The Way of the Dollar

in at the start” of a new move. That means we are often “bottom-fishers” whether we like it or not; and we know we can’t catch absolute bottoms. So we have to cope with the kind of volatility you get at bottoms (or tops: there’s no distinction in currencies) –which can be a stomach-churning exercise. With this, options can help greatly, because they lose value increasingly gradually in the event of adverse price movement. Conversely, when the script is right and the gamble pays off, options gain value at an increasing pace. Thus our dollar exposures increase and that can help to remind us – when we’re in danger of thinking we’re smart – that our risk has risen geometrically. So we’re positively encouraged to take partial profits, which is alright as a percentage play.

CHAPTER TEN

“The perfect speculator must know when to go in;

more important he must know when to stay out; and most important he must know when to get out once he’s in. “

Attributed to JAY GOULD

Getting In.

Perhaps we should consider’ staying out’ before considering ‘going in’ , for as Jay Could said, knowing when to stay out is more important. But the rule for staying out is simply “do so unless all the pieces fit”. So there we have it. Unfortunately it’s a rule that almost every– body has to learn again and again and again.

The ‘pieces’ have been described in earlier chapters: they are our friends A) the main trend and its underlying rationale and B) the 4 sentiment indicators, that tell us how near to an extreme turning point we are.

In the summer of 1989, as we know with hindsight, the 18-month-old slide in the European currencies was coming to an end. At the time, the signs were tentative: what we saw at the end of May 1989 was 1) that the interest rate differential between the dollar and the rest had narrowed significantly (from 4.5% to about 2% in the case of the D-Mark); and 2) high bullish sentiment in the dollar, as reflected in CB’s sentiment gauges.

Well, there are no such things as certainties in financial markets (when

the dust has settled, the train has left the station). But all the pieces suggested at that point that some kind of extreme in the dollar was close: high bullishness of the dollar was accompanied by substantial short positions in the Chicago currency contracts. That called for immediate action to liquidate all long dollar trading positions: that means that treasurers and other speculators go ‘flat’, while investors cut back to ‘core’ positions, which are those positions which they are happy to hold through a multi-week correction of maybe 10%. We can’t see into the future: we do not know whether the main trend is threatened. Stage I, getting out of the old position, is the first step in “getting in” to a new one. It helps you to look both ways – up and down – rather than just the way you were facing before. Having got out, there is a good case for staying out longer than you may be inclined to. This is a hundred times easier to say than to do.

If we use sentiment gauges to get out, we’re likely to be early. At this stage, we have to be unconcerned with whether we are right or wrong: the only issue is whether we follow our rules faithfully. If we’ re early, the crowd will still be ‘making money’ following the old trend. That’s OK: the crowd is going to be ‘right’ before it’s wrong-footed, which it always is at turning points. This is where we have to think about time- frames. Inevitably, our time-frame has to collapse as we get closer to the turning point: we look for the day and the hour for getting out –and indeed for getting in. The trouble is that this reduces us to the lowest common level. Everyone is shooting for the exact turning point; but no- one has any way of locating this point except with hindsight. The solution is to keep on saying to ourselves: “let that be someone else’s problem”. Having no way of picking the exact turning point in advance, we will not worry about doing so.

To return to the dollar in mid-1989, the sentiment gauges told us to flatten our positions in May .The dollar’s peak came in June with a violent blow-off on what CB called “loony Thursday” 14 June. And for once we had as clear a signal as you can hope to get in financial markets that an important peak in the dollar had actually been made on that day. The only hindsight we needed was a few hours. That Thursday was full moon (hence “loony”); IMM speculation in Yen and DM was at record levels; and to cap it all, we had “key reversals*” (one of the few reliable chart patterns – see Chapter 6) in all the major Chicago currency contracts. Thus It was possible to conclude at the time that “Thursday saw a multi-month high in the dollar” (CB of June 17). This was the signal to move to stage II and get in.

We can’t expect a bell to ring at the exact top or bottom. But the lesson is that if a bell is going to ring, we cannot know it before the event. So we must give the market a chance to tip its hand. We must give it time to make

a little tinkle if it’s going to. We get out when the sentiment gauges tell us it is time to do so –but we don’t get back in until all the pieces fit. We don’t have to be right. We don’t have to worry about catching the exact extreme. What we have to do is get as little exposure as possible to doubt. Which means staying out, until we can go in with confidence. Doubt equals losses.

If we are fortunate enough to have as clear a signal as we had on June 14 of an extreme in the dollar, there is no doubt that traders should play for the reversal with as big a position as they are comfortable with –for such opportunities are not common. The size of the position is determined by the maximum loss you are prepared to sustain in the event you’re wrong or your timing turns out to be wrong. This was a possible moment to use call options* , though not ideal, because our script had clearly located the dollar’s extreme already, making a better case for a straight bet in the forward or futures market. (A better moment was to come soon for call options).

On futures or forward purchases, the maximum exposure can be determined by a stop-loss, which could be placed, on the D-Mark for example, at a close at just beyond the previous dollar intra-day high of DM 2.05, i.e. at a closing price of DM 2.06, say. You determine what you are prepared to lose as a percentage of available funds and in dollar terms (that helps to concentrate the mind); and the drawdown to the stop- loss tells you how big a position to take on. If you’re risking a 2.5% drawdown (price decline), and wish to limit your loss to 5% of funds, your exposure must not exceed 200% of available capital.

The currencies rallied a respectable 12-15% from their June lows. The

central banks had won an expensive battle – the Fed alone having spent $12bn in support of the greenback. But the next three months were to be a difficult and instructive period, during which it was by no means clear that the banks had won the war. Initially the currencies were driven up by heavy short-closing. Then the speculative interest began expanding in line with price as can be seen from the IMM charts. But this was a trap, and down came the currencies, up went the dollar from the start of August – so that by early September the dollar looked as if it might retest its June peaks and maybe continue its bull trend.

Yet once again, as in June, there were warning signs of an extreme approaching. There was “too much dollar bullishness” – with a big speculative short interest; and the greenback’s yield premium had been whittled back as low as 1.5% against the DM in August. Once again, it looked as if “prudential profit-taking” on long dollar