Tactical trading considerations in USD/JPY

Before this I mention that USD/JPY’s tendency to either be active directionally or consolidating - the on/ off switch. As such, we like to approach USD/JPY on a more strategic, hit-and-run basis - getting in when we think a directional move is happening and standing aside when we don't. We look for breaks of trend lines, spike reversals and candlestick patterns, as our primary clues for - spotting a pending directional move.

On the tactical level, USD/JPY is generally a cleaner trading market than most of the other majors, so I like to approach it with generally tighter trading rules. The idea is that if I’m right, we’ll be along for the ride. But if I’m wrong, we jump off the bus at the next stop.

Actively trading trend-line and price-level breakouts

One of my trigger points for jumping into USD/JPY is breaks of trend lines and key price levels, such as daily or weekly highs/lows. Earlier I said that it usually takes a significant amount of market interest to break key technical levels. We look at the actual breaks as concrete evidence of sizeable interest, rather than normal back-and-forth price action.

Jumping on spike reversals

After USD/JPY has seen a relatively quick (usually within two to three hours) move of more than 70 to 80 pips in one direction, we’re on the lookout for any sharp reversals in price. Spike reversals of 30 to 40 pips that occur in very short timeframes (5 to 20 minutes) are relatively common in USD/JPY. But you pretty much have to be in front of your trading screen to take advantage of these, because they’re a short-term phenomenon by their very nature.

Monitoring EUR/JPY and other JPY crosses

USD/JPY is heavily influenced by cross flows and can frequently take a back seat to them on any given day. In evaluating USD/JPY, we always keep an eye on the JPY crosses and their technical levels as well. A break of important support in GBP/JPY, for instance, could unleash a flood of short-term USD/JPY selling, because GBP/JPY is mostly traded through the dollar pairs.

EUR/JPY is the most actively traded JPY cross and its movements routinely drive USD/JPY on an intraday basis. Be alert for when significant technical levels in the two pairs coincide, such as when both USD/JPY and EUR/JPY are testing a series of recent daily highs or lows. A break by either can easily spill into the other and provoke follow-through buying/selling in both. 

Price action behaviour of USD/JPY

In my previous post, we note that USD/JPY seems to haze an on/off switch when compared to the other major currency pairs. Add to that the fact that USD/JPY liquidity can be similarly fickle. Sometimes, hundreds of millions of USD/JPY can be bought or sold without moving the market noticeably; other times, liquidity can be extremely scarce.

This phenomenon is particularly acute in USD/JPY owing to the large presence of Japanese asset managers. As mention in my post before this,  the Japanese investment community tends to move en masse into and out of positions. Of course, they're not the only ones involved in USD/JPY, but they do tend to play the fox while the rest of the market is busy playing the hounds.

Prone to short-term trends, followed by sideways consolidations

The result of this concentration of Japanese corporate interest is a strong tendency for USD/JPY to display short-term trends (several hours to several days) in price movements, as investors pile in on the prevailing directional move. This tendency is amplified by the use of standing market orders from Japanese asset managers.

For example, if a Japanese pension fund manager is looking to establish a long position in USD/JPY, he’s likely to leave orders at several fixed levels below the current market to try to buy dollars on dips. If the current market is at 116.00, he may buy a piece of the total position there, but then leave orders to buy the remaining amounts at staggered levels below, such as 115.75, 115.50, 115.25, and 115.00. If other investors are of the same view, then they‘ll be bidding below the market as well.

If the market begins to move higher, the asset managers may become nervous that they won’t be able to buy on weakness and raise their orders to higher levels, or buy at the market. Either way, buying interest is moving up with the price action, creating a potentially accelerating price movement. Any countertrend move is met by solid buying interest and quickly reversed.

Such price shifts tend to reach their conclusion when everyone is onboard - most of the buyers who wanted to buy are now long. At this point, no more fresh buying is coming into the market, and the directional move begins to stall and move sideways. The early buyers may be capping the market with profit-taking orders to sell above, while laggard buyers are still buying on dips. This leads to the development of a consolidation range, which can be as wide as ¥l or ¥2, or as narrow as 40 to 50 pips.

