop and represents the raw material for a self-reinforcing trend.

But this micro-feedback loop, if you will, carries even further. Why? Because not only does the perception of the fundamentals impact price, e.g. deflationary pressures will lead to lower interest rates by the central bank, so prices of the currency should go lower. But keep in mind, fundamentals are also effected by price, e.g. as the price of the currency is pushed lower and lower the ability of a country to increase exports improves and this growth indicates deflation is in the process of fading.

It this process 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, and 2) “overshooting,”—prices becoming extremely detached from the fundamentals; or put the other way, fundamentals become extremely detached from price.

This is what we may commonly refer to as boom-bust. It is driven by self-reinforcing cycles in turn triggered by feedback loops. But what is interesting is boom-bust is asymmetrical in almost all actively traded asset markets, whereas it is symmetrical in currency markets.

Boom-bust is asymmetrical when the bust is much faster than the boom; this is primarily because fear is a bigger motivator than greed. We see this pattern again and again in the stock market, often a year of market gains can be wiped out in a few days during a crash. But because a currency is always paired against another currency, i.e. long EUR/USD means you bought the euro and sold the dollar, a boom in the euro is a bust in the dollar. Therefore, in currencies we can say the boom-bust cycles are non-asymmetrical. (This has interesting implications for the use of Elliott Wave analysis for currencies; but I am not sure what that is yet and it is a story for another day.)

So our goal is to ride the beast with the knowing all too well at some stage the players will begin to realize the widening gap between expectations and reality, i.e. the impact of the self-reinforcing process they created. This is when we as traders need to start looking in the other direction than the crowd. In short-term time frames our technical price action helps us here, but over the longer term if we can judge sentiment extremes, it is the best.

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 that information is reported for the currency futures traded on the Chicago Mercantile Exchange (CME). And these measures (the non-commercial players, aka speculators) 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 or what in hindsight represents that overshoot territory I discussed above. 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 CME on a daily basis, you probably will be surprised to learn how often changes in trend correspond with unusual fluctuations and/or extremes 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 trading in 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 traders who were facing the other direction capitulating 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 points for us: currencies trend, the crowd will be right during the middle of the trend, and because of the overshoot quality in currency price action 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 or at minimum exit based on the belief in a new rationale.

The new rationale(s) 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.

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!
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.
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.
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.
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 you are being guided by expectations of your own, i.e. your ability to forecast events. Simply watch how consensus expectations play out relative to real world events and watch the way the market reacts to the that interplay. Easy in theory, but very difficult with all the news flow available to us and the fact we effectively have slot machines on our desks now.

Of course, it is never easy or we’d all be rich, as they say. 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. Mr. Percival has generously shared his insights for more years than I dare to count, as my grandchildren shuffle in and out of my office this morning (lucky I am indeed), in his newsletter Currency Bulletin.