Online Trading Academy Lessons from the Pros 10/05/05: Forex Insights

Gold and the Aussie
Lessons in Shaping Your Next Trade
October 5, 2005

Abe Cofnas has spent over a decade as an equity broker, futures trader, and technical analysis instructor. Abe was one of the first professional trainers in the world to provide web-based interactive training exclusively on Forex trading. Since 2001, Abe's Forex Trader column in Futures Magazine has been a mainstay of the publication, providing innovative observations and educational tips on Forex trading to a world readership of over 65,000 traders. You'll enjoy learning Forex from this master!

Currencies are ultimately a play on the economies that they represent, as well as expectations of future economic performance. As a result, Forex traders need to look beyond price action in a particular currency pair and need to assess the global economic climate as well. Gaining a good handle on how Forex prices are affected by fundamentals will help the Forex trader detect important moments of opportunity to trade.

The driving factors in assessing global economic health and prospects are interest rates, and global growth. But a good indicator that demonstrates global sentiment regarding a currency pair’s valuation is the price patterns of Gold. Gold acts an alternative haven for money flow. When there is increased uncertainty about the prospects of the US economy, Gold attracts capital that is flowing out of equities and other assets. Therefore the Forex trader that is scanning the globe for clues about the "sentiment" on the dollar can look to Gold patterns as a psychological measure of market expectations about not only the US Dollar, but other currency pairs. The inverse relationship between Gold and the USDX is an important phenomenon illustrated by the chart below.

Although Gold and the dollar move inversely, Gold also has a positive correlation with some currency pairs. We would expect this positive correlation since money is looking for alternatives to the Dollar and other currencies, as well as Gold can act as a safer haven. A good recent example is the price action of Gold compared to the Australian /USD pair, also known as the Aussie. It is estimated that the correlation between the Australian dollar and Gold is nearly 85% due to the significant Gold production coming out of Australia. That is why the recent moves in gold are so interesting.

The recent price action in Gold shows a broad ranging behavior from approximately $410 to $445 and then a breakout of Gold starting at the beginning of September.

This breakout however, looks very different when one compares Gold with the Aussie.

The following chart shows a spread between the two and we see a dramatic divergence starting right after September 12th. Gold started sloping up, while the Aussie started sloping down! This relationship is commonly known as divergence, and is one of the most important concepts in technical analysis of price movements. Divergence means that the price is moving opposite to another price or indicator. When divergence is detected, it is worth further attention by the trader. The fact that Gold started moving opposite in its direction to the Aussie about Sept 12th signaled that the move in Gold was unusual. Either the Gold move was likely to revert back down, or the Aussie was likely to turn up.

The market, soon after, in fact began to see this divergence slowdown and began to revert back to the traditional alignment between the Aussie and Gold.

What can we learn from this example? This is a classic case where knowledge of inter-market patterns and fundamentals helps traders both in commodity and Forex markets. The commodity trader looking at the Gold price action wants to look for confirmation of the sustainability of the move. The sharp, almost parabolic path is usually a prelude to a reversal. The Forex trader, knowing that a currency pair like the Aussie is usually highly correlated to Gold moves, seeing a divergence, the Forex trader needs to reexamine and reshape the trading strategy.

While divergence is not a fool-proof predictor, the one that happened with Gold was serious because a divergence between Gold and a currency cannot be sustained or long lasting due to fact that fundamental forces have tied both together.

As the Gold story unfolds, the trader looking for signs of further strength in Gold will find important confirmation if currency pairs that usually move in tandem with Gold follow the Gold patterns. In shaping your next trade, keep that in mind.

Fundamental Tip - Inter-market relationships between commodities and currencies are a valuable method of improving your Forex analysis. Forex traders should also involve evaluate how currencies correlate or diverge from other commodities and futures instruments, such as the energy complex, (crude oil), the CRB index, and even grains.

DISCLAIMER:
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results.