Friday’s headline in the Financial Times gave us a quick reading on the emotional state of the markets. It says, “World Equities Slide as Markets Shun Risk.”

This may be unwelcome news for stock traders, but it is not bad news for investors who take part in forex currency trading. The swings from risk aversion to risk appetite are always with us. It may change from day to day and week to week, but it is not a surprise. The key to success is to correlate the prevailing sentiment with the trading opportunity. Let’s look a bit closer at the current risk-aversion sentiment.

The chart below shows an interesting co-movement between the S&P 500 and the USDJPY from October 2009. When the S&P strengthens, the USDJPY chart also moves up. When the S&P weakens, the USDJPY chart moves down. This is clearly showing that the yen is acting as a “safe-haven” basket when the market is risk averse.

For equity investors, this is a significant contemporary correlation. It means that equity portfolios can be protected with currency options. That is, a put on the USDJPY becomes a protective strategy for those fearing further declines in the U.S. equity markets. If the S&P falls, you can expect the USDJPY to fall in tandem – increasing the value of your protective put.

A Reuters article last week provides further insight into the dynamics of how risk aversion plays out in the currency markets. Under the headline, “U.S. Dollar Rises Broadly On Global Growth Fears,” it says:

The U.S. dollar rose against major currencies on Thursday, extending the previous day’s gains, as an unexpected rise in U.S. weekly jobless claims and weaker-than-expected euro zone data spurred safe-haven demand.

Why would the U.S. dollar get stronger when the U.S. economy is weakening? I’ve discussed this before – from a global perspective, money still has to go to where it is protected. In times of trouble, the U.S. dollar becomes, like the yen, a “safe-haven” basket. That is why holding the DB U.S. Dollar Index Bullish Fund (UUP) is a risk-aversion play. The U.S. Dollar Index is breaking out of a downside trend and has the potential of moving 10% within weeks, taking UUP along for the ride.

What we have, however, is a very interesting situation. We have the dollar weakening against the yen, but also strengthening as a global basket. It is a balancing act and very delicate. Too strong a yen provides great problems for the Japanese economy. As a result, intervention expectations are being voiced. The USDJPY pair is nearing major support at 84.60.

All this bodes well for formulating option-trading strategies – I think a USDJPY play could deliver impressive gains for investors in the next few days. If you’re new to playing forex options, stay tuned; I’ll have more details on this lucrative investment strategy in a future edition of the Penny Sleuth…

Sincerely,
Abe Cofnas
Penny Sleuth

August 17, 2010

Abe Cofnas

Abe Cofnas has been a full-time analyst of global currency trading for over twenty years and ranks among the top Foreign Exchange (Forex) traders working today. He has written three books on the subject. The most recent, Sentiment Indicators was published in 2010. Cofnas is the managing editor of the Fear & Greed Trader, Agora’s primary source for currencies information. He has also been Futures Magazine’s Forex Trader columnist since 2001, having written over 100 pieces.

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