The opposite of "better late than never" is "worse early than never". Many young men have learned this lesson the hard way by showing up early at the college party and starting to drink too soon. Far better to be late and sober than early and drunk if the goal is impressing the opposite sex. Likewise in trading there is nothing worse than being early because you run the risk of taking a loss that handicaps you just as the party is heating up and people are loosening their inhibitions...I mean the market has finally capitulated, and turned in your favor.
The Short Squeeze
I'm reminded of that party analogy by the current situation in the Euro. Undoubtedly the majority of speculators are bearish on the Euro as seen by Oanda's most recent Open Position Ratio: nearly 71% short -- bearish --while CFTC data in the futures markets shows leveraged funds, i.e. market makers, long 121,400 contracts compared to short just 34, 682 contracts. (One Euro futures contract has a face value of $125,000) Dealers and Institutional money managers are also decidedly short Euro as seen in this week's CFTC data. In other words there are a lot of folks who are looking for a turn lower in Euro, but who are early. With so many players already short and undoubtedly bleeding - the short position as been increasing steadily since 1.30, a full $5,000 per standard Forex contract ago - the question becomes at what point do brokers have no choice but to margin out their client's short positions? In other words at what price level does "the short squeeze" finally burst, allowing market makers to sell out of their massive long position and into the buy stops of everyone else?
Risk Tolerance Threshold Theory
The short squeeze, or in academic terms, Risk Tolerance Threshold Theory postulates that the majority of speculators and traders can be right but still lose money, because of their penchant for entering positions too soon based on emotion - i.e. gratification -- and then repeatedly, in fact chronically underestimating their own risk tolerance levels. It also points out that those levels which speculators routinely capitulate at are as predictable as the behavior itself. W.D. Gann theorized that a market can retrace up to 5/8ths of itself and still maintain its overall pattern, while for Dow Theory the number is 2/3rds. Most traders see the .618 level as significant because of its repetition in the markets. In the weekly chart of the Euro in Figure 1 we used 5/8ths as our RTT level - marked in orange -- and highlighted a sell zone between 1/2 and 5/8ths. The number that creates the top of the sell zone is not as important as the repetitive behavior itself. As long as price is closing below the orange line the pattern is still bearish. Where price eventually stops and then reverses at represents that level where the majority of traders can no longer subconsciously take the pain of being wrong and losing money, and exit their previous positions. It is no coincidence that professional traders and market makers are well aware of this behavior, and those predictable levels, because over the course of their careers they have been caught on the wrong side of it also.
Because of the emotions brought on by the pursuit of money, we can always count on speculators getting to the punch bowl earlier and often. The very saying "making a killing" in reference to taking a large speculative position and being right on both timing and direction highlights the dangerous emotions brought on by speculative fever. The billion dollar question becomes at what level will the large short position in Euro capitulate at? Speculation and trading are not nearly an exact science as much as an art, so, while not even the Oanda margin man knows the exact level when the shorts "go full tilt", many experienced traders will recognize the climactic behavior when we see it.
Jay Norris is the author of "The Secret to Trading: Risk Tolerance Threshold Theory". To see Jay highlight trade set-ups and signal in live markets for free go to: Live Market Analysis
Disclosure: I am long UUP.