Trading Tip Charting Economic Surprises

A good tip for traders is to stack up economic data surprises against price action to help explain and forecast the future movement in currencies. Figure 3.2 presents a sample of what can be done. The bar graph shows the percentages of surprise that economic indicators have compared to

U.S. Dollar Date and EUR/USD

Durable Goods Empire State Manufacturing Philly Fed

Leading Economic Indicators Personal Income Industrial Production ISM Nonmanufacturing Current Account Existing Home Sales GDP Annualized U. Michigan Consumer Confidence ISM Manufacturing Consumer Price Index Personal Spending Change in Nonfarm Payrolls

figure 3.2 Charting Economic Surprises

100%

150%

200%

100%

150%

200%

consensus forecasts, while the dark line traces price action for the period during which the data was released; the white line is a simple price regression line. This charting can be done for all of the major currency pairs, providing a visual guide to understanding whether price action has been in line with economic fundamentals and helping to forecast future price action. This data is provided on a monthly basis on www.dailyfx.com, listed under Charting Economic Fundamentals.

According to the chart in Figure 3.2, in November 2004, there were 12 out of 15 positive economic surprises and yet the dollar sold off against the euro during the month of December, which was the month during which the economic data was released. Although this methodology is inexact, the analysis is simple and past charts have yielded some extremely useful clues to future price action. Figure 3.3 shows how the EUR/USD moved in the following month. As you can see, the EUR/USD quickly corrected itself during the month of January, indicating that the fundamental divergence of price action that occurred in December proved to be quite useful to dollar longs, who harvested almost 600 pips as the euro quickly retracted a large part of its gains in January. This method of analysis, called "variant perception," was invented by the legendary hedge fund

Nov Dec 2005 Feb figure 3.3 EUR/USD Chart (Source: eSignal. www.eSignal.com)

Nov Dec 2005 Feb figure 3.3 EUR/USD Chart (Source: eSignal. www.eSignal.com)

manager Michael Steinhardt, who produced 24 percent average rates of return for 30 consecutive years.

While these charts rarely offer such clear-cut signals, their analytical value may also lie in spotting and interpreting the outlier data. Very large positive and negative surprises of particular economic statistics can often yield clues to future price action. If you go back and look at the EUR/USD charts, you will see that the dollar plunged between October and December. This was triggered by a widening of the current account deficit to a record high in October 2004. Economic fundamentals matter perhaps more in the foreign exchange market than in any other market, and charts such as these could provide valuable clues to price direction. Generally, the 15 most important economic indicators are chosen for each region and then a price regression line is superimposed over the past 20 days of price data.

TECHNICAL ANALYSIS

Prior to the mid-1980s, the FX market was primarily dominated by fundamental traders. However, with the rising popularity of technical analysis and the advent of new technologies, the influence of technical trading on the FX market has increased significantly. The availability of high leverage has led to an increased number of momentum or model funds, which have become important participants in the FX market with the ability to influence currency prices.

Technical analysis focuses on the study of price movements. Technical analysts use historical currency data to forecast the direction of future prices. The premise of technical analysis is that all current market information is already reflected in the price of each currency; therefore, studying price action is all that is required to make informed trading decisions. In addition, technical analysis works under the assumption that history tends to repeat itself.

Technical analysis is a very popular tool for short-term to medium-term traders. It works especially well in the currency markets because short-term currency price fluctuations are primarily driven by human emotions or market perceptions. The primary tool in technical analysis is charts. Charts are used to identify trends and patterns in order to find profit opportunities. The most basic concept of technical analysis is that markets have a tendency to trend. Being able to identify trends in their earliest stage of development is the key to technical analysis. Technical analysis integrates price action and momentum to construct a pictorial representation of past currency price action to predict future performance. Technical analysis tools such as Fibonacci retracement levels, moving averages, oscillators, candlestick charts, and Bollinger bands provide further information on the value of emotional extremes of buyers and sellers to direct traders to levels where greed and fear are the strongest. There are basically two types of markets, trending and range-bound; in the trade parameters section (Chapter 7), we attempt to identify rules that would help traders determine what type of market they are currently trading in and what sort of trading opportunities they should be looking for.

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