Short-term traders can usually find trading opportunities in such consolidation ranges, but medium and longer-term traders may want to step back and wait for a fresh directional movement.

Technical levels are critical in USD/JPY

So if you‘re a regular trader or investor and you don’t work at a Japanese bank, how can you know where the orders are? Simple: Focus on the technical levels.

Perhaps no other currency pair is as beholden to technical support and resistance as USD/JPY. In large part, this has to do with the prevalence of substantial orders, where the order level is based on technical analysis. USD/JPY displays a number of other important trading characteristics when it comes to technical trading levels:

• USD/JPY tends to respect technical levels with far fewer false breaks. This situation is typically due to the presence of substantial order interest at the technical level. If trend-line analysis or daily price lows indicate major support at 118.20, for example, sizeable buying orders are likely to be located there. The bank traders watching the order may buy in front of it, preventing the level from ever being touched, or tested. If the selling interest is not sufficient to fill the buying order, the level will hold. On the other hand, if the technical level is breached, it’s a clear indication the selling interest is far greater and is likely to continue.
• USD/JPY’s price action are usually highly directional (one-way traffic) on breaks of technical support and resistance. When technical support or resistance is overcome, price movements tend to be sharp and one-sided, with minimal pullbacks or backing and filling (prices coming back to test the breakout level). This situation is the result of strong market interest overcoming any standing orders, as well as likely stop-loss orders beyond the technical level.
• Spike reversals (sharp – 20 to 50 pip price movements in the opposite direction of the prior move) from technical levels are relatively common. Spike reversals are evidence of a significant amount of market interest in the opposite direction and frequently define significant highs and lows. They’re also evidence that the directional move that was reversed was probably false, which suggests greater potential in the direction of the reversal.
• Orders frequently define intraday highs and lows and reversal points. Japanese institutional orders also tend to be left at round-number prices, such as 118.00, 118.25, or 118.50. When you look at charts involving JPY, always note tops/bottoms are close to round number price levels because there could be significant orders there.

East Meets West: USD/JPY

USD/JPY is one of the more challenging currency pairs among the majors and trading in it requires a higher degree of discipline and patience. Where other currency pairs typically display routine market fluctuations and relatively steady, active trading interest, USD,/JPY seems to have an on/oft switch. It can spend hours and even days in relatively narrow ranges and then march off on a mission to a new price level.

USD/JPY can offer some of the clearest trade setups among the major pairs. When you’re right in USD/JPY, the returns can be astonishingly quick. When you’re wrong in USD/JPY, you’ll also know it pretty quickly. The key to developing a successful trading game plan in USD/JPY is to understand what drives the pair and the how price action behaves.

Trading fundamentals of USD/JPY

The Japanese yen is the third major international currency after the U.S. dollar and the European single currency, the euro. USD/JPY accounts for 17 percent of daily global trading volume, according to the 2004 BIS survey of exchange markets. Japan stands as the second largest national economy after the United States in terms of GDP and the JPY represents the third major currency group after the USD and the EUR groupings.

Trading USD/JPY by the numbers

Standard market convention is to quote USD/JPY in terms of the number of JPY per USD. For example, a USD/JPY rate of 115.35 means that it takes ¥115.35 to buy $1.

USD/JPY trades in the same direction as the overall value of the USD, and inversely to the value of the JPY. If the USD is strengthening and the JPY is weakening, the USD,/JPY rate will move higher. If the USD is weakening and the JPY is strengthening, the USD/JPY rate will move lower.

USD/JPY has the U.S. dollar as the base currency and the JPY as the secondary or counter currency. This means,

• USD/JPY is traded in amounts denominated in USD. In online currency trading platforms, standard lot sizes are $100,000, and mini lot sizes are $10,000.
• The pip value, or minimum price fluctuation, is denominated in JPY.
• Profit and loss accrue in JPY. For one standard lot position size, each pip is worth ¥1000; for one mini lot position size, each pip is worth ¥100. To convert those amounts to USD, divide the JPY amount by the USD/JPY rate. Using 115.00 as the rate, ¥l,000 = $8.70 and ¥l00 = $0.87
• Margin calculations are typically calculated in USD. So it’s a straight forward calculation using the leverage rate to see how much margin is required to hold a position in USD/JPY. At 100:1 leverage, $1,000 of available margin is needed to open a standard-size position of 100,000 USD/JPY.

