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FOREX - introduction

To earn money on FOREX, commodity or the equity market, a trader should either buy an asset and sell it higher or sell it and then buy back lower. This however, is not that simple. The key to a successful transaction is to know when the price is relatively low or high, and then - is it going to fall or to rise? In order to achieve that, traders basically use two types of investment analysis:

• Fundamental analysis - method of predicting exchange rate movement on the basis of economic and political data and factors, those influence supply and demand of currencies, commodities or equities and other markets.

· Technical analysis - method of predicting exchange rate movement and future market trends on the basis of charts, oscillators and other indicators constructed from historic exchange rates and turnover data.

In practice investors usually apply both investing techniques, combining methods and relying on their own investment experience.

Technical Analysis

General Information and Principles

Before describing how investors use technical analysis in order to predict future price movement, the general definition and prime principles of technical analysis cannot be omitted. Technical analysis is the study of price movement on the basis of charts. It is also the study of repetitive price patterns portraying our psyche. The first notes with regard to the subject date back to XVIII century Japan, where a rice trader described that without price analysis no one could become a successful trader. He didn’t know then, that in the future there would be a possibility to actually earn or lose money by predicting what prices could do in the future.

Technical analysis is based around three prime principles:

1. Market action discounts everything

What this means is that to a technical analyst, everything that happens around us from natural disasters to presidential elections, is portrayed in the price itself. Things happening around us obviously do affect the market price, but this can be anticipated or observed on the charts themselves.

2. Prices move in trends

If you take a look at any chart you could realize that prices move in trends, keeping hold of one long term trend. Obviously even a long term trend could change and does on many occasions but most of the time prices remain in the main trend. Larger trends are divided into smaller ones which are also later divided into even smaller ones…etc. From this principle we could reach a significant conclusion which will also be our most important rule. It comes from George Lanes famous words “The trend is your friend”. More about the trend itself will be discussed in later materials but bare in mind that these words should NEVER be forgotten.

3. History likes to repeat itself

Technical analysis as mentioned before is the analysis of repetitive price patterns. How and why are these patterns repetitive? The answer is quite simple but on the other hand very complicated. It is simple due to the fact that these patterns portray our behavior and our psyche; they portray what we do and how we react to different market events. The complicated part is that these patterns are often very precise what shows, that people behave exactly the same way now as they did in the distant past. It is easy to realize, but nearly impossible to explain. It seems like a “Big Brother” is watching over the market and precisely controlling what occurs. If an investor takes hold of the knowledge necessary to understand the repetitiveness of market patterns, then he is on a good way to earning lots of money.

Technical Analysis

How to survive on investment markets

Investors should keep in mind that both technical and fundamental analysis is not enough to earn money on investment markets. Investors often forget about two significant aspects. The first is the management of our capital and the second is market psychology. Here are a set of basic rules that will help you achieve your goals in the world of investment.

Rules:

• Always open positions in the direction of the trend. Never break this rule even if it helps you earn money a few times. Break this rule and you will learn that the market is the ruler of the world of investments and unfortunately not the investor.
• Keep a hold of your plan. You should forge a plan according to which you will invest your money with the addition of strict rules that should never be broken whatever the circumstances. Strict rules will help eliminate emotions like hope, greed, fear and many other emotions that could prove destructive on the market.
• Do not invest all your capital in one particular investment. 10-20% of your capital in one transaction should be enough.
• Do not change the level of your stop loss with hope that the market will change direction. Hope will lose you money and should be eliminated.
• Cut losses as soon as possible. On the other hand do not fear losses. They are part of the game.
• Do not be afraid to earn money. Hold winning positions as long as possible. Remember that before opening a position you should have an aim. If this aim is fulfilled then you may close your position, never earlier.
• Do not force yourself to open a market position. If you do not see anything happening, just take a break.
• Always evaluate how much you can earn in comparison to what you can lose. Try to hold at least a 3:1 relation.
• Note down all your transactions. Analyze both the winning and losing transactions. By doing so you will not only understand your mistakes but you will understand your emotions when making different decisions.
• Do not invest in a group. The more opinions, the more emotions. Does this mean that you should not read the analysts comments and reports? No, but it does mean that if you have a planned position, then do not change your decision upon reading some analysts differing opinion. Why should you be wrong? And remember, analysts are not always good traders.

Technical Analysis

The Trend

In simple words the trend is the direction in which market prices moves in. Prices could move in three directions specifying what type of trend we are encountering:

1. Increase trend: An increase trend is a trend where tops and bottoms are higher and higher.
2. Decrease trend: A decrease trend is where tops and bottoms are lower and lower.
3. Horizontal trend: A horizontal trend is where tops and bottoms are situated horizontally, portraying calm in the market and a break prior to a new impulse.

