A Forex Lesson from the “Dollar Bear”

Technical Readings Can Help

Perhaps it was due to watching currency guru and fellow Democratic-supporter George Soros make huge successful bets on currencies that motivated him. Maybe it was the money he could potentially lose in his substantial U.S.-dollar-denominated assets if the dollar dropped. For whatever reason, Warren Buffett, the Oracle of Omaha, in 2002 decided  to make a large bet against the buck, and in so doing enter the realm of currency trader. 

According to a January 2005 Forbes magazine article entitled “A Word from a Dollar Bear,” it started with a $12-billion “wager” by Warren Buffett as his company Berkshire Hathaway began buying the euro in early 2002 at $0.86 (see Figure 1). The company continued to buy the euro until it hit $1.20 in a stake that grew to $20 billion. But Buffett remained negative enough on the dollar as the euro was hitting new all-time highs for Forbes to dub him “the world’s most visible dollar bear.”

Figure 1: Weekly Euro/USD

This reveals the period over which Buffett purchased the currency pair from a price of $0.86 to $1.20.   Source: VantagePoint Intermarket Analysis Software

A Winning Trade
There is little doubt that Buffett and company made the right decision between 2002 and 2004. In total, the value of the dollar fell by nearly 33 percent, providing them with a handsome profit.  However, since the beginning of 2005, the dollar began making a comeback. This begs the obvious question, is this short-dollar strategy still sound?

Technicals Versus Fundamentals
It is well known that Warren Buffett generally takes a long-term fundamental approach.  But for those with any doubts, an examination of Figure 2 demonstrates this fact when it is juxtaposed with his published dollar comments in late 2004 and 2005.

As seen in the chart of the U.S. Dollar Index between May 2004 and July 2005 – Figure 2 (which is the inverse of Figure 1), there were plenty of indications warning of a bottom in the dollar (top in the euro).  Buffett still may rely on the fundamentals that initially drove the dollar down, but the smart trader would have exited in May 2005 at the latest.

Here’s why he would.  In Figure 2, the dollar acted as expected by dropping just after points A and B when the indicator in the lower graph was overbought.  But it also is clear that the price continued to drop through the oversold indicator that followed at point C.  In fact, it was almost completely ignored, which is a dead giveaway of inherent weakness.  It was only at point D that the index began to respond to the oversold indicator by moving up slightly with an even stronger positive response at point E.  Price then charged right through the overbought indicator at point F after pausing slightly, even though it is the most extreme overbought indicator on the chart!

Technical Clues Were Key
As price moves past point H and comes down and tests support of the down-sloping trendline, the price of the dollar index turns and heads higher, validating support and confirming the existence of a new uptrend once and for all.  By ignoring the triple bottom (at points D, E and G), the change in chart sentiment from a series of lower highs and lower lows to higher highs and higher lows past point E, the fundamentalist remains short at his own peril. At horizontal line 2, the technician has a number of serious clues that a trend change has occurred (or at least is in the process of occurring) while the fundamentalist carries on oblivious to those clues.

The point is that while fundamentals are important, the technicals are equally as important - if not more so - especially when market conditions change while the fundamentals remain essentially the same.

As George Soros once cynically quipped, “Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited.” Fundamentals may be singing that price should go in one direction, but if the majority is listening to a different tune, the trader will be long broke by the time the crowd finally comes to its senses and price moves in the originally anticipated direction.

For a number of reasons, forex may be the ideal market for the experienced trader who has paid his or her dues in other markets. It is by far the largest in dollar volume, is less volatile than a number of other markets, experiences longer, more accentuated trends and does not have commissions.  But there are no free lunches.

Traders must use all tools at their disposal, and the better the fundamental and technical tools, the greater the chance for success. While intermarket and other relationships often are complex and difficult to apply effectively, with a little high-tech help, traders and investors can enjoy the benefits of using them without having to scrap their existing trading methods.  

