Prior to the close of trading on Friday, 20 February, several major currencies appreciated strongly against the U.S. dollar for no apparent reason. Many forex traders, including some of the “big money,” were caught napping when the landslide began and before they could reposition their stops to ride out what seemed to be a short-term move, those stops were triggered and their trades terminated, profitably or otherwise. The resulting selloff, of course, increased downward pressure on USD crosses, triggering stops further distant and causing a cycle that lasted several hours.

EUR/USD shot up almost 200 pips in two hours; the move continued following the opening on Monday morning and nearly reached the important 1.3000 resistance level. USD/CHF was just as dramatic, falling 200+ pips during the same time frame. Other major runs came from the pound sterling and Canadian dollar, with significant one-hour moves for the Japanese yen and Australian and New Zealand dollars.

So that was what happened, but what caused the selloff in the first place?

Some of the move was due to profit-taking; however, more was driven by self-protective investors. Over the past year, actions taken by the U.S. Federal government regarding a bank have occurred over the weekend. For example:

•    Bear Stearns: sold to JP Morgan Chase Sunday 17 March 2008;
•    Freddie Mac and Fannie Mae: first rescued Sunday 14 July then seized Sunday 7 September;
•    Merrill Lynch: sold itself Sunday 14 September;
•    Lehman Brothers: was unable to find a buyer over the same weekend and filed bankruptcy Monday 15 September; and
•    Wachovia Bank: sale to Citi organised the weekend 27–28 September
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Although this list is incomplete, the pattern is obvious.

The current fear, of course, is Citigroup, BoA, or another major U.S. financial institution may be nationalised without warning, sending global equities and USD tumbling. This fear, whether warranted or no, has been intensified by the impending bank “stress tests” scheduled to begin as early as this week and which are broadly and cynically expected to display widespread insolvency within the U.S. financial system. The increased volatility could easily lead to currencies gapping at open, therefore missing a trader’s entry point—or, more dangerously, his exit, leaving him with a losing and disastrous trade.

Will it happen again? Friday trading is already shaping up for drama. Fundamental announcements scheduled for release that day include (all times GMT):

•    Eurozone January CPI (1.6% y/y previous, 1.1% expected) and unemployment (8.0% previous, 8.1% expected) at 10:00 AM;
•    Swiss February KOF leading indicator (−87 previous, −93 expected) at 10:30 AM; and
•    U.S. second reading 4Q2008 GDP (−3.8% annualised previous, −5.3% expected) and February Chicago PMI (33.3 previous, 33.0 expected) at 1:30 PM and 2:45 PM, respectively.

Each of these announcements could be a market mover and all have downside potential. Unless the financial crisis is settled and risk aversion routed prior to Friday, another round of position squaring is also possible. The combination is volatile and holds true profit potential for the forex trader savvy enough to monitor all open positions carefully, with special emphasis on protective stops and short-term indicators such as moving average crossovers.