There is so much talk out there about what moves currencies. Granted, at any point in time it could be anything ... news, geopolitics, economics, earthquakes ... on and on ad infinitum. But I want to step back a bit from the news and hot trade of the day, and share a couple of things I focus on that has served me well over time when it comes to currency analysis.

First ...

A Look at How Pricing in Real Markets Works

I think former hedge fund manager and global macro guru George Soros summed it up best when he said currency markets are driven by real people based on their best guess of what future currency prices will be.

I know that sounds a bit trite ...

But the reality is that expectations create price trends. And it's important to understand that it doesn't matter if these trends are based on flawed expectations or a focus on the wrong underlying fundamentals. What is important for the trend is simply price validation — higher prices begetting higher prices.

Participants, who have their expectations validated by the direction of price, are prone to believe their rationale for the price trend is the right one. It doesn't matter that their rationale for making the investment could be totally wrong, which puts them in the "better to be lucky than good" category.

Growing confidence in their rationales leads them to commit more money to the trend. So you can see this can create a self-reinforcing price cycle that is detached from the actual fundamental reasons for a move in the underlying currency.

It is precisely why we tend to see what is called "overshoot" more often in currency markets than we do in other markets. The rationales for a price move are often hard to identify in the currency world. There is no income statement, balance sheet, or cash flow available to evaluate a currency as there is with a stock, for example.

So it's only a matter of time before a currency can get so far out of line with its underlying fundamentals that people riding the trend start to recognize the misalignment, so to speak. This of course then sets the stage for a change in the trend. And those so positioned are in for a very nice ride in the other direction.

This price action in currencies tends to be fractal in nature, because currencies are so sentiment driven. And we tend to see this process, of what Soros termed a "boom-bust" cycle play out in multiple time frames.

Here is a graphic look at this price dynamic:

Source: Black Swan Capital

Now a look at sentiment and the most important rule of currency trading ...

Sentiment is defined as the collective expectations of the millions of players in the market placing bets and talking about placing bets.

As legendary currency analyst John Percival put it,

"The ultimate driving force for currency movement is participants' expectations of total return."

The reason sentiment plays an unusually large role in currencies is because few people have a handle on what really moves currencies, as I discussed above.

Is it budget deficits, trade deficits, industrial production, interest rates, inflation, deflation, war, housing, Asian bank reserves that drive currency prices?

Don't get me wrong. If you know what is going on across the globe, it helps. But if you don't have time to focus on that stuff all day, you can still win in these markets; that's because there is one rock solid rule that applies especially to currencies:

Extreme Consensus + Extreme Speculation= Extreme Price

... and extreme price means it's time for the trend to change! When you can identify that extreme, it's a great opportunity to get on board early to a new trend in the opposite direction.

There are quantitative and qualitative ways to gauge price extremes.

One easy way to follow the quantitative factor is to watch the open interest — the total number of contracts that are not closed — each day for the currency futures traded on CME's Globex. Granted, the trading volume in currency futures is small compared to spot forex. But currency futures prices key off spot prices, and the CME open interest is an excellent barometer that applies across foreign exchange.

From a qualitative aspect, one of the best indicators to follow is price action relative to the background news ...

For example, if Australia reported that job growth had soared, but the Australian dollar traded lower on the day against the U.S. dollar, we would say that's poor price action relative to the news. And it's probably a good indication the Aussie will continue to trade lower, at least in the near term. It tells you, there is strong selling pressure in the Aussie based on something we don't know.

And that is the nature of markets — they discount often before everyone is aware of the fundamentals; it's why this simple indicator has stood the test of time.

Sentiment is the main force driving the markets.

Sentiment analysis is so important because it embodies the collective wisdom of the market ... it's grounded in human action. And in the end, after all the sophisticated analysis is complete, we are left with irrational human beings making decisions to buy or sell based on their expectations, needs, fear, and greed. Market sentiment sums it up for us to see.

Price action and sentiment are just two aspects of what I use to help make trading choices. I think it's something you can also easily incorporate into your trading tool box.

Stay tuned for my future columns in Money and Markets, and I will share with you how I evaluate the fundamental side of the currency equation.

 

Source: Mony and Markets

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