Sterling’s on the way down – but the road won’t be straight

Sterling has taken a pounding of late, moving from a high of 1.58 on 25 August to a recent low of 1.5160 last week – a considerable drop of over six cents in less than two weeks. This unrelenting decline has occurred in the face of generally positive sentiment towards the UK economy, which has reported decent GDP growth combined with low unemployment levels.

So, why the sharp decline in the pound versus the dollar, otherwise known as ‘cable’? This break must have surprised a lot of analysts who believe it is the news and fundamentals that drive markets. But I am sure they can come up with some plausible rationalisation for it – in hindsight, of course. But looking back doesn’t accumulate profits, so it is a fruitless exercise.

I can offer a different explanation for the decline in GBP – and it lies in the Elliott waves and Fibonacci levels that direct the size of the waves. In fact, GBP/USD offers a textbook case study in how to use basic Elliott wave theory and Fibonacci levels to forecast likely outcomes – something which very few news-followers can do.

A £27,000 trade on sterling

Below is the daily chart going back to 2013. The stand-out feature is the almost non-stop decline off the July 2014 high at 1.72 to the plunge low of April at 1.45. Now that was a very decent swing! In fact, at only £1 per pip, the profit on that one could have been £27,000.

But note that the decline occurred in five clear waves and at the low, there appeared a stunningly large-momentum divergence:

GBP/USD spread betting chart

My rule, when such a large divergence is presented, is to expect a very sharp counter-trend move that should take the market back by a Fibonacci 50%, or even 62%. These are worth trading from the long side.

And because I had a completed five down in April, I know what to expect – a very rapid and sharp three up – and that is precisely what occurred. That much was written in that chart in April. But how high could the resulting A-B-C rally carry? For that, I needed my trusty Fibonacci tool.

The market rallied hard out of the gate and quickly climbed to the first rally high, dipped and then surged to complete my A wave, which fell shy of the Fibonacci 50% level. But because I was expecting three up, I believed the wave down would be my B wave – and that was traced out (also in three sub-waves, as marked):

GBP/USD spread betting chart

Finally, the market gave me my C wave rally to a precise hit on the Fibonacci 50% level (also in three sub-waves) to confirm my analysis. Then the market turned back down. Remember, the Fibonacci 50% and 62% levels are the most common retracements after a strong five wave move.

To recap: all I did was to note the clear five down to April and then the momentum divergence at the low. I then applied the Elliott wave rule that states that after a five down comes a three up. It is what I call the five/three rule. I forecast this rally in early April and it lasted about ten weeks – plenty of time to plan my next move. And I did not require any input from the news.

I got the textbook decline I expected

After the wave C high, how did the market develop – did it decline, as Elliot wave theory predicts?

GBP/USD spread betting chart

Yes, it did – and then I could draw a nice tramline pair as the market rallied off my lower tramline in July and August – and right into the Fibonacci 78% level:

GBP/USD spread betting chart

The 78% resistance level is a deep retracement and is commonly found at major turns. Knowing that the market had completed the previous A-B-C relief rally, and was very likely in a downtrend, any further rally attempt was an opportunity to position short. That accurate hit offered a classic short trade – and at very low risk.

The market confirmed the downtrend by moving down hard off that top and within three days had broken the lower tramline. This morning, the market has rallied off Friday’s low, but was there any way of estimating where this turn-around would occur?

Cable rallied at an important level of support

The market declined to the Fibonacci 50% level and overshot it slightly. But it made the turn right at support from the previous June low. The market evidently thinks that level is very important. So today, the market is attempting a rally to kiss the lower tramline:

GBP/USD spread betting chart

All along, there have been several excellent low-risk trades available simply by following the simple tramline methods.

But in terms of the long-range outlook, the five down/three up pattern points to an eventual resumption of the major downtrend, but as we have seen, sharp rallies are to be expected. It won’t be straight down – but by monitoring the Elliott waves and Fibonacci levels, you can keep one step ahead of the markets.