A great example of extreme sentiment

Today, I will be going off piste a touch in covering the pound/US dollar, or ‘cable’, as it is affectionately known. The name comes from the early days of transatlantic communication, when great cable-laying ships ploughed the Atlantic to bring the continents together. GBP/USD currency traders used the first cables to trade, and the name has stuck ever since.

This market is a great example of extreme sentiment. That’s the point at which turns often occur, which catch the majority flat-footed. I love doing that!

The currency markets today are highly fragmented in terms of sentiment. There is massive bearish sentiment towards the yen, and the USD/JPY cross, which I follow, is in vertical lift-off mode. Then the EUR/USD cross sports massive bullish sentiment with many forecasting an extension of the rally to the 1.40 area.

And then there is poor old cable! Sentiment is becoming more and more pessimistic due to the flat UK economy.

As an example, here is a headline from a recent Sunday Times article: “Sterling set to slide as trade gap widens”.

The article makes a convincing case, citing many negative-looking statistics such as the trade gap, the budget deficit (increasing government borrowings), and the possible UK exit from the EU.

With fundamentals like this, who would want to challenge the bears?

Here is the daily chart of GBP/USD for the past year:

GBP/USD spread betting chart

(Click on the chart for a larger version)

Right away, we see no clear trend. In fact, the market is trading in about the same area as a year ago!

But in the meantime, there have been many large swings (these are the swings I attempt to catch with my methods, of course!). And since the peak on 2 January at 1.6360, it has been downhill all the way, while the bearish comments accelerated.

This is normal. What we have to realise is this: by the time you read headlines, it will be time to look for a market turn – and a tradable low. And this is exactly what I have done.

The other thing we have to realise is that there is another currency involved – the US dollar. While the pound was sinking in January, all the media’s eyes were on it, while the dollar was virtually ignored, because traders had breathed a collective sigh of relief over the non-event of the fiscal cliff.

Does Commitments of Traders (COT) agree with the headlines?

So let’s see what real traders were doing in the futures market – the COT data.

Here are the latest figures as of 22 January when the market was trading around 1.58: 

Non-commercial Commercial Total Non-reportable positions
Long Short Spreads Long Short Long Short Long Short
60,201 42,623 2,153 69,899 93,288 132,253 137,704 28,567 23,116
-3,595 6,805 585 8,291 -15,265 5,281 -7,875 -7,756 5,400
37.4 26.3 1.3 43.5 58.0 82.2 85.6 17.8 14.4
25 29 7 22 30 52 61

True to form, the large speculators (non-commercials), who are largely hedge funds, massively increased their shorts/reduced their longs. These traders are primarily trend-followers, using algo systems.

A similar pattern exists in the small speculator sector, where there’s a massive swing to the bearish camp. They were obviously buying the bearish story.

Meanwhile, the trade (commercials) took the other side of these trades.

Since then, the market has declined further and I am confident that the next report will show an extension of these changes.

So, early this week, I was on the lookout for a low. And I did find a great set-up on Tuesday:

GBP/USD spread betting chart

(Click on the chart for a larger version)

I could draw a superb trendline of the decline off the mid-January high – and the market was challenging that line. Was this the turn I was looking for?

To give me more evidence, I needed to go back to the long-term daily chart:

GBP/USD spread betting chart

(Click on the chart for a larger version)

Aha! The market declined to 1.57 – bang on the Fibonacci 63% retrace of the huge move up from the sub-1.54 low to the sub-1.64 high (red arrow). This is exhibit A.

And then, the 1.57 level is right on the support zone provided by the highs from last summer (pink bar). This is exhibit B.

Exhibit C is, of course, the extreme bearish sentiment, which usually precedes a turn.

Putting all this together, I had a strong case for at least a decent bounce and that 1.57 was a tradable low.

Let’s forward to this morning:

GBP/USD spread betting chart

(Click on the chart for a larger version)

I have a tramline pair, but it is less than ideal, so I am not placing great store by it – yet.

