The Way of the Dollar

performance of the whole industry has been ruled by the performance of a few managers who have produced outstanding track records. In fact, just three of these, Mint Group, Caxton Corporation and Paul Tudor-Jones, manage about a quarter of the entire futures fund industry –and only one of them, Mint Group, follows a strictly chart-oriented, trend-following system.

People are often impressed at first acquaintance with chartism. If you look at a bunch of charts, you may see, in retrospect, many patterns that seem to have “worked”. But, as with fundamental analysis, what works with hindsight is neither here nor there. It makes no more sense to ask whether charts “work” than it does to ask whether homeopathic medicine works, or allopathic medicine, or psychoanalysis or fundamental analysis. The only thing that matters is whether a tool works for you, or for your doctor, shrink or money manager.

Not being what could be described as a chartist, I just want to set out here those aspects of price analysis which I have found to be helpful in currency trading– those which work for me. Since there are many charts in Currency Bulletin, casual and cursory readers have sometimes wrongly thought CB’s approach to forecasting was price-based. Some of the charts provided in CB are indeed included to allow the reader to “take the patient’s temperature”. But their main purpose over time has been to demonstrate relationships between currency movements and various other “fundamental” data, such as money supply, inflation, interest yields, trade, economic activity et al.

In the special case of the relationship between price and IMM open interest, we are trying to discern a feedback process. In this, the daily price movements in the lMM contracts are used to help interpret the significance of the speculative open interest in order to see if speculation holds any implications for currency prices. Are you with me? This isn’t what you would call “chart analysis”, though you might call it “technical analysis”. But there are things that are which all of us can use in the currency markets for our profit. Here are the cherries in chart analysis.

Using Trends

The first is what I’ve called the trend-line imperative. You all know the cliches. “The trend is your friend” and “a trend is a trend till it ends”. Well,

in the tautological rhyme lies a nugget of gold, which may alone explain the superior performance of the futures funds (mainly trending systems) over time. Markets, we are told, only trend 15% of the time (the rest of the time they are ranging); but by definition, when they are trending is when the big moves happen. Moreover the big moves are quite often made in a narrow range, which can surprisingly often be defined at an early stage in the move.

That’s the cherry in trend1ollowing systems. They are useful when, and only when, you have been able to define a more or less narrow trend channel early on. All the rest of the time they are useless.

Of course it’s only with hindsight that we are able to know we have defined a trend channel early on. Pure trend-following approaches that use only price will be constantly whipsawed by ranging markets and ill-defined trends. That’s not news: trend followers are “right for the trend and wrong at each end”. They know this, and they expect to make a lot of small losses along with a few big wins. But there is this difference between a trend– following system and a pin, namely that on those occasions when the market offers a clearly defined trend, the trendline imperative keeps the system in, whereas a pin lets you out half-way along.

The trendline imperative, let’s be clear, says that you must stay with a trend until it’s broken. That’s all it says. It does not say you must get out when the trend is broken: in that event it simply no longer applies. Trends have no predictive value: they just prescribe “no action” in certain circumstances. The golden nugget lies in the fact that trends often run on much further than we can possibly imagine –and much further than we can predict on the basis of the most perfect “fundamental” analysis. So on those occasions when you happen to be riding a well- defined trend, you have a special advantage if you adhere strictly to the trendline imperative. It may be this small statistical advantage which has enabled some disciplined trend-followers to “beat the market” over long periods. If it does nothing else, the imperative removes fear and greed from the equation while it’s operative.

We shall consider later the question whether markets tend to trend because that is their nature –or whether some markets trend more than would be statistically normal. It is certain that the dollar did trend in a remarkably well-defined fashion in the 1980s –though that means nothing for the future.

Unlike pure chartists, we have other tools than price for analysing the currencies. How do we make use of trends? Answer: we cherry-pick. We don’ t use trends – or any other aspects of charting (see below) – unless we

see the cherry hanging there. In other words, if as a result of our independent analysis we hold a position which subsequently develops into a well-defined trend, then we can take advantage of the trend line imperative –to hold us in a winning trade which we might otherwise leave too early. On the odd occasions when this happens we hope to pin down the statistical advantage.

Consensus Realism

A lot of currency participants use charts –perhaps because the fundamentals have proved so confusing to so many for so long. It pays to recognise this. If certain price patterns producesome kind of consensus among the players, we shall not only not fight it: we shall try and profit from it. This approach to charting has been labelled “consensus realism”. It acknowledges that some patterns that chartists think have predictive value can be in a way self– fulfilling.

The more obvious the pattern, the more realistic we should be about not standing in its way. One thinks first of the big-ticket items like the “head and shoulders*” reversal, and the “break-out*” from long consolidation ranges.

Given independent tools of analysis, we are not going to initiate positions in the event we should see such patterns formed. But if we already have a contrary position, we would consider closing it quickly; and if we have an aligned position, we would let it run until any chart-driven thrust that might develop ran out of steam. In any event, we would be on the look-out for the extreme of the chartist thrust, in order to go contrary.

The chart above depicts the big head and shoulders pattern in the D-Mark, at the peak of the dollar’s great bull market in 1985. The break of the “neckline*” at DM 2.97 clearly signalled “ get out of the way” .But the

break down to DM 2.85 amid extreme bearishness of the dollar shouted for a contrarian trade, going long of the dollar for the ride back to DM 2.97– ahead of the famous New York Plaza meeting, when the dollar was once again ready to follow the line of least resistance, which was obviously down. Without hindsight, no kidding. Note that the dollar retraced all the way back to the original neckline break of DM 2.97, blowing away all the short-term traders who waited for the break to sell it.

Patterns that Work

Chart patterns that work, as I say, are the ones that work for you. The test, as always, is the bottom-line profit and loss account, not hindsight. Very few work for me. But there are a few