When I’m hunting for profitable trade ideas to share, I often come across stocks that are hardly what you’d call “mainstream.”

Essentially, I’m searching for great chart setups that can hopefully produce profits for members, in stocks whose movements have little implications for the broader markets.

Perhaps my favorite pattern to trade is the “bull flag” pattern.

Why am I always trying so hard to find these patterns?

Because of their potential in relation to well-defined risk / reward parameters.

Right now, I am looking at a “bull flag” in the most important asset there is, and its development demands everyone’s attention because of the potential market-moving implications.

The US Dollar has been “flagging” bullishly since the FOMC’s recent inflation shift

Unless you’ve just returned from vacation, where you were catching up on all the partying you could not do pre-vaccine, by now you know that members of the Federal Reserve’s Open Market Committee (FOMC) revealed a meaningful adjustment in the timing of their next rate hike.

Specifically, the FOMC now believes US economic activity will move at a more rapid clip than originally thought.

In return, boosting inflation to the Fed’s desired 2.0% average in the next one to two years, which is sooner than anticipated.

In the currency world, where relative economic strength and rate differentials are everything, this sent shockwaves through the system by causing the US dollar to surge against a basket of trade-weighted currencies. This basket is the US Dollar Index (DXY). 

This bullish action can be seen on the chart of DXY below, where the late-week rally that occurred the prior week formed the flagpole and this past week’s pause seems to be forming the flag.

Figure 1

Note: On stockcharts.com, the ticker used to pull up the dollar index (DXY) is $USD.

Guess what?

Not all “flag” setups work, and there is reason to question whether this one has what it takes to deliver on its bullish potential.

Positioning is key when it comes to big currency moves

Several weeks ago, I introduced you to the Commodity Futures Trading Commission’s (CFTC) Commitments of Traders Report (CoT).

You can find a full explanation of the CFTC’s methodology in gathering and reporting this information by going here.

The CoT report is released every Friday afternoon at 3:30 EST, holiday schedule permitting, consisting of data collected the prior Tuesday, and measures the long vs. short futures positioning (i.e., net positioning) of the three following groups of traders:

Large Speculators can be thought of as hedge funds and CTAs (Commodity Trading Advisors). This category of traders is viewed as trend followers.

Small Speculators are folks like you and me (i.e., retail traders). This group is also viewed as trend followers.

Commercial Hedgers are Swap Dealers and producers that may be producing a commodity and are in the market to hedge their costs. This category is considered to be the “smart money.”

Typically, professional traders will use this information to identify instances when these groups are positioned too aggressively relative to history.

In other words, it’s an important sentiment indicator that measures the sentiment of the smallest traders all the way through to the largest traders in the market.

On the chart below, the top panel shows a weekly bar chart of the US Dollar Index futures contract.

The bottom panel contains the net positions of the three groups of traders discussed above.

Anything below the zero line on the bottom panel chart means there is a net-short position, while anything above means there is a net-long position.

Remember, the CoT report is a weekly report, so everything you see on this chart is weekly increments.

Figure 2

Source: Barchart.com

As the chart shows, there is no extreme positioning taking place from either of these groups of traders.

For many of you who may have been trading “to the moon” rallies in meme stocks this year, think of it this way…this chart is showing that there are no extreme positions to be squeezed at this time.

Because of the dollar’s status as the world’s reserve currency, it’s movement can impact a great many markets.

If you think the dollar’s movements don’t have the potential to affect your portfolio, you’re probably wrong.

Dollar strength that is sustainable and long-lasting can cause commodities to decline, large multinational stocks to underperform, emerging market stocks to come under pressure, and have meaningful implications for the “carry trade,” which is a subject that is probably best left for another day.

Because of this, the dollar is the single most important instrument that traders should always have an eye on.

Again, the key is that sustainable appreciation in the dollar is required for there to be a tectonic market shift that can really start to weigh on commodities, large multinational stocks and emerging market stocks.

Bottom Line

Right now, the dollar’s ability to sustain a reversal of its long-term downtrend would not be signalled until DXY closes above the 92.70 to 93.45 area, as the chart of DXY above (Figure1) shows.  

Given the mostly neutral positioning being indicated by recent CFTC CoT data, such a development is in question.

The best chance of this happening is if economic data start to come in on the strong side in the coming weeks to months, and if US monetary policy shows signs of being more restrictive than its global partners, especially those in the European Union (EU).