Monthly Archives: December 2023

JAPANESE YEN FUNDAMENTAL BACKDROP

The Japanese Yen kicked off the post-Christmas trading day on the back foot after the Bank of Japan’s (BOJ) Summary of Opinions (see economic calendar below) revealed a split panel who seem to be erring on the side of caution regarding tighter monetary policy. While all members agreed on maintaining the ultra-loose policy for the time being, future changes and the timing thereof are now being debated. Some key statements made include:

“We must confirm a sustainable and stable achievement of the price target is foreseen in order to end the negative rate and YCC.”

“We must scrutinise wage and price moves under YCC given the strong upward pressure on prices has likely stablised.”

“We are not in a situation where we would fall behind the curve in raising rates, even if we decided to wait after seeing wage talk outcomes next Spring.”

“One member said that the BoJ should not miss the opportunity to normalise policy to avoid the risk of high prices damaging consumption and achievement of the price target.”

“It is important for the BoJ to continue deepening the discussion on issues such as timing of exit from current policy and the appropriate pace of a rate hike thereafter.”

Overall, the news was taken in a less favorable light for the Yen and was consequently supplemented by Japanese housing start data that missed forecasts. The lack of new construction taking place has fallen to its lowest level since August and reinforces a struggling Japanese economy. Ultimately, these data points will be crucial for the pivot to a more normalized monetary policy in the face of elevated inflation.

USD/JPY ECONOMIC CALENDAR (GMT +02:00)

Source: DailyFX economic calendar

The resultant effect from an interest rate cycle perspective has been dovish with money markets reducing the scale of rate hikes in 2024 (refer to table below).

BANK OF JAPAN INTEREST RATE PROBABILITIES

Source: Refinitiv

USD/JPY TECHNICAL ANALYSIS

USD/JPY DAILY CHART

Chart prepared by Warren Venketas, IG

Despite a flat USD, daily USD/JPY price action shows the yen down roughly 0.20% for the day. Bulls attempt to retest the 200-day moving average (blue) as the pair exits the oversold zone of the Relative Strength Index (RSI). I do not expect much in the way of price volatility in this final trading week of 2023 therefore, we are likely to remain in this recent consolidatory phase around the 142.00 psychological handle.

Key resistance levels:

• 148.52
• 147.37
• Channel support
• 145.00
• 200-day MA

Key support levels:

• 141.62
• 140.00

IG CLIENT SENTIMENT: BEARISH

IGCS shows retail traders are currently net SHORT on USD/JPY, with 62% of traders currently holding short positions (as of this writing).

Curious to learn how market positioning can affect asset prices? Our sentiment guide holds the insights—download it now!

What is the VIX in the stock market?

The VIX was created by the Chicago Board Options Exchange (CBOE) in 1990 to act as a benchmark for measuring expectations about future stock market volatility. It’s a real-time index which reflects market participants’ expectations of volatility over the next 30 days.

At the most basic level the VIX index is constructed using weekly and traditional SPX index options and their levels of implied volatility. One can think of implied volatility as expected volatility derived from market participants’ activity in the options market. Understanding why the VIX behaves inversely to the S&P 500 is important because the volatility index acts as a measure of market sentiment, hence the reason it is called a “fear barometer”.

What is the relationship between vix and S&P 500 (SPX)?

The S&P 500 VIX has a propensity to rise in bearish stock market environments and fall or remain steady during bullish environments. This happens because of the long-term bullish bias of the stock market and the fact that the VIX is calculated using implied volatility.

Implied volatility goes up when there is strong demand for options, and this typically happens during declines in the price of the S&P 500 as market participants (who are collectively bullish) are quick to buy protection (put options) for their portfolios.

When the S&P 500 rallies we see demand for protection dissipate and as a result a decline in the VIX. This process in recent years has become exasperated, in all likelihood, because the VIX has gone from just a market gauge of volatility to a tradable asset class through product offerings on various futures, equities, and options exchanges.

Created with Tradingview

S&P 500 VIX correlation

The S&P 500 VIX correlation is simply how the S&P 500 and the VIX move relative to one another. From the chart above it’s easy to see the strongly negative correlation between the stock market and the VIX. Stock market slumps lead to spikes in the index. Dating back the beginning of the VIX in 1990, the correlation between daily changes in the S&P 500 and VIX is -77%. Over the past 10 years the inverse correlation has become even stronger at -81%, while prior to October 2008 it was -74%.

