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A Reasonable Trading Approach for Doldrums and Surprise

A Reasonable Trading Approach for Doldrums and Surprise

2018-08-21 04:00:00
John Kicklighter, Chief Currency Strategist
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Talking Points:

  • There is no single trading approach or strategy that works for all market conditions - and we face a clear dichotomy
  • The weeks preceding the US Labor Day holiday are often some of the most quiet of the year, but there are notable exceptions
  • Markets that can move in the same direction regardless of illiquid drift or intense surprise (Gold, Dollar, Yields) are ideal

See how retail traders are positioning in GBPUSD, EURGBP, GBPJPY and other FX majors along with indices, gold and oil intraday using the DailyFX speculative positioning data on the sentiment page.

One of the Most Anxiety-Ridden Doldrums in Recent History (key examples of volatility)

We are in the thick of the Summer Lull. Historically, the month of August is the least active of the calendar year for the speculative markets. I qualify this through averaging the monthly performance of the S&P 500 as a sentiment benchmark in both percentage change and volume going back for decades. From where does this market norm arise? There isn't a series of closures for the market as with the month of December. Rather, the so-called doldrums are a result of general expectations following year after year of reinforced habit. That said, there are notable examples where explosive market volatility has developed in August specifically. The broad and intense tumble in all risk-oriented markets in 2015 is perhaps the most notable corollary. In fact, the three year anniversary of this date finds us in the midst of a long overdue tumble for speculative assets following years of artificially buoyant markets based on extreme monetary policy. It just so happened that the stumble in 2015 kicked off with a sudden devaluation in the Chinese Yuan that was the result supposedly of a new pricing approach. The market assumed this would touch off another currency war or that it was perhaps evidence of Chinese losing control of the reins. We are in similar straights today. Complacency and misplaced market conviction are readily apparent for most traders. Meanwhile, we have a litany of potential catalysts, and China just happens to again be one of them.

SPX Average Monthly Volume & Change Chart (1980-Present)

A Reasonable Trading Approach for Doldrums and Surprise

SPX 500 Daily Chart (2008)

A Reasonable Trading Approach for Doldrums and Surprise

The Difficulty in Trades Optimal for Quiet Drift and Surprise Drive

We find ourselves trading between two dichotomous market types. If we are throw our conviction behind seasonality, the assumption would be for thin liquidity to reinforce technicals' influence while clipping any bids for momentum short. Alternatively, if the market has set up to another explosive market rebalancing triggered by any of these high-level fundamental themes (trade wars, currency wars, sanctions, the implosion of monetary policy), the shallow market will exacerbate large moves that could even tip into a systemic reversal that could force an early dawn into fall trading conditions. For the former market type, we would look to employ range trades, fade attempts at overzealous breakouts and look for 'paths of least resistance'. For the latter, lower probability conditions, the preference would be to position for hyperbolic moves on assets that are directly in the line of path to either general risk trends or the specific fundamental themes that have kept the financial markets unsettled. These are obverse conditions that would necessitate very different approaches to navigate the markets successful. How do we reconcile these possible scenarios? We can filter markets where the path of least resistance happens to align to the course markets would take should a fundamental shock ripple through the system. There are many of these options, but there are some particularly well-suited ones.

Suitable Options in Gold, Dollar and Treasuries

One of the most remarkable convergences in technicals, fundamentals and positioning to favor contrasting outcomes can be found through gold. The precious metal has been buffeted for months owing to the persistence of both risk-leaning benchmarks like equity indices and the US Dollar itself. Both trends carry their own fundamental shortcomings that place them at risk. However, the metal's slide has also drawn notable contrast to an important role it plays as a safe haven - all while the aforementioned anxiety picks up. In a turn for volatility, it would add more weight to a drive to revive the metal. Yet, it is the past of least resistance that could prove far more promising for a bullish recovery. After months of decline, we have seen net speculative futures positioning (from the CFCT) drop to its first net short position since 2002. That is a heavy, one-sided position that can be unwound. A factor in the metal's push, the US Dollar shows itself in a similar situation whereby both market scenarios could support a USD retreat. In a sudden shock, the Greenback's suitability as a haven at the center of so many provocative international threats will increasingly place pressure on its shoulders. In a seasonal range, the EURUSD's drift can spread to the broader market and the aggregate net speculative futures positioning having swung to the biggest net short in five years to the most robust net long in nearly two will offer some gravity. And, then there are Treasuries. While fewer people trade these assets, risk aversion would likely follow any shock of volatility which would raise yields and undermine Treasury prices. Alternatively, status quo tests the appetite for paying a premium for low market yields, the same sentiment that has driven a record net short position from the open markets on the 10-year Treasury note futures. We discuss filter traders for options that are appealing whether we hold pace of break from it in today's Quick Take Video.

Speculative Positioning (Futures, COT) Gold Chart

A Reasonable Trading Approach for Doldrums and Surprise

Speculative Positioning (Futures, COT) US 10-Yr Treasury Yield Chart

A Reasonable Trading Approach for Doldrums and Surprise

Speculative Positioning (Futures, COT) DXY Dollar Index Chart

A Reasonable Trading Approach for Doldrums and Surprise

--- Written by John Kicklighter, Chief Currency Strategist for DailyFX.com

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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