Technical Analysis

As we have already stated in the previous lesson, technical analysis tries to determine the future performance of any financial instrument based in the study of historic prices (price behavior).

By studying the price behavior and technical analysis we are actually analyzing the behavior of all traders involved in a certain market. Traders and investors are behind every price movement; after all, they all drove the price to a certain level. The price moves based on traders’ expectations; on what they think the future price of any given instrument should be.

Most of the time traders are driven by their emotions (fear, greed, hope, etc.) and these emotions are visible on the charts as repetitive price patterns. The outcome of these specific patterns is what technical analysis tries to forecast.

Technical analysis is based on the Dow Theory which has three main principles:

Price Discounts Everything - All information available is already reflected in price, it reflects the knowledge of everyone involved, including fundamentalists.

Price Behavior is not Random - Although there are periods of trendless or random behavior, the price tends to trend. Our job as technicians is to identify those periods where the price is trending and profit from them.

The “What” (or “Where”) Question is more Important than “Why” - The “What question” refers to where is price and what is its historical behavior. Those questions are to be answered by technical analysts. Why is price at certain level? This one is of concern of fundamental analysts; they look for reasons behind certain price movements.

And here we go with Technical Analysis...

This will be  in the following way:

   

1-Types of Charts - We will review the most common types of charts used by technical analysts.

2-Support and Resistance - We will review one of the most important concepts of trading; we will see what makes support and resistance and how to identify them.

3-Support and Resistance FAQ’s – Here you will find common questions about support and resistance zones. 

4-Trends and Range Bound Conditions - How to identify a trend and a range market. We will also see how to measure its intensity through trendlines.

5-Candlesticks Intro - We will review the most popular type of charting used by technical analysts.

Some Thought on News and Event Trading

News and event trading has become a very popular trading style in these days. The reason behind it lies in the huge profit potential made in just a few minutes - with no effort at all.

Take for instance the first Friday of the month, when the non-farm payrolls report is released. The price of the EUR/USD can move around 150 pips in less than 10 minutes. That is US$1,500 (trade based in only one standard lot).

What traders fail to realize are all the risks involved in such practices. What if those 150 pips go against you? Even with a stop loss order, sometimes your broker won’t be able to honor it, because the price gaps (values between prices are not printed). In these cases, your broker won’t take the loss, so he will give you the closest printed price, meaning 70, 100, or 150 pips against you. That amount of pips could mean a margin call or a huge loss. In how much time again? …10 minutes.

The important thing here is that your job as a trader is to make sure you are going to be able to trade the next day, week, and years to come. Taking these kinds of risks won’t help much.

Other traders instead of using market orders to get in the market use stop and limit orders. But the same happens there, it is too risky, the market could again gap and your broker won’t be able to honor your stop. Traders that use this kind of strategy are taking uncalculated risks, risks that could cost them their trading account, and probably their trading careers.

Also, price movements are not always steady in one direction. It could go up and trigger some orders just to go back to the other extreme, then trigger the other side orders and then come back to where it all started.

The truth is, there is no possible way to forecast price movements in such circumstances. As we already know, the price moves based on traders and investors expectations. This is the combination of all traders perceptions on where price should be. To possibly know where the price is heading we need to ask every single trader and investor around the world what their intentions are during such announcements (something impossible to do). To go a little further, sometimes as the news report comes out, nothing happens, or worse, the price goes against the fundamentals.

Take for instance a day of interest rate announcement. It is rumored that there will be an interest rate cut. In this case, the currency will go short before the actual decision. Once the interest cut is announced, it is possible that the currency will be bought back, as all traders that could have shorted the currency, had already been short days or weeks ago. So there is no one else to short the currency. In this case, the price could be pushed up, against the fundamentals.

The point I want to make here is, trading itself is risky, and there are risks that you just cannot avoid, like the possibility to lose one trade. There are however some other risks that traders must avoid, as in event trading. The more you control your risks, the better results you will have. Take care of your risks; your profits will take care of themselves.

We consider trading the news announcements to be very risky.

Is there a system based solely on fundamental trading?

I am sure there is. But as with every system, it should have rules and setups that have to be present in order to get in the market, as well as money management controls etc.

Common Practices Used by Fundamentalists

Figure Deviation

A common practice used by short term fundamental traders (or more accurately news and event traders) is trading based on the deviation of an economic indicator actual figure vs. the expected figure.

