What are the lessons we should learn from the huge move in EUR/USD on Friday December 27th?

Dec 31 • Between the lines • 1866 Views • Comments Off on What are the lessons we should learn from the huge move in EUR/USD on Friday December 27th?

shutterstock_68321776Many trend/swing traders will have been ‘caught short’ during the exponential rise of EUR/USD last Friday December 27th. With hindsight it’s quite straightforward to analyse and pinpoint the reasons for the move which saw the major currency pair gain up to circa 200 pips in a two hour window.

Firstly, the Bundesbank head and member of the ECB governing council Mr Weidmann, stated that the ECB would have to raise base interest rates if inflationary pressures continue to mount. Secondly, on the Friday banks adjusted their positions ahead of the year end. The European Central Bank was also conducting what’s termed an “asset-quality review” (AQR) which could have revealed European banks needing more capital after taking a snap-shot of their balance sheets at the year-end of 2013. This led to demand for euros to help shore up their balance sheets.

Now if trading wasn’t thin on the Friday, due to many institutional traders still being away from their desks on extended holiday, then these two outlier news events, not covered in the standard forex calendars many of us subscribe to, might not have had the impact they did. However, in thin trading conditions the ice cracked fairly quickly and the USD plunged in value versus the unassailable euro.

Now if you’re a trader operating a what we often term a “between the lines” trading strategy – placing orders, stop losses and take profit limit orders around the key areas of resistance and support and using the various pivot levels from 1 to 3 effectively, you may have enjoyed a perfect quick scalping result, assuming that the trading platform you work from executed your (three part trades) efficiently.

However, if you were a trend/swing trader you were probably caught the wrong side of the trade as based on the obvious observations on the daily chart, prior to the dramatic rise, EUR/USD looked as if it was in a down trend and had been since December 18th, the day that the USA Fed announced the throttling back of their latest quantitative easing programme.

The more experienced amongst us accept that losses are in fact an inevitable part of trading, but swing/trend trading losses can be substantial if we fail to operate a trading plan with stop loss features at the very heart of the plan. With that in mind were there any procedures that we should have adopted which would have seen our losses mitigated when the EUR/USD began its exponential rise? If so what lessons can we learn for our future trading so we can avoid such circumstances working against us in the future? Moreover, if we’d have closed our short trend trade would we have received a signal to go long based on our swing trading strategy. And if so should we have taken it given that the time of year dramatically affected the exponential move?

Stops, where ours should have been placed.

If we accept the rationale that the trading conditions on December 18th would have encouraged a swing short then our stop should have been placed near the recent high, which would have been placed at approx. 13800, which also represented a key level in terms of being what we’d term a “crucial looming round number”, or “psyche level”. On December 18th our signal to enter, by using many of the typical indicators we refer to in our trading examples, would have triggered at circa 13700, therefore our risk was approx. 100 pips. Now if we’d employed the use of a trailing stop, as price moved lower over successive days after the Fed’s taper announcement,  our trailing stop would have adjusted accordingly, resulting in our risk being even less. Perhaps the stop would have been moved circa 25 pips resulting in our risk being now 75 versus the original 100 pip risk.

Moreover, if we’d risked originally 1% of our account on this single trade, then our risk may now be down to 0.75%. Therefore when the exponential rise in EUR/USD came on Friday December 27th, in one of the most inexplicable counter trend moves witnessed recently, it would have left us ‘licking our wounds’ over a 0.75 – 1% trading loss. Whilst any loss hurts we could have actually indulged in a feeling of satisfaction given that we’d followed our trading plan and that one of the more bizarre movements this security experienced during 2013 hadn’t left our account terminally damaged.

To conclude; this recent sharp break to the upside on EUR/USD illustrated several key issues. Firstly, that our percentage risk should always be underpinned by the effective use of stops. Secondly that during this time of year unexpected moves, due to outlier news events underpinned by thin trading conditions, can often take traders by surprise. Thirdly and most importantly, the further up the time frames you trade the less impact these seismic moves have.

For example, if traders were trading off low time frames, looking for ten pips as a move and risking 2% of their account balance, but failed to attach a stop to this trade, then the loss could have been a catastrophic 40%. A loss that could take six months or more to recover from.

With hindsight the lessons of the exponential EUR/USD move are obvious; strict money management, risk, and the effective use of stops will protect traders’ accounts and ensure that whatever the emergency situation they’ll stay in the game.

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