The tighter relationship could very well be attributed to the various products introduced over the past 10-15 years which allow market participants to trade the VIX. As said earlier, this would also make sense as to why we are also seeing larger spikes in the VIX when the market weakens, as trading of the VIX itself is causing exaggerated moves in implied volatility.

The relationship between the S&P 500 and the VIX has largely been consistent and reliable over the years, though. The rolling 1-year correlation between daily changes has on average been around -83% over the past 10 years, staying within a relatively tight range of -70% to -90%.

S&P 500 VIX chart: One-year rolling correlation

Using VIX to predict S&P 500 Volatility

The S&P500 VIX can be used to identify market turns, more specifically bottoms. Because the stock market tends to rise in a gradual fashion the VIX too will decline in a gradual to sideways fashion. This can lead to very low levels which warn of complacency as investors feel no need for protection, but these periods can last long enough that using the VIX as a sell signal can be rendered largely ineffective.

However, because the S&P 500 is long-biased by nature, when there are declines investors buy protection (put options) quickly, driving up the VIX. Often there is an overreaction by market participants when the market declines, hence the reason why the VIX is called a “fear barometer”.

The spike-like behavior which the VIX exhibits during times of market stress can be a timely signal for determining when selling has become overdone and the market is due to bounce or even bottom for a longer-term move higher. This strategy is typically best employed when the VIX ‘signal’ arrives within the context of a generally bullish trend in the S&P 500.

S&P500 VIX chart: Spikes can be used to indicate trading bottoms

factor seen when the VIX is at very low levels, there is a nuance to this which can help identify when the stock market may be nearing a turning point to the downside, but they don’t happen frequently. When the VIX and S&P 500 both rise together over a period of time it can indicate growing instability in the trend which sets the market up for a sell-off.

Using S&P 500 volatility for risk management

When trading the S&P 500 there should be an inverse relationship between trading size and market volatility, or the VIX. One common mistake traders make is that they will simply trade a fixed lot size regardless of the distance their stop-loss is away from the entry price. This means the at-risk amount of capital will be highly variable (likely due to levels of volatility) and thus lead to inconsistent results. Additionally, a trader is putting themselves at greater risk when they should be doing the opposite.

A prudent approach to risk management is to determine how much of your capital you are willing to risk per trade and then adjust the trading size accordingly. For example, if you are willing to risk 1% on an S&P 500 trade and have a 10-point stop-loss, and have another trade where you are willing to risk 1%, but with a 5-point stop-loss, for both trades to equal 1% in risk the second trade would need to be twice as large as the first trade given the distance to the stop-loss. This provides a dynamic approach to position-sizing when trading the S&P 500 for more consistent results.

Average True Range (ATR) and the VIX

On average, the distance to your stop-loss will largely depend on the level of the VIX. Another way to measure volatility is with ATR (Average True Range). From the chart below, you can see that ATR and VIX look very similar, despite ATR using historical data and the VIX calculation relying on an options pricing model. When the VIX spiked so did the trading ranges of the S&P 500, which means a trader using a dynamic position-sizing strategy would adjust their trading size down to account for the new level of volatility. Simply put, if you are risking specific amounts of capital like in the example above, versus trading fixed lots, then you will be adjusting dynamically with S&P 500 volatility. For more on the topic of risk management, check out this article and video on sound risk management techniques.

S&P 500 VIX & ATR (Changing volatility requires changes to trading size)

Created with Tradingview

S&P 500 and VIX Key takeaways

To summarize, understanding stock market volatility and the CBOE Volatility Index (VIX) is important for trading equity indices. There are benefits to understanding the nature of volatility from both an analytical and risk management standpoint. Like all things, getting a feel for the relationship between the VIX and the S&P 500 will take a little experience to get a handle on, but well worth the time.

For more information on the S&P 500 Index, read our guide to trading S&P 500. Or for an in-depth review of the major stock indices, we have rounded up the top differences between the Dow, Nasdaq and S&P 500.

DOLLAR INDEX FUNDAMENTAL BACKDROP

The US dollar attempts to stop yesterday’s bleeding after US GDP missed expectations alongside a decline in core PCE prices. The stubborn jobless claims data was not enough to pushback against these factors and now places the greenback roughly 1.6% lower year-to-date. After the Fed’s dovish shift in tone, some Fed officials have tried to resist the extreme repricing in rate expectations as to the timing of the first cut. As it stands, money markets (refer to table below) forecast the possibility of a rate cut as soon as Q1 2024. This may be a bit too optimistic, leaving room for a risk to the upside for the USD.

