Strong Risk/Reward Setup Unfolding in AUD/JPY

Recent moves in the EUR/USD have caught most of the forex market’s attention but this has left trading opportunities available in some of the more peripheral pairs.  One pair that should always be on the radar for any forex trader is the AUD/JPY, which is typically associated with the carry trade section of the market.  As a commodity currency, the Australian Dollar (AUD) is generally associated with high interest rate levels.  This presents a marked contrast with what is seen in Japan, where low interest rates have been a factor in the economy for several decades.

Forex Chart: AUD/JPY Daily Price Action

Forex Chart: AUD/JPY Daily Price Action
Since October 2016, we have seen steady rallies in the JPY and significant bear trends in the AUD/JPY.  The sequence of declines followed by moderate corrective rallies suggests that there is validity in the move but price action since then seems to suggest that these events have run their course.  Traders with experience in Elliott Wave analysis will notice the textbook purity in the recent moves.  But the recent rallies through the 50% Fib retracement of the entire move suggests that a new trend is now in its early stages.

Market Context

In terms of news events that are likely to influence the pair, it will be important for traders to watch for potential turmoil in the Bank of Japan’s recent decisions to end monetary stimulus programs.  On balance, this is something that should be bullish for the JPY -- but the opposite will almost certainly be true if we start to see deterioration in trade balance numbers and broad GDP figures.  Japan is an export economy and the BoJ is notorious for its efforts to take a proactive stance in currency markets.  So if we see any weakness in the above mentioned data points, there is a strong chance we will see some backpedaling on the policy stances promoted by the Japanese finance ministry.

At the same time, there is mounting evidence that the Reserve Bank of Australia will be forced to raise rates from historically low levels (currently at 1.5%).  Better housing data and retail sales figures suggest that the RBA will have more room to normalize rates in line with historically appropriate levels.  If both of these trends are seen, it will improve the carry value that is seen in carry trade pairs like the AUD/JPY.

Short-Term Perspectives

When we are looking at the long-term perspective, there is relatively clear evidence that the broad downtrend has run its course.  This means that it will be important to look at the shorter-term views to find advantageous trade entry points that might benefit from potential rallies.

Short-Term Perspectives
To this end, we will look to use resistance-turned-support at 81.60, which has already held on the first test.  The uptrend beginning in July gives us the latest higher lows that suggest long trades in AUD/JPY can be taken at current levels near 83.00.  With a 160 point stop loss, forex traders should be looking for potential profits of at least 480 pips.  Looking at the current price charts, important resistance lies almost exactly 500 pips away, and there is even scope for an extension another 200 pips higher.  This makes the setup excellent as far as risk to reward requirements are concerned.

Key Resistance Levels

In defining these price targets, we must define the key resistance levels that could eventually stall rallies.  The first level to watch comes in at the highs from the middle of February, which came in at roughly 88.10.  This is only resistance when looking at things from the historical basis, so this is something that can be viewed as an initial price target that is suitable for taking partial profits once it is reached.  

From here, stop losses should be trailed higher (to the breakeven point at 83).  The next profit target can then be seen at 90.60, which is also historical resistance (from December 2015).  But what makes this level even stronger is the fact that is marks the 61.8% Fib retracement of the major decline that marked JPY strength.  

The combination of these two factors (after the AUD/JPY has already broken resistance at the 50% Fib retracement) makes this level the true price target.  Structurally, this trade falls into the ‘superior’ category given the fact that we are leaving 160 pips risk on the table in exchange for the potential to capture 500 or 700 pips in profit (depending on when the trade is closed).

Indicator Readings

Since we have evidence supporting the trade in the price action itself, it is a good idea to look to the indicator readings in order to get a more objective analysis of the historical activity.  Currently, the balance of the evidence on the indicator readings falls largely in line with the broader perspective.  Prices are bouncing from the bottom 2-standard deviation Bollinger Band and the Commodity Channel Index (CCI) is turning back upward into its mid-levels.  

This ultimately suggests that the indicators suggest prices have plenty of room to extend higher from current levels.  It is also something that suggests that there is a low probability prices will be able to extend to the downside.  Any time we are looking to enter into long trades, it is important to remember that we are looking for scenarios where upside potential exceeds the probability for downside declines.  When we combine these factors, we are able to reduce risk and position trades for maximum profits.

Closing the Trade

Now that we have all of the rationale for the trade itself, we need to start looking for situations where it will make sense to close the trade.  This must be done both from the positive side and the negative side -- before the trade is even initiated.  Positive in this case refers to profitable trades and negative refers to situations where the stop loss should be triggered.  To the topside, we will have to monitor market activity as prices are moving toward the historical resistance level at 88.10.  This area actually worked as a small head and shoulders pattern on the very short-term timeframes, so any additional failures here would be enough evidence to close out the trade.  In this scenario, we would see gains of 500 pips.  

If we do not see a forceful in this area, it makes sense to take partial profits and move stop losses to break even.  This is the only way to unlock the true risk/reward potential that exists in the current setup.  The true target here is the 61.8% Fib retracement move of the broader decline in the AUD/JPY and this is based on the fact that the initial percentage retracements have already been removed.  Total positions should be closed if we approach these levels, as most instances in the market see problems overcoming this key resistance mark.  
To the downside, forex traders will need to watch for breaks in the logic supporting the burgeoning uptrend.  Remember, this is something of a contrarian trade which means that it is on the onus of the trader to justify whether or not the underlying reasons make sense when getting long.  If we see prices fall through the uptrend line from June of last year, it makes sense to close out positions and start reassessing.  This means that stop losses should be triggered if the AUD/JPY falls below 81.60.

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