Talking Points:
- Volatility draws speculators in, but diving into such active markets requires a better handle on conviction
- Large moves may reflect temporary motivations that are quickly retraced or major, lasting shifts in value
- We evaluate what category the S&P 500 and GBP/USD moves fit into as well as the risk of a lasting shift for Euro
See how retail traders are positioning in the majors using SSI readings on DailyFX's sentiment page.
Aggressive and sudden moves from the markets often draw out the contrarians. The volatility pulls in traders that hope to take advantage of the aftermath, and the presumption usually runs that a comparably dramatic move is most likely to be found in the correction. It is true that volatility generally reverts to a 'normal' level given time. However, strong moves in the market do not necessarily reflect a misalignment that needs to be corrected. Strong moves may reflect a permanent change in fundamental value or the supply-demand balance that can mark the new balance for prevailing price.
Separating the 'temporary' from 'permanent' large-scale market moves is critical to entering the market with the correct bearings and expectations after the flush of volatility has appeared. To identify the one from the other, motivation is generally the best metric - this means the fundamental shift that prompted the swell in activity in the first place. If the move arises from the 'animal spirits' or pure speculative drive, the conviction is typically short-lived and reversals are reversals to levels more indicative of value are likely. This is arguably the case of the risk-oriented assets like the global equities in the aftermath of the Brexit.
In contrast, the substantial drop in the GBP/USD and Pound-based crosses after the UK's decision to leave the EU is more likely an enduring shift in the perceived level of balance for the currency. The long-term uncertainty and complexity that follows in the wake of the vote with profound implications to its reserve status pose a fundamental weight that does not simply ease to a quick Pound rally. The same risk of a sharp and lasting shift looms for the Euro. As one member pursues a withdrawal from the Union the risk other others following suit undermines the perceived sanctity of this number two global reserve. We discuss the difference and trading approach between temporary and lasting shifts in markets following large market moves in today's Strategy Video.
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