A Ray of Hope for Stocks?
By Ed Ponsi, FXEducator.com
Since the middle of last summer, one of the most reliable currency trades has been to short GBP/JPY, EUR/JPY, and/or USD/JPY on rallies. These currency pairs have had a strong correlation to the equity markets since the early part of what we used to call the "subprime mess," so as stocks fell, these pairs fell along with them. But now we are seeing this correlation fall apart, at least temporarily. As the stock market continues to plunge, reaching depths not seen since the 1990's, several currencies pairs that feature the Japanese Yen appear to be staging reversals. In fact, GBP/JPY appears to be forming an inverted head and shoulders, a bullish formation, despite the recent setbacks in the stock market (see figure 1).
Figure 1: GBP/JPY forms a bullish inverted head and shoulders formation. Source: Saxo Bank
At the same time, USD/JPY also appears to be forming a bullish reversal pattern; in this case, the pattern takes the form of a double-bottom. In fact, USD/JPY has passed beyond the breakout point and has climbed above 95.00, a level not seen since November of last year (see figure 2).
Figure 2: USD/JPY breaks out of a bullish double bottom pattern. Source: Saxo Bank
Undoubtedly, this scenario will lead to the following question: since the equity markets fell along with the GBP/JPY and USD/JPY currency pairs, does a reversal in those pairs foretell a similar reversal of fortune for U.S. and world stock markets? I wish that I could tell you for certain that this is the case. On the one hand, one can't deny that a strong relationship exists between the JPY and equities. This has been a bread and butter trade for a long time, and something I've written about frequently in this column (see last week's article, "Using Inter-Market Analysis to Trade Forex" and last October's "Using Stocks to Trade Forex"). But that doesn't give me the right to ignore the possibility that the market may be changing, as constant change is a hallmark of all trading markets (and the anathema of back testers everywhere).
On the other hand, correlation is not causality; in other words, just because the JPY pairs and stocks fell together, this doesn't mean that they have to rise together. If I scratch my nose and it begins to rain, those two events are a coincidence; yet a child or a primitive man might believe that he caused it to rain by scratching his nose, leading to elaborate nose-scratching rituals in an attempt to duplicate the earlier result. In other words, two things can happen at the same time despite the lack of any relationship between the two. Correlations come and go, new ones are born and old ones fade away all the time. If the same correlations remained intact on a constant basis, our jobs as traders would be much easier. Constant change keeps traders on their toes, and the ones who can adapt quickly tend to do well.
One thing that is disturbing to me about the recent push to new depths in the stock markets is that there seems to be a complete lack of panic. Major lows are often accompanied by panic selling, but there has been no hint of indiscriminate dumping of stocks as of this writing. We have not seen a spike in the Volatility Index or VIX, which would indicate a high level of emotion in the markets. If there are buyers lurking, they might be waiting for just such a sign. It's likely that many long-term traders are "keeping their powder dry," waiting for panic selling as their indicator to initiate long positions.
Question of the Week
It seems that our discussion of mini and micro lots created a big response, so I'd like to handle a question on that topic.
Q) Hi Ed, how many lots can I trade in the Forex with $5000? There are so many factors to consider. Would you be kind enough as to give me some pointers as what to look for or avoid? A little advice would go a long way right now. Thank you in advance, Cindy.
Ed Ponsi) Thank you for your question, the number of lots you can trade with $5000 depends on the account type. In a standard account, you must put up margin collateral of $1000 to enter a one-lot trade; this would be highly unadvisable because just a one-lot trade would use up 20% of your buying power. This means that your flexibility would be severely limited, especially when faced with multi-lot scenarios. Many traders prefer multiple lots because it allows them to exit a portion of their trade at a profit while allowing another portion of the trade to run.
However, the requirement to enter a trade in a mini account is only $100, and in a micro account the requirement is only $10. The temptation is to worry about the fact that it will be difficult to make a large sum of money under these circumstances, but that is putting the cart before the horse. Instead of thinking about money, consider opening a mini or micro account with the intention of mastering the skill of trading. In a smaller account, this can be done with a minimum of risk, if good techniques are applied. Once you have learned proper technique and risk management, you can always scale your trades to a larger size. The mistake some people make is that they are too blinded by greed and are in too big of a hurry to make money, so they skip training and dive right in to large sized trades, with negative results. Meanwhile, traders who study hard and risk little while they learn are giving themselves a chance for success.
Ed Ponsi
