Forex Journal

I would like to walk you through a trade that was placed using a technique that might seem a little unusual – using intermarket relationships and correlations to create trading opportunities in the Forex market. Sound complicated? 

It really is not – so please sit back and enjoy as we explore the use of the stock market as a leading indicator to trade Forex.

On Monday, October 13, 2008, the Dow Jones Industrial Average skyrocketed to its biggest point gain ever, a move of a whopping 936-points. The 11.1% gain was the largest in percentage terms since 1933, and the fifth largest percentage gain in the history of the index. Similar moves were also seen in the S&P 500 and the NASDAQ, as the markets celebrated the end of capitalism, as we know it.  Now that the U.S. Treasury is buying bank stocks, I guess I should congratulate you, since you and I are now are the owners (through the use of our hard earned tax dollars) of stock in many of the nation’s beleaguered financial institutions. Congrats, comrade!

On Tuesday October 14, the markets were bid sharply higher after closing near their highs on the previous day’s rally. A little leftover euphoria, if you will, but all was not well. If the government was starting to back the banks, why was the TED spread not responding by falling back to earth from its record levels?  The TED spread measures the difference in interest rates between the 3-month LIBOR and 3-month Treasury Bills and is a key indicator of risk. The higher the TED spread, the greater the aversion to risk.

Despite the bailout, the TED spread, while off of its record highs, was still above 4%.  Why were banks still charging other banks in excess of 4% above the going rate of a 3-month T-Bill for loans?  What were they afraid of? Could it be that fear and loathing of this rescue plan was lurking just beneath the surface? Clearly, something was not right. The VIX (Volatility Index) also indicated that fear levels were high. It seemed that the public was buying into the rally, while the institutional side remained leery of the bailout package.

As the rally carried through and the indices shot higher once again, I wondered if the market would sputter after the initial excitement wore off.  Many orders for the open of trading came rolling in from an excited public, taking advantage of the opportunity to pick up some Apple or Google shares at what was believed to be bargain prices. Stocks opened higher, but after all of these orders were filled the chance of a reversal seemed pretty high, considering the previous day’s gains and the bullish opening. 

The fact that the TED spread remained relatively high seemed to confirm this outlook, as not everyone seemed to be buying into the idea that all of the market's problems had been solved.  Looking at the 15-minute chart of the E-Minis, there clearly was a reversal taking shape. Please note that my charts reflect Greenwich Mean Time (GMT), which is used almost universally by Forex traders and is five hours ahead of U.S.

This is an excerpt from November 2008 issue of Forex Journal.