Forex Markets Fall Prey to Reversals

FOREX MARKETS FALL PREY TO REVERSALS     

Let’s examine a market that is not correlated to stocks, such as the euro currency, to see how this market phenomenon known as a trend reversal occurs. Keep in mind that the markets are a reflection of the cumulative total (or sum) of market participants’ perceived value of a given product at a given time. We went over the fact of how massive the spot forex market’s liquidity is; not a single entity can manipulate prices. Something or some event must drive traders’ opinions of the markets. One such event is a news or economic report, which can change people’s opinions on a given market’s value.

As we look at the euro currency chart in Figure 2.9, we see the market develop into an uptrend, then consolidate, and then, bang, on the drop of a dime, drastically reverse. This is the kind of trading environment in which traders can and do make lots and lots of money. If you know what to look for and if you understand once a market goes from trend to consolidation, you should be aware that the next possible outcome might not be a trend continuation but rather a complete trend reversal. Then you have a better chance of not fighting against the current of the market, otherwise known as the tape.

MOVING AVERAGES HELP!  

The next method for identifying whether the market is bullish, bearish, or in a consolidation phase is utilizing moving averages. The most familiar one is the benchmark 200-day moving average. Most technicians and short term traders feel this is a worthless time period, with which I agree for short to intermediate-term trading.

Remember that the idea in using moving averages is to help determine the true direction of the market. The longer the time period used in a moving average, the less effective it is for shorter-term trading. Keep in mind that a 200-day moving average is over 28 weeks, more than half a year. The Federal Reserve raised rates four times in 2005 in that same time period. That leaves way too much time and, more important, distance between prices and the moving average to generate buy or sell signals.

When using moving averages the general guideline is simple:

• If prices are above the moving average, look to buy pullbacks or to take buy signals, as the market is in a bullish mode or in an uptrend.
• If prices are trading below the moving average, look to sell rallies or to take sell signals, as the market is bearish or in a downtrend.

Another instance in which traders use moving averages in helping their trading is determining what is called “regression to the mean.” This is a term many traders hear but really do not understand. It refers to the condition when prices deviate too far from the mean or average. At that time, prices will regress, or return, to the average; or the market will pause or consolidate until the average catches up to the price. You will notice what I call a “gap band” signal. This is what will occur when the prices gap too far away from the moving averages or bands and give a trader an opportunity for a countertrend trade. Another way to describe this is that when a market deviates, or departs, too far from the moving average, it gives an opportunity for a speculator to take advantage of this condition, which generally ends up with prices reaching an unsustainable extreme and then returning back toward the moving averages for a short term price swing. The question is at what distance or price level do prices deviate, or move too far away, from the moving average before market prices return to the moving average or the market pauses in order for the moving average to catch up to the prices.

As you can see in Figure 2.10, the market trends higher; but at times we see reactions that shift values from one extreme to another. How do we use moving averages effectively? More important, which time frames and which set of conditional settings should we employ to give us a true sense or value of the market? We will cover a different concept using a pivot point method later in the book.

Right now, I want to set the foundation behind the principle of why we use moving averages to help determine bullish, bearish, or neutral market conditions and how to trade these conditions. I try to figure out not why a market moved, but rather where the market is now in relation to specific points of interest, such as past opens highs, lows, and closes.