NEWS / Foreign Exchange

The Clubber Lang Index

By Edwar Ponsi

In the movie "Rocky III", our pugilistic protagonist battles a wrecking machine with a Mohawk haircut, no neck, and a bad attitude named Clubber Lang. When a television journalist asks Mr. Lang to predict the result of his upcoming fight with Mr. Balboa, Lang glowers menacingly into the camera and replies, "My prediction? Pain."

Unlike Mr. Lang, I am not one for prognostication. I believe that good trading does not require prediction, but is instead a reaction to a specific set of circumstances. But there is one widely followed index that currently looks even more threatening to the U.S. Dollar than Rocky's nemesis. I'm speaking of the U.S. Dollar Index (see Figure 1).

Figure 1: USD Index closes beneath its December lows. Source: FX Street (www.fxstreet.com)

What is the U.S. Dollar Index? Just as the Dow Jones Industrial Average provides a general indication of the value of the U.S. stock market, the U.S. Dollar Index (USDX) provides a general indication of the value of the U.S.Dollar, as measured against a basket of currencies. Here are the components of the USDX, and their weightings (see Figure 2).

Figure 2: Breakdown of the components of the USDX. Source: Akmos Trade (www.akmos.com)

The index's close beneath the December lows comes at an inopportune time, as the greenback is swooning like a punch-drunk palooka. Euro is pushing the buck toward the brink, as the EUR/USD pair creeps toward its all time high, which was reached in December of 2004 (see Figure 3).

Figure 3: Euro nears its all-time high vs. the U.S. Dollar. Source: Saxo Bank

The Great Britain Pound also has the dollar up against the ropes, pushing ever closer to the infamous "2-handle". The GBP/USD pair has been testing this area for several months, but hasn't breached 2.0000 since 1992, when the Bank of England pulled out of the Exchange Rate Mechanism (ERM) and plunged the Pound into chaos. It has taken nearly 15 years for the British currency to regain its 1992 losses (see Figure 4).

Figure 4: British Pound is pressing toward multi-year highs against the dollar. Source: Saxo Bank

What does it all mean? The U.S. Dollar has fallen very close to key technical and psychological levels. GBP/USD has been flirting with 2.000 for since early December, and is less than 200 pips away from breaking a key level. If it does finally break, there is no resistance in sight - unless you consider trades from 1992 and earlier (see Figure 5).

Figure 5: GBP/USD once again tests resistance. Will it break this time? Source: Saxo Bank

There is simply not much room left for the U.S. dollar, and if these key levels break, we may not see them again for quite a while. The Thunder from Down Under has already pummeled the beleaguered buck, and it is worth noting that once the Aussie reached new highs vs. USD last week, it never looked back (see Figure 6).

Figure 6: Australian Dollar breaks to a series of new highs vs. the USD. Source. Saxo Bank

Will the same thing happen if GBP/USD and EUR/USD break their key resistance levels? A severe trade deficit, rampant government spending, and other fundamental issues burden the U.S. Dollar. Because of this, many analysts have been predicting the demise of the greenback for years. If the USD Index is any indication, the knockout punch may be about to land.

Forex Mailbag

Q) I love your newsletter, keep up the good work! Everyone keeps talking about having a trading plan, but as a newbie it is hard to know what items should be included in a trading plan. Do you know of any good guidelines for creating a trading plan?

Ed Ponsi) Thank you for your kind comments and your question. In his classic work "The Art of War", author Sun Tzu is credited with the following quote: "The victorious strategist only seeks battle after the victory has been won, whereas he who is destined to defeat first fights and afterward looks for victory". What this means to me is, do your work before you place the trade. Once you enter the trade, your work is essentially over - now all that the trader needs to do is follow the plan, and cut off all other possible avenues of action. This removes much of the stress from trading, and makes it easier to take an objective approach.

Here is what having a trading plan means to me: Before I enter the trade, I know exactly where I am going to enter, where I am going to place my stop, and where I am going to exit. I also need to know when I am going to raise my stop, if I am long (or lower my stop if I am short). I need to know the criteria for each of these, and there should be nothing left to interpretation.

Q) What is your opinion on trading the news, and getting in before the spikes or even getting into a trade on the retracement?

Ed Ponsi) Trading the news can be a risky proposition, and is usually only done well by traders who have spent years watching the markets react to economic reports. This is because it is often what is beneath the surface that creates movement, as opposed to the more obvious "headline number". For example, the Chicago Purchasing Manager Index (PMI) report contains the headline number, which garners most of the attention, but also contains sub-numbers (known as "components") which deal with employment, inflation, and other sub-sectors. There are also revisions of last month's headline and component numbers.

Suppose that the Chicago PMI number is released, and the headline number is mildly positive, but the employment component is disappointing and last month's headline number is revised lower. Traders who pay attention only to this month's headline number would expect the U.S. dollar to strengthen slightly, while those who give more attention to detail might expect the USD to weaken. In a situation such as this, I would expect the U.S. dollar to slide - especially if the markets are particularly focused on employment. Meanwhile, traders who only follow the headline number complain that the market's reaction to news "doesn't make sense". The truth is, the market's reaction to news usually does make sense, but only if you are looking at the big picture and paying attention to the details of the news.

Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.