IMPLED FED FUNDS FUTURES

That being said, projections for today’s core PCE index (Fed’s preferred measure of inflation) is lower and could extend the current narrative. Durable goods orders and Michigan consumer sentiment may tick higher but if inflation dips, I expect markets to place more emphasis on the inflation measure. Today marks the last day for 2023 that could set the tone for the final week trading week of the year as no other high impact economic data is due from a dollar point of view. Next week is likely to reflect a continuation of today’s data with minimal volatility across the board.

US ECONOMIC CALENDAR (GMT +02:00)

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TECHNICAL ANALYSIS

U.S. DOLLAR INDEX (DXY) DAILY CHART

Price action on the daily DXY chart above shows a breakout from the recent symmetrical triangle pattern (dashed black lines) with bears looking to push below the long-term trendline support zone (black)/101.74 swing low. This key inflection point could give us an indication as to short-term directional bias heading into 2024. The Relative Strength Index (RSI) suggest bullish/positive divergence that may keep USD bulls in play.

Resistance levels:

• 104.45/50-day moving average (yellow)
• 104.00
• 200-day moving average (blue)
• Trendline support

Support levels:

• 101.74
• 101.00

What is Market Sentiment?

Market sentiment defines how investors feel about a particular market or financial instrument. As traders, sentiment becomes more positive as general market consensus becomes more positive. Likewise, if market participants begin to have a negative attitude, sentiment can become negative.

As such, traders use sentiment analysis to define a market as bullish or bearish, with a bear market characterized by assets going down, and a bull market by prices going up. Traders can gauge market sentiment by using a range of tools such as sentiment indicators (see below), and by simply watching the movement of the markets, using the resulting information to make their decisions.

What is Sentiment Analysis in forex trading?

Forex sentiment analysis is the process of identifying the positioning of traders, whether net long or net short, to influence your own trading decisions in the currency market. While sentiment analysis can be directly translated to forex, it is also used for stocks and other assets. Contrarian investors will look for crowds to either buy or sell a specific currency pair, while waiting to take a position in the opposite direction of sentiment.

How Forex Sentiment Analysis Works

An example of how sentiment analysis can be applied in forex trading is a large single movement in GBP/USD in 2016, with negative sentiment sending GBP slumping to a 31-year low following Britain’s vote to leave the European Union. After broadly positive sentiment in the year that followed, negative sentiment then took over much of 2018 again before prices started to trend higher in 2019.

Another example of net short sentiment can be seen in the EUR/GBP chart below, with 21.9% of traders net-long with a ratio of traders short to long at 3.58 to 1. The chart shows in blue the percentage of IG traders taking a net long position, and in red the percentage taking a net short position.

Chart to show net negative sentiment alongside price action

Rising sentiment may mean there are few traders left to keep pushing the trend up. In this case, traders may want to watch for a price reversal. On the other hand, a price moving lower, showing signals that it has topped may prompt a sentiment trader to enter short. The below chart shows an example of the EUR/USD pair experiencing net positive sentiment.

Chart to show net positive sentiment alongside price action

Using Sentiment Indicators

Sentiment indicators are numeric or graphic representations of how optimistic or pessimistic traders are about market conditions. This can refer to the percentage of trades that have taken a given position in a currency pair. For example, 70% of traders going long and 30% going short will simply mean 70% of traders are long on the currency pair.

The best sentiment indicators for forex traders include IG Client Sentiment (as seen in the charts above) and the Commitment of Traders (COT) Report.

IG Client Sentiment

IG Client Sentiment can be a useful tool to incorporate into your trading strategy. It can give a helpful picture of the number of long and short trades occurring in a particular market, giving an impression of the turning points in sentiment. For more on this indicator and how it can assist your trading, be sure to click the link above.

Commitments of Traders Report

The Commitment of Traders (COC) Report, published weekly by the Commodity Futures Trading Commission (CFTC), is compiled from submissions from traders in the commodities markets, giving a picture of the commitment of classified trading groups. The CFTC’s report is released every Friday at 15:30 Eastern Time and can be a useful market signal.

What is a gap?

A gap refers to the area on a chart where no trading activity has taken place. This will appear as an asset’s price moves sharply up or down with nothing in between, meaning the market has opened at a different price to its prior close.

Why does the gap occur? The most frequent cause is fundamental factors. For example, in the chart above, ASOS stock rallied overnight as the company’s full year results showed it avoided another profit warning – along with traders showing confidence in the company’s ability to fix critical operational issues.

Other news such as product announcements, analyst upgrades and downgrades, and new senior appointments can lead to gaps. This is because they can move the market significantly between trading sessions in either direction.

