In December, the foreign exchange market behaved in a peculiar way. The euro/dollar was trending strongly upward on dollar-negative news, but the trend then wobbled and gave back some of its gains on news that traders chose to interpret as not dollar-negative, even though it really was just as dollar negative as the earlier news. Why did that happen? The answer lies in traders twisting the meaning of the news to match the price action they expected to see on the chart. Traders wanted a retracement of the upmove, so they manufactured it out of the smallest evidence. A manufactured retracement is very common in foreign exchange. To recognize a manufactured retracement, you need to understand how professional traders view FX market trendedness.
Most professionals trade in all timeframes, but even if they trade in only one, they consult charts on all. A trader at a bank or brokerage firm is usually in and out of the same currency at least five, and as any as 50, times a day, with a one- to two-hour holding period. The goal is to make a few bucks on the spread between buying and selling with customers and counterparts. To do that consistently a trader must get the price direction right, not necessarily focusing on heavy-duty economics. Ask a trader whether a particular factor is important, and he or she will answer in terms of how many points he or she expects it to move the currency.
A smaller group of professionals, including traders at hedge funds, are “position traders,” meaning they delve into the big-picture economics and put on trades with holding periods of many months. This can be the most profitable form of trading, because of the potential to capture virtually all of a trend with almost no transaction cost. (Actually, if transaction costs are very low, more profit is made by entering and exiting the same trend several times and picking up a little extra gain on the retracements –– and every trend, no matter how well-behaved, contains retracements.) People who don’t work for big institutions are the nonprofessionals, but they number in the hundreds of thousands and are all over the world. The timeframes they trade mirror the professional timeframes, but they tend to concentrate in the shorter end, because low capitalization generally means shorter term trades with fewer chances for the market to jump up and bite the trader with a nasty loss. People who have been in the market a long time see the change in price behavior resulting from the influx of the new nonprofessional FX traders.
Trendedness is reduced and hoppy moves are choppier. FX prices don’t trend all the time, and opinions differ over exactly how much they do. It is a monthly chart of the euro over its lifetime. The green lines on the price series represent one perspective of the euro’s trends, although other lines may be equally valid. Notice the move from 2002 to the end of the chart can be considered a single trend with several big retracements, two of which are marked. A position trader who bought the euro at the low of about 86 cents in January 2002 and was still holding it today would have a gain of 46.50 cents, or a percentage return of 54 percent on the face amount. Assume leverage of 10 times, and the return is 540 percent, or 180 percent per annum. To do that, of course, you would have to have ridden out the retracements, which are the secondary moves opposite to the trend.
Now consider trendedness in the Japanese yen. It’s difficult to say this chart shows a single downtrend from mid-May to mid- December 2004. The retracements look like uptrends in their own right, and in fact they are identified as “trends” by the crossovers of multiple moving averages (7, 10, 15 and 20 days). By that reckoning, there are nine trends on this chart. This demonstrates that a trend is in the eye of the beholder, and in the techniques you use to identify it. A different technique might zero in on any of the smaller retracements and classify them as trends, too.
Every trader picks his own timeframe and therefore his own definition of a trend. The trend concept is useful chiefly to maintain perspective and sanity. It doesn’t necessarily dictate the next trade. You may be able to see the euro or yen is in a long-term uptrend, but also perceive the trend is momentarily tired and the next best trade is to bet on a minor correction; i.e., go short. You can use technicals to make a countertrend trade, and most professionals do. That’s why we have indicators that show a currency is overbought or oversold. A simple observation of a loss of momentum works pretty well, too. But in FX, a new appreciation of how retracements develop (or should develop) is becoming widespread. On the whole, it is based on the Elliott Wave theory which states that a trend proceeds by impulse waves punctuated by corrective waves, and the corrective wave contains at least two moves in the countertrend direction.
Nobody has ever published empirical evidence proving that FX moves follow an Elliott Wave sequence, and there is plenty of evidence that other patterns are more common. But that hasn’t stopped traders from expecting and sometimes getting them –– the self-fulfilling prophecy.
In fact, one of the most fascinating aspects of the forex market is how commentators twist and bend news and data to fit what they think the price should do, based on an unproven theory.
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