Thursday, October 01, 2009

How To Trade Friday's Unemployment Report

AVAFX
The Biggest Economy's Biggest Trading Event:

Monthly US Employment Reports. What It Is, Why it Matters, And How To Profit From It

What It Is

The US Department of Labor's Non Farm Payroll, Unemployment Rate, and Average Hourly Wage reports, released together on the first Friday of the month, combine to form what is arguably the month's key economic news event for the United States. It is intended to represent the total number of paid workers in the U.S. minus farm employees, government employees, private household employees and employees of nonprofit organizations.

The underlying idea is is to capture changes in the number of workers that contribute to GDP. The US Department of Labor releases it on the first Friday of every month 08:30 EST (the day before if that Friday is a holiday). At the same time, the US also releases monthly reports on the unemployment rate and average hourly earnings.

Why It's So Important

Together these reports consistently cause largest rate movements of any news announcement in the forex market. This is because about 70% of US GDP is from consumer spending, which ultimately depends on employment conditions and their affects on consumer income.

Thus these reports are arguably the most significant indicator of growth of the largest market in the world. Right or wrong, the market’s interpretation of these reports often causes significant movements in global stock, commodity, and forex markets, and can even reverse prevailing trends for the following week.

How Markets Are Affected

Exactly how this event affects the markets has varied over time. Historically, good news (lower than expected unemployment, higher than expected average wages) caused the USD and other assets that benefit from growth, like stocks, to rise. For the past two years, the USD has generally been bought as a safe haven in times of fear ,and thus moves like other low yielding safe haven assets. It moves up on bad news, and down on good news, the opposite of "risk assets," like stocks, commodities, and higher yielding and commodity based currencies. Thus most of the time, a disappointing report boosts the dollar while stocks and other risk assets fall. At times, a very positive report can even boost both the USD and stocks, for reasons we'll discuss another time.

Given the profit potential of trading the related market movements, many analysts, traders, funds, investors and speculators anticipate the NFP number - and the directional movement it will cause. This means that there can be increased volatility and trading opportunities days before the actual report release, because there are reports that come out in the preceding days that hint at the actual result. These include the employment section of manufacturing and services PMI reports, as well as the ADP non farms payroll report. Thus NFP related volatility can begin early in the week of the actual report.

How To Anticipate It

While we do not recommend attempting to trade the NFP based on one's personal prediction the results, it is still helpful to form an initial bias about whether it exceed or fall short of expectations. There are different methods for trying to predict the NFP result using different combinations of leading indicators. Here are some of the more popular ones.

• ADP Non Farm Payroll Report. Attempts to measure the same thing as the US Government report. Generally accurate in predicting the US NFP direction if not the exact magnitude of the change. The ADP figures have been weaker than the initially reported government number by 117K per month on average over the past 4 months.

• The employment component of the service sector ISM. Over the past 10 years, the index has had a nearly 90% correlation with non farm payrolls.

• The employment component of the Manufacturing sector ISM. Over the past 10 years, the index has had a very strong 87% correlation with non farm payrolls.

• The 4 week moving average of new weekly unemployment claims.

• The direction of continuing claims as shown by the prior 2 reports. That is, did the most recent show greater or fewer continuing claims, and was the rate of increase/decrease greater or less when comparing the prior 3 reports.

• Consumer Confidence as per the Conference Board – polls 5000 families about their expectations over the next 6 months/

• U. Michigan Consumer Confidence Survey – polls 500 people about their expectations for the next 5 years. Because of this smaller sample and longer time horizon, this report is considered less accurate than the Conference Board's report.

• The level of strike activity. A rising # suggests worse NFP, a falling # suggests a lower nfp.

• Monster.com Employment Index (based on the # of online job ads) rising or falling.

• Challenger, Grey, & Christmas y/y Layoff Report on the number of job cuts announced by employers. Limited short term correlation with overall labor conditions.

With so many different parties watching this report and interpreting it, even when the number comes in line with estimates it can cause large rate swings when the report finally does come out at the end of the week. Here's a way to trade this move without getting knocked out by the irrational volatility it can create.

Trading News Releases

This news release creates a favorable environment for active traders in that it provides a near guarantee of a tradable move following the announcement. As with all aspects of trading, whether we make money on it is not assured.
Watching how the market is reacting can provide us with more consistent results than trying to anticipate the directional movement the event will cause

Trading news releases can be very profitable, but one needs to stay calm and patient. This is because speculating on the direction of a given currency pair upon the release can be very dangerous. Fortunately, it is possible to wait for the wild rate swings to subside. Then, traders can attempt to capitalize on the real market move after the speculators have been wiped out or have taken profits or losses. The purpose of this is to attempt to capture rational, more sustained movement after the announcement, instead of the irrational volatility that pervades the first few minutes after an announcement. (For more, see our separate report Trading On News Releases)

A Strategy for Trading Moves Within the First 4 Hours on 5-15 Minute Charts

There are many ways to trade this event. Here is just one example.

