Trading Fundamental Pullbacks is a simple strategy that involves patience to wait for the medium term sentiment to bring prices back to a place where it makes sense for large investors to see a bargain and want to get back in or add to an existing position. In this Wiki, we will explore this concept and understand how you might be able to capitalize from these types of opportunities in the Forex market.
This Wiki is part of our Fundamental and Sentiment Trading Strategies Wiki. Be sure to check that out HERE.
Trading Fundamental Pullbacks
Trading fundamental pullbacks is probably the simplest strategy of all and basically involves patiently waiting for the short or medium term sentiment to change the flow of the price away from the overall fundamental trend.
A classic example of this can be taken from the example we used earlier when in 2013 the BOJ’s decision to launch its QE program. This had the effect of the severe weakening of the Yen as the BOJ printed trillions worth of Japanese Yen every month in an attempt to get inflation up to its target range. At the same time, the Federal Reserve in the US was about to stop their own QE program and start the long march towards raising interest rates and normalizing monetary policy. This gave the perfect divergence between two central banks both moving in completely opposite directions with their monetary policies. One central bank was starting and the other was stopping QE. When this happens there can only be one way that the USDJPY will go which is up provided all else remains equal.
As traders, we would buy dollars and sell Japanese Yen. However, it’s not as simple as the pair moving up every single day. There are short term events that will cause the pair to drop and sometimes quite heavily. Let’s look at one example of this and how it affected the pair during this time.
At the beginning of 2014 we had a crisis in emerging markets as traders started panicking about the fact that the Fed was ending its flow of cheap money via QE. They reasoned that this meant that emerging markets would suffer as the investment from that cheap money would dry up. The equity markets went into a chaotic freefall and everyone headed for the traditional safety of the Japanese Yen.
Despite overall fundamentals being in place the short term move saw the USDJPY drop over 450 pips as highlighted by the blue box on the chart below. This was quite a large move given how strong the central bank divergence was at the time. However, when the market is fearful it will react strongly. The USDJPY eventually recovered and reached over 125.00.
Other Yen pairs such as the GBPJPY fell as much as 1,000 pips as everyone bought the Yen as a temporary safe haven. Many traders also panicked out of their long term fundamental positions but other traders had been waiting for this type of event. The reason was that they now had a really cheap price at which to enter the trade and ride up the move as the markets calmed down and regained their rational thinking and returning to the central bank divergence trade.
This type of trading requires patience and focussed research but can yield fantastic returns if you can keep a cool head when the rest of the market gets sucked into some temporary story that will not last longer than a few weeks.
If you are already in a long term fundamental position you should have your stops in place because you never know how far the market will move against you as not many people can stomach 10-20% drawdowns especially if they are managing client accounts. At the same time make sure to plan ahead. Perhaps you could identify a few key price levels that look good to get back in if the market gives you a chance.
The Yen pairs are generally more volatile than most because of the safe haven element but these types of pullbacks will happen across all currencies for reasons as simple as traders exiting their trades and taking profits.
The best way to approach this type of trading is to do your daily research as normal and then relate this to where the prices of various pairs have been trading over recent days or weeks. You will naturally notice that some pairs are just not where they should be trading and in the completely opposite direction based on the policies of the two central banks. When you see this it’s time to zoom in on the pair and find out exactly why it has been moving as it has using the research and news feeds. If it is due to some temporary event then you can consider this an opportunity to enter the pair. Splitting your entries could be used to enter which is a perfectly valid method for your trading as a whole.
What questions should you be asking when investigating an opportunity?
When the short term sentiment is over will the fundamental divergence between the two central banks still be in place?
If the answer is yes then you need to start planning your entry and identify the best time to start getting involved in the market. There is no perfect time because anything can happen at any time which is why we go to great lengths at making risk management a large part of everything we do. This way, whatever happens in the markets we are protected.
If you are day trading then you will naturally see these opportunities as well but please do not feel that you should only be trading a specific strategy for your system. Remember, trading is about finding opportunities. If you find gold in your garden you wouldn’t leave it in the ground because selling gold is not your method of making money, you would seize the opportunity and make the extra money. The same is going to be true of your career as a trader. Your job is to seek opportunities to make money and everything that you have learned here will help you spot these opportunities like a professional. As you trade and practice these skills the amount of money you make will gradually increase over time.
Trading Pullbacks against the Long Term Fundamental Trend
Once you have determined which currencies should be moving in which direction you then wait for these currencies to move in the opposite direction that they should be moving. Essentially you are waiting for a pullback to happen against the overall big picture.
Pullbacks against the long term fundamental picture can happen for a variety of sentiment reasons that we have already looked at in our previous Wiki on Sentiment Analysis. Some of the more common reasons are profit taking, risk on risk off, safe haven flows, etc.
Marking key levels of support and resistance can give you great ideas and potential entry points of where to get in when price is running against the fundamentals.
As long as the move counter to the fundamentals has not changed the overall fundamentals and is just short term sentiment or profit taking move then the trade in the direction of the overall fundamentals is still valid.
This style of trading takes a lot of conviction to hold against the current market move. Traders will need to have a lot of patience to wait for the right moment to enter.
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