One of the most important elements of entering a longer term trade is understanding why you are doing such. Price will go higher or lower alone is not sufficient. You need to understand the basis for such movement in price.
That way as the trade evolves you can begin to understand if your thesis is correct or not. Price and other indicators can then validate keeping the trade on or invalidate in which you need to reassess and or take the trade off.
The basis for what I wrote above is that as this current trade evolves failure to understand the thesis for the trade will unfortunately get you out of your position prematurely. The original basis for this trade was that strains within credit would first appear in the currencies and then force a selloff in equities. First through commodities and various sectors which are inversely correlated to the USD and then eventually across the entire equity complex.
So far the basis for this trade, credit and the currencies has been validating the thesis. Some will say markets have sold off because they were stretched or due for a mild pullback where a base can be built and new highs achieved in the coming months. There is a stark contrast in the basis for being short here based on both of those trade thesis.
If you believe it is related to the credit event as I do then currencies and divergences within equities will guide you. This trade continues to play out as originally discussed and so far nothing has violated the thesis. Time has elongated the trade but it was interrupted with two central bank bailouts and a year end dash for beta as some hedge funds apparently are going “all in” in hopes of finding enough yield to satisfy investors.
So unless something changes in credit, the currencies and commodities I remain steadfast in this trade and the basis for why I am short.
The move in the currencies today was simply the completion of a two week consolidation in both the EUR and USD. It was rather telling in fact that the EUR was weak on a day that Italy had a relatively positive short dated debt auction.
The cause for today’s move in the currencies was simply the completion of multiple technical patterns. The EUR bear flag pattern had been failing while the USD bull flag was very close to failing as well. Within those patterns a wedge pattern was also in play that for the most part was due to resolve one way or the other today. The result a very violent breakout in the EUR and USD.
There are too many charts to post but pretty much all commodities are in a complete breakdown right now. Both oil and copper have taken out their 2009 up trend lines and have failed a backtest. Gold has also failed the 2009 up trend as of today but has yet to confirm the validity of this move.
A number of other commodities from wheat to soybeans to natural gas are well off their 2011 highs, in some cases 30-40% lower. Clearly the commodity sector is not looking very bullish.
Below is a six month daily of 10 year treasury futures. After breaking out to all time highs (in price, low in yield) in September price has consolidated the past few months into yet another wedge pattern. Earlier in the month there was a false breakout above the wedge which coincided with record auctions in the shorter end of the curve that may have simply crowded out 10 year future buyers.
Regardless the 10 year is close to another breakout after putting a very bullish reversal today which will confirm continuation of the bull market in treasuries.
The credit event trade is still on. Nothing has changed to alter the basis for being short here. Personally I have been trading 20% of my core position and will continue to do so as a hedge to buy more theta (time) on the trade should it be necessary.
Images: Flickr (licence attribution)
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