Gap down stocks vs Gap up stocks

Gap down stocks and gap up stocks refer to the direction of the price movement either side of the gap. A full gap down is when the opening price is lower than the prior low price, while a full gap up (as shown above) occurs when the opening price is greater than the prior high price.

The four types of gaps in trading

Aside from gap down and gap up, there are four main types of gap, dependent on where they show up on a chart: common gaps, breakway gaps, continuation or runaway gaps, and exhaustion gaps.

1. Common gaps simply show a gap in price action independent of price patterns and usually don’t provide exciting trading opportunities.

2. Breakway gaps signal a new trend where the asset ‘gaps away’ from the price pattern, as can be seen below where the gap triggers a breakout. If a breakaway gap is accompanied by higher trading volume, it may be worth taking a position long for a breakaway gap up, and short for a breakaway gap down, on the candle following the gap. (see our gap trading example below).

3. Continuation or runaway gaps show an acceleration of an already bullish or bearish pattern in the same direction. This can be caused by a news event that confirms the sentiment and furthers the trend. Traders might look to follow the trend and place a stop just below the gap for a bullish runaway gap and just above for a bearish runaway gap.

4. Exhaustion gaps are, conversely to continuation gaps, where price makes a final gap in the trend direction, but then reverses. This is often caused by a herd mentality of traders rushing to the trend and moving the stock into overbought territory. Therefore, experienced traders will be watching for the reversal and take the contrary position to the prior trend.

See How IG Client Sentiment Can Help Your Trading

What does it mean when a gap has been ‘filled’?

A gap being ‘filled’ refers to the price returning to the original level before the gap happened. This usually means the price action, in the following days or weeks, retraces to the last day before a gap.

There are a range of factors that come into play with gap fill stocks:

• Price corrections: An overly optimistic or pessimistic initial spike may invite a correction.
• Support and resistance isn’t left behind when a price moves up or down sharply.
• Patterns: Price patterns dictate the likelihood of a gap being filled. For example, price reversals seen with exhaustion gaps are likely to be filled as this type of gap signals the end of a price trend.

Trading the gap: Gap trading strategies & tips

There are a range of gap trading techniques to explore,from fading and predicting gaps to using indicators to help you gauge price action.

Fading the gap

‘Fading the gap’ is when gaps are filled within the trading day they occur. Let’s say a stock gapped up at the open with a higher price than the previous close, on a positive earnings report. Now let’s say, as the day progresses, tradersdelve deeper into the company’s presentation deck, see things they don’t like, and start selling. Eventually, the price hits yesterday’s close, and the gap is filled.

Irrational exuberance from less experienced traders can be particularly advantageous for more seasoned market practitioners when it comes to fading the gap, as the volume that causes the gap is often caused by FOMO in trading .

Predicting a gap

If technical or fundamental factors point to the potential for a gap on the next trading day, it may be time to enter a position. For example, having detailed knowledge of a given company and its operations can help a trader predict a gap for that stock ahead of an earnings report.

Using indicators

Traders can use tools such as the Exponential Moving Average and RSI to ascertain key price points and inform their decisions. For example, the below chart shows how an overbought RSI signal can be used to enter short after an exhaustion gap.

The next chart shows an aggressive approach to the breakaway gap example. It reveals where a long position is entered in response to increased trading volume following the gap, and a possible initial stop loss level to protect against the higher risk.

A more conservative approach to this breakaway gap would be to enter on a pullback , which gives the opportunity to test the gap. While it may offer smaller upside, this approach means traders can get away with a much tighter initial stop loss order.

Gap Trading Rules: Key things to consider

• Classify the gap you are going to play : It’s important to know which of the four types of gap you have identified. A continuation gap will prolong a trend while an exhaustion gap is set to reverse it – two very different outcomes.
• When a gap has started filling, it will rarely stop due to there often being no immediate support or resistance.
• Has a move been fueled by amateur or professional investors? Amateur investors may exhibit irrational exuberance that sets up an exhaustion gap, so waiting for the price to start to break before taking a position may be wise.
• Pay attention to volume. Breakaway gaps normally exhibit high volume (see trading example above) while low volume should occur in exhaustion gaps.
• Be careful. Trading the gap means trading stock market volatility with low liquidity so caution must be exercised. Read more on trading psychology and using stop loss orders to make sure you’re trading with the right mindset and managing risk properly.

Further reading on trading stocks and the stock market

Mastering gap trading techniques is useful for stock trading in particular. Read more on the major stock indices and download our free, quarterly equities forecast to boost your understanding of the markets and help you trade more consistently.