anything specific in mind. The trader has an existing position to defend and therefore a bias against reversing from pessimism to optimism – unless and until it becomes profitable to drop the position.
Technical analysis is so important in FX trading that we can say that a FX market event gets some of its importance from what is happening on the chart at the time. Untangling what is technical and what is fundamental in any specific move thus becomes complex. Unlike the situation in equities, where price-earnings ratios are a fixed (if evolving) number, fundamental events do not have a fixed hierarchical ranking in FX but rather gain or lose power over the minds of traders depending on how the chart looks. A bad news release will be dismissed if a currency has just made a decisive upside breakout, but the same news may be fatal to an existing upmove if it comes when the price is already flirting with reversal.
It’s a mistake to dismiss technical analysis as some strange sideline of a minority. Professional traders bet hundreds of billions of dollars per day using technical analysis and they would not do that if technical analysis failed to help achieve profits and avoid losses. Virtually everyone in FX applies some concepts from the technical analysis world, even if they are not self-described techies; a trader who does not subscribe to technical analysis concepts will still be aware that others in the market are using them.
Every once in a while, you may meet a brilliant, intuitive trader who uses no technical indicators at all and yet succeeds in generating winning trades. He is almost certainly using the same ideas as the technical trader, just not measuring and labelling the ideas with the same terms. After all, most of the indicators in technical analysis derive from long-standing trading practices. Ask an intuitive trader why he changes from long to short, and he may say “I couldn’t see any more buyers out there – the bid was gone.” The technical trader will point to three or four indicators and say “It was overbought.” Same thing.
The pinball effect
Sometimes a price change comes out of left field and we literally cannot find an explanation for it in the fundamentals, technicals or what little information we have on professional positioning. It’s as though one deep-pocket trader had an epiphany that inspired him to take a huge new position. Some of these initiatives fail and are never heard of again, but in the time-honoured way of crowd behaviour, others take a profitable ride. As recounted in the many books about the Soros 1992 sterling trade, many other FX players declined to believe the statements of UK officials and instead put their money on the same trade as Soros, short the pound, because they could see a clear trajectory on the chart. Soros did the hard work of analysing the situation, but it was his positioning that everyone could see, even if they didn’t know exactly who was behind it. [2]
Where do these inspirations come from? Oddly enough, they often come from outside the immediate conditions in the financial markets themselves, from perceiving a historical analogy, from maths, or even from superstition. Thus is created a pinball effect, where a new idea (or an old idea resurrected) shoots around several markets along multiple interconnecting and criss-crossing pathways. An inspired trade in oil futures can pinball to emerging market currencies, to advanced country fixed income securities, to mutual fund valuations, to the new-technology energy names on the NASDAQ, to the Shanghai and Nikkei indices, to the dollar/yen… and so on. Transactions are conducted at such speed and the world is so interconnected today that we can’t explain everything, and often, ex-post explanations are unconvincing. Explanations do exist, but we may never know them. This is a wonderful and frightening thing. [3]
The actors
Let’s take the actors, or agents as academics might call them. How you interpret FX market developments depends on what sort of trader you are, so it is important that we consider how various actors think.
Let’s say, for example, a key technical level is being hit – but it’s Friday at 3 pm. The FX market’s reaction to the key level is entirely different from when a key level is hit at 8:30 am on a Monday morning. More nuanced than this, a key level being hit at 3 pm in London on any day is different from the level being hit at 3 pm in New York. In the London case, traders still have several hours to see what the New York market will make of the development. If New York responds predictably to the key level, London traders have a new profit opportunity, although it means working late.
The New York traders do have an overlapping time zone – New Zealand opens around 3 pm New York time, Australia opens around 5 pm and Tokyo opens around 7 pm. But these are much smaller markets than London and New York, and New York traders have different work habits. They arrive at work early to partake of the London and European action, rather than staying late to join the Asian markets. The importance of the key level is far lower in New York at 3 pm on any day than at 8:30 am on any day.
Now consider which group of actors cares the most about a key level at any time of day – technical traders. After all, with algorithm-trading and pre-set electronic entries and exits, the trader doesn’t have to be physically at the trading terminal to respond to a technical event like a key level. If the key level is a match of a past benchmark high or low, or a round number, or widely publicised (like a Fibonacci level), then non-technical traders know about it, too. If the technical group responds as expected, the non-technical groups feel compelled to react, whether defensively or opportunistically.
In other words, the sets of players are interactive. Because we have so much news and chatter in the electronic age, we are all getting a great deal of information about the other players, and we are getting it 24 hours a day. A good case is when the FX newswires have reported where a big buy-side client has an option strike, often a round number. The existence of the option and its strike price is a mechanical aspect of the market and not strictly speaking technical, but the strike level is almost always set by technical considerations. It may be just past a moving average, a historical benchmark level, or some other calculation.
The financial institution that wrote the option will have hedged at least part of its position (although not all, or it wouldn’t make a profit on the transaction), but still probably prefers not to have to pay up, while other market players know that a failed test of the level opens the door for a big move in the opposite direction of the strike. This is a case in which the widespread knowledge of the option strike is the top factor and it would take a big event in the macroeconomic world to overwhelm it.
Positions
The option strike price case illustrates the most important aspect of the player groups – their positions. When the vast majority of the market holds a particular belief, their positions reflect those beliefs. If a set of factors lines up against the pound sterling, for example, a short sterling position is rewarded with every news release reinforcing the negative tone. Good news is dismissed and disregarded. Every trader is gunning for sterling. It doesn’t matter that by any objective measure on a fundamentals matrix, five factors are negative and two factors are positive.
But there is always a tipping point at which the market gets oversold sterling – something experienced traders can smell and that technical analysts can measure – whereupon a key level gets hit and a cascade of short-covering ensues. The tipping point may appear with or without a news announcement pertaining to a factor. Sometimes the factor is directly relevant, whereupon the press says “the release of the XYZ data caused the pound to firm.” In other instances, and we say it’s the majority of the time, the release of the XYZ data is just an excuse for traders to get out of Dodge. If you can’t sell it (anymore), buy it.
Hence the seeming perversity of the FX market. The objective measure would still have four negative factors versus the new count of three positive ones; it would still be net negative. Logically, we say the pound should remain in a falling trend and the factor weights do not
