The Exciting Risk/Reward Opportunities That Are Finally “Coming Out to Play” After Months of Playing on the Sidelines.
For the first few weeks of the new year, I've been saying that it's probably safer to stay on the sidelines of the FX markets in a capital preservation mode. However, I'm now seeing some high-conviction trades as the market sorts itself out and begins offering some good risk/reward opportunities.
Today I’ll go through every promising trade and my thinking behind each one, starting with EURUSD (the Euro versus the U.S. dollar).
The first thing I do when I open any chart is to make an assessment. I ask myself ‘what’s the phase (or direction, or condition) of this market?’. Everything else flows from that.
And in this case, it’s not hard to figure out. Going back several years, EURUSD has dropped from 1.70 in 2009 to about 1.08 currently. It’s clearly in a well-defined primary downtrend.
Once we identify the major trend, it’s time to look for certain patterns that support that trend. With EURUSD, that pattern is the first double top...
Normally a double top is a reversal pattern. And here it reversed EURUSD’s attempted rally out of the downtrend. You can see that once EURUSD crossed the 1.15 neckline of that double top, it’s been downhill ever since. EURUSD has continued in the primary direction, albeit quite slowly until very recently.
What’s changed now to make me so bearish on EURUSD?
EURUSD has just formed another, more recent double top. After penetrating the latest neckline, the pair made multi-year lows. To my mind, EURUSD will be seeing 1.04 – 1.06 (previous support) quite shortly.
So even though EURUSD has been a frustrating pair to trade for the last several weeks, it’s now opening up new territory to the downside. In fact, there's nothing standing in the way of EURUSD falling below recent support at 1.04 – 1.06 to the 1.02 level and perhaps ultimately to parity (one-to-one) with the U.S. dollar. Any rallies in this pair should be shorted for the ride down.
Here’s another strong short candidate: in this chart, I'm looking at AUDUSD (the Australian dollar versus the U.S. dollar.
A few weeks ago, it looked like the dollar was stalling out with some support appearing in this pair and even a small rally.
However, I couldn’t make a case for a sustainable move higher because (as with EURUSD) the primary direction in AUDUSD is down and the governing pattern is a double top to reinforce that trend.
Over the last five years, AUDUSD has fallen from 0.95 to 0.67 today. And since the neckline of that double top was broken, AUDUSD has established a pattern of lower highs. Any rallies have been nothing more than dead cat bounces within a well-defined downtrend line.
There’s nothing to my mind that suggests AUDUSD is about to reverse. Any rally that appears now should be shorted. I think we’re going to see new lows in AUDUSD soon. As with EURUSD, short any rallies and wait.
Now let’s examine USDJPY (the U.S. dollar versus the Japanese yen).
The governing pattern in USDJPY is the double top at 126 five years ago where it made an all-time high, backed off, retested the high and formed a perfect M top pattern.
This M top was also part of a head and shoulders pattern since there was a lower high on each side. This was a decisive reversal pattern that spelled the end of USDJPY’s earlier rally. Once USDJPY crashed through the neckline around 116, its downward path was set.
This pair has since made only lower highs. The resulting descending triangle means USDJPY is still bearish. If it were to break out from the triangle decisively, I would revise my bearish opinion.
But it hasn’t, and so I’m not. In fact, I’m more bearish than ever due to the chance that history will repeat here.
On the chart, I’ve pointed out not one but two mini-double tops. Each one has a narrow range bar defining part of the second top.
Note how USDJPY plunged after the first instance. It dropped all the way down to the neckline at 104.
I think the same thing is likely to happen again. We’re seeing a double top forming at resistance with a narrow range bar that indicates all the upside energy of the recent rally has been dissipated.
A quick word on narrow range bars: they’re defined as a bar with a very small range from the high to the low in comparison to other recent bars. It’s especially important if it shows up after a sustained trend as this one has.
Since 109 has been a brick wall for this pair for several months, I think the path of least resistance is down. The narrow range bar indicates the bulls have no more power left to drive USDJPY higher.
That last time around, I made 650 pips on this pattern before with several different USDJPY short positions. I’m hoping to do that again.
The nice thing about taking a trade after a narrow range bar has formed is that you don't have to take a large amount of risk. Your stop goes above the narrow range bar. Your profit target goes near the neckline above 104.
If USDJPY breaks down below last week's low, that should be the final catalyst for a significant move lower. And it's not going to cost you a whole lot to find out.
Remember, every trade isn’t going to be perfect. But USDJPY offers a terrific risk/reward opportunity right now. Whether it's a few days or couple weeks from now, this pair looks very likely to drop and retest earlier lows several hundred pips below.
Now let’s look at a non-USD pair: GBPNZD (the British pound versus New Zealand dollar).
This is effectively an upside-down version of the USDJPY chart. Just like there was a double top to act as the governing pattern in USDJPY, there’s a double bottom to play the same role for GBPNZD.
That double bottom has set this pair on a long run higher, one with lots of volatility but also lots of profit to be taken.
Note that after the price first broke through the neckline, it retreated to the neckline and put in a rounding bottom which acted as the final setup for the launching pad we see now.
You can see that despite all the recent volatility (this pair has dropped as much as 1,000 pips from its recent highs) it’s still 4,000 pips off the lows at that double bottom. And now I think GBPNZD is poised to go a lot higher, especially when you realize it’s been hovering at the neckline of its most recent double bottom pattern.
Just like there was a retest of the earlier neckline, there’s been a rest of this one too.
