GBP/USD - daily candle chart

If forex trading can be defined in any way, it can be said to be the process of trading and managing risk. This is something many new traders find difficult to understand but perhaps one simple way to explain it is by looking at a candle pattern which, in all my years of trading, has rarely let me down and has proved to be one of the most consistent trading signals, appearing in all time frames and in all markets.

The candle in question is the hammer. The hammer or, as it is sometimes called, the down thrust, occurs at the end or bottom of a sustained down trend when the bears have driven prices to the point of exhaustion, before the action is taken up the bulls, who then take control and begin the process of moving prices back up again. The end result is a candle with a small, or even non existent body , but with a very long and deep shadow. The beauty and simplicity of the hammer candle pattern is that it occurs across all markets and in all time frames and in the past couple of days we have been fortunate to see two hammers, one on the daily eurodollar chart and the other almost identical signal, but perhaps an even more dramatic example, on the daily chart for cable.

As you can see from the pounds to dollars daily chart Tuesday’s price action saw the pair fall dramatically to a low of 1.5780 before recovering to close at 1.5925 leaving us with a classic hammer. This technical signal was duly validated on Wednesday, with cable climbing almost 300 pips from 1.5905 to close at 1.6183 although today, it’s no surprise to see a minor pullback following such a sharp move higher. As I said earlier, trading forex is all about trading risk and whilst adopting a trading strategy using a single candle may, on the surface appear overly simplistic and also require iron discipline and patience, the return is that the risk is dramatically reduced, given the consistency of this signal.

Furthermore, the candle becomes even more powerful when read in conjunction with other technical signals – a subject for another video!The good news is that whilst these candles appear relatively infrequently on the longer term charts, they do appear more regularly on an intra day basis and are therefore equally valid, and provided you are prepared to wait and be patient, and only enter a position once the price has moved back above the close of the candle then you will be more successful than most. Of course, it goes without saying that you should always deploy a stop loss, which initially should be set below the bottom of the wick and moved up accordingly as the trade progresses.

USD/JPY - Daily candle chart

Following the Japanese earthquake in mid March where the dollar yen promptly sold off sharply, before G7 intervention managed to send the pair back to the 86 level, since then the dollar yen has been on a downwards slide back towards the 80 level where we have seen an extended period of sideways consolidation for the past few months. Yesterday’s price action finally broke out of this sideways movement, breaking through the strong level of support in the 79.80 area to close at 79.46 as a wide spread down candle, albeit one with a deep wick to the lower body.

This bearish sentiment has continued in early trading this morning with the pair moving lower once again to trade at time of this video, at 79.26Throughout the recent extensive consolidation phase the 100 day moving average, in particular, proved to be a significant barrier in any rally and coupled with the shorter term moving averages, these should now combine to produce additional downwards pressure.

Indeed the 9 day moving average has now crossed below the 14 day moving average to give us a bear cross signal, adding further weight to any downwards move. With the deep area of price resistance now above – between 80 and 82 – the dollar yen looks set to fall further, possibly to re-test the lows of early March in the 76.50 area, although as always this assumes that the Bank of Japan does not intervene and, of course, the stronger the Yen becomes, then the more likely this is to occur.

USD index daily chart

Following two months of sideways consolidation the dollar index is now approaching a key technical level on both the daily and weekly charts, and coupled with various other signals the next few days could dictate the future direction for the dollar and consequently the major currency pairs during the summer months. So, the first point to note is that we are now approaching a key breakout level at the 76.50 area which is a well defined level of resistance which promoted the sharp pull back of late May and early June and, to date, has also proved a barrier to short term rallies throughout June.

However, following yesterday’s strong rally for the dollar in the wake of an escalation of the sovereign debt issues in Europe, this has helped to push the dollar index back to test this level once again today, and any break and hold above this price region will then provide a potentially strong platform of support for a sustained move higher for the dollar.This upwards momentum is further confirmed by the series of higher lows, established in early June and followed by a repeat in early July, suggesting, once again, a bullish trend for the US dollar and, indeed, this is further confirmed by two other technical signals. First, yesterday’s price action broke and held above the 100 day ma, which is always a strong signal, and second, the chart is now forming a strong pennant pattern which will reinforce any breakout to the upside.

