Monday, April 4, 2011

EURUSD—Reaction versus change in trend

Is the price rally from the 1.1876 low a corrective reaction or a change in trend? This is almost impossible to answer at this point but looking at the price behavior from the perspective of different theories is useful. Today, I'll discuss the monthly chart considering Dow Theory, Elliott Wave analysis, and simple trend lines.

From the Dow Theory point of view, Euro remains in a primary downtrend on the monthly chart. In Dow Theory, a primary downtrend lasts one to several years and there is at least a 20% decline in value. The Euro had a 23% decline from the1.6041 July 2008 high to the October 2008 1.2329 low. The low of 1.1876 in June 2010 resulted in a percent decline from the high of 26%.

In a primary down trend, there are intermediate trends or reactions that result in price rallies. During these reactions, price retraces 33 to 66% of the prior price change. In the Euro's first reaction from 1.2329, price retraced 76% of the 3,712-pip decline. An intermediate rally fails to bring price above the top of the preceding rally. The rally that began from the low of 1.2329 stopped at 1.5147 in November 2009, well below the prior 1.6041 high. The rally that began at the low of 1.1876 is still in progress. This reaction is well past the 66% retracement of the prior decline of 1.5147 to 1.1876. A 76% reaction would bring price to 1.4362.

Differentiating between the first leg of a new primary trend and an intermediate reaction within the primary trend is difficult. Dow stated that the secondary trend often consists of three or more minor waves. On the monthly or weekly chart, one can see this as a three-wave reaction. One can also examine volume, unavailable in the spot market, and the maturity of the primary trend.

Maturity is tricky. The downtrend has been going on since July 2008 three months shy of three years. Is that mature or immature? In comparison to the prior long uptrend from 2000, it's immature. Dow spoke about three stages within primary trends, with the third stage of a bear market finding assets liquidated regardless of their underlying value. This is not happening. It is questionable if it has happened at all during the downtrend given the financial woes of various Eurozone countries. Another third stage sign is little interest in buying. Obviously, someone is buying or price would not be going up. All this leads to the appearance of this being a corrective rally rather than a change in trend.

By the way, many expect the ECB to raise the interest rate this month. Increasing an interest rate often boosts a currency. However, the proverb of buy the rumor, sell the news, comes to mind. How the Euro reacts to the actual news (if the rate increase takes place) will be interesting to watch.

Obviously, if price exceeds 1.5147, the primary trend has changed from down to up. For short-term traders that seems too far away to be useful; for longer-term traders, it is not that far.

Dow Theory is one piece of evidence. Elliott Wave can be another. From an Elliott point of view, one could argue that the C leg of an ABC correction on the monthly chart is over and that price is beginning another rise. It is possible. However, if one looks at my wave counts on a weekly chart, it seems more likely that price is in a third wave with this current correction being wave two of three. If price exceeds 1.4282, this interpretation is invalid (wave two cannot exceed the start of wave one). The high this morning was 1.4269, tantalizingly close. If it exceeds 1.4282, is a bearish interpretation out of the question? No. The correction could still be taking place. On February 28 I blogged that if one assumes the C wave is currently "in progress, then .618 of the A wave would bring price to 1.4347."

There are no absolute answers from either Dow or Elliott Theories. However, one needs to keep them in mind as many traders follow them.

Another thing to use is a simple trend line. Trend lines can be surprisingly valuable. Clearly, Euro is at an important resistance trend line. This line is currently at 1.4326. A sustained break above this line would be compelling evidence that the trend is breaking upwards. Note that while Euro has clearly broken below a major uptrend line (the dotted line), it has yet to break below the second uptrend line drawn in solid red on the chart below. That trend line is currently at 1.2226.

From doing only this limited analysis (Dow, Elliott and trend lines), I now have a resistance zone beginning at 1.4326 (the trend line) and ending at 1.4366 (the same percentage correction as the prior correction). The mid-point of this zone is a.4346, almost exactly the price projection from the C wave calculation. This zone also coincides with a price resistance on my three-hour point and figure chart. As a result, I will most likely think about selling if price reaches those levels. If price exceeds that zone, the next major resistance is at the upper boundary of the upward sloping rectangle. This is currently around 1.5150. Obviously, on a daily chart, one would see interim resistance levels.

What about time? Time is not as useful as some Gann followers would have you believe. I do look at it, though. One thing to say about it is that the prior correction took 13 months to reach the high of 1.5147. This rally is now in its tenth month. If the rally continues beyond 13 months then it might be significant.

An important factor is momentum. It plays a role in all trade analysis I do, particularly in shorter time charts. On the monthly chart below, RSI has broken above its downtrend line. However, note that it is not pushing into overbought levels (above 70) even though the price rally has been steep.

Here's the monthly chart:

© Dianne Fecteau, 2011. No part of this material may be reproduced in any form, or referred to in any other publication, without the express written permission of the author. My purpose in writing this blog is to show you how one trader, me, makes trading decisions and survives while trading Forex. One of the biggest problems I had when I first started trading was trying to apply the “rules” to actual trades. Another was the psychology—limiting losses and letting profits run. If you study my blog, you’ll see how I deal with both those issues. So my writings are not trade recommendations but rather educational in purpose. You have to decide on your own approach to trading. Remember that trading is risky.

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