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REVERSAL


An Intraday Head And Shoulders Top In EUR/USD

08/11/03 10:35:50 AM
by David Penn

An old rally, a MACD negative divergence, a 1-2-3 trend reversal ... after bouncing at the beginning of August, the euro starts to slip against the greenback.

Security:   EUR/USD
Position:   N/A

I've been writing about the increasing bullishness of the U.S. dollar for some time -- first tentatively in "Down Goes the Dollar," (Working-Money.com, February 11, 2003) and more recently in Traders.com Advantage ("The September Greenback's 1-2-3 Reversal" June 26, 2003 and, in essence, in "Head and Shoulders Top in European Currencies" June 23, 2003). What is bullish for the U.S. dollar tends to be bearish for other currencies such as the euro and the Swiss franc. Thus, one way to play dollar strength is to bet against international currencies.

Kristian Kerr makes an excellent point in the August 2003 issue of Stocks and Commodities that forex traders/dealers are often best off focusing on hourly charts for the most accurate depiction of how currencies trade ("The FX Daily Conundrum"). Others, such as Alexander Elder, have pointed to the utility of using daily currency futures charts and weekly spot currency charts as part of a screening method for honing in on opportunities in shorter time frames (see Elder's important book, Come Into My Trading Room -- A Complete Guide to Trading). In the case of the EUR/USD, evidence of weakness in the daily charts of euro futures led me to what appears to be evidence of weakness in the hourly chart of EUR/USD.

This rally in the hourly chart of the EUR/USD appears to be consolidating into a head and shoulders top. Note the negative divergence between the MACD's peaks on the 5th and 6th and those of the EUR/USD during the same period.
Graphic provided by: FXCM.
 
There are a couple of things that are noteworthy about the EUR/USD chart displayed above. Most important for a head and shoulders top is the pre-existence of a significant uptrend. Here, EUR/USD rallied from under 1.1150 at the beginning of August to over 1.1400 by the sixth of the month. This 250+ pip move in just a few days is clearly indicative of a strong upmove. This suggested that a top was increasingly likely as EUR/USD climbed -- whether or not the top appeared at 250 pips or 350 pips is not the point. The point is that after a certain level, the risk begins to shift to such a degree that consolidations are more likely to be tops rather than mere continuations.

Another thing to notice about this intraday look at the EUR/USD is the negative divergence between the MACD (moving average convergence/divergence) indicator and price action. Specifically, compare the two peaks in EUR/USD on the fifth and sixth of August to the two peaks in the MACD at the same time. The peaks in price action show a pattern of higher highs while the peaks in the indicator show a pattern of lower highs. This is a classic negative divergence that suggests that prices are not likely to move much higher -- for example, not overtaking resistance at the top of the higher price peak. While the negative divergence alone can be tricky as an explicit trading signal (i.e., the rally on August 7th would have likely stopped out more than a few short-sellers, it is a development that must be factored into the overall technical equation.

Third, this hourly chart of EUR/USD so far is an excellent example of the 1-2-3 trend reversal. Prices broke through the up trendline on August 6th -- the "1" of the 1-2-3 trend reversal. They put in a short-term low and then rallied up in an attempt to resume the previous trend. This movement, which took place on August 7th, is the "2" of the 1-2-3 trend reversal. The "3" of the 1-2-3 trend reversal comes as EUR/USD fails to make a new high and, instead, falls beneath the low not only of the original trendline break, but also below the short-term low established when the move that resulted in the trendline break exhausted itself.

What does this confluence of technical factors suggest for EUR/USD in the near-term? Applying Stan Weinstein's swing rule (Secrets for Profiting in Bull and Bear Markets) to this head and shoulders top in the hourly chart, we can subtract a formation size of approximately 116 pips from the support level at the bottom of the formation (about 1.1309). This provides for a downsize target of about 1.1193 in an initial move.




David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Date: 08/12/03Rank: 5Comment: Mr Penn Articles are always among the best in TT. I really apperciate them as a trader and as an analyst. F. Jorio Fili
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