Boris and Kathy's FX Blog www.bktraderfx.com

"Trying to understand what's happening in the currency markets is like watching South Park for the first time and trying to figure out what the plotline is. At first, a viewer
has confusion, then revulsion, then anger, and then maybe some laughter as you realize the absurdity of it all."

Our good friend Andy Busch. Global FX Strategist at BMO Capital Markets expressing our feelings this week far better than we ever could.

Last week we wrote that, “There are only two types of assumptions underlying every trade ever made.

1. A trader either anticipates some future events that will force the market to re-price the current value of the position in his favor. Or -
2. A trader believes that the most recent news events are so significant that they will result in continuation of price direction as more and more market participants accept his point of view”

For simplicities sake lets call the first method, proactive trading and the second reactive trading. In proactive trading we are trying to anticipate some future event while in reactive trading we believe that the current price action will extend further in the same direction. Note that these two approaches have nothing to do with fundamental or technical analysis per sei. There are simply two overarching methodologies of trading. The actual reasons for the trade can come from either fundamental or technical analysis or perhaps both.

For example, a trader who looks at the hourly chart of the EURUSD pair and notices that prices are approaching 200 SMA and then decides to short the pair on the assumption that this area will serve as strong resistance is practicing proactive trading based on technical analysis alone. Meanwhile another trader who believes that the upcoming piece of economic data will be extremely bullish for the dollar and also decides to short the EURUSD is practicing pro-active trading as well, but this time strictly from a fundamental point of view. Thus, an exact same trade can often take place in the FX market for markedly different reasons. The key element that unites both traders is the anticipatory nature if their approach.

Now let’s flip the scenario around. Suppose the EURUSD rallies strongly through the 200 SMA on the hourly charts and closes near the top of the candle signifying a strong breakout to the technically oriented trader. Based on this information he decides to go long, forecasting that the strength in the pair will continue. Meanwhile our fundamentally driven trader sees that instead of being bullish the US economic release prints a major disappointment, taking the markets by surprise and completely changing the price direction of the pair. Therefore based on this new information the fundamentalist also decides to go long, as the new data suggests far gloomier prospects for the US economy.

Note, by the way how frequently technicals and fundamentals express the same story, however, that not the point we want to make. The unifying aspect on the technician and the fundamentalist in the second example is that they are both behaving reactively.

Once we understand, the two approaches the next question we must answer is how to best execute each setup. Ironically enough, the matter of timing each strategy is the exact opposite of what common sense would dictate. Normally, most traders would say that reactive trade setups should be put on instantly after the event occurs. However, markets can be maddening in their ability to frustrate the most logical of plans.

When news hits the tape, prices do adjust instantly, but continuation often does not take place for a while. Lets look at out first trade of the week the USDJPY long which we actually took a week ago Friday, after the much better than expected US NFP numbers convinced us that US yields would rise and provide further support for the carry trade.

http://docs.google.com/Doc?id=dn8z7zs_89cmhj4s

Prices did move higher, but did not follow through as defense of the 119.50 option barriers kept a lid on any gains. In fact the pair retraced strongly during the trade coming close to our stop. However, during all of this time the fundamentals facts for the trade did not change (US yields continued to rally and Japan stated that it had no intention to raise rates anytime soon) so we stayed in the trade. Eventually the fundamentals overwhelmed resistance and took out our first profit target at 119.52.

The two lessons to learn here are:

1. Reactive trades can often provide you with better entries on the retrace of the move rather than immediately following it
2. Unless the reason for the trade changes, traders should stick with the trade until they either reach their profit target or hit their stop

Pro-active trades, however are a totally different matter. Typically anticipatory traders try to get into the move well ahead of their expected action, but that can be a mistake because prices can be effected by a myriad of factors preceding the event. This Friday’s short USDJPY was a perfect case in point. We entered the position on the assumption that there was a strong chance that G-7 officials would not necessarily be as accommodative on the issue of yen weakness as the market thought. Specifically we thought that while the official communiqué would include the standard neutral diplomatic language, side comments by the EZ ministers would not be nearly as tolerant of yen strength and may produce some USDJPY selling in post G-7 reaction. Already, EZ car manufacturer sales showed a sharp decline this month, while the Toyota juggernaut continued as the Japanese car maker was well on it way to selling 1.3 million vehicles on the continent in 2008. With political election in France scheduled this month we thought the fiscal authorities in the 13 member union may lash out at the persistent yen weakness. Our idea was predicated on some possible news out of the G-7 on Saturday but unfortunately we entered the trade too early. When y Friday morning news came out that G-7 communiqué would not criticize the yen we were swept in a vicious short covering rally and got stopped out before our thesis had a chance to be tested in the market. Therefore the lessons to take away from proactive trading is:

1. Don’t anticipate too early
2. Position yourself just before the event is about to occur (no more than 2 hours preceding the news)

Please understand that neither reactive nor proactive trades in and of themselves will guarantee you profits. In reactive trades, prices may adjust but not necessarily continue in your direction. In proactive trades events may come true as you expect them, but the market may not necessarily respond to the event.

Still, as one very wise man once said "The battle does not always go to the strong; nor the race to the swift - but that's the way to bet." By trading reactive setups a bit we may be able to get better pricing on the retrace while trading proactive setups just before the anticipated event, we should be able to eliminate some of the noise risk that could sabotage the trade. By fine tuning not jus the analysis but the mechanics of the trade we hopefully put the odds in our favor.

Have a great week-end,

We’ll be in touch next week with new trades

B & K