What’s more, GBPNZD has finished two narrow range bars in a row. The highs and lows of the last two weeks are within the high and low of the bar that preceded them. Two narrow range bars in a row are even more ominous that just one (as we just saw with USDJPY).
In fact, I’m convinced GBPNZD is compressed and ready to explode in the direction of the major trend (up).
To help understand this, I like to use the metaphor of a beach ball held underwater. You push it down and hold it, and then what happens after you release it? The ball rockets into the air as all the energy gets uncorked and this is what I foresee happening quite soon in GBPNZD.
To me it's a question of not if but when this pair takes off.
So I feel the risk here in GBPNZD is not being long. Just be mindful of the volatility here, which can be severe. If you put an 80 pip stop or a 180 pip stop it's probably not going to be enough.
Even when this pair drops 500 pips, it’s not really a major move on this chart. When you view GBPNZD in the context of the last couple of years you can see that it's just consolidating at its latest neckline. The good news is that the longer this pair consolidates, the greater the compression and the larger the explosion that’s going to erupt when it finally takes off.
That’s why I’m holding on to my positions here with confidence. The double bottom governing pattern and subsequent price action is going to get me to my (much higher) destination. I just don’t know when … yet.
Now for XAGUSD (spot silver).
Spot silver is another great example of how the governing pattern wins out over countertrend patterns or fake out patterns. Very often the market throws different patterns at us and it's our job to discern which is the real one.
In my mind, silver’s major governing pattern remains the very large double top. Price action after that double top traced out a bearish descending triangle. Then the price collapsed below the neckline of that triangle and silver has gone nowhere special.
In fact, silver hasn’t even come close to the $28 level of the neckline. So the double top remains the governing pattern until proven otherwise.
If the market can crack above $20 and make higher highs then all the multiple lows at $14 could be seen as laying the groundwork for a move higher. But it’s not happening yet.
I’m not sure that a big move is imminent, either. If a market's getting ready to move, it shouldn't give you many opportunities at the same level to a buy (or sell) that market. If $14 really is a bottom worth trading, then why has silver given us five years and six opportunities to get in?
A good market for trading will give you just a couple of chances and then it’s gone.
The next few weeks will tell us if silver is finally ready to break out and launch a new bull or if it's condemned to be rangebound for a while longer. I’m not inclined to chase any silver rallies right now.
I want to see further confirmation above the $19.50 or $20 area before I’m willing to place a trade here.
Now when we look at XAUUSD (spot gold), it looks very different than the languishing silver chart.
In fact, there’s a double bottom and then a complex inverted head and shoulders numerous shoulders on each side. Once gold broke out of its long basing formation above $1,380 It’s been going higher ever since.
Gold formed a pennant continuation pattern along the way. This was a wonderful opportunity to go long on the breakout. Right after gold escaped the confines of the pennant, I bought it at $1,479 and rode it to $1,607. That was a very nice $125 profit.
Since then gold has been consolidating, although gold still looks like it’s ready to go higher.
I’m basing that idea without considering the gold/silver ratio, by the way.
That’s because I think it's a mistake to look at correlations. You must look at each instrument on its own merits and evaluate the risk/reward opportunities of individual price action. After all, correlations could be stretched to extremes for a couple of months without any consideration for what’s “normal” for that correlation.
For example, we might see a fast move in gold, perhaps another a hundred dollars or so, before silver either drags it down or finally decides to play catch-up. It’s not worth missing such an opportunity just because of a stubborn fixation on a correlation.
As for gold, I’m not ready to go long with a trade yet. I’d like to see if gold can set new highs or if it’s going to slide sideways after re-testing its recent lows. Time will tell and I’m on the sidelines until I see a clearer signal.
Now let’s compare the three major U.S. stock indexes, starting with the Dow Jones Industrial Average (DJIA)
The DJIA barely poke through its all-time high last week, whereas the S&P and NASDAQ made much more definitive breakthroughs.
You can see how the NASDAQ powered through to a huge new high:
And the S&P500 was nearly as impressive:
Right now the path of least resistance in all these indexes is higher.
I do feel that at some point these indexes will enter a consolidation period, of course. But it’s certainly foolhardy to get in front of these freight trains by taking a poke at the short side.
But let’s say you’re feeling brave. The one instrument I would look at is DJIA. Here’s the short-term short thesis:
There are two compression bars at the top of the DJIA’s trading range. For two bars in a row, the highs and lows have finished inside the earlier longer day. That suggests the rally is running out of energy.
Since the market can't push through to new highs, therefore a quick counter-trend movement becomes possible. I could very easily see the DJIA retesting its support area within the context of the bull market.
If you want to test this idea, put a sell stop under Friday's low and give it a spin.
Just remember this is still a bull market. If you get any movement to the downside in any short position here, don't overstay your welcome.
And remember that anything can happen. The DJIA could make new lows and then explode to new highs immediately afterward. So keep your risk low and your wits about you. I’m only mentioning this because I keep getting questions about shorting the stock market. This potential opportunity in DJIA is the only one I’ve seen, even though I have no intention of taking such a trade myself.
And that’s it for this week!
To recap, I’m very bearish on EURUSD, AUDUSD, and USDJPY. I’m very bullish on GBPNZD.
I’m moderately bullish on gold but not in any long positions as I’m waiting for new highs. I also think we could see some short-term weakness in the DJIA stock index despite the extreme bullishness in the U.S. markets right now.
I wish you a happy and healthy trading week,
Mark "GBPNZDKnocking" Shawzin