Since the 1.57 level is my new low, I have my Fibonacci levels using the most recent significant high as high pivot point.

This is the level where I expect some resistance.

Trader tip: In Wednesday’s post, I covered this point at length. Get your Fibonacci tool working as soon as you can and identify your pivot points. These levels will prepare you for likely support/resistance. Do not trade unprepared!

Where do we go from here?

I have a long trade and my protective stop is now at break even. But what are the likely scenarios from here?

Let’s examine the move down from early January:

GBP/USD spread betting chart

(Click on the chart for a larger version)

These are my main options (there are others).

We are either dealing with a large A-B-C, where the rally will progress, or with a five-wave pattern, leading to a new low well below 1.57.

I really do not have anything else to go on, and so I will sit with my long trade, happy in the knowledge that whatever happens, I will not lose money on it.

And that, believe me, is a very comfortable position to be in. I advise all traders, no matter what systems you use, to do likewise. It is the low-stress way to trade – and stress is what kills trading performance.

• 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

• Don’t miss my next trading insight. To receive all my spread betting blog posts by email, as soon as I’ve written them, just sign up here
. If you have any queries regarding MoneyWeek Trader, please contact us here.

  • Gold Bug

    Anything but the Dow John!

    You won’t stick your neck out so I will. We are topping at 14,005, there or thereabouts.

  • Mike

    Informative email as usual John. I’ve clicked on your link to the ctfc website but I can’t seem to find the COT tables you use in your emails. Where exactly are they?(!) And how often are they updated – the 22nd Jan is a week out of date now.

  • Toadie

    How can you say that the speculators were bearish? Long positions outnumbered shorts 60,000 vs 42,000. As such the move was probably more to do with bullish capitulation than bearish trend following. Which may also explain why the rally was short lived and the market reversed hard today.

    Still it was a good call on the 1.57 support and 62% Fib.

  • goadie

    Toadie – see the highlighted row – the change , minus 3.5k longs, plus 7k shorts, I think JB is referring to the switchover.

    Hey guys – were not all perfect – JB might have said some stuff you dont agree with such as the inflation thing, but if you dont like it, youre allowed to discard it from your memories.

    I for one enjoy JBs blogs as it gives me something to think about, a different angle on my trades. and for that i am grateful. I may not agree with everything JB says, everyone is entitled to their opinion, but keep up the blogging JB.

  • bangkokrover

    Here’s the link to the latest COT report. http://www.cftc.gov/dea/futures/deacmesf.htm

    To navigate to it, Go to John’s link, http://www.cftc.gov>Market Reports>Commitments of Traders>Current Legacy Reports>Chicago Mercantile Exchange>Futures Only/Short Format
    The GBP is somewhere below Lean Hogs in the list, so I was wondering if that is an additional (anecdotal) bearish signal. LOL

    To find gold, do the same as above, but from Current Legacy Reports>Commodity Exchange Incorporated.

    COT data is updated every Tuesday but not published on the website until Friday of the same week at about 1500hrs New York time.

  • bangkokrover

    I think it’s very dangerous to short the the GBP/USD here at 1.5695. Apart from the fib support mentioned by JB, There is also the 38.2 retracement of the whole up move from the crisis low of January 2009, @1.5695. Also just below that at about 1.5620, there is the long term rising trend line from the crisis low. It has at least 7 touch points on the weekly chart. Judging from the Friday close, it looks like price could gap down toward 1.5620 at the open, which could justify a long. I think it will take something mega to break that trend line.

    COT positioning seems more or less neutral to me.

    Possible up coming mega event. Mark Carney, the messiah will be in London next week to speak to the UK Parliament (Daily Telegraph). I guess the GBP will take its cue from his level of dovishness.

  • Mike

    Bangkokrover – many thanks for directions to the relevant COT data.