When economic figures are to be announced, usually 3 numbers are shown:

Previous, expected (also called consensus or forecast) and actual figures.

Previous Figure:

                        The actual figure of the previous period (usually the previous month).

Expected Figure: 

                       What experts think the figure should come out as. Usually and average is made between say forecasts of 20 experts on the field.

Actual Figure: 

                     The actual number of the figure.

What news and event traders focus on is on the last two figures: the expected and the actual figure. The more the deviation the actual figure has from the expected value the more the impact it should have in the exchange rate.

Carry Trades

Most fundamentalists trade the currency market for the long term. This is because most of the time changes in supply and demand take longer to be reflected in the charts.

Carry Trades or Rolling over is a common practice that consists of taking advantage of the interest rate differentials between two currency pairs. Most of these trades have a long-term span. Aside from taking advantage in the currency pair movements, they also benefit from buying a high yield currency and simultaneously selling a low yield currency or selling a low yield currency and simultaneously buying a high yield currency. This way, traders are paid an interest or roll over.

Equity Market Correlation

When a given equity market offers greater returns than other equity markets, it is common that fundamentalists buy the currency of the equity market that offers greater returns.

This is because investors around the world will see benefits by investing in that country. As the sentiment gets better, that currency will increase its demand, pushing its price up.

Gold and Oil and it's relationship with the Forex market

Gold and Oil have an important relationship with the Forex market. Often these two commodities are used as a leading indicator in making trading decisions in the Forex market.

Gold

Ok, before going through some analysis let’s take a look at the following table:

Gold Production by Country

[Table 2]

Why would gold have a negative or inverse relationship with the USD if United States is the second larger producer of Gold (out-placed Australia in 2006)?

The answer is simple (or maybe not)...

The obvious reason behind this inverse relationship is that gold is always priced against the USD: naturally a strong dollar will buy more ounces of gold (and a weak dollar will buy less ounces of gold).

But there is also another less evident reason of this inverse relationship: decades ago, during periods of uncertainty investors tend to migrate away their capital from USD to gold as a safe-haven.

Ok, to check some numbers: The USD has fallen to historic lows against some currencies including: EUR, CHF and CAD while gold (XAUUSD) has reached all time highs.

Majors that have a positive or direct relationship with gold are the Canadian dollar and the Australian dollar.

AUD - Australia is the third largest producer of gold in the world and as a result, the correlation coefficient of the AUD and Gold prices is close to 80%. So the AUD always benefits from rising gold prices and it also decreases when gold prices decline.

CAD - Canada is the third world largest exporter of the commodity. This makes the CAD and Gold move in the same direction, although its correlation coefficient isn’t as large as the AUD and Gold.

What would be the case for the EUR or other major currencies where there is no relationship (at least not a clear one)?

Other majors will have a direct relationship with gold because both of them (majors and gold) are priced in USD.

Oil Prices

Generally speaking an increase in the price of oil results in increasing costs of transportation, utility and heating costs as well as the cost of practically every finished product (particularly in oil-dependent economies such as the US, China India and other developed countries).

Arguments in favor of an indirect relationship between oil and the USD:

• US accounts for only 5% of the world’s population but it consumes 25% of the world's fossil fuel-based energy.
• US imports about 75% of its oil, but owns only 2 percent of world reserves.

Because of this dependency on both oil and foreign suppliers, any increases in price or supply disruptions will negatively influence the US economy (hence the USD) to a greater degree than any other nation.

Canada is one of the few developed countries who are net exporters of energy (i.e. oil). Canada has the second largest oil reserves in the world (only behind Saudi Arabia). For this reason the Canadian dollar has a very tight positive relationship with oil prices.

Where is oil heading?

Oil experts adopted Hubbert’s Curve to forecast oil production for the following decades:

[Image 1]

According to their prediction, world oil production was to peak sometime around the second half between 2000 and 2010 (like now?). Right now the oil barrel is pretty close to US$100, but what could happen to if this prediction is true? It will probably keep going that way for a few more hundreds...

Brain Feeder 4 – Recently a few presidents from large oil producer countries have announced their concerns about the weak US dollar and have declared they would be willing to change the oil pricing in Euros instead of US dollars. What to you think could happen to the USD if they price their oil barrels in Euros instead of US dollars?