THE METHODOLOGY DURING HEIGHTENED VOLATILITY
During the infamous Financial Crisis of 2007-08 and its aftermath, many trading strategies began losing money because of the dramatic increase in market volatility. Methodologies that functioned with very few hiccups before the Crisis, were no longer profitable and could not adjust to the new scenarios that unfolded over subsequent years. Nevertheless, the methodology outlined in the Trading Manual held firm despite the market turbulence experienced during that time.
The methodology uses Price-Action patterns on the Daily & 4 Hour Charts to identify high probability trades that provide between 100 and 200 Pips. The setups that provide these opportunities exist during normal periods of market activity as well as heightened periods of volatility coinciding with safe-haven investment flows.
The European Sovereign Debt Crisis and the 2007-08 Financial Crisis stand out as strong examples of factors that lead to increased volatility. Since the formation of consolidation tends to characterize these market conditions, we can look at examples of how the strategy would have been applied to this type of setup. In each of these examples, explanations of the technical factors that would justify entry and exit are provided.
Consolidation and breakouts from consolidation are typical market patterns seen throughout the currency market. Consolidations are periods of indecision and low market liquidity in which traders are uncertain as to how a currency pair will be affected by a major, underlying economic factor. The larger the consolidation, the more significant is the underlying scenario that is unfolding. Whenever this issue finally comes to light in the form of a single or series of news releases, a sharp breakout at the Support or the Resistance of the consolidation will take place. The direction of this breakout will be in favour of the currency that benefits from the reaction to the news by investors and traders.
The graph below shows the large Pennant consolidation that was formed for the EURO JPY pair between July and August 2011. The Pennant coincided with one of the periods of the European Sovereign Debt Crisis in which Greece was believed to be on the brink of exiting the eurozone due to its severe fiscal and economic challenges. It was also feared that such an exit would have a ripple effect that led to other countries leaving the Union as well.
FIGURE 1- EURO JPY – DAILY CHART
In July, Greece was eventually provided with the assistance it needed to resolve its crisis and prevent contagion among other European countries. However, the market went back into crisis mode in August when European Commission President Jose Manual Barros warned that the Sovereign Debt Crisis was spreading beyond the periphery of the eurozone. Yields on government bonds from Spain and Italy rose sharply as investors demanded larger returns to lend to these countries. As a result, the European Central Bank said it would buy the government bonds of these countries to reduce their borrowing costs, amid concerns that they would be also be hit by a crisis.
Adding fuel to the fire of market uncertainty were developments taking place in the United States- the epicenter of the 2007-08 Financial Crisis. In August, Standard & Poor’s made a landmark decision to downgrade US sovereign debt from its prized AAA rating amid a political stalemate over the country’s debt ceiling. Citing a lack of confidence in the country’s ability to reach a political solution, S&P lowered its long-term sovereign credit rating and said it was pessimistic about future decision making. The historic move by S&P reflected the rating agencies’ push to become more proactive than they were during the financial crisis.
Within this context, a breakout short from the Pennant to reflect the selling of Euro and the safe-haven buying of the Japanese Yen was inevitable. This began on September 8, 2011, with a bearish candle signal on the Daily Chart.
FIGURE 2- EURO JPY- DAILY CHART SIGNAL
As the currency pair presented this trading opportunity, entry took place immediately, with the target set for 200 Pips as per the methodology.
FIGURE 3 – EURO JPY – DAILY CHART RESULT
The target was hit after few days for 220 Pips, with slippage taking place to capture a few extra pips. This exit point also coincided with the appearance of Tweezer Bottoms, which are signals that indicate the end of a Breakout.
During this time, a Range had been formed on the Daily Chart of the USD CAD pair that also reflected the pessimistic sentiment of the market. This Consolidation would also be broken to reflect the safe-haven buying of the US Dollar.
FIGURE 4 – DAILY CHART- USD CAD
The signal to start the breakout came on September 21, 2011 in the form of a bullish candle breaking Resistance. That signal coincided with statements from the International Monetary Fund in which it forecast slower growth in the UK and the US and warned that the Sovereign debt and banking sector problems in the euro area had proven much more tenacious than expected.
FIGURE 5 – USD CAD – DAILY CHART
Once again, entry took place on the same day of the signal, with the target of 200 Pips being set. This target was successfully hit a few days later.
FIGURE 6- USD CAD- DAILY CHART RESULT
The exit point for this trade took place at the area where consolidations normally end. This area is referred to as the Breakout Equivalent and is a concept that is applied to all consolidation types. Once this is correctly identified – based on certain parameters related to the consolidation in question- exit points for trades can be more confidently established. This allows the trader to be able to avoid the volatility and the pullbacks that normally follow the end of these breakouts.
The 2008 Financial Crisis also provided opportunities that were clear, strong and in sync with the types of setups that are targeted for trading. These setups formed part of the back-testing of the methodology and confirmed its robustness during these tail risk events. Consolidations were also formed during the early stages of the crisis, but these were much larger given the severity of the situation that was unraveling.
TRADING WITHIN CONSOLIDATION
Trades can also be executed within Consolidation boundaries instead of waiting until they are broken. To justify trading within these volatile setups, however, the distance between Support and Resistance should at least be 300 Pips. The EURO USD provided such a Consolidation, when it formed a 600-Pip Range between March and August of 2008.
FIGURE 7 – EURO USD-DAILY CHART
There were several important financial events that took place during this period, that sustained the high level of tension in the market. These included;
- The US Federal Reserve Board announcing the creation of the Term Securities Lending Facility, which would lend up to US$ 200 billion of Treasury securities for 28-day terms;
- The Federal Open Market Committee increasing its swap lines with the ECB;
- The Federal Reserve Board approving the financing arrangement announced by JPMorgan Chase and Bear Stearns while also stating that it would closely monitor market conditions and provide liquidity as necessary to ensure the orderly function of the financial system;
- The Federal Reserve Bank of New York announcing that it would provide term financing to facilitate JPMorgan Chase & Co`s acquisition of The Bear Stearns Companies Inc.;
- The Office of Thrift Supervision in the US closing IndyMac Bank, F.S.B.;
- The US Securities Exchange Commission issues an emergency order temporarily prohibiting naked short selling in the securities of Fannie Mae, Freddie Mac and primary dealers at commercial and investment banks;
Shortly after these events, a Bear Crown Setup appeared on July 29, 2008 at Resistance to signal a move down to Support. This would be the final bearish trend inside the Range, ahead of the breakout short and more aggressive safe-haven buying of the Greenback.
FIGURE 8 – DAILY CHART- EURO USD
With the strong signal given, entry would have taken place at the close of the candle at 1,5589 and the 200-Pip target set at 1,5389. This would have been hit a few days later, just above the Support at 1,5320.
The examples presented here are a mere small sample of the opportunities that have arisen over the last 6 years. Regardless of the prevailing market conditions, there will always be currency pairs that provide high probability setups that fit the criteria established in the trading strategy. The key is to have the right tools to accurately identify these setups and capture as many of the pips on offer, as often as possible.
Additional details related to these and other trade setups can be found in the Trade Manual available at Lulu.com.