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Trend Reversals in the Currency Market: How to Time Them?

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As traders, we are continuously told by veterans not to try to time markets due to the great risks involved. It is a fact that if you make a sizable commitment in either direction and the market fails to act in the anticipated manner, the losses could be sizable. Such losses are not suffered by retail traders only, but are also the bane of hedge funds managers, and investment and trading legends.

But while it is true that timing the markets in the short-term can be dangerous and counterproductive with respect to the acquisition of prudent and conservative trading techniques, it is possible to take advantage of certain events in such a way that a reversal in a long-term trend can be recognized in time to allow the prevention of losses, and maximization of profits. When we speak about catching reversals and timing the market, we are not emphasizing precision and scientific accuracy, but rather the aspect of profitability. In this context, successfully timing a trade allows a trader to gradually build up his position with minimal risk, and maximum long-term profitability. The exact beginning or end of a trend may not be evident, but it is still possible to time it for optimal results within the constraints of retail trading.

Before going on with our discussion, we must repeat that in order to apply the ideas presented here, one must be very conservative at the earliest stages of a potential trend. Only by minimizing our exposure at the initial stages can we expect to survive the inevitable disappointing results that we will encounter every once a while.

1. Interest Rate: Forex trends follow the dynamics of interest rate gaps. It is generally understood that directions of forex trends coincide with the direction of interest rate policies of the central banks involved.

Two considerations must dominate the validity of interest rate reversals before traders determine if the change is tradeable or not. First, is the central bank following its own wisdom and analysis in changing the course of policy, or is it obeying the dictates of the market? Second, does the central bank follow the prevailing trend in its group, or is it taking an isolated course for whatever reason? If the central bank is being forced to change policy direction by market events, or other factors, the trend reversal generally possesses a lower degree of tradeability, because such decisions can often prove to be counter-productive in the longer run. The 80s and the 90s are full of such examples in the emerging market universe. Similarly, if the central bank is changing policy in defiance of the general trend in its own group of peers (like emerging economies, advanced economies, or third world countries), one must carefully consider the possibility of a policy error. The bank may simply be responding to internal conditions that are isolated, at least for the short term, from external developments, which could justify the independent course of monetary policy. But it is equally possible that a policy error is being made, which could signal a false trend change. A recent example is the ECB’s June 2008 interest rate rise, which had to be reversed in a few months.

2. Interventions: Interventions fall into the two categories of coordinated, and isolated. If a central bank is intervening in the currency market, for whatever reason, there is a good chance that the behavior will lead to a trend reversal, at least for a period of a few months. The criterion that will help us isolate false signals from reliable ones, once again, is the relationship between external trends, and the policy direction of the central bank. Our basic assumption is that interventions that go against prevailing external trends are highly unlikely to be successful, while those that are in harmony with them emit some of the safest and easiest trade signals. An example of central bank intervention that goes against the overall trend is the 2010 Euro purchasing program of the SNB, which failed to reverse the appreciation trend of the CHF since it was initiated in isolation and went against general market consensus. An example of a successful central bank intervention is that of the RBNZ(Reserve Bank of New Zealand) in 2007, which in fact precisely marked the reversal point in the NZDUSD pair. In that case, the RBNZ policy was in positive alignment with general USD appreciation and risk aversion trends soon to emerge, and proved to be highly successful.

Coordinated interventions constitute another case which is even easier to trade and rarely fails. In this case, a currency is thought to be so much out of harmony with fundamentals, and so discordant with the objectives of governments and policy makers that multiple central banks buy/sell it in huge quantities to demonstrate their determination to punish speculators. Such a show of force generally happens once or twice decade, and is quickly exploited by traders, all of which make it a good sign of trend reversal in any currency pair. An excellent example of this kind of reversal is the intervention by the Fed, the ECB, the BoJ, and the SNB at the beginning of this century to stem the slide of the Euro. That intervention marked the beginning of the 7 year long bull market of the EURUSD pair.

3. Bubbles: Bubbles are harder to identify, but offer the greatest short-term potential among these categories. They are easiest to trade when they burst, but because of the high volatility that follows the breakdown, it is difficult to be sure that the bubble is really finished. A good example is the bursting oil bubble of 2008. After the end of the bubble, prices quickly collapsed to around $20 from a peak close to $150, but within a few months they were back near $80, as volatility made directional long-term trading very difficult.

The rule of thumb in exploiting bubbles for identifying trend reversals is keeping in mind that the longer they last, the faster and the more violent they crash. The greatest advantage in trading them is the fact that they almost always come with warning signs, since bubbles easily outlast the end of the fundamental conditions that created them in the first place. The rapid deterioration in ABX indexes in February 2007 before the subprime bubble burst with great power, or the stock market crisis of January 2008, leading up to the end of the oil bubble in June of the same year, are suitable examples. While our cases are from the commodity markets, one could easily regard them as general risk plays and extrapolate to carry trade trends for the ancticipation of reversals.

Conclusion

Timing markets in the short run is unadvisable and rarely leads to great results. Long term reversals are harder to trade, but are far easier to identify, since the fundamental causes that create them are often declared loudly by the parties involved, be they businesses, central banks, or speculators. We will not go into the detail of the processes that create the dynamics of the interaction between the various market forces behind reversals, but even with a basic understanding of the big picture, the chance of a speculator to make it big in the forex market is greatly amplified.

Further reading:

Learn the currency carry trade.

Using the COT reports to predict forex price movements.

Strategies for trading forex on news releases.


Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.


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