Understanding Drawdown/Market Drops Part II

August 1, 2008 at 4:41 am Leave a comment

By FX Insights

Understanding Drawdown/Market Drops Part II

2. What causes the EUR/USD to drop or correct?

Profit taking – profit taking is one of the biggest factors that account for drops in the market. When a large bank or institution closes a multi-million or multi-billion dollar entry, this will have an adverse affect on the market, and cause the market to de-value the price of the currency based on the liquidation of that position. A profit taker literally takes money out of the market – somebody had to loose in order for that trader to win. 

Example: suppose you and I bet on a football game… you bet me $100 that the Packers would beat the Giants in the NFC playoff game… we both put our $100 dollars in a bowl… at the end of the game the winner would not only get his $100 back, but would get an additional $100… game’s over, Packers are victorious, and you win the bet, so not only do you get your $100 back, you get my $100 and all of the cash in the bowl is drained… your money came from my loosing bet, but all of the money was removed. That example is basically the same principle of how it works in our FX market when a position is closed for profits. 

Loss taking – a bank/institution/trader who closes a loosing trade will also affect the market by causing a drop. The same principle of how it works with profit taking is also how it works with loss taking. The bigger the loss, the bigger the affect it can have on the market. 

Currency reserve moves – as retail traders, we never actually exchange currency, but banks and central banks do, and when these banks shift literal currency reserves or do a literal currency exchange, this can cause big moves in the market. Seasonally speaking, there can be quite a bit of reserve shifting done in the springtime, especially with the Asian countries. Even a mere mention from a central banker or finance minister about possible reserve shifting can cause 200+ pip moves instantaneously. 

Many traders don’t know this, but each central bank has their own FX trade team. The Fed has a 24/6 FX trade center at the New York Federal Reserve in New York City and that trade team is responsible for the Fed’s FX moves. And no, the Fed doesn’t use a retail broker… they are directly linked into the inter-banking system and do their trading that way. This type of set up gives central banks unbridled control to manipulate markets and to price fix, which is something as retail traders we are powerless against. 

Stop hunting/stoploss triggering – stop hunting is something most retail brokers do during thin markets, many times between the end of the NY session and the beginning of the Tokyo session when it’s easiest for them to manipulate prices. Retail traders who place stoplosses are hunted by the broker and the broker can manipulate the price by causing a quick spike up or down to close out entries. The price will almost always return to the point of where the spike took off from. 

Stoploss triggering is a slightly different concept… we saw stoploss triggering in action this week when the EUR/USD dropped from 4815 to 4593 in about a 50-minute timeframe… this is how it works… as the euro kept gaining in value against the dollar since Christmas, traders undoubtedly were putting stoplosses on those positions, and stops were building for weeks on end… and because so many traders use the same 5 or 10 technical indicators, those stoplosses were set on a buttload of so-called “key technical levels.” 

So, as you know, a dude from the ECB got the ball rolling and started the market on euro profit-taking and loss-taking, which sped up the momentum of the euro drop, then the stops started getting triggered, which caused even more losses, then it continued to drop violently, causing more and more stops to get taken out, so on and so forth… it’s almost like a self-fulfilling prophecy for the herd-mentality tech traders who set stoplosses on technical levels like Fibo lines or whatever… they are just pure cannon fodder for those types of moves… 

Fundamental – obviously a shift in the overall fundamentals can cause market drops/market corrections, but this is more of a bigger picture type thing… for example, if current forecasts hold true and stay on track, there will be a fundamental change within the Eurozone this year as growth appears to be slowing and signs are pointing to a considerable slowdown during the second half of 2008. This shift in overall market fundamentals should certainly be more USD supportive against the EUR. 

The banks control this market and they trade on the bigger picture using fundamental analysis of the market. Now here is something very important about drawdown you must understand – with the banks wielding so much control in this market, trading on the bigger picture fundamentals, if they have an open position that goes several hundred pips in the negative, they will let those trades run… banks will not even blink an eye at a trade that might be 500 pips in drawdown if it’s a bigger picture, fundamentally based trade take on a swing basis (i.e. position trade). 

So, as a retail trader, you’re in a market controlled by banks who don’t crap their pants when they go into drawdown. And with proper money and risk management, you shouldn’t be crapping your pants either when you go into drawdown because first of all you’re powerless to do anything about it, and if your trade was taken with a proper game plan, based on sound analysis of the market, the drawdown should give you an even better entry and more ROI when the market goes back the opposite direction. 

Real life drawdown lesson: some of you may remember that back at the end of September (2007) we started telling you to short the cable (GBP/USD) as we felt the U.K.’s fundamentals would turn south, particularly their housing, and that the BOE would start cutting rates within a month or two… back in September we predicted the cable would fall to at least the 1.9800 level, but possibly go as low as 1.9400 in the months to come. 

Well, I took my first cable short at 2.0604. Then the Fed cut rates again, which weakened the dollar even further. Guess what happened to my cable short? It went into over 500 pips of drawdown. Now to most traders, especially tech traders, that would seem like a terrible trade and a trade that would have to be cut for a loss… instead of cutting my trade that was over 500 pips in drawdown, I added another short at 2.1105, and that trade went into drawdown too! So, I’m sitting with two cable shorts, paying interest on them, and they are both in drawdown… 

Instead of panicking, I simply held both shorts with the faith and trust that my overall, long term, big picture fundamental outlook would play out perfectly. Long story short, my 2.0604 was closed at 1.9668, making those 500 pips of drawdown laughable when you look at the net bottom line ROI gained on that trade. And the 2.1105 is still open… 

Conclusion

Hopefully, this info gives you more insight into why the market does what it does… and why it’s so important to have a game plan for the trades you take – a game plan based on sound analysis of the market, not based on emotions… 

I do want to be clear about one thing – I absolutely, positively take losses on trades. I do not close every single trade I ever take for a profit. There is nothing wrong with taking losses in this market, it’s going to happen. When I do take a loss, I have a sound reason for it. 

During the end of November the euro was way up against the dollar, but based on the price action, I saw a change coming, and many of you will remember I took some losses on some euro longs and then went totally net short… and that is when we saw the euro go from 1.4968 down to the 1.4300’s… so, if I see a bigger market move on the horizon, and I’m going the opposite direction of where I think that move is headed, I’ll take my losses, and recoup my losses by going the opposite direction. 

If you have any questions based on this post, please find me in the chat so we can discuss. Or you can post your questions in this thread. 

-FX Insights

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Understanding Drawdown/Market Drops Part I Trade Team Call UPDATE (7/29/08 Call)

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