The logic behind this strategy is to wait for the market to digest the information's significance. After the initial swings have occurred, and after market participants have had a bit of time to reflect on what the number means, we will enter a trade in the direction of the dominating momentum. We wait for a signal that indicates the market may have chosen a direction to take rates. This avoids getting in too early and decreases the probability of being opening a position before the market has chosen a direction.

The Rules

The strategy is generally traded off of 5 -- 15-minute charts. For the rules and examples, a 15-minute chart will be used, although the same rules apply to a five-minute chart. Signals may appear on different time frames, so stick with one or the other.

1. Do nothing during the first bar after the NFP report (8:30-8:45am in the case of the 15-minute chart).

2. The bar created at 8:30-8:45 will be wide ranging. We wait for an "inside bar" to occur after this initial bar (it does not need to be the very next bar). In other words, we are waiting for the most recent bar's range to be completely inside the previous bar's range.

3. This inside bar's high and low rate sets up our potential trade triggers. We use it to define the tradable breakout levels. That is, when a subsequent bar closes above or below the inside bar, we take a trade in the direction of that breakout up or down. We can also enter a trade as soon as the bar moves past the high or low without waiting for the bar to close. Whichever method you choose, stick to it. The first is safer, the second gets you in the move earlier and thus has higher profit potential, but with a greater risk of having the move reverse against you.

4. Place a reasonable stop loss order on the trade you entered. (For more, see our report A Logical Method Of Stop Placement.)

5. Make up to a maximum of two trades. If both get stopped out, don't re-enter. The inside bar's high and low are used again for a second trade if needed.

6. Our target is a time target. Generally, most of the move occurs within four hours. Thus, we exit four hours after our entry time. A trailing stop (one that is defined by a percent or # of pips from the furthest advance in the direction of your trade) is an alternative if traders wish to stay in the trade.

Example 1: Click The Image For A Larger View


Figure 1: February 6, 2009. GBP/USD 15-minute chart. Time is GMT.

Looking at Figure 1, the vertical line marks the 8:30am EST (1:30pm GMT) release of the NFP report. As you can see from the chart, there are three bars, or 45 minutes, of back-and-forth action following the release. During this time, we do not trade until we see an inside bar. The inside bar has a square around it on the chart. This bar's price range is fully contained by the previous bar. We will enter when a bar closes higher or lower than the inside bar. The next bar's close is circled, as that is our entry; it closed above the inside bar's high. Our stop in this example is a fixed 30 pips below the entry price, which is marked by a solid black horizontal bar.

Because our entry occurred at approximately at 9:45am EST (2:45pm GMT), we will close out our position four hours later. By entering the trade at 1.4670 and exiting four hours later at 1.4820, 150 pips were captured while risking only 30 pips. However, it should be noted that not every trade will be this profitable. (Before attempting to trade any strategy, be sure to read our report: Practice Trading with a Practice Account- What You Learn, What You Don't.)

Example 2: Click The Link For A Larger View


Global equity markets generally move together. Note how closely the 15 minute chart below of the DAX 30 (a German stock index) mimics the moves of the S&P 500 in both timing and magnitude. The above strategy would have worked well here too.

Sept. 30th 15 Minute Charts of the S&P 500 and DAX 30 Index After the 13:30 GMT/08:30 EST Release of the ADP Non Farms Payroll Report.

Strategy Disadvantage

While this strategy can be very profitable, it does have some faults to be aware of. For one, the market may move in one direction aggressively and thus may be beginning to fade by the time we get an inside bar signal. In other words, if a strong move occurs prior to the inside bar, it is possible a move could exhaust itself before we get a signal. It is also important to note that in high volatility times, even after waiting for a pattern setup, rates can reverse quickly. This is why it very important to have a stop in place.

Summary

The logic behind this strategy of trading the NFP report is based on waiting for a small consolidation, the inside bar, after the initial volatility of the report has subsided and the market is choosing which direction it will go. By controlling risk with a moderate stop we are poised to make a potentially large profit from a huge move that almost always occurs each time the NFP is released.

The View from Wednesday: Negative

So far, the indicators suggest a worse than expected report. Just a few easily available indicators thus far ALL point to a worse than expected report.

ADP Non Farm Employment Change was -245K vs. -200K expected and -277K prior. Over 20% worse than expected, but slightly better than last month's result. This should be seen as negative, but both media and the markets have managed to focus on the positive. As of this writing, one hour after the release, global stocks are down on the news but after the first half hour bouncing back, erasing half the drop. Overall suggests a weaker report than expected. As noted above, the ADP tends to be weaker than the initial BLS figure by 117K, making this one too close to call.

Online job ads are down over 100K from last month, suggesting a worse than expected report.

Chicago PMI came in at 46.1 (below 50 = contraction) vs. 52.1 forecasted and 50.0 last month, again suggesting a worse than expected report.

The Conference Board's Consumer Confidence Index was 53.1 vs. 57.0 forecasted and 54.5 prior, suggesting a worse than forecasted report.

Combined with the already extended rallies in risk assets, the above indicators tentatively suggest a disappointing Friday and pullback in risk assets and currencies.

Beware again, however, that markets have been very resilient and focused on whatever positives there are.

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