Fighting Central Banks

Posted June 7th, 2011 by Rick Wright in Education

Fighting Central Banks

Hello currency traders! This post is going to explore a little bit about why a central bank may intervene in its currency, and how we can trade (or not trade!) this development.

First, we need to understand a little bit about Economics 101, particularly WHY a central bank may want a stronger or weaker currency. When I refer to Economics 101, it merely means this is the theory behind why certain things are done, according to our basic textbooks. As we have all learned in real life, what is taught in school isn't necessarily how things really work! The very basics are that you and I want a strong local currency because when we go shopping at our local neighborhood superstore, car dealership, or electronics store, imported goods are cheaper relative to our own currency. The longer our currency strengthens against another currency, theoretically, the cheaper these imports should become. The central banks and government want a weaker local currency as it helps our country's exports which should help Gross Domestic Product, trade deficit, employment and pull forward domestic demand, therefore, increasing tax receipts. While many central bankers when interviewed SAY they want a strong currency to give the hint that they aren't manipulating their currency, what they say vs. what they do is often different.

Here is a long-term weekly chart of the USDJPY.

Figure 1

As you can plainly see, the JPY has been strengthening vs. the USD for several years, in fact, more than doubling vs. the USD going back to 1990! Has the Bank of Japan been happy about this? Doubtful.

Figure 2

From the blue arrows indicated on the above daily chart, you can plainly see the result of the Bank of Japan's September 15th intervention where the USDJPY rallied approximately 300 pips and held for about three days. The second and third interventions resulted in much less of a move and didn't even hold for a single day! (While direct evidence of the second and third interventions are more difficult to come by, interviews with several analysts and traders indicate the Bank of Japan was behind these very short-term counter trend moves.)

So what we have is an obvious downtrend on two long-term charts, which leads many traders to look for short positions. The trend is your friend right? But trading with the trend is only one thing to consider in our trades. When entering a trade, we must also look for our two exits - where must our stop loss be located, and where is a reasonable place to exit for profit. In a downtrend, the profit target generally goes where this pair bounced before and the stop loss above the previous rally or swing high.

Figure 3

Looking at this 120 minute chart, how many stop loss orders were hit on these different JPY interventions? Hard to tell, but I would guess thousands! So we have ourselves a bit of a dilemma. Knowing we want to trade with the longer term trend, but the central bank is trying to change the trend, what should we do as traders? We have several choices. The first is don't trade it! I personally took a few weeks off from trading any JPY pairs as the added uncertainty and occasional volatility spikes didn't fit into my trading plan. Knowing that the market is always going to be stronger than any central bank intervention would lead a stubborn trader to keep selling short. However, having your stop loss hit on these interventions could be a costly mistake!

The second choice you have is to trade smaller position size. Taking a hint from George Soros and believing that any central bank's intervention will only last for a short time, we could still trade with the bigger trend knowing that another intervention may happen and take out our stop loss. With this possibility in mind, trading smaller position size makes sense so you can still be in a longer term trend, but also lessen your losses if your stops get hit. Always remember to sell into a supply zone and buy in a demand zone, maximizing your risk to reward ratio.

A third choice suggested to me by a student in class was to look for trades going along WITH the central bank's desired currency direction. Logically, it makes sense to enter a trade where the central bank previously "defended" a level - defended basically means the price where the central bank came in and started trading the currency pair. Looking at the previous chart, you can see this technique didn't work out very well.

Knowing WHY a central bank wants to intervene in their currency is a factor in trading, but knowing WHEN they will do it is the hard part. All we can do as traders is accept the fact that we may have our stop loss hit when this happens. Provided you still stick with the bigger picture trend and always take the small losses that are inevitable in trading, unexpected currency interventions shouldn't cause any undue stress.

Rick Wright

About Rick Wright

Rick studied economics and psychology at Iowa State University, and entered into the brokerage business in 1992. He earned the NASD Series 4,7,9,10,24,55,63, and 65 licenses. He helped grow an online brokerage business which was eventually sold off. Rick has also held positions as broker, branch manager, and several VP positions in the brokerage business.Rick began trading equities in 1997, and was introduced to the Forex market in 2002. Currently trading from home in Dallas, Rick is also a frequent contributor to various TV and business talk radio shows.Rick's goal in class is to accelerate your learning curve of trading, instead of figuring things out with your own money. He will show you several examples of trading mistakes that he and others have made, which cost thousands of dollars in the past so you won't make the same mistakes.You will learn how to recognize the differences between long and short term trends, where to enter trades, and where to exit based on previous price action.

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