Market

05/06/2015 - 23:00

Volatility in the Forex market has spiked drastically since last December, and it has become particularly pronounced after the FOMC statement on 18 March which saw swings in EUR/USD to the up and down sides in excess of 200 pips, all in a matter of hours.

Even the daily chart we show below makes little sense to the veteran traders on HiWayFX’s trading desk. Given a strong downtrend for the past year, you would expect some type of consolidation pattern near the recent lows 1.0450. Maybe this should have played out to be some sort of descending triangle formation, or a rough trading range between 1.11 and 1.0450. But instead what we got was an insane spike off the lows for the FOMC, then one month spent consolidating in this 200 pip range, and then for very a little reason, the break out that we’ve had recently to 1.1350.

We can name a couple of reasons behind such a sharp reversal in a seemingly solid downtrend.

The first one is the fact that the Commitment of Traders report from the CFTC showed an all-time record of short positions in EUR/USD, one that was truly for the history books. The fact that we are so easily shooting up from lows of 1.0450 just last month is mainly due to most of these short positions being liquidated and stopped out, causing the price to go higher.

But this doesn’t account for the wild swings we saw in the days after March’s FOMC.

Yellen’s Surprise

The head of the Federal Reserve did surprise markets on the Wednesday meeting in March by removing the word ‘patient’ from policy statements. After the announcement, a massive unwinding of short positions occurred that was driven mostly by high-speed trading algorithms.

The concept behind high-frequency trading algorithms, which are used by hedge funds and large HFT shops, are nothing like the ones seen in Expert Advisors that retail traders use in MetaTrader 4. They are much more concerned with liquidity, and the volume of bids and offers, which are available moment-by-moment. So they are not simply a scalping bots looking for signals to trade on for 1 or 2 pips at a time.

As traders started covering short positions, the Euro became illiquid. But instead of volatility levelling out, algorithms continued searching for the next-best price execute a trade, causing a cascade of buying which drove the price higher.

The spike was short-lived though, as human traders got their bearings back and clearly saw an over-reaction in the short-covering, selling it back the 200 pips which it rose.

Given the massive unwinding we are now seeing, it is probably a good idea to let the FX market settle into a new range before making too many bets.

The information provided is for educational purposes only and should not be considered as investment advice.

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