The only technical issue that now remains to be resolved is the 200 day moving average, which sits at the 76.95 price point and should we see the index break and hold above this level then this will complete our technical set up for a strong bullish breakout. The weekly chart for the dollar index also confirms this bullish picture and, here once again, we can see a pennant formation now developing, and a break and hold above the 76.50 will confirm the present bullish sentiment. Finally on the weekly chart the 40 week moving average is sitting immediately above at 76.88 and this will need to be breached to provide additional support to any move higher. Beyond this level we can then look to a move to re-test the underside of the resistance which sits at 78.73 where this also combines with the 100 and 200 week moving averages and should this level be breached then this will add a further dimension to the trend.

Finally, from a fundamental perspective, of course, we have the ongoing sovereign debt issues in Europe and later today the release of the FOMC minutes, either of which could provide the catalyst for further dollar strength.

Next week sees a further round of scheduled meetings for EU finance ministers, which will no doubt result in more lukewarm words which mean little and achieve nothing. With the US dollar now showing signs of renewed strength and with the euro likely to come under further pressure this week as the markets react to further disagreement in Europe and potential defaults as a result, we are likely to see sustained euro dollar weakness this week.

From a technical perspective on the weekly chart, we now have three consecutive doji candles, which are clearly signalling a pullback and move lower, which may test the 1.3363 area early in the week, and should this level fail to provide any support, then expect to see the pair fall further, possibly towards the 1.3241 region as a result.

Once the excitement had died down yesterday’s low  did manage to find strong support from the key 100 day moving average and this technical indicator has once again provided solid support in this morning’s trading  with the pair breaking and holding above the 50% fib retrace level at USD1.5815 and, as such both these signals suggest a recovery and move towards the 38.2% level at USD1.5927.  Any break and hold above this point would then open the way for a re-test of the USD1.6023 region in due course.  Below, the 200 day moving average continues to provide excellent support to the downside and provided we breach the potential resistance in the USD1.5953 area we should see a further recovery in the pound dollar and the continuation of the upwards trend in due course. The pair was given a further boost this morning following release of the MPC minutes which confirmed that 2 members of the committee are now calling for a rise in UK interest rates.

Whilst there was some relaxation in the German position, in that they are prepared to consider further assistance to weaker member states, their broad views remain virtually unchanged, insisting that other EU states will also need to match any additional help with that given by Germany. This of course then raises the issue of how these indebted countries, such as Spain, Italy and Belgium will be able to cope, struggling with their own economic problems whilst at the same time being asked for additional funds, and as such begs the question as to the validity of current bullish sentiment towards the euro.

From a fundamental perspective last week, the German data for both the ZEW and IFO suggested a strong economic picture, but then this hardly comes as any surprise, since Germany has been the leading economy of Europe for some time, and by some margin, and to be blunt, without it, the euro would have sunk without trace some time ago. However, core strength is not really the issue at present, and it is how the other members will muddle through that is the central issue here, and despite the strong technical picture, with the euro dollar breaking and holding above the 1.3500 region, we believe that this is a fake out rally, and that fundamental pressures will take hold in due course, probably within the next 2-3 weeks, and as such we can expect to see the euro dollar back below the 1.3000 level in the short term, with a further fall during February, to test the 1.2500 – 1.2700 level by the end of the month. From there however, expect to see the euro dollar climb dramatically for the remainder of the year, as we expect the see the eur/usd trading at around 1.4750 – 1.5000 by the end of the year as inflation begins to bite and interest rates rise accordingly.

As such the current bullish breakout should be viewed as an opportunity to add further short positions in preparation for the pullback and reversal lower, particularly once we see a shooting star candle on the daily chart. Once in the 1.2500 to 1.2700 area, these positions should then be closed and longer term bullish trades placed on the relevant signals. One of the best ways to play this trade is to look at a 10 month put option on the ISE.

