Trading the pound against the US dollar

The GBP/USD cross has traded in very wide swings recently. The market chatter has been all about interest rates. UK inflation (as measured by consumer prices) has been running at twice the Bank of England’s 2% ‘target’. So the pressure is on to raise official interest rates as the standard policy response.

On the other hand, the economy is still trying to recover from the 2008 recession, and higher rates could well hurt the recovery. We are on a knife-edge, and the GBP is swinging one way and then the other as sentiment shifts.

But, as ever, we should ignore these arguments and see what the charts are telling us. If ever there was a time to concentrate on the technicals, this is it. I cannot stress enough that being ‘married’ to a particular macro-economic view can lead the trader down the garden path.

Human nature being what it is, many of us will stubbornly cling to a losing situation for too long, even in the face of what the market is telling us.

What the USD/GBP chart tells us now

OK, so what is the GBP chart telling us? Here is the daily chart going back to last September. This shows the rally from the $1.53 area to the $1.63 area in November, then back to $1.53 in December, and the current rally back to the $1.63 level.

Now these ten-cent swings represent a move of £1,000 on a £1-a-point bet. That’s not the sort of thing you want to be sitting through as a long-term trader! The only rational way to play these swings is in the short-term, and this is where the Fibonacci system comes into its own – helped along by Elliott wave analysis.

GBP/USD spread betting chart

(Click on the chart for a larger version)

The dip from the November high to the December low shows a three-wave pattern. This is a corrective to the main trend, which is up. We should therefore expect another rally here.

Now let’s take a look at trading so far this year. This rally has occurred in five Elliott waves, complete with a strong wave 3, and a negative divergence with momentum (green arrows) into wave 5. Here it is in finer scale:

GBP/USD spread betting chart

(Click on the chart for a larger version)

I have drawn tramlines for both the dip and the rally. When the upper tramline (for the dip) was broken in mid-January (indicated by the second red arrow), that was a clear ‘buy’ signal. Note the positive divergence with momentum (green arrows) at the low – another tell-tale signal the trend was about to change.

Another five-wave pattern is completed

I have drawn my tramline pair. Note the ‘overshoot’ at wave 3. When the market overshoots a tramline and then falls back inside, it expresses a temporary over-exuberance that is quickly corrected. We see this effect many times, especially in third waves, as they are usually the strongest.

GBP/USD spread betting chart

(Click on the chart for a larger version)

Now, since we have completed five waves up, the next trend will be down. We should be looking to take profits on longs and looking to short. After the market hit the upper tramline on 3 February, the market started a decline that took it to a break of my lower tramline on 11 February (indicated above by the box marked ‘Break!’). That was a good shorting point.

However, if you like to short only on rally peaks, there is an even better place. Here is the hourly chart, from the start of February:

GBP/USD spread betting chart

(Click on the chart for a larger version)

As expected, after the break, the market rallied to try to get back between the tramlines, and on 15 February, it made it (indicated by the red arrow).

Using Fibonacci to pin-point entry points

Now we can bring in our Fibonacci tool to give us an idea how far the rally will likely carry.

My high pivot is the wave-5 high (from 3 February) and the low pivot is the recent low (at 11 February). The market carried to the Fibonacci 61.8% retrace, tried to move above it (on a minor negative divergence with momentum as shown by the green arrows), but then failed.

The plunge down on 16 February was overdone, and the market is currently in rally mode.

Again, if we are in a new down-trend, we must ask: how far will this current rally carry?

Again, we bring in our Fibonacci tool and this time our pivots are the most recent wave extremes:

GBP/USD spread betting chart

(Click on the chart for a larger version)

The market has reached the Fibonacci 61.8% retrace level, which would be a good place to short using a close stop. Normally, the market will at least pause at this level, giving us an opportunity to move stops to break-even using my break-even rule.

If the market rallies a little more to the Fibonacci 76.4% level, we can enter short trades again, placing protective stop just above the $1.6185 high for another low-risk trade, then moving the stop to break-even as quickly as possible.

If you look at the hourly chart from 2 February, there are many Fibonacci relationships between the minor waves which could be used for short-term trading, each giving swings of 50-80 pips.