How is fear and risk aversion effecting your trading?

I can’t help but think about this as Ben Bernanke has effectively handcuffed the market as traders and investors all-over-the-world wait for his Jackson Hole speech. Fear and risk aversion is a chicken or the egg question but one that I have been thinking more about since this week has been one of the tightest ranging weeks in the U.S. Dollar and the pairs I trade in some time. The recent rejection at the 20 period SMA on the daily Dow Jones Industrial Average also added the negative mood of this market.

It’s not that the Dow Jones Industrial Average or even stocks for that matter are necessarily a reflection of the economy. But as far as a gauge of fear and risk aversion, the Dow is an excellent barometer. When prices rallied to the 20 period SMA close and exhausted, unable to attract further buying momentum, this was just another sign that not only has the ceiling on the risk appetite of the market been found but that also that ceiling has moved lower from 11,500 to 11,300.

As primarily a forex trader, why do I pay such close attention to the Dow? Because the “herd” does and even people who are not active traders or investors know where the Dow is day to day. Therefore not only does it reflect psychology is effects psychology too.

Interestingly, I’ve received more questions regarding handling losses this week than any other week all summer – maybe all year. The question usually comes when the market is directionless and targets for price action are unclear and unmet. This brings up the idea of long term and short term ambiguity. (In fact Chairman Bernanke’s speech is titled “Near and Long Term Prospects for the U.S.”) If “investors” are in the market for the “long haul” near-term problems, issues, and surprises should not be a factor, but of course, being human, they are! For the short-term trader, these issues, problems, and surprises are the very thing that moves the market and sets up trades.

The risk aversion in the market is an unwillingness to take on risk but think about what is underneath that as well. Traders (and investors) want to be rewarded for taking risk. If they don’t see the potential for reward it doesn’t necessarily mean they are fearful, it simply means that they don’t see a tangible reward.

The idea behind why we take risk and what we fear is one that each trader has to determine for their own because it’s quite different from trader to trader. If I were to gauge myself based on a scale from trigger happy (an active trader who would rather take risk than miss a trade) to gun shy (a typically less active trader who would rather wait for a specific entry and miss a trade than enter aggressively) I would favor gun shy. Now no one should be at either extreme but we favor one or the other, if even slightly. I personally would rather wait for my trade, my price, and clarity before entering. I miss trades, but that is far less painful than entering aggressively for me. Some traders can’t stop kicking themselves for missed trades, and will then often over-trade or a chase the market in an effort to make up for the “lost trade”.

Fear causes risk aversion not necessarily fear of losses but a lack of a clear reward. Fear (and fear of missing the move) is causing gold to continue to rally. The franc for instance has bounced significantly from its prior downtrend. In fact the downtrend has not transitioned into a more sideways, neutral market phase. This is confirmed by the flat “three o’clock” 34EMA Wave angle and the blue GRaB candles are evidence of the shift of sentiment and momentum away from the downtrend and bearishness. This shift though was caused by an external factor: The Swiss National Bank (SNB). What the SNB did was make the expectation for the long and short-term prospect of the franc continuing to strengthen ambiguous. Traders and investors no longer had a clear picture of franc strength and left due to fear. Are traders still risk averse in this environment? Clearly the Dow Jones Industrial Average says “yes”.

This is how a shift occurs in a market. Notice the “twelve to two o‘clock angle of the 34EMA Wave has transitioned into a more flat “three o’clock” angle? The dominance of blue GRaB candles confirm the lack of bullish or bearish momentum.

 

With QE2.5 or QE3 off the table, look for the U.S. Dollar Index to rally off the support are that was around the 74.00 area. This move higher is technically sound as well since the index is trading off the range lows of the daily.


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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