Foreign Exchange Correlation Trade (Incl video from NASDAQ market site)

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Jill: I am very pleased to introduce Ed Ponsi of Barchetta Capital and our foreign currency expert on Real Money Pro. Ed and I review the FX markets from the NASDAQ market site monthly (every third Wednesday of the month). Be sure to check out our content across all of the TheStreet's premium sites. His insight is a valuable tool for a well-rounded portfolio.

Ed: To be fair, nobody expected great numbers out of Europe overnight. In fact, for the three biggest European Monetary Union economies, a contraction was expected in the gross domestic product. What wasn't anticipated was the parade of weak data that emerged that showed European economies dissolving at a faster-than-expected pace in the fourth quarter.

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If French President François Hollande is as concerned about the strong euro as he claims to be, he has less to fear now. Quarter over quarter, French GDP fell 0.3%, and German GDP contracted by 0.6%. Today's soft numbers rapidly brought the currency to its lowest point since Jan. 24 as it became apparent that nearly everyone had overestimated European growth. The plunge was exacerbated by word that Standard & Poor's may issue downgrades of France, Spain, Italy and Portugal later this year.

I'm still long the euro from $1.34, per my Feb. 4 article. I'm not going to panic and bail out here, although I'll admit that was my first impulse upon seeing the size of today's red candle. The overnight activity appeared to ruin any constructive action that had occurred over the past four trading days. Then I remembered that today's candle wasn't complete, and that my stop is still in place at $1.3225. There are three layers of support between the current price and my stop: the ascending trendline (black), the 50-day moving average (blue) and horizontal support (red). I'm sticking with my plan.

It has occurred to me that a head-and-shoulders pattern may be forming on the euro. I stashed my stop (red letter S) beneath a support level at $1.3250 that is beginning to look suspiciously like a left shoulder (black arrows). Now I'm debating whether my stop should be supplemented with an entry order to sell short, should that level give way.

As of right now, I can't do that because I'm already short the British pound-dollar cross via CurrencyShares British Pound ETF (FXB). Remember that there are two sides to every currency trade; in my euro play, I'm long euros and short U.S. dollars. Via my FXB short, I'm also long dollars and short British pounds. You could say that the dollar positions cancel each other out, and I'm in a synthetic long euro/short pound position. If I close the euro long position and sell short, I'll have long U.S. dollar positions vs. both the euro and the pound. I'm not keen to "load the boat" and take an oversized long U.S. dollar position -- at least not yet.

Unlike my euro trade, which is currently showing a small loss, the FXB short has been a big winner. The fund reached a six-month low Wednesday as the scenario that I discussed here continued to unfold. FXB appears headed for $152, an area that acted as key support several times last year.

Will all of this European negativity derail U.S. stocks? It might, but equities are resisting this headwind. A falling euro usually pulls U.S. equities down with it, but the wild card here is cash on the sidelines. January was a record month for fund inflows, and there is still plenty of dry powder available.

Also, many of the correlations that bedeviled markets last year have faded, as correlations often do. Just because the correlation trade worked last year -- in this case, that between a falling euro and falling U.S. stocks -- doesn't mean it'll work this year. Markets are always changing, so don't fall into the trap of blindly believing that they've become static. Just when you believe you have the markets figured out, they have a way of pulling the rug out.

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At the time of publication, Ponsi was long the EUR-USD. He was short the FXB.