Understanding Drawdown/Market Drops Part I

August 1, 2008 at 4:34 am Leave a comment

By FX Insights

Understanding Drawdown/Market Drops Part I

With the EUR/USD making anywhere from 300 to 600 pip swings the past few weeks, this has certainly caused a lot of confusion for newer FX traders, tech traders, and really just about any other trader that doesn’t quite understand the main factors that cause bigger market moves/drawdown/market drops/market corrections. 

For me it’s usually easy to identify why the market did what it did on a daily basis, because we can watch the correlated variables and we can watch price action to get the answers and piece the clues together… but every so often, like we saw last week, the market will make a 300 pip correction, which leaves many traders scratching their heads… 

The other confusing thing to traders is something like we saw last August – it was mid August when all the subprime and credit crunch stuff really hit the fan. Logic would have told you to go heavy buying the euro and go heavy selling the dollar as the news coming out at that time was abysmal for the U.S. economic situation. But over the span of one week saw the euro fall 500 pips against the dollar, defying logic. 

Those of you who were with us last August will remember we kept buying the euro all the way down to the bottom of that mega move, which probably didn’t make any sense at the time, unless of course you were able to see the bigger fundamental picture and have a confident understanding of why we saw such a violent drawdown and market drop. 

One of the toughest aspects for many traders to wrap their brains around in regards to our signal is what to do when it goes into drawdown… it doesn’t matter that 100% of our signal trades have paid-out with full profits because as soon as a signal trade goes into drawdown, the panic sets in, the questioning begins, traders get rattled and squirm, and then they start praying the market will move back up… you should see the panic-stricken emails I get! 

As you know Cisco’s original EUR/USD signal issues “buys” or long positions only. It does not trigger shorts. The signal, fueled by historical and real-time fundamental and price-action data is 100% predictive in nature… it creates a picture of the market and when all the data comes together in perfect alignment, a signal is issued, saying, “in the future, the market will go up at least 20 pips from the price point the signal was triggered.” 

1. So why do some signals go into drawdown? 

Buying – because the signal is predictive, often times the signal will trigger when it sees that the “market” is starting to buy or will start buying the EUR/USD. Quite simply, many times buying the EUR/USD (taking long positions) will cause the market to initially go in the opposite direction. On the retail side, a retail broker will take the opposite side of trades being taken – so, if retail traders are loading up on euro longs, the brokers are loading up on euro shorts to push the market against those trades to either shake them out of the trade or to trigger stoplosses. 

I know this doesn’t make sense, but again, buying many times causes the market to go the opposite direction. The market’s direction will begin to change when a bigger banks and market movers jump in with large entries, which causes the other banks to jump on the bandwagon as they think “maybe the big boys know something we don’t.” At this point you’ve got momentum building, the banks within the inter-banking system will start raising the prices they offer EUR/USD contracts to the brokers, who in turn raise the prices they charge to us on the retail side. As this momentum-based move continues, the banks raise the price on the “ask” and the process continues. 

So, if we look at this from the perspective of the inter-banking system, which are the source for EUR/USD contracts, it would go something like this:

Broker “A” buys a 20 million EUR/USD contract from Bank “A” at the price of 1.4620. Then Broker “A” displays the ask price on their platform at 1.4623 – this is the price you pay to take that trade, meanwhile, a split second later, all contracts offered at the price of 1.4620 from the inter banks were bought up, so the only thing the banks can do is raise the price of the contract, based on supply and demand… so this process continues at break-neck speed… contracts get bought up, price goes up, more contracts keep getting bought, price keeps going up… 

If you’re having trouble picturing this in your mind, think about it like you’re at an auction… a piece of artwork hits the bidding stand and the bidding starts at a certain price. Now, what would make the price of that artwork go up? Offers – which is equivalent to the “ask” in our FX market. If no bidders made offers on that piece of artwork at the auction, obviously the price couldn’t move. But if several hundred bidders kept offering a higher price, the value of that artwork would rise accordingly, but eventually the bidding would stop when the perceived highest value at that point in time has been reached. In this case, as in FX, the “market” decides the price and decides what they’ll pay and what they won’t pay. 

The market drives the price as the momentum builds and the market movers are actively trading. When the price gets so high that it’s no longer an attractive price or perceived to be a value buy, the offers cease, the market stabilizes, and then will either hang out in a range or make a correction back down to a certain level. 

And what will help us determine what kind of correction or retracement to expect? The way I do it is by gauging the speed and degree of the spike or big move, the possible causes for the market volatile activity, the time of the move, the amount of pips it moved, and what the real-time fundamental situation is. 

In conclusion, buying is one of the main reasons a signal or the market in general would go into drawdown, until the upward momentum builds to a point where the market can no longer drop but must start climbing up… of course, we also have to watch correlated variables such as gold, oil, bonds, equities, etc. in conjunction with the spot FX market to help us determine why the market might be going against the prevailing trend.

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Trade Team Update – – 7/31/08 (Non Farm Payrolls) Understanding Drawdown/Market Drops Part II

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