A lesson in risk management from trading the euro

published 23 May 2011

In my last post, I showed how by using my simple tramline method, I could have performed some good short-term trades in the Dow Jones. And now the euro is giving us some terrific opportunities.

I have said that the euro and the Dow (and S&P) are moving in lock-step, so this is not surprising. If you watch the short-term movements on your screen - you can put up both charts on one screen if you wish - you will see this very clearly.

Why are the two markets moving in sync? Good question.

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From a macro perspective, stock prices are being supported by the waves of liquidity being thrown at the US economy. These changes in liquidity are instantly reflected in stock prices. By liquidity, I mean the sum of cash and credit.

As we all know, cash is rising from the effects of quantitative easing (QE - money printing), but credit is another matter entirely.

In general, the amount of credit outstanding in the US has been falling for some time. Debts are either being wiped out (via home foreclosures), or cut (individuals paying off their debts).

It is the constant inter-play between cash and credit in the economy that is giving us the ups and downs of the stock market at least that is how I see it.

The value of the euro reflects liquidity

The value of the EUR/USD is changing mainly by the same mechanism. As cash and credit declines (falling stocks), the value of the dollar rises (investors see a more balanced economy ahead and believe the dollar is cheap).

Recently, the euro has seen a large decline from its 4 May peak at the $1.4940 level. Here is the daily chart:

(Click on the chart for a larger version)

The chart goes back a year and shows the recent lowest tramline break - and the almost inevitable pull-back.

(Click on the chart for a larger version)

Note the good tramline trio I am able to draw (if you put this up on your screen, you will find they have more good touch-points in previous trading!).

In particular, the lowest tramline has held right down to the low on 16 May. Also note the generally rising momentum readings at the various lows (green arrow), indicating a lessening of selling pressure. This is often a fore-warning of a rally ahead.

And that is what we get - my central tramline was penetrated late on 17 May. Short-term traders could set buy-stops there, looking for a rally.

(Click on the chart for a larger version)

What next?

The rally continued (but in a choppy fashion) - towards my upper tramline.

But wouldit make it? After all, the market has bounced to the Fibonacci 23.6% retrace of the big move down, which can represent big resistance.

The other big factor is that the rally off the $1.4050 low can be seen as an A-B-C pattern. Elliott wave theory clearly puts three-wave movements as corrective to the main trend (in this case, down).

This means we have two very strong technical forces fighting over this market - one pulling up, and the other pushing down.

As a result, the move out of this dilemma should be very powerful.

But a disciplined trader, having entered around the central tramline as noted above, would move their protective stops to break-even, following my break-even rule. At worst, they would come out of this trade with no loss.

Depending on what happened next,a trader who had gone long around the central tramline would either be stopped out for no loss, or could see a rally up to my upper tramline. Either way, a satisfactory position to be in.

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John is is a British-born lapsed PhD physicist, who previously worked for Nasa on the Mars exploration team. He is a former commodity trading advisor with the US Commodities Futures Trading Commission, and worked in a boutique futures house in California in the 1980s.

He was a partner in one of the first futures newsletter advisory services, based in Washington DC, specialising in pork bellies and currencies. John is primarily a chart-reading trader, having cut his trading teeth in the days before PCs.

As well as his work in the financial world, he has launched, run and sold several 'real' businesses producing 'real' products.