How I cashed in on the ‘Draghi Bounce’

The euro has strengthened in recent days by around four cents. Was that the result Mario Draghi was looking for in order to achieve his stated aim of boosting the ‘EZ’ inflation rate when he launched his Big Bazooka last week? Well, with a stronger euro, imports become cheaper to buy – and instead, the deflationary pressure is intensified, not weakened. Oops.

But of course, my readers were fully prepared for this seemingly perverse market reaction. Logically, the prospect of having a huge pile of euros fresh off the ECB printing press would weaken it. But we know that logic has little bearing in the markets when everybody believes it.

Because all currencies are connected as a result of trade and speculation, what was the effect on cable (GBP/USD)? After all, with the UK outside the eurozone, Draghi’s moves should not have too much effect on cable – at least in theory.

But of course, the EUR/GBP rate is a very important one because of the massive cross-border trade volumes.

So did cable rally alongside the euro? It was a result I was looking for because the waves in the two charts suggested a rally was at hand. That put me on high alert for a buy signal starting last Wednesday.

Below is the chart I took on Tuesday. The market did accompany the euro in the Draghi bounce with a sharp move up, but I wanted to see what form the inevitable pull-back reaction to it would be. The structure of the pull-back would tell me a lot about the prospects for a continuation of the rally (or not).

GBP/USD forex spread betting chart
But the potential for a substantial rally phase in either a five up or an A-B-C was in evidence, especially when the commitments of traders (COT) data is examined. Here are the figures as of 1 December, just prior to the Draghi rally:

Non-commercial Commercial Total Non-reportable positions
long short spreads long short long short long short
CONTRACTS OF £62,500 Open interest: 210,983
Commitments
38,412 66,263 16,857 137,134 88,700 192,403 171,821 18,580 39,162
Changes from 24/11/15 (Change in open interest: 12,920)
6,008 1,480 -790 8,075 10,997 13,292 11,685 -372 1,235
Percent of open interest for each category of trader
18.2 31.4 8.0 65.0 42.0 91.2 81.4 8.8 18.6
Number of traders in each category (Total traders: 269)
28 47 25 28 39 74 93

 

Although the specs were lined up about 2:1 bearish, the hedge funds had the foresight to reduce their short bets, proving they don’t always get it wrong at market turns!

Of course, I am discussing the activity of the entire group of hedge funds in aggregate; there are always some that buck the trend of the majority.

I knew a correction was coming – but what form would it take?

The sentiment picture told me that a short squeeze was definitely a possibility, as it was in the euro.

And that is why I wanted to see what form the pull-back would take – it could tell me a lot about the prospects for a more substantial rally phase, or whether the market was headed lower.

The initial move up was either wave 1 or an A wave, and the dip was either a wave 2 or a B wave. In either case, a rally was  coming – I had to look for a long entry.

The only event that could spoil this picture was a move to new lows.

I noted that the pull-back looked corrective because the mini waves overlapped in a stair-step fashion, which is typical of a correction.

So, armed with this observation, I looked for a long trade either at the Fibonacci 62% or the 78% level (which was my line in the sand) and either would provide a low-risk opportunity. Remember, I am only interested in low-risk trades where I can place a close protective stop.

Below is the result of my analysis. The Fibonacci 78% level held and the market proceeded to take off like a rocket (in the same manner as the Draghi bounce). This action is impulsive, and suggests there is more to come. My trade was entered near the 1.50 level:

GBP/USD forex spread betting chart

But for now, I cannot rule out either of the two labels – are we in a third or a in C wave?

Note that the rally hit the Fibonacci 50% level at 1.52 – a natural place to take at least partial profits of around 200 pips using my split-bet strategy. And the large momentum divergence is a clear warning that the C wave interpretation is very much in play. With that in mind, I have moved my protective stop on the remaining position to break even.

I always keep an eye on the big picture – and here it is:

GBP/USD forex spread betting chart

The correction to the major bear market from April to the high in June and now to the recent low is very complex – and a nightmare for Elliott wave technicians!

But I can say that the decline off the summer’s highs appears very corrective with highly overlapping waves (see above), which could indicate a more substantial rally phase is in prospect.

Also, there is a budding wedge pattern forming and of the upper line can be breached, a rally would be on. Incidentally, next week I will show some great recent examples of wedges and how you can trade them.

Note the large positive momentum divergence – another clue that a major turn may be at hand where a test of the summer’s highs is a distinct possibility.

I am prepared for anything – I have a banked profit and a break-even trade that is also in profit. And that is all a trader could possibly want!