With the ECB lowering the overnight deposit rate to negative territory last week, many traders were left disappointed. Euro-dollar did not break lower. The reason was market expectations and risk reward ratios, which many fail to take into account when trading. Markets are forward-looking: people take positions today, expecting a specific outcome in the future. This is true for euro-dollar, as the ECB had hinted in May that a cut might be implemented in June. Euro-dollar declined by 400 pips over the period.
Since investment professionals were already short the euro, they were reluctant to enter new short positions, even if the long-term implications of the ECB’s June actions are, according to most market participants, euro negative. To entice them to short further, a corrective rally in the market is needed. With the euro already down 400 pips, the decline was exceeding the historical monthly range by 50 pips. This makes the short-term potential gain lower than the short-term potential risk.
A corrective rally to the $1.38 zone is what traders would like. If this happens, we would leave the lows, generating a potential gain of 300 pips if we revisit the $1.35 low, while price would also be about 200 pips from the $1.40 level, the yearly high. A trader with a longer-term bias and bearish euro-dollar view would be happy to sell close to the $1.38 zone, as the risk would be about 200 pips and the potential gain about 1,000 pips. This is the decline that market consensus is expecting on the back of the ECB rate cut and higher US rates by 2015. With these setups, we incorporate the risk reward ratio and adjust for short-term expectations already being priced in.
Alejandro Zambrano is a currency analyst at DailyFX. Azambrano@dailyfx.com Twitter:@AlexFX00