Why the euro could surprise a lot of traders

It’s been a while since I last covered the EUR/USD – a month ago, in fact. It’s just that there’s been so much terrific tramline, Fibonacci and Elliott wave action in gold and the Dow recently that the euro’s been crowded out.

But today could be a critical time for the euro, as I’ll explain a little later. Let me set the scene.

A month ago, the euro was finishing up a wedge-shaped consolidation phase and was butting up against the major tramline on the daily chart:

EUR/USD Forex spread betting chart

(Click on the chart for a larger version)

The question then was: Will it or won’t it?

In the end, the lower wedge support line broke. Not surprising, given the weight of huge selling, induced by the bearish noises emanating from the eurozone particularly.

So how’s the euro looking now? This daily chart shows the situation this morning:

  EUR/USD forex spread betting chart

(Click on the chart for a larger version)

A sensible policy would have been to set entry sell-stops just below the wedge line around the 1.30 area. Being short is definitely the correct stance, so far.

You can see that the decline away from the wedge has been very sharp and relentless. The fall to the 1.25 area has also taken it to below January’s major low, which confirms the major downtrend.

Everyone is short the euro

But as the decline gathered pace, the good ship euro is listing heavily to port, as every trader and his dog has rushed to the bear side! The euro is rapidly losing what friends it had on the starboard side. If this keeps up, the ship will capsize.

What trader wants to be long the euro? Surely, everyone knows the eurozone will break apart soon. Catastrophe! It’s certain, isn’t it? The story is all over the world’s media. Who could possibly disagree?

Well, if I am to retain my contrarian credentials, I need to look for reasons to cover my shorts – and even, dare I say it, go long.

And first off, here is one reason – the latest Commitments of Traders (COT) data on the make-up of the futures market:

Non-commercial Commercial Total Non-reportable positions
Long Short Spreads Long Short Long Short Long Short
(CONTRACTS OF EUR 125,000) OPEN INTEREST: 356,674
COMMITMENTS
38,475 212,344 1,668 286,563 66,730 326,706 280,742 29,968/  75,932
CHANGES FROM 05/08/12  (CHANGE IN OPEN INTEREST: 35,637)
2,453 32,338 220 33,965 -2,982 36,638 29,576 -1,001 6,061
PERCENT OF OPEN INTEREST FOR EACH CATEGORY OF TRADERS
10.8 59.5 0.5 80.3 18.7 91.6 78.7 8.4 21.3
NUMBER OF TRADERS IN EACH CATEGORY (TOTAL TRADERS: 190)
29 89 16 48 42 88 136

Recall, the non-commercials are the large speculators – hedge funds, bank trading desks, and so on. The non-reportables are the small traders.

Just compare the relative holdings of the large specs – the bears have 5.5 contracts to each bull. And similarly with the small specs – the bears have 2.5 contracts to each bull.

And note the week’s changes – a 15% increase in large specs bearish bets, and an 8% increase in small specs bearish bets.

What we can see is that traders large and small filled their boots with bearish bets in the week ending 15 May.

If my memory serves, this is the identical set-up at the $1,920 gold top last summer. Hmm.

And as the market has fallen since 15 May, we can be assured this situation is even more extreme.

Five reasons there could be a bounce in the euro

To my mind, this data proves the extreme bearishness in the market – and could possibly be the full extent of it.

But as we all know, surely, just as one opinion prevails with such overwhelming force, that is the time the market usually surprises. Remember, markets exist to punish the majority.

The bears must be getting really comfortable with their positions as the market has fallen by over five cents in a month. That is long enough to become complacent, especially with the chorus of doom and gloom getting louder seemingly by the day as the day of reckoning approaches.

This is a classic herding behaviour.

So, at this point, I like to look at the charts. Here is the 15-minute chart as I write:

  EUR/USD forex spread betting chart

(Click on the chart for a larger version)

Several points:

1. Positive momentum divergence (green arrows) at yesterday’s low – Bullish
2. Possible A-B-C pattern forming and in C wave – Bullish
3. Tramline break – Bullish
4. Can there be any new shorts left out there? Bullish
5. The Dow is currently finding support, so the euro should follow – Bullish

That is why I placed protect-profit buy stops in the market this morning. Where, I hear you ask? Let’s zoom in:

  EUR/USD forex spread betting chart

(Click on the chart for a larger version)

This is the 15-minute chart showing a nice rally above this morning’s minor high marked by the grey bar in the 1.2550 area.

With that move, I took a substantial profit from my short trade, and I am now long and protected by my close stop.

What should I expect to see now? With the market working its way through the overhead resistance from yesterday, I expect some backing and filling this morning.

But I expect to see a quick move up to my Fibonacci/tramline target area (pink box). If this occurs, that would place yesterday’s congestion zone now as support – previously resistance. This is the key event for my bullish case.

If the market follows this roadmap, a further rally to the 1.27 area becomes feasible. With the market so heavily short, very sharp rallies become entirely probable. This move could surprise a lot of traders.

We shall see.

• If you’re a new reader, or need a reminder about some of the methods I refer to in my trades, then do have a look at my introductory videos:

The essentials of tramline trading

Advanced tramline trading

An introduction to Elliott wave theory

Advanced trading with Elliott waves

Trading with Fibonacci levels

Trading with ‘momentum’

Putting it all together

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