Since the start of the New Year, many markets seem to have changed direction. This is especially true for the dollar. What could have happened to induce these totally unexpected changes?
As they say, nobody rings a bell at the top. So what is it that causes a major market such as the dollar to change direction?
During big rallies, such as we have seen in the EUR/USD, there was no shortage of reasons offered by pundits for the bull move. Last year, we were told that the eurozone sovereign debt crisis had passed. Bond yields of the debt of Spain, Greece and other ‘problem’ countries were falling and were reaching ‘safe’ levels.
At the same time, spreads over the German bonds reached very low levels. The euro was seen as a solid bet again. Confidence had returned.
But just before the holiday break, the EUR/USD made a top and has fallen sharply since then. This was my chart from last time I covered the euro on 20 December:
But the market had not finished its rally and it made one more final push up. Here is the chart updated to this morning:
The rally pushed past the critical 1.38 level, but was met with heavy selling. This produced the key reversal in the Dollar Index, which I showed last time. The euro is the largest component in the Dollar Index, which is made up of a basket of currencies. They trade very much in anti-sync.
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Why the euro fell
What brought about the change of heart in the euro? After all, it is down around 300 pips in just a few days. The sovereign debt yield spreads have hardly budged, so that is not the culprit. Scanning the news has not revealed a major story either.
The fact is that markets are moved by changes in aggregate sentiment of the traders. This is an unseen effect that only manifests as a change in direction of the market. Major market turns are made when the majority least expect it.
But even with the sharp decline off last year’s high, my lower wedge line on the daily chart has not been broken and the major trend remains up. But the market is getting very close to the line. And if it breaks, that should confirm the trend was now firmly down.
What information can the hourly chart divulge?
I have called the 1.39 high as a blow-off top. This is where the market made a desperate lunge into a new high as it took out the multitude of protective buy-stops placed above the 1.38 level. This level was widely watched by many traders.
The buying then became exhausted as some longs decided to take profits and new shorts emerged to reverse the market. This occurred outside of any ‘fundamental’ news development.
There was a major shorting opportunity when the market broke below the wave 1 low.
The basic rule of trading
Now I can place the Elliott wave labels with confidence. The big move down is clearly a third wave: it is long and strong, and this morning there is a large positive-momentum divergence building (red bar). Given this, it is natural to expect a rally soon in wave 4.
And when this wave 4 completes, we should see a fifth wave down. That could perhaps take it below my lower wedge line. That will be my roadmap. If the market veers off this road, I shall be amending it accordingly.
Remember the basic approach to trading is this: let the market speak to you, and make sure you listen!• If you’re a new reader, or need a reminder about some of the methods I refer to in my trades, then do have a look at my introductory videos:
• The essentials of tramline trading
• Advanced tramline trading
• An introduction to Elliott wave theory
• Advanced trading with Elliott waves
• Trading with Fibonacci levels
• Trading with 'momentum'
• Putting it all together
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