2010-06-24

Who's making the trading decisions in the market?

I had read this Macro Man post earlier—Follow your leader—but it didn't click until I read this post from EWI: EUR/USD: "Initial Reaction Will Be To Sell Dollars"
The U.S. dollar weakened on June 23, pushing the euro-dollar exchange rate as high as $1.2340.

Analysts attributed dollar weakness to the Federal Reserve's decision to leave U.S. interest rates unchanged and cautious talk about the economy.

But here's what's interesting.

Look closely at the day's action in the EUR/USD and you'll notice that the pair began to rally (i.e., dollar began to weaken) around 10 AM Eastern. By the time the Fed's announcement rolled around at 2:15 PM, the EUR/USD was already at $1.2285, some 70 pips higher. It only added another 60 or so pips after the announcement.

So it's clear that the market was way ahead of the Fed. But how can that be -- aren't prices supposed to move only when something is "moving" them?

The Elliott Wave Principle explains that markets are not driven by cold, hard reason. The real driver is market players' shared mood. It doesn't change with the news; it moves in Elliott wave patterns. That's what makes forex markets predictable.
Now, here's what the Macro Man had to say about trading desks:
Let's start with a situation once witnessed while working in the Far East markets.

When a junior trader was asked what he had in EUR/USD he said he was small long. Why? Because the trader next to him was longer and he knew something. When asked what he knew, he replied that his Head of Desk was long even more. So the Head of Desk was approached and interrogated. It turned out that he was long because the Head of the Room was longer still. Not easily put off the trail, he too was approached and asked if he knew anything about EUR/USD? "Not really, but the Treasurer has put a position on so something must be up". On we go. As it turned out the Treasurer was long because "A friend at another bank had told him that China were on the bid". When told what the whole room's exposure was on the back of this chain of rumour he was horrified. And this was only in one bank. If this was being repeated in banks across the region then the positions amassed on this whisper were huge and at some point were going to have to be unwound, which duly happened in a massive dump at about 9.30 London as Asia went home.

So why does this happen? Well behaviourally it's simple really. If you mirror your boss's position in a smaller amount you have 2 possible outcomes:

1. You make money.
2. You lose money, but not as much as your boss so he can't chastise you.

Since then watching the Asian close has always been an interesting time of the day to gauge the spread between rumour and fact. Which brings us to today. The Chinese-inflicted kicking of the FX market yesterday appears to have elevated their general FX status back to old Voldermort levels. And it appears that the whole world is so terrified that they may be buying EUR/USD around the 1.2240/50 level that is enough for everyone else to be long ahead of that level. But how much?
At least in this example, the market players were not even behaving rationally (from an investment perspective, not an employment perspective) to being with. The dynamic within the trading firm is not that different from the dynamic in the market, both exhibit herding behavior.

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