Obviously these are not the only rules specifying what type of trend we are in and additional tools will help us as investors specify where we exactly are.

One of the tools that could help us specify where we are and what we can expect from the market is the trend line. Basically the trend line is defined as the line which is formed by connecting two following bottoms in an increase trend and two following tops in a decrease trend.

Example:

How should we interpret this tool?

By connecting points 1 & 2 in this decrease trend we draw a trend line. If this trend line is broken, i.e. if the market breaks through the line in the upward movement, then this could be a signal that this trend could be over and that we could expect the market to increase. The strength of this trend line is portrayed where the market wasn’t able to break the trend line in points 1 & 4.

In the world of investment you will often come around two significant terms: Support& Resistance. For now we will stick to the basics concerned with the terms, but on later materials you will come to see how relevant they really are.

Support: Support is the level where the market is likely to bounce back from abottom and not break through. On the other hand if the market breaks through then it will continue its decrease movement seeking a further support level.

Resistance: Resistance is the level where the market is likely to bounce back from atop and not break through. On the other hand if the market breaks through then it will continue its increase movement seeking a further resistance level.

It is not easy to find all relevant support or resistance levels. In later materials you will find out more about how to find significant support and resistance levels and why the ones that you found are more important than others. For now let us accept bottoms as support levels and tops as resistance levels.

Support and resistance levels will not only help us understand how the market can react at different market levels but it will also help us in forming one of the most popular technical analysis tools, i.e. the trend channel.

The trend channel is formed by drawing a trend line and drawing a parallel line to the first line, connecting bottoms in a decrease trend and tops in an increase trend starting from the first bottom or top.

The trend line was formed by connecting points 1 & 3. Later a parallel line was formed and initiated from point 2, which is the first top following bottom 1.

How can this trend channel be interpreted?

In order to draw such a channel we should be in point 3. Later points can be interpreted as follows. The points which bounce back from the support level at the bottom, i.e. points 1,3 & 7 portray the strength of support at this market level, whilst the points which bounce back from the resistance level at the top, i.e. points 2,4 & 6 portray the strength of resistance at this market level. As we can observe points 6 & 8 were placed lower than the former peaks showing that the market is becoming less and less dynamic in the upward movement. This could be the first signal that the trend may want to change its direction. This is confirmed when the trend channel is broken at point 9 and the increase trend turns to a decrease trend.

It may seem like a simple question, but knowing what we know from only this educational material, try to think about which points from 1-9 seem like good points to open a position, taking into account that the trend channel we see started earlier and point 1 is not the beginning of the channel?

Try to obviously answer on your own but I will give you a hint from George Lane: “The trend is your friend”.

Increasing Trend:

Technical Analysis

Charts

Charts are the basis of technical analysis and are where the market expresses its feelings by creating different types of patterns. There are many types of charting techniques. Some may seem better, some worse. In this presentation I would like to point out some of the most popular types of charting techniques but on the other hand I would like to concentrate on one specific type which in my belief is most effective. I will obviously tell you which and why.

Line Charts

Line charts are formed by connecting the closing prices of the specific market, at the given interval. Some trading systems also allow you to forge such charts with the use of opening, maximum, minimum or even average prices.

As you can see you can only make one choice which means that you will lack more information about what the market wants to express.

Bar Charts

Bar charts are richer in information, in comparison with line charts because they include:

• Open Price
• Close Price
• Maximum Price
• Minimum Price

This can be observed on the picture below:

We can see that a bar is made up of a vertical line showing the range of where prices moved within the given interval. In other words the top of the line is the highest price of the interval, whilst the bottom of the line is the lowest price in the interval. The horizontal line on the left side represents the opening price, whilst the right horizontal line represents the closing price.

So if the left horizontal line is situated higher than the right horizontal line, then this is an decrease bar, while if the left horizontal line is situated lower than the right horizontal line, then this is a increase bar.

You may believe that bar charts include everything that an investor needs to understand the market. I do not believe so. The next charting technique will give you even more information about the market and its behavior.

Candlestick Charts

In my opinion candlestick charts are the best way to understand the market. Before telling you why, let’s have a look at how a candlestick is built.

A candlestick is formed like a bar chart with one exception. The horizontal lines are expanded to both sides, boxed and later filled with a specific color depending on whether this interval encountered an increase or decrease.

In the case of an increase candlestick the color of the boxed part, which we will from now on call the body, will be white or green, whilst the color of a decrease candlestick will be black or red. Obviously these colors can be changed according to will but these colors are most common.

