Lessons Learned from Shorting the British Pound

We recently recommended short positions at 163.50. One thing no one can ever know is the outcome for any given trade. Developing market activity will provide the answer, as new price information becomes available.

Where can this market go? It could very well retest the 140 area, but if it does, it will not happen in a straight line down.

As an aside, if anyone ever tells you that technical analysis is useless, you can rest assured that person is incompetent or ignorant in the art of it. This British pound trade is a perfect illustration of how the proper application of a chart(s) analysis draws from the best available source of reliable information, the market itself. You will never see us use RSI, (Relative Strength Index), MACD, Bollinger Bands, moving averages, etc. They are a past-tense effort to capture and define future market behavior.

The very notion is capturing and defining the future is absurd in itself. We are always willing to acknowledge that a stopped clock is right twice a day, and with consistency. The same cannot be said for mechanical tools, but people want a holy grail, so the popularity of these applications will continue to have a following.

Back to our notion of reality. Let us point out that most of the lines drawn on our charts are a priori to future events. The daily British pound charts will illustrate this clearly.

Markets are dynamic and ever-changing. Be confident in knowing that there are no cookie-cutter forms to apply for any market. There are tools that do come in handy, but just as you cannot use a wrench when a hammer is needed, one has to have an understanding of how markets work in order to know what to use and when. Our tools are price, volume, lines to denote support/resistance, and experience.

On the first chart, a gap is shown on the current March contract, when December was the lead month at the time. We also will deal with the application and use of trend channel lines. Let's start with the gap.

A gap is formed (a space between the high of a bar and the higher low of the next bar, or the low of a bar and a lower high on the next bar, in a down market) when there is a sudden demand as buyers enter the market in an overwhelming capacity that drives price higher. What we know about such areas of demonstrated strength is that they will be defended. This gap was formed in mid-October and becomes a potential source of information. We can expect the 160 -160.90 area to be defended sometime in the future.

Next is the trend channel. It requires three points; a high, A; a low, B; and a lower high, C; (the reverse in a uptrend). A straight line is drawn, connecting the two highs and extending into the future, as a broken line. From point B, a parallel line is drawn into the future, called a reverse trend line, [RTL]. All we need are these three pieces of market information to create the channel lines.

Why draw these lines?

The top line functions as potential resistance for rallies. The bottom line serves as an oversold indicator, and it may act as support. Understand that these lines are just guides and not absolute points from which to take immediate action to buy or sell. At times, they can work quite well. What is more important is to watch how price reacts to them. It is the reaction that conveys a market message.

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Fast forward to Friday, December 18 and a second chart.

We are getting some valuable pieces of market information. Rally bar D tells us that the attempt to get back to the upper channel failed to make it beyond half way in the channel. When a rally fails to recover to a halfway retracement, it tells us the market is weak. Bar D tried to go higher, but in the attempt, there were no willing buyers to support the rally, and we know this by the position of the close. It is about mid-range, indicating that sellers were present on the top half—what one would expect in a weak market.

The next bar, second from the end, broke hard with ease of movement down. This is where we went short at 163.50, (British Pound—Trouble Across the Pond, mentioned above). The low of that bar touches the RTL, alerting us to the pound being in an oversold condition. Remember, this line is just information, a guide, a red flag to pay closer attention to market activity. Price can stay in an oversold condition, and it can become more oversold by trading under the RTL, as happens. This is why we said to watch how price reacts to these areas and not to use them as absolute trading points, as many who misunderstand technical analysis do.

Volume does increase, and the close is off the low so we know there was some buying, most likely short covering and not new long positions from strong hands.

As a reminder, there was that gap which formed back in mid-October, and we said the information it gave us was to expect the 160 -160.90 area to be defended because it is here that new buying came in, at that time. You can see that the RTL also goes through the same price area. One indicator can be good; two or more separate indicators converging is even better. There are no accidents, so take note.

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The third chart is a 240-minute chart (four hours), used by professional forex traders, including us. Now we are getting into greater detail because of the convergences (alerts), just mentioned. The last wide range bar down from 162.50 to 160.43 touches the RTL, is in the gap area, and it has high volume. The increased volume is third piece of important market information. To repeat, high volume bars often denote a transfer of risk from strong to weak hands.

We drew a horizontal line from the bottom of the bar D, just in case it gets retested. If it does, we want to see how the market responds to it, after the rally from that low. Two trading days later, we get an answer. There is a retest. It becomes a probe lower, looking to see if there are any more sell stops under the market. The high volume tells us a lot of sell stops were triggered (smart money covering while weak players who have missed the selloff and want in before they miss any more, sell down here. Some things never change).

The failed probe lower on high volume, at the gap support and RTL areas is the market's message that shorts are being covered. We were one of them, at 160.75, for a 275-pip gain. We had already taken partial profits on half positions at 160.90, for a 260-pip gain, on the first decline to the RTL, just to reduce risk exposure by locking in some profits.

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MORE: Article Concludes with Review of the Hourly Chart

The last chart is a 60-minute chart that amply illustrates the market activity we have been describing. Artwork is always helpful. Look at the large bar down, sixth from the end, and note the volume. The clincher is the next bar, fifth from the end. It has equal volume to the previous selloff bar, but this one is much smaller. Why is it smaller? Because buyers, (those covering shorts) were in the market in a big way at support (as we have defined it), and the buying activity was much greater than the selling activity, which kept the bar from extending lower. Those two bars were the culmination to the selling effort down from the failed 164.00 rally high two days earlier.

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This is how one reads market activity, and it shows how the market acts as a reliable guide. Not a bad trade, but we cannot take a lot of credit because we missed the sell from the 165 and higher level after price failed at 167 on December 3. Not all market reads are this “easy,” but when we can harmonize with the present tense developing market activity, risks are less and profit potential is greater.

Now you can see why anyone who says technical analysis does not work simply does not know how it works. On to the next trade! May it be as clear and as profitable as this one. In fact, the next trade may soon be in the British pound, for this market is still going lower.

By Michael Noonan of Edge Trader Plus