A Buy Set-Up for Beaten-Down Dollar

04/18/2011 12:08 pm EST

Focus: FOREX

Nobody is bullish on the beaten-down US dollar right now, but the charts show several factors aligning that would make for a good risk/reward set-up on the long side. Here's how to trade it.

Could the dollar possibly move higher? This certainly is not a popular trade at the moment, and we might not see an actual buy set-up, but one is forming on the charts. I like trading wedges, and there is one setting up on the dollar index. Below is a daily chart:

chart
Click to Enlarge

We have a number of variables aligning for a buy set-up. The first is the obvious wedge formation where the market is working into a tight range as it moves lower. The second variable is that volume has been decreasing on the move lower, which is typical of wedge formations. The third is the major divergence in momentum on the MACD as the market has moved lower.

There is also weekly chart support just below the market around 74.30, which goes back to the low in 2009. I would feel better if the weekly and monthly charts were in uptrends, but nothing is perfect.

The dollar has the makings of a reversal formation, but we need to see an actual buy set-up before this pattern is viable. You can see there was a minor wedge formation (red line) that broke below the lower trend line and had a minor bounce. 

Buying above the first penetration of a previous day's high when the lower trend line is broken is often a good trade. The first move is sometimes a probe and the market never closed above the upper trend line, but the odds increase for a successful trade on the second set-up. 

I would look for a touch or break of the bottom trend line as the set-up. The next move above a previous day's high can be an entry for aggressive traders. Stops should be placed below the low of the signal or entry day. 

More conservative traders should wait for a break and close above the upper trend line. This could be a good risk/reward trade and would certainly be a contrarian play. As we have witnessed time and again, the dollar never seems to bounce when you expect it to. 

This is a market to keep on your radar screen as the set-up could happen any day. 

Futures traders can use the dollar index to trade. Stock traders can use an ETF that mirrors the dollar index, like PowerShares DB US Dollar Index Bullish Fund (UUP). 

A reversal in the dollar could put pressure on commodities and possibly stocks, so you might want to consider that for other markets you're trading if a breakout does occur.

By Chuck Kowalski of FuturesBlog.com

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