DX Possible Bullish Divergence In Works

10/08/10 08:24:04 AM

by Donald W. Pendergast, Jr.

With gold on a northbound tear, it's little wonder that the US Dollar Index is currently in a descending mode. Will the significant support area near 76.00 even hold, much less act as a reversal point?

Security: DX, UUP
Position: N/A

Currencies -- you've gotta love them, whether you trade them by way of the futures or forex markets. These markets really like to trend, and across all time frames to boot. The US Dollar Index (DX), one of the heavies in the currency world, is no exception, and it is well enmeshed in a substantial intermediate-term downtrend of its own. Let's take a look at this key market's daily chart and see if we can't decipher some of its technical warning bells that are currently seeking to capture the attention of savvy, opportunistic traders. See Figure 1.

FIGURE 1: DX. Unlike�most oscillators, Keltner bands tend to provide�accurate identification of support/resistance levels. They frequently function as leading indicators, much like Fibonacci retracement and expansion levels�do. Price moves to either the extreme upper or lower band may be early warnings of a high-probability price reversal zone.

Graphic provided by: MetaStock.

Graphic provided by: WB Detrend RT EOD from ProfitTrader for MetaStock.

Swing analysis is a time-honored technique among many traders, and nowhere is the task easier than in markets that make nice, clean price swings over sustained periods of time. In the case of DX, the AB swing covered 8.63 points, finally making a minor reversal in the area of a Keltner band (point B). Not surprisingly, swing BC terminated at the next higher Keltner band (yes, these things really do identify key areas of support and resistance; these Keltners are plotted 4.2 and 7.5 standard deviations away from a 45-period exponential moving average [EMA], respectively).

Once swing CD got rolling (with point D yet to be determined), sharp traders would have already been doing some basic math in order to calculate a possible termination area for CD, multiplying the length of swing AB (8.63 points) by 0.618 and then subtracting it from the value of point C (83.635). That calculation yielded a price value of 78.30, which also happened to coincide with Keltner band 3 (with 1 being at the top and 4 at the bottom). Keltner 3 was violated and the DX has continued to drop, which means that traders will now grab their calculators and run the same calculation again, only this time plugging in a Fibonacci ratio of 0.786 into the equation instead of 0.618. And guess what? This calculation comes up with a value of 76.85, which is just 79 (oh no, another Fibonacci number!) cents above Keltner band 4 at 76.05.

Hmmm, let's see -- maybe we should look for the area just north of 76.00 to act as a meaningful support and/or turn area for the DX. This is highlighted by the pink shaded area on the lower right portion of the chart. If this area is also violated (if gold really starts to bust above $1,400, for example), then pull out your calculator and plug Fibonacci ratio 1.00 and/or 1.272 into the formula to arrive at the next set of likely support zones.

Now that we have that numbers game out of the way, let's focus on the very real bullish divergence between the Chaikin money flow (CMF)(34) and the price of the DX itself. This is a major early warning signal of a potential reversal, but it can only be confirmed by the price action on the chart after the fact. Clearly, some big money interests in the futures market are starting to nibble on the DX at current levels, so be sure to monitor this chart carefully over the next few weeks, just in case the contract catches a major bid and a short-covering rally erupts.

At the top of the chart, a mildly bullish hint is also provided by the detrend oscillator. Note how the recent lows in the indicator have been bottoming off of the same level, even as the DX has been grinding lower -- again, another possible warning of slowing selling pressure.

Now, as far as playing this, here's an unusual twist -- instead of trying to time a reversal in the DX (risky business), why not either sell a far out-of-the-money (OTM) put in the DX or even sell a far OTM call in the gold futures market instead? The more profitable play is likely to be selling a wildly overinflated, deferred month, far OTM gold call option with a $2,000 to $2,200 strike price once you see both the DX and the gold (GC) futures markets do an about-face. For extra safety, wait for the trend reversal to be confirmed by way of simple swing analysis (higher highs and lower lows in DX and lower highs and lower lows in GC) before selling any DX puts or GC calls.

Since there is also plenty of early warning of a possible gold market reversal too, this could be a great double-dip futures option selling play in a pair of markets that generally have a high negative correlation.

Take your time, do your own analysis, and see if you don't agree that this could be a unique and potentially profitable way to play the currency and gold markets by selling overvalued far OTM puts and calls that are highly unlikely to ever go in-the-money.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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Date:�10/09/10Rank:�3Comment:�Make things simple, Regards,

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DX Possible Bullish Divergence In Works

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