With ECB in focus, euro downtrend looks strong

The European Central Bank in Frankfurt, Germany
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The European Central Bank in Frankfurt, Germany

Charts suggest that the downtrend in the euro/dollar is firm ahead of the European Central Bank's (ECB) policy meeting on Thursday.

A decline in euro zone inflation to a five-year low in August amplified dovish comments by ECB president Mario Draghi at the Jackson Hole central bankers' meeting. Draghi acknowledged that inflation expectations have been falling at the August meeting and said the ECB, "within its mandate, will use all of the available instruments needed to ensure price stability over the medium term."

The developments fueled speculation that the ECB will consider easing action as early as Thursday with some analysts arguing that a quantitative easing – or bond buying – is on the horizon.

Growing expectations for ECB easing saw the euro/dollar decline decisively below $1.34 in August, marking a significant downtrend confirmation. The $1.34 level has acted as a long-term support and resistance, defining price activity starting in December 2011. The pair has remained in a broad trading band since September 2012; $1.34 is in the middle of this band.

The upper edge of the trading band is near $1.40, a level defined by support and resistance activity in 2010 and 2011. Starting in September 2013 the euro/dollar traded in the upper section of the trading band between $1.34 and $1.40. In May 2014 it briefly touched the top of the trading band and then started a new prolonged downtrend.

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The width of the upper section of the trading band is projected downwards to set the lower edge of the trading band near $1.28. This level provided support in November 2012, and March, May and July 2013. This is a significant and well-tested support level.

There is minor support and resistance near $1.31 that helps define the development of the downtrend.

Price activity between $1.34 and $1.40 had relatively low volatility, while activity between $1.28 and $1.34 had more rapid volatility moves. This suggests that a fall below the minor support near $1.31 can move rapidly to test lower support near $1.28. Traders will be ready to add to short trades when the euro/dollar moves below $1.31.

Any rebound from $1.31 meets trend line resistance near $1.33, the current value of the downtrend line. There is a low probability that the pair will rise above the downtrend line. Traders who are not in the market will wait for the rally to hit the downtrend line and then take short side trades with a downside target near $1.28.

The key feature of trading behavior on the weekly chart is the higher degree of volatility between $1.28 and $1.34. Falls can be very rapid. Once support near $1.28 is reached traders will tighten stop loss to protect profits. The reason is that the historical behavior shows there is often a very fast rally rebound from $1.28. This fast rebound behavior developed in November 2012, and May and July 2013. Future rebounds from $1.28 will first find resistance at the value of the downtrend line and then at the long-term support resistance level near $1.34.

Read MoreEuro zone inflation its 5-year low; ECB action eyed

In the short-term traders will trade from the short side and followed the downtrend move towards support near $1.28.

Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders – www.guppytraders.com. He is a regular guest on CNBCAsia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.