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"The casual connections [in the currency market] are reflexive, the participants' bias may engender, sustain, or destroy a vicious or benign circle." - George Soros

Reflexivity and boom-bust go to the heart of it

Mr. Soros is saying that prices in the currency markets are driven by real people based on their best guess of what future currency prices will be. These expectations create price trends and it's important to understand that it doesn't matter if these trends are based on flawed expectations or a focus on the wrong underlying fundamentals. What is important for the trend is simply price validation -- higher prices begetting higher prices.

And as peoples' expectations about the trend is validated, evidenced by rising prices, more money is committed to the trend, and it is sustained. It is a self-reinforcing process. Eventually the expectations of the people who have created the trend become so far out of touch with underlying market fundamentals, the trend can't be sustained. A trend in the other direction will begin.

In essence, the explanation above defines a boom-bust cycle. We see this boom bust price action in all asset classes. But we see it intensified in the currency markets because most of the people who trade currencies only focus on price -- they have little clue as to the underlying fundamentals that make these markets move. It is why currencies tend to go far beyond the fundamentals. This process actually operates with every time frame you analyze -- it is fractal.

Now a look at sentiment and the economic fundamentals you should focus upon.

"The ultimate driving force for currency movement is participants' expectations of total return." - John Percival

Sentiment is defined as the collective expectations of the millions of players in the market placing trades and talking about placing trades. The reason sentiment plays an unusually large role in currencies is because few people have a handle on what really moves currencies - they are price-led instead, they consider real economics. And often if they do, they look at the wrong things and link cause and effect to the wrong variables.

The number of potential variables impacting the movement of currencies is vast. Is it budget deficits, trade deficits, industrial production, interest rates, inflation, deflation, war, housing, Asian bank reserves...on into infinitum, that drive currency prices.

Extreme Consensus + Extreme Speculation = Extreme Price

There are quantitative and qualitative ways to gauge price extremes. One easy to follow quantitative factor is open interest published each day for the currency futures traded on CME's Globex. Currency futures prices key off spot prices and the CME open interest is an excellent barometer that applies across foreign exchange.

Sentiment analysis is so important because it embodies the collective wisdom of the market-it's grounded in human action. And in the end, after all the sophisticated analysis is complete, we are left with irrational human beings making decisions to buy or sell based on their expectations, needs, fear, and greed.

Knowing the fundamentals can give you an edge

Below are two fundamental drivers of currency prices -- interest rates and economic growth. But keep in mind, sentiment embodies how the crowd views the real underlying economic reasons why currencies are doing what they do. However, if you understand how interest rates and economic growth drive currency value over time, and continue to monitor this reality relative to the crowd's view of that reality, you can sometimes see a divergence which suggest there will soon be a change in trend -- an position for it. That's a great edge to have.

1. Interest rates (entices short-term money flow)
2. Economic growth (entices intermediate capital flow and foreign direct investment)

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John (Jack) Ross Crooks Jr.,
President and Chief Trading Officer

Mr. Crooks has close to 20 years experience in the currency, equity, and futures arena. Jack is a investment advisor who has held key positions in brokerage, money management, trading, and research. Jack is founder and president of Black Swan Capital LLC and Black Swan Capital Management. He was also founder of Ross International Asset Management and General Manager of Plexus Trading. Ross International was a discretionary money management firm specializing in global stock, bond, and currency asset management for retail clients. Plexus Trading specialized in currency futures and commodities trading. Neither firm is now in operation. Prior to entering the investment arena, Jack worked in various corporate finance positions. He has written extensively on the subject of global currencies and international economics.

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