Euro Bulls Hope Fed Research Is Only For Shampoo

Includes: FXE
by: Chris Ridder, CFA

The euro fell under 1.28 vs. the US dollar yesterday, May 15th. The evening before Moody's downgraded 26 Italian banks, and most certainly investors do not want to get caught holding the bag if a bank implodes, or even a country. Then Tuesday morning news that Greece could not form a new government; hence, another round of elections, and likely results in the withdrawl of Greece from the euro.

This news even over shadowed the positive news of better than expected German GDP. A trading floor axiom says that if a market doesn't go up on good news and still falls on bad news then the "bottom" is not in. Therefore, traders should look for short entries or be even more patient in waiting to buy. An investor also has to consider the new socialist government elected in France and the changes that will bring. Already some entrepreneurs are making plans to move out of the country, and into countries that do not use the euro, such as Great Britain, Switzerland, and Singapore.

These facts all suggest that the euro should weaken. Typically, an investor would gather economic data, do econometric analysis, and be provided with a forecast. However, because of a potential regime changes, with at least one country dropping out of the euro and maybe more, any econometric analysis is suspect. The elements of what is being measured have changed from the past, and an analysis of the euro would come to a faulty conclusion because at the present time there are different countries, changing governments, and a less business friendly environment.

How then is a trader/investor supposed to take a position and come up with price forecasts and risk/reward scenarios? A possible answer is technical chart pattern trading, but can this really work?

Well, The Federal Reserve Bank of New York was interested enough to conduct research into the question. It resulted in a published research paper concerning technical trading rules, titled Head and Shoulders: Not Just a Flaky Pattern, which determined "significant profits" could be found in foreign exchange markets (page 38).

I observed this Head & Shoulders chart pattern in the EURUSD currency pair. Investors or traders who do not have a forex or futures account can use the exchange traded fund FXE to enter positions.

First I saw this pattern on the daily chart.

One can clearly see the neckline and both shoulders. It even looks like there was a double right shoulder made before the market broke lower. Possibly the bulls thought Europe would sort their problems out, but after the Greece and French elections the EURUSD has been in a consistent downtrend.

Classical chart reading techniques give a price objective using the distance between the tip of the "Head" (about 1.35) and the "Neckline" (around 1.30). Subtract this difference from the neckline to get an initial target and see if the risk is worth the reward.

1.35 - 1.30 = .05

1.30 -.05 = 1.25

Simple math points to the 1.25 area as an objective.

Things become even more interesting when one looks at the weekly chart of the EURUSD. Another massive head and shoulders top can be seen here.

The question here is, which "neckline" is correct? The one that says a short position is already warranted or the one with the yellow end, in which a short position has not yet been signaled? I don't like the "sharpness" of the first right shoulder, I wish it had taken more time to fill out. If this is the correct signal point then the pattern suggests an area around 121.70-ish as an objective.

If the second "neckline" is correct, the one with the yellow end, then the market has not yet given a weekly sell signal. However, if the daily chart ends up being correct the "neckline" could be broken this summer and that would imply falling to around the 115.50-ish level. A daily close above 133 or a weekly close above 135 would invalidate these patterns. However, it is exciting to find a daily setup that could turn into a longer term trend, on the weekly charts, which would result in a significant payoff to those short the EURUSD.

Disclosure: I am long options in the FXE.

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