Figure 2: Daily May 2004 to July 2005 U.S. Dollar Index

This reveals numbered points when Buffett’s comments about the dollar hit the media. On August 7, 2004 (# 1) when the first story broke, the index was trading at 88.67. Next on January 19, 2005 (# 2) when Buffett reiterated his negative comments about the dollar, it had already put in its low at 80.39. By March 7, 2005 (# 3) Buffett proclaimed that he hoped his bet was wrong - looking at the chart, it looks like he got his wish.   Source: VantagePoint Intermarket Analysis Software

Forex Basics
The primary purpose of the forex market is to provide the mechanism for making cross-border payments and determining exchange rates between currencies. Major components that make up forex are the spot market (37 percent) used by traders and speculators, swaps (43 percent) and finally options and forwards (20 percent).   A forex trade is executed through the simultaneous buying of one currency and selling another (currency pair), and while most currencies are tradable, five currencies (four currency pairs) represent the majority of trading volume - the euro (EUR/USD), Japanese yen (USD/JPY), British pound or cable (GBP/USD), and Swiss franc (USD/CHF).

A major difference between forex and other financial markets is that the former is open 24 hours per day. The trading day begins in Sydney, Australia, on Monday while it is still Sunday in North America and Europe and ends in New York on Friday. There are no commissions, only point spreads measured in pips - with one pip being equal to one-tenth of one percent.  Because the point spread in pips represents the cost of entry, it is desirable to keep it to a minimum.  This is why major currency pairs are most popular; they experience the tightest spreads, often as low as three to four pips.

Spot trading lots typically are worth $5 million to $10 million, with the minimum contract size being $500,000. Amounts smaller may be traded with some firms offering minimum investments of as little as a few hundred dollars on margin far exceeding 100:1, so beware of the risk with this type of leverage.  Currency futures and options contracts also may be traded for much smaller initial margin amounts, and those firms handling FX futures trades – just as for all futures contract – generally charge commissions.

Technicals.  Of all financial instruments, forex is believed to be the best suited for technical analysis for a number of reasons in many traders. First, it dwarfs all other markets in trading volume. According to an April 2004 triennial survey for the Bank for International Settlements, average daily turnover in traditional foreign exchange markets amounted to $1.9 trillion in the cash exchange market and another $1.2 trillion per day in the over-the-counter (OTC) foreign exchange and interest rate derivatives market. Markets never close, so there is no build-up or backlog of client overnight orders or pent-up reaction to news stories hitting the market at the open.  This means that there are no gaps to create instant losses (or gains) for those holding overnight. Additionally, there are very few groups - central banks included - capable of influencing the forex market due to its huge size.  As a result, technical analysis indicators and chart patterns work beautifully once the trader understands the rules. Like their commodity and stock counterparts, however, successful forex traders can’t forget about the fundamentals.

Trend Friendly.  There are two basic types of markets: trending and trading range markets. It is far easier to make money in the former. Currencies tend to experience long- lasting trends that can last for months or even years, making them ideal vehicles for trend trading and breakout systems. This explains why chart pattern analysis works so well on forex. With such widespread groups playing the game around the world, crowd behavior plays a large part in currency moves, and it is this crowd behavior that is the foundation for the myriad of technical analysis tools and techniques.  As a result, most trend-following systems like moving averages, support/resistance, chart patterns (such as triangles, pennants, flags, cups and handles, triple tops/bottoms, etc.) and trend lines also work well.  

Volatility Advantage.  As mentioned earlier, thanks in part to its size, forex is less volatile that other markets.  For example, the S&P 500 Index volatility can range between four and five percent daily (however, the average daily range for S&P futures in 2005 is more than 50 percent less than it was in 2001 – 11 points per day versus roughly 27 points in 2001).  The daily volatility range in the euro is around one percent.

Complex Relationships Abound.  First introduced to the mainstream trading community in a tome entitled Intermarket Technical Analysis: Trading Strategies for the Global Stock, Commodity and Currency Markets by John J. Murphy, the book explained in detail how stocks, bonds, commodities and currencies impacted one another in markets around the world. Trading and investing would never be the same.  In his 2004 book, Intermarket Analysis – Profiting From Global Market Relationships, Murphy performs a post-mortem on what happened in 1997 and how dropping Asian currency markets impacted commodity prices, bonds and, finally, stocks around the world. This dispelled any doubts once and for all about the power markets have on one another.  The challenge from a trader’s perspective is how to take these often-complex relationships and integrate them into a workable trading strategy.

About the Author:  Matt Blackman is a technical trader, author, reviewer, keynote speaker and regular contributor to SFO and other trading publications and investment/trading websites in North America and Europe. He writes a weekly and monthly market letter and is a consultant to Market Technologies, LLC. He can be reached at matt@tradesystemguru.com.

Reprinted from SFO Magazine
Copyright © 2005 SFO Magazine
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