Just prior to major market reversals, market makers often find themselves in a precarious situation. They are seeing a lot of smart money coming into a market in anticipation of a sea change move, and because they are market makers they are forced to take the other side of that money. This means that if they are to remain profitable they must "rebalance" their own books by reversing their positions in-line with the new direction, and they must do it in a way that does not cost them additional money. This is an equally tricky time for speculators anticipating the same market reversal. We feel that the U.S. Dollar is very close to being in that situation right now - see chart in Figure 1

Figure 1. Weekly Dollar Index Chart

While there is no love lost on market makers by most investors and traders they do a necessary service by taking the other side of all trades and maintaining a relatively tight spreads. The people running the market making operations are also some of the savviest traders around because they are in the markets all day, every day. We feel that market makers are currently very likely short U.S. Dollars by virtue of the current 3-month rally, and accompanying bullish press - HSBC analysts this week went on record as being in the U.S. Dollar bull camp.

Short and Nervous

Technically the Greenback is in what we at Trading University call a balanced market, which means the long-term pattern is still down while the short-term patterns are higher. This would account for the current sideways pattern over the last couple of years. Market makers and other "mean reversion" traders appreciate a balanced market. With long-term and short-term traders offsetting each other the market tends to move sideways which means less volatility, more predictability and less risk. What can "unbalance" the market however would be a price moving outside that established trading range, which is what analysts and traders call a "break-out". Breakouts are what many traders look forward to because it can mean sustained price movement. Breakouts however make market makers nervous because of the possibility of getting run over - such as occurred in the 2008 currency collapse. It is the market makers job to take the other side of all trades which can be a dangerous position if there is all buying and no selling, or vice versa. Given the U.S. Dollar's current sideways stance after a 12 year bear cycle, and numerous buy recommendations by prominent firms such as HSBC, and bullish comments by market watchers such as Harvard professor Niall Ferguson, the drum beat for a bullish dollar breakout is getting louder. And this likely means market makers need to rebalance their books to take down the risk of being "too" short. Larger speculators' feeling "long and strong" generally leaves market makers feeling short and nervous.

So how do market makers rebalance their books to put themselves in a position to continue to be profitable, and still make a market in the face of a sea change reversal in a market as big as the U.S. Dollar? The answer is they need to get the market to rebalance itself. And the results of this are not always pretty for speculators. Market makers need to engineer a move to prompt the speculators to exit their positions out of fear of losses. In trading parlance the specs need to be "stopped out" of their long positions with the market makers buying into that short-term liquidation to complete the rebalance. Once the market makers can swing long, at the expense of the speculators, they are back in a position to be profitable even as they take the other side of everyone else's trades in a rising market.

Our concern right now is not will the U.S. Dollar will go up. We think that based on the deflating of the commodity boom alone that the U.S. Dollar will strengthen in the coming quarters and years. Our concern right now is deciding how to get long the U.S. Dollar long-term, yet be in a position to ride out what could be an epic "rebalancing" act by institutional market makers. Figure 2 gives an estimate on how we think a rebalancing act could play out, and marks the levels where such a sell off would pick up at, and then potentially end.

Figure 2. Daily Dollar Index Chart

While we like the idea of buying a dip in the U.S. Dollar, we are not advocating that it will go down; only that it could go down. We still believe long is the way to be, we just think you need to have any long positions sized to be able to withstand a rebalance.

Past Rebalancing Acts

While there are always examples of rebalances prior to most major market reversals a couple stand out for us. In the summer of 1987 the U.S. stock market had become dangerously overbought, and rumors were flying that a small group of local speculators in the S&P 500 pit in Chicago were betting big on a market crash. The most obvious way to profit was to go short futures, which they did. It was rumored that they added to their existing shorts in a big way the first time the S&P 500 futures moved below 2500 intraday. Long story short, to this day we don't know how the 2-week rebalance was engineered that essentially cleaned out the floor speculators the week before the stock market collapsed - see chart in Figure 3. They were right about the market, but they still lost money.

Figure 3. Weekly U.S. Stock Market Chart, Circa 1897

The greatest rebalance we have seen to date occurred in the corn market in mid-2006. The markets were seeing huge demand for U.S. agricultural products from the around the globe but particularly from China. Energy prices were also surging, and to add to the overall bullish environment in corn was the demand for corn ethanol. Ethanol plants were being built all over the U.S. Midwest and analysts were saying that it was unlikely that corn prices would ever see $2.20 a bushel again and prices would average closer to $4, even $5 per bushel. Anyone you talked to on the commodity side of the business was talking about how corn at $2.50 per bushel was a steal. Retail traders were "loading the boat" with corn calls throughout the first half of 2006 in anticipation of the rocket ride higher. Then inexplicably in July of that year corn started to drop. Brokers who had recommended buying corn to all their clients held their breath as prices continued to fall, approaching the March '06 lows, where many speculators had placed their stop loss orders at $2.20, see Figure 4.

Figure 4. Weekly Corn Chart, Circa 2006

Even with bullish news on both crop conditions, and demand from overseas, prices continued lower. The rebalance was set, or as they say in Chicago, "the fix was in". Many speculators carrying futures were stopped out as prices made a new 6-month low, and the August and September out of the money call options - millions of dollars of speculators premium - expired worthless. All this against a back-drop of historically bullish conditions which may never be replicated - it was the perfect time to be buying a commodity, yet most people who bought corn in the spring of that year lost money! Over the next couple of years corn moved as high as $7.50 per bushel.

There are valuable lessons learned in these examples for sure. As speculators we always need to expect corrections and we always need to keep positions manageable and keep plenty of dry powder on hand to insure we are not among the crowd that gets tapped out just before the historic move! If we like long dollar here at 83.30, we love it at 81.00. It is best to view long-term positions as the investments they are and understand the value of dollar cost averaging and patience. This is what makes Forex markets so appealing also. While we favor futures in short-term trading we love Forex because of the mini and micro contracts. Rather than bet the mortgage payment on a $125,000 futures contract, you can start to scale into short Euro positions or long USDCHF positions as small as $1,000 with a margin of $20, and a transaction cost of less than 20 cents! Do not think that catching big moves in the markets today is not possible, or out of your price range.

To see article with charts go to: http://seekingalpha.com/instablog/1642421-jay-norris/1912971-the-u-s-dollar-rally-the-great-rebalance

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