How a Currency Trader Plays the Ukraine Crisis

28/03/2014 11:07 GMT | Updated 27/05/2014 10:59 BST

Trading is not what you think it is. It's not about black boxes or super high tech algorithms. It is about playing chess. An excellent example is the current Ukraine/Crimea/ Russia drama.

Of course, the heat was turned up with Mr. Putin's actions and most traders and investors took heed. Uncertainty creates emotion-mainly fear-and sets the stage for some following action. Meanwhile, the "smart money" makes its moves....usually way before the rest of the world knows what's happening. Indeed, all the projections and scenario evaluations mean little because the inference is only about probability. As traders, we learn how to read and understand what the markets are telling us. After thirty five years as a professional trader, I can tell you that trading is nothing like investing.

As it has played out so far, the anticipation of financial sanctions set a course for the smart money. After the financial meltdown of 2008, financial regulators and pressure from governments started to make some gratuitous moves to shine some light on safe havens, offshore banking and other high finance shenanigans. Indeed, the recent blows to Swiss bank secrecy has had some obvious impact as witnessed by recent events in the Forex market.

The "smart money" is indeed smart. They don't telegraph their moves. A few weeks ago, the currency markets began to take on a different mood. Financial reports and Central bank news didn't seem to have quite the affect they usually do. As a matter of fact, the Japanese Yen started to show some strength even after the BOJ said it was planning to devalue its currency. At around the same time something similar happened with the AUD as the Central Bank of Australia made similar statements about devaluing its currency only to have the AUD start creeping up in price.

Not only that, the price of gold, which normally rises in times of crisis, didn't react as most would anticipate. But the icing on the cake was after the sanctions were announced, the European currencies stated selling off after a period of strong gains. Something was in the wind for those who pay close attention to price behavior.

So, trained traders are constantly on the prowl for potential trading opportunities. Winning traders make money by exploiting the consistently irrational behavior patterns of other traders. They know that someone else's errors in judgment are opportunities and good traders understand how these errors manifest themselves in price action.

But we need to confirm our analysis. We turn to our main tool for verification-our charts. No, not astrology charts, Price charts! which present the graphic price movements of the specific assets. First, we check what has been the recent short term trend in Gold. As we mentioned, during periods of crisis, Gold is a safe haven and should increase in price. As we can see from the chart below, that has not been happening. We then look for our structural points on the charts, which tells us when price has moved through a key price based on recent movements. These are needed to confirm our action for entering into a trade. In this case, we would short gold and place an appropriate stop to limit our upside risk.

Likewise, we turn to another traditional safe have, the Swiss Franc. Low and behold, the CHF has been devaluing relative to other currencies. We look at the USD (a safe haven in most times of crisis) and see that the USD/CHF has been moving up in price meaning a devaluing CHF relative to the USD. We check our charts for the pair and look for structural price points. Thus, the position would be long (buy) the USD/CHF pairs anticipating a continuing relative increase in the USD relative to the CHF. In other words, the USD will be worth more in terms of CHF.

As traders, we look at patterns from different angles. We confirm our analysis by examining the charts. We then drill down to define specific entry points. We establish our risk control stop and we prepare to execute the trade. We do not, as most investors do, forecast price movement and lay in wait. Traders take real-time price movements and when the trade is confirmed by penetration of our structural price point, we take immediate action and place the trade.

The below charts show the Swiss Franc and Gold. Parochial thinking is that both should move up in price as both are normally considered as safe havens. However, this recent crisis shows that this may no longer be true.

Under normal circumstances, a country's currency value is determine mainly by three factors. First, interest rates. Second, Balance of trade and budget status (does the country producing more than it consumes) and capital flows. In the current geo-political situation, capital flows are having the most impact. Once a seasoned trader sees these patterns develop, he analyses the knock on effects and anticipates those events happening. Once the actual market prices demonstrate what is really happening, it becomes evident what positions to take. However, capital flows move much quicker than do the other factors that effect currency prices and traders need to be on their toes when things start to change.

And here is an important part of trading: understanding human behavior. Once it becomes apparent to the general trading public what is taking place, there is the tendency to pile on. Institutions, large funds and retail traders pump more energy into the upward (or downward) price movement. However, once profit taking starts to take place, other traders who have gained paper profits begin to fear the loss of those "imaginary profits". Before the profits can be realized, the positions need to be closed out. This has a direct effect on price. As price begins to go down, fear begins to take over and there can be sudden and drastic reversals in price. Fear follows greed. Traders need to be several moves ahead based upon what is actually happening in the market. It is much more of an intuitive process rather than the sophisticated models and technical analysis that is mainly based on historical data.

Traders are chess players; watching and strategizing moves ahead of what is actually taking place. It takes patience and discipline to play the game successfully, but those virtues can pay off handsomely.