All the above data simply confirmed that China’s economy expanded faster than expected at the end of 2010, and as a result worrying the markets further this morning, on the expectation of additional tightening over the next few months, with Chinese interest rates likely to rise further in due course. These figures also confirmed that China is now the second largest economy behind the US, pushing Japan into third place for the first time. It is interesting to note however, that the overnight data appears to have had little effect on the US dollar, which continues to remain waterlogged below the key 78.76 price level, having reacted little to the news, and indeed has continued to fall in the early London trading session, to currently trade at 78.58 on the dollar index chart. What is particularly interesting this morning is that we have risk off appetite in equities, and yet the dollar is also falling, suggesting a breakdown in the once traditional inverse correlation, with the US dollar once the ultimate paper based safe haven status. In addition, gold is also falling, which starts us wondering where the money flow if today – possibly to the Swiss Franc once again? Should this technical picture continue for the dollar, then we could see this fall to retest the 78.23 region once more, and if breached then a further fall to the 76.81 low of early November last year.

In early news elsewhere, the European PPI data came in higher at 0.7% against a forecast of 0.5% raising further concerns over inflation and helping the euro higher in early trading, adding the Jean Claude Trichet’s comments last week that inflation would be closely monitored, and interest rates increased without hesitation should the need arise. This has been counterbalanced by continued unrest in Europe with the euro-bond solution, as ministers continue to argue over the timescales for implementing any plan, but so far these negatives comments have not weighed on the euro, which has pushed back to retest, the 1.3468 region once again in early trading.

Longer term we expect to see the euro dollar pull back by the end of February to test the 1.23 to 1.27 region, before having a sharp rally for the remainder of the year where we could see it end 2011 in the 1.50 region or beyond as interest rates begin to take effect, but the low of last year at 1.1876 is likely to remain untested as part of the longer term 5 year cycle for the pair. As such we see a 6 week call option on the USD/EUR as an excellent trade for the next few weeks in anticipation of a pull back before the longer term recovery begins in earnest.

From a technical perspective we are once again testing the 1.3500 area on the daily chart, and any break and hold above this level will then signal a continuation of the recent trend higher, with a run towards 1.3800 region now looking increasingly likely. Both the 9 and 14 day moving averages are now turning higher and look set to cross the 40 day moving average as a result, and should this occur by the close of trading this evening, then this will add a further bullish signal to the short term picture, as we look to the current bullish momentum developing into a longer term upwards trend. The resistance between the 1.3800 region and through to 1.400o could present a solid barrier in due course, but provided none of the EU states default in the next few weeks, then the current fundamental picture in Europe could provide the driving force for a sustained move higher for the euro.

The longer term picture remains unchanged with the 200 day average providing a platform of support in the 1.5426 area and indeed this picture is replicated on the weekly chart with the 40 week average playing a similar role. Whilst we may see some further sterling strength in the short term in the longer term dollar strength is expected to return and from a technical perspective the 1.62 area may provide the turning point once again for cable in due course.

With very little real news to excite the forex markets, Europe will be focusing on the EU finance ministers meeting which gets underway in Brussels this morning, and continues tomorrow, with sovereign debt issues high on the agenda. Whilst the euro bond option remains the only credible alternative to stem the flow of casualties in Europe, opposition from Germany may halt any further progress with this solution, and if so this will increase the likelihood of further problems with bond auctions in Spain and Portugal as a result. Any failure to present a coherent plan on Tuesday is likely to weaken the euro against the US dollar and other currency pairs including the UK pound. The only other fundamental news item today is a speech by FOMC member Plosser, who is delivering a talk entitled “Thoughts on the scope of Monetary Policy” at the Global Interdependence Conference Centre in Santiago, with a question and answer session to follow. Should the speech be more hawkish than expected then this could provide some support for the US currency today in thin trading conditions.

Overnight, the euro sold off against the US dollar as concerns over China’s monetary policy continued along with the news that the People’s Bank of China had raised the RRR rate ( Reserve requirement ratio ) by 0.5% with effect from the 20th January, causing markets to stumble, which in turn is rippling through European markets in early trading. The shooting star candle on Friday’s daily chart for the euro vs dollar has also signalled a potential reversal today, and with the pair currently trading at 1.3259, down from Friday’s close at 1.3387, then if this is confirmed at the close tonight, this would signal further weakness and validate Friday’s bearish signal.