How To Fade A Gap

However, take a look at the chart below, not only has Average True Range (ATR) collapsed (not atypical for the summer, but it is also in a long-term downtrend as well) but the market is still unable to take out the highs set in June.  In fact, only the early August thrust bested the previous test at the June highs.  I frankly think the technicals look weak, but this is no time to be drawing lines in the sand -- a momentum-driven market can be dangerous when it comes to making predictions.

My plan going into today's session is to be on the lookout for potential opening reversals.  Remember to keep in mind the basic characteristics of a Fade The Gap trade:

1.  Thrust well outside Bollinger Band on 1 and 5-minute chart

2.  A corresponding thrust in the S&P futures

3.  Confirmation from stochastic of potential reversal

These types of trades frequently occur on Monday mornings, (Tuesday for today) as well at inflection points.  This being the beginning of the home stretch for the year may simply magnify these trades.  There is simply too much optimism baked into the market, any little curve ball will allow the professionals to come in and catch everyone flat-footed.  With bonds under decent pressure this morning, they bear watching.  Thus far the equity markets have disregarded the bond market rout; at some point though, bonds may matter.

A reader recently asked me about my rationale on entry and exit regarding the recent short in EUR/JPY.  First off, no this is not a radical departure from my normal format, HVT, but I will continue to share these types of trades/observations with you as a way to broaden the scope of the daily commentary.  You will notice fairly quickly that much of my longer term analysis is based on fundamentals, coupled with confirmation from technical analysis.  For me, this is a matter of preference, given my typical short-term (extremely) holding period I need more than simply a moving average or chart pattern to provide conviction if the trade will last several days or weeks.  Ultimately fundamentals play out, charts allow you to hopefully time you decisions more effectively.  Bottom line:  A "story" (fundamentals) is something I can hang my hat on and it provides conviction; long-term I do not get that same conviction from technical analysis alone.

The rationale for the short EUR/JPY trade was ultimately based on fundamentals.  Consider the following, it pens a compelling story:

1.  Europe's seemingly sluggish economy (recession again in France and Germany) while the US, and Japan in particular, are showing continued signs of life does not bode well. 

2.  The demographics and entrenched union mentality will not allow for reforms which are required in order to turn the mess around. 

3.  The strong Euro (EUR) has had a negative impact on exports.  Meanwhile massive Bank of Japan (BOJ) intervention in the Yen to keep it weak (relative to importing nations) has propelled exports.

4.  The ECB's (European Central Bank) reluctance to cut interest rates has slowed prospects of a recovery.

5.  Industrial Production in Japan is on the rise as is Business Sentiment.

6.  The ECB predicts growth of only 0.7% versus the OECD forecast of 1% growth in Japan.

7.  Labor costs in Europe are simply not competitive, given the rising dominance of China and India as low cost producers -- the writing is on the wall.

While this trade was originally intended to be long-term as this course of events seems likely to play out for some time, the markets immediate confirmation provided a rare opportunity to capture what I would consider outsized profits relative to the time frame.  Ultimately I will get back in the trade, but for now, the charts, not the fundamentals, dictate remaining on the sidelines and seeking a better re-entry.

As always, feel free to send me your comments and questions.

Dave