It's politically sensitive to trade

USD/JPY is the most politically sensitive currency pair among the majors. Japan remains a heavily export-oriented economy, accounting for more than 40 percent of overall economic activity. This means the JPY is a critical policy lever for Japanese officials to stimulate and manage the Japanese economy and they aren’t afraid to get involved in the market to keep the JPY from strengthening beyond desired levels.

A weak currency makes a nation‘s exports cheaper to foreigners and, all other things being equal, creates a competitive advantage to gain market share. The flip side of a weak currency is that it makes imports from abroad more expensive, putting foreign exporters at a disadvantage in the domestic market.

In the past, this has led to accusations of currency manipulation by trade partners and efforts to force the JPY to strengthen. But with China's incredible growth in this decade, lil’ ol’ Japan and the yen seem to have dropped from the radar screen as the primary target of free-market advocates. But this is more a function of China's vast current and future potential rather than any change to how the Japanese effectively manage the JPY.

The Ministry of Finance is routinely involved in the Forex market

Currency intervention is usually a last resort for most major national governments. Instead, the Japanese Ministry of Finance (MOF) engages in routine verbal intervention in not-so-subtle attempts to influence the level of the JPY.The chief spokesman on currencies is, of course, the Minister of Finance, but the Vice Finance Minister for International Affairs is the more frequent commentator on forex market developments.

The Japanese financial press devotes a tremendous amount of attention to the value of the JPY, similar to how the U.S. financial media cover the Dow or S&P 500. Press briefings by MOF officials are routine. During times of forex  market volatility, expect near-daily official comments. These statements move USD/JPY on a regular basis.

Beyond such jawboning, known as verbal intervention, the MOF has been known to utilize covert intervention through the use of sizeable market orders by the pension fund of the Japanese Postal Savings Bank, known as Kampo. This is sometimes referred to as semi official intervention in various market commentaries.

JPY as a proxy for other Asian currencies

The JPY is sometimes considered as a proxy for other Asian currencies that are not freely convertible or have poor liquidity or other trading restrictions, such as the Korean won, Chinese yuan, or the Taiwan dollar. Speculation that the Chinese government would revalue (strengthen) the Chinese yuan relative to the USD in early 2005 led to speculation that the JPY would also strengthen.

Japanese asset managers tend to move together

If Americans are the ultimate consumers, then the Japanese are the consummate savers. The Japanese savings rate (the percentage of disposable income that’s not spent) is around 15 percent. (Compare that with the U.S. savings rate at around -1 percent!) As a result, Japanese financial institutions control trillions of dollars in assets, many of which find their way to investments outside of Japan. The bulk of assets are invested in fixed income securities and this means Japanese asset managers are on a continual hunt for the best yielding returns.

This theme has taken on added prominence in recent years due to extremely low domestic yields in Japan. The continual off-shoring of JPY-denominated assets leads to continual selling of JPY to buy the currencies of the ultimate investment destination. This makes domestic interest-rate yields in Japan a key long-term determinant of the JPY’s value.

Japanese financial institutions also tend to pursue a highly collegial approach to investment strategies. The result for forex markets is that Japanese asset managers tend to pursue similar investment strategies at the same time, resulting in tremendous asset flows hitting the market over a relatively short period of time. This situation has important implications for USD/JPY price action.

Important Japanese data reports

Keep in mind that politics and government officials’ (MOF) comments are quite frequent and can shift market sentiment and direction as much as, or more than, the fundamental data. The key data reports to focus on coming out of Japan are:

• Bank of Japan (BOJ) policy decisions, monthly economic assessments, and Monetary Policy Committee (MPC) member speeches
• Tankan Report (a quarterly sentiment survey of Japanese firms by the BOJ - the key is often planned capital expenditures)
• Industrial production
• Machine orders
• Trade balance and current account
• Retail trade
• Bank lending
• Domestic Corporate Goods Price index (CGPI)
• National CPI and Tokyo-area CPI
• All-Industry Activity Index and Tertiary Industry (service sector) Activity Index