Contrarian View – Australian Dollar and Euro vulnerable to a squeeze higher

June 13, 2012

FOREX

When I did links this morning over at Macro Business I posted an article noting that US money continued to flow out of Europe last month. I also saw that the Euro was back above 1.25 and the Aussie Dollar was around 0.9950.

Chart courtesy of AVAFX Mobile off my iPhone

Given the European malaise and the potential catastrophic catalyst the Greek election could be on the 17th you could posit that the Euro should be somewhere closer to its lows and the Aussie Dollar shouldn’t be close to parity once again.

You’d be right but also wrong.

The key here is market positioning. What’s market poisoning and why is it important?

20120613-090450.jpg

The best way to explain it is to use a metaphor.

So imagine a stunt plane like the one doing spins, loops and barrel rolls above. It goes along fine up and down. But then the pilot decides he is going to climb vertically – he goes up and up until at some point the engine stalls and then what happens? He falls back to earth – gravity is unavoidable. Equally he has a lower limit called the ground of the sea and he has to be wary of mountains as well too.

Markets are no different.

If too many traders pile in to the long side and drive it ever higher or, has been the case latterly, pile into the short side at some point the selloff runs out of more people to sell – it simply stalls because everyone who wants to be short is short. Without more negative catalysts or bad news there is no more selling.

But you’re probably wondering how do we judge if we are nearing the stalling point.

It’s a good question and trying to figure out where positioning is in a $4 trillion dollar a day market is very difficult. But traders use proxies. The best proxy is the CFTC Commitment of Traders report for futures traders in US Futures exchanges. It is only a small portion of overall trade on any given day but the types of trade it represents tells us something about the “trading” community and where their positions probably are skewed.

As you can see in the chart above of the latest data from the CFTC Aussie Dollar and Euro bears were at or around record levels as at the 5th of June. Last night’s positioning will be released later in the week but even the rally will still likely leave the market quite short and therefore like our stunt plane  gravity will or has taken hold.

So what does it all mean.

There is a chance for an asymmetric pay off here if  you are of the view that Europe will pull itself together, if you think the Greek election and the Government the Greeks choose may not be as scary as the Market thinks or if you simply think that the recent run of poor data will be reversed.

This last point about the data is important in the context of why the market positioning is so skewed to the short side.

As you can see in the chart above it is no surprise that the heavy build up in Euro and Aussie Dollar short positions accompanied the really poor economic performance – or at least the fact that the market punditry was overly ebullient and data outcomes were weaker than expected. Obviously last week’s data in Australia was different and as a mean reverting series (at least they look that way to me very long-term – even if I haven’t run the statistics over the top) expectations will have been re-calibrated so that data may now provide upward surprises.

So there is risk to the Bears here as well.

So maybe for traders who have a high risk tolerance or, as I say above, think that there is already much bad news priced into a short market might like to buy Aussie Dollar and Euro or less risky use the options market to buy calls – it could reward handsomely. In the current environment it’s not for the faint hearted but then again trading never is.

Have a great day

Greg McKenna

www.twitter.com/gregorymckenna

Please remember these are not recommendations for you to trade these are my views and I have my risk management tools and risk parameters that you do not have access to. Thus, this blog is for information only and does not constitute advice. Neither Greg McKenna nor Lighthouse Securities has taken your personal circumstances, objectives or financial situation into account. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation or needs.

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