Tuesday, April 1, 2014

Trading a crisis

By Abe Cofnas

The Russian military actions in the Ukraine on the first weekend in March caught the markets, as well as U.S. intelligence, by surprise. Markets around the world responded.

On the Asian opening the yen strengthened as it took on a safe-haven appeal. Gold (COMEX:GCJ14) and oil (NYMEX:CLJ14) also surged. When European markets opened, the Dax index gapped down. While the news was a surprise, these market reactions were consistent with a reaction-diffusion pattern. A reaction-diffusion pattern is seen in nature. An acid is dropped in a base, reacts and diffuses. This is a non-linear process. In a sense, the Russian actions were the acid and global markets were the base. The speed of the reaction is greater in the age of the Internet. The resulting signal/noise ratio declines distorting the effectiveness of traditional technical analysis. The question arises, how can traders sharpen their strategies when the unexpected punctuates the balance of technical analysis and fundamental expectations?

First we need to acknowledge that during a crisis emotions trump technical analysis. Initial market moves triggered by sudden events require a shift in the application of technical analysis. Traders need to employ a strategy of analytical triage. Some key questions are: What pattern is occurring? Is it a spike or surge? Is it parabolic? Where are the key Fibonacci resistance barriers? Traders need to apply Newton’s first law of motion and consider that a price will stay in a pattern until news moves it out of its patterns. The lesson for the trader is to anticipate the temporary nature of the initial reaction. There will be a change. However, following the crowd of traders in sudden-event conditions and putting on a trade in the midst of the action is inviting disaster. It is equivalent to joining the stampede. The strategy that better fits sudden-event trading is waiting for an appropriate trading signal to arise. The signal will be either a break in the pattern, or an attempt, but failure to break that pattern.

A second lesson reinforced by the Ukraine crisis for traders is to prepare contrarian trading tactics. Particularly on a Monday’s price action. With a full week to go, any initial reaction is likely to be replaced with new information and resulting new patterns. Therefore, on the morning of most crises, fade and don’t follow the crowd. On the date of the attempted coup on Mikhail Gorbachev (Aug. 19 1991), the Dow closed at 2897.03, down 71 points from the Friday Aug. 16 close of 2968. By the following Friday, the Dow closed at 3040. Fading the news on the previous Monday was going against the crowd. It is classic contrarian thinking. On Monday March 3, the Dow closed at 16168 and in the contrarian tradition proceeded to close on March 10 higher at 16418. Similarly the USD/JPY, gold, and oil reversed their initial reaction by the end of the week (see “Safe haven”).

A third point relates to correlations of markets. When a crisis occurs a shift in correlations occur. This is especially true in the Internet age as underlying markets become entangled. In this physics of light, white light is what we perceive but it is really consisting of a spectrum of different colors. Similarly, during a crisis, all markets are converging into one major frequency of fear.

Traders that believe they are trading the yen, gold, S&P 500, or oil, are taking too narrow a view. Different underlying markets all perceive the same color of fear. The lesson is to closely monitor the co-movements of several markets because as the fear subsides the underlying markets detach from their strong correlations at different rates. In the case of the Ukraine crisis, the most important currency was the yen which acted as the canary in the coal mine signaling Asian global risk aversion that subsequently followed in the European and U.S. markets.

A fourth lesson is the importance of not holding positions on the weekend. In today’s world, news occurs over the weekend, whether it’s a North Korean missile test or a Russian military action. Those holding positions when markets are closed or illiquid, are vulnerable to being on the wrong side of surprise.

A fifth lesson is that cash is king in crises. It provides opportunities to put on evidence-based trading. In other words, keep more money aside in your account and don’t be fully invested. When a crisis occurs, having the ability “listen to the market” and detect changes in the patterns, will provide moments of opportunity and profitability in cash is available. We can’t know when the next sudden-event trading will occur, but we can be ready. It is more important tool than ever before.

Abe Cofnas is author of “Sentiment Indicators” and “Trading Binary Options: Strategies and Tactics” (Bloomberg Press). He is editor of binarydimensions.com newsletter and can be reached at abecofnas@gmail.com.

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