How I predicted the ‘Draghi drop’

I am away this week for a short (and much-needed) break. But I didn’t want to leave you in the lurch! I wanted to remind you of some great tips I hope will help improve your trading. I will return on Wednesday 23 December with a review of what effect the Fed announcement of 16 December is having on markets.

The wedge is one of my top trade setups

Recently, I have spotted a whole host of wedge patterns in many of my favourite markets. And that observation has enabled me to get on board some very juicy trades at an early stage. Those patterns tell me that many markets I follow are ready to change trend.

So let’s review what a wedge is. Some technicians call it a diagonal, but when it appears following a lengthy trend, it usually signifies a trend reversal, especially when there is a notable momentum divergence. A wedge pattern within a congestion zone is not a good predictor of anything. I only take a wedge seriously after a trend has been established for some time.

And when I see a wedge after a long trend, I automatically look out for signs of a reversal. For a trend to change, most speculators must be lined up in the direction of the old trend. After all, it is their actions that have driven the market in that direction in the first place.

And to change that trend, those same speculators must begin exiting their positions – and that is often an overwhelming force if there are enough of them (Commitments of traders (COT) data can help there).

This means that when I see a wedge pattern forming, I always refer to the sentiment picture contained in the DSI (Daily Sentiment Index) and COT data. And when it is lopsided (as it has been in the euro and gold in particular), I know I am onto something.

The Dax German stock index

In common with my main trading vehicles the Dow and the FTSE, I also follow this major index. It is the best European index that reflects changes in the eurozone economy and also the euro. On ‘Draghi Day’, Thursday 3 December, it was hit very hard and lost about 4% that day.

But the move was flagged beforehand by anyone who drew in the very clear wedge pattern:

Dax spread betting chart

This pattern came after a substantial rally, thereby qualifying it as a likely ending pattern. The market had convinced itself that Draghi was going to unleash his Big Bazooka and ran the market up to a new high on December 2, expecting a massive liquidity boost. Note the large momentum divergence into the high – a sure sign the rally was running out of puff.

But surprise, surprise – after the traditional wave 2 kiss on the underside of the lower wedge line, the market entered a staggering scalded-cat bounce down to the Fibonacci 38% support level within a couple of hours.

There were two terrific short trade entries – the first on the lower wedge line break and an even better one on the kiss.

And this is a great example of how to set price targets following a rising wedge break. The general rule is that when the market breaks out of the wedge to the downside, the minimum price target is back to the region at the start of the wedge pattern – in this case around the 10,600 area. This lies right on the Fibonacci 38% support level which the market tested.

The EUR/USD

I have shown this chart before, but it is a classic example of how to trade the wedge. In this case, it is a falling wedge, but the same rules apply.

EUR/USD spread betting chart

This pattern comes after a lengthy decline and so qualifies as a candidate for a trend reversal. The wedge lines are very accurate, especially the lower one which has at least eight accurate touch points. This large number is very unusual – and I therefore treat it with a great deal of respect!

Combined with the extreme bearish sentiment, this was a market ripe for a major surprise. Here is the COT data as of 1 December showing the trend-following methods used by most speculators: 

Non-commercial Commercial Total Non-reportable positions
long short spreads long short long short long short
(Contracts of EUR 125,000) Open interest: 582,253
Commitments
79,343 251,373 75,625 375,821 158,556 530,788 485,554 51,465 96,699
Changes from 11/24/15 (Change in open interest: 24,274)
999 6,711 9,214 12,446 5,239 22,660 21,163 1,615 3,111
Percent of open in terest for each category of traders
13.6 43.2 13.0 64.5 27.2 91.2 83.4 8.8 16.6
Number of traders in each category (Total traders: 275)
65 124 79 58 67 168 227

 

Just before the huge spike up, hedge funds and the small speculators had added even more short bets to their already hefty pile. The result: small speculators are two to one short and large speculators are over three to one short. That is a disaster (to the bears) waiting to happen.

And at trend reversals, trend-following methods completely break down – to the advantage of alert traders.

The low-risk trade was to set resting short sales just above the upper wedge line. Note that there was no kiss back to this line. If you were waiting for one, you would have missed out. Sometimes, we get a kiss and sometimes not – I haven’t found a simple rule that can indicate whether a kiss is likely or not.

And my minimum price target was hit almost immediately – at the start of the wedge.

So look out for wedges – they can offer you some very fast profits.