By Pinchas Cohen
Dollar traders received the best economic news in a long time yesterday, when US second-quarter GDP showed that the economy grew 3.0 percent, the fastest in two years, beating the 2.7 percent forecast. However, dollar investors have demonstrated this year that they are very sensitive to political risk. Unlike equity traders who remain less influenced by political turmoil, the dollar remains more threatened by the lack of unity in the US administration.
The latest uncertainty weighing on the dollar concerns the possibility of military action in North Korea. US President Donald Trump has said that all options are on the table to contain Pyongyang's bellicose posturing, but he's also tweeted that talking is not the answer. In stark contrast, both his Secretary of Defense, James Mattis, and his top diplomat, Secretary of State Rex Tillerson, continue to pursue diplomatic alternatives.
While dollar investors may allow themselves a measure of consolation that Trump’s two most important secretaries may be keeping him in check, the blatant inability of the administration to get its act together induces unlimited potential for uncertainty. Therefore, the only dollar traders who should be happy about the 1.62 percent upward reversal from Tuesday’s lowest price since January 15, 2015 are, ironically, bears, as it allows them a better entry point for a short position.
No Bottom Yet
The reversal since Tuesday should not be considered a bottom. Rather it's merely a return-move to retest the bearish rising flag, completed with the downside breakout last Friday.
The dollar broke out of a previous continuation pennant on July 14, beginning another leg down, which dropped 3.40 percent, or 325 points. That move makes up the “pole” of the latest continuation pattern, the rising flag. The flag is a period of consolidation, in which investors “take a breath” after a sharp move.
Investors who have made a lot of money cash out, while new investors—attracted by the strong move—want to join in, hoping for profits of their own. When a financial asset’s price makes a significant move, a correction or consolidation provides the opportunity for new investors to get in. This is considered important for the sustainability of the move. The more a price changes, the higher the profits for investors on the right side of the trade, and the higher the expectation of a take-profit, which would naturally cause the price to correct or consolidate.
Therefore, once “tired investors” leave the trade, the expectation is that the new traders, who just joined during the consolidation or correction, also want to profit. As such, they would not exit the position but stay in the trade for that profit, allowing the next leg down.
The reason a consolidation provides a higher probability of a continuation of the previous trend is that it demonstrates a roughly equal number of new traders to the ones leaving who would be the ones taking the next leg. A correction shows more traders on the side of the correction than the side of the original trend – which is why the price moves in the opposite direction of the trend. In this way, a correction may turn into a reversal.
Additionally, some investors may think the price has moved too far, too fast and are waiting to see which way the wind blows next.
The breakout triggers stop-losses of traders on the wrong side of the market and causes them to unwind their losing trades. This propels the price in the breakout move, in the direction of the trend prior to its interruption. The first move attracts more investing in that direction, kick-starting momentum for that trend.
The flag breakout point was 93.20, three points above today’s high, as of 4:47 EDT, while a return move has the potential to return to the pattern’s bottom, at 93.36 per today’s angle and rising.
Trading Strategies
Conservative traders would wait for a full return-move, until it actually touches the pattern (which may be up to 93.50) and confirms its resistance.
Moderate traders would wait on a short – either for a full return-move, until the price touches the pattern, or at least a confirmation of resistance with a decline. One such confirmation would be a close beneath the key 93.00 level.
Aggressive traders would be satisfied with the 1.62 percent correction and rely on its proximity to the breakout price level and the short-term downtrend line since August 16 (dotted red line) and enter a short now, with a stop-loss anywhere from 93.50 up to 94.14, which are the August 15 and 16 highs. (Beware, however that the price is unlikely to return to that high.)
Very aggressive traders might go long, hoping for a continued correction until the price touches the pattern on yesterday’s exceptional economic news along with no additional geopolitical risk. Then, upon reaching the pattern or signs of resistance, they will short the dollar according to the specifications above.
Amateur traders will get excited and jump in without a plan. They’re not being aggressive – they’re gamblers. However, there are no free lunches and no quick, easy ways to make money legally and morally. Trading is hard work and you’re going to get out of it only what you’re willing to put into it.
Price Targets
The minimum target price is the length of the flag’s pole, which is the previous move from the high of July 14 at 95.83 to the August 2 low with 92.55, providing an expected 328-point move from the 93.25 breakout, with the price target of 89.97. However, with all due respect to target prices, investors should take into account other factors that might affect supply and demand.
First, the 90.00 level should provide a powerful support, as many traders would expect there to be one. Since traders want to beat others, support might surface even higher than exactly at 90.00. This self-fulfilled prophecy would attract a lot of demand, supporting the price.
Second, traders should be cognizant that while Tuesday’s low penetrated a two-year trading range for the first time, it failed to close below it. That demonstrates demand. The first test would be Tuesday’s 91.62 low. Depending on your entry point, you need to calculate your potential reward and incorporate that with your acceptable risk, namely the placing of your stop-loss.
If your entry point is at 93.20, and your target is 91.62, that’s 158 points. Your risk, therefore, should not be more than a third – 52 pips above 93.20, at 93.72, which should give you plenty of buffer in case of a fuller return-move.