The maximum and minimum prices are represented by shadows coming out of the candlestick bodies themselves.

Now do you know why candlesticks prevail over bar charts?

Candlesticks are not only easier to perceive and observe due to the colors, but they also portray something that other charting techniques do not, the emotions that the market wants to show investors. It may seem that this aspect isn’t all that important and that the major asset of candlesticks is the fact that they can easily be read to determine whether a certain interval encountered an increase or decrease, but what comes with that could be of much help to us. Clear colors and shape give us emotions. We as people smile when we are happy and cry when we are sad. Those are our emotions. I see candlesticks as the emotions of the market. If any investor wants to understand the market in a better way he has to understand the markets emotions.

These emotions take the form of candlestick formations, which means that certain candlesticks form certain shapes portraying what the market may be feeling at the moment. As there are many emotions, there are also many candlestick formations. Some occur more often, some less. If something doesn’t occur often enough then it could be treated as though it doesn’t even exist. For this reason I would like to only describe some of the markets emotions, thus explaining only the most important and most often found candlestick formations. This subject will be treated in the next presentation.

Technical analysis

Elliott Wave Theory: Basics

Ralph Nelson Elliott discovered in the 1920’s that stock markets do not behave, as many thought, in chaos but in harmony. Why? It is difficult to state but most probably due to investors emotions and psychological influence. All this points to the fact that due to the eruption of our emotions on markets, the market itself could be interpreted as a living organism with harmonic movements, whether in shape, proportion or even time.
Basically, Elliott stated that market swings whether in an increase trend or decrease trend moved in repetitive movements which he called waves. In his typical wave structure market movement was made up of five waves in the direction of the trend and three waves forming a corrective movement.

There are many rules regarding the structure of the waves and the following are some of the most significant:

1. Wave 2 cannot break the bottom of wave 1 in an increase trend and cannot break the top of wave 1 in a decrease trend.
2. Wave 3 cannot be shortest in term of length and time, in comparison to waves 1 and 3.
3. Wave 4 cannot break the top of wave 1 in an increase trend and cannot break the bottom of wave 1 in a decrease trend.
4. Wave 4 cannot be longer than wave 2.

Example:

1. Rule one is not broken as wave 2 represents 78.6% of wave 1.
2. Rule two is not broken as wave 3 is the longest of all waves in the direction of the decrease trend.
3. Rule three is not broken as the bottom of wave 1 is not broken by the top of wave 4.
4. Rule four is not broken as wave 4 represents 78.6% of wave 2.

As seen on the USACAD market this decrease was followed by corrective movement ABC.

Conclusion:

Many believe that the Elliott Wave Theory can only be used on structures that have already been formed and that it is very unlikely to use this tool in real time investments. I believe that this is not true. Many great traders like Ed Seykota, Bryce Gilmore and Robert Miner make use of this tool with great success. It is not easy to specify where in the five wave structure the current market movement is and this could lead to many losing transactions due to the fact that investors may believe that they are in one specific wave whilst being in another. Personally, I do not seek which wave I am currently encountering but I do analyze markets and trade on the basis of many of Elliott’s rules assigned to specific structures with strong concentration on corrective movements and their possible end. If you are able to recognize when a correction has ended then you may be on the right track to making money. Why? Because after every correction a new top or bottom could follow, enabling investors to assign a minimum reach of market movement. When trading a minimum reach or in other words the investors trade target is very significant because this decreases the effect of destructive emotions such as the fear of loss or the greed to earn more.

Price Patterns

Double Top

This price pattern is also known as formation "M" due to its shape. It is made up of two tops where the second top should not be higher than the first one. A perfect "M" is where both tops are exactly on the same level, but these types of situations cannot be always found. Most often this pattern is formed, where the second top is lower than the first, though the difference between the two tops should not exceed 10% counting from the support break (green horizontal line in example below). Before explaining how you could make money on this pattern, let’s take a look at the shape itself.

Example:

In this pattern the market forms one top and later forms a corrective movement, after which another top is formed. On the minimum of the bottom formed (correction), we should draw a horizontal line which will be called the support break. If the market breaks the support break then we could open a short position. What is interesting in this price pattern is that we can actually expect how far the market can go after breaking the support break. After breaking the support break the market should decrease by the distance counting from the first top to the support break itself.

Price Patterns

Double Bottom

This price pattern is also known as formation "W" due to its shape. It is made up of two bottoms where the second bottom should not be lower than the first one. A perfect "W" is where both bottoms are exactly on the same level, but like in the previous patter, it is not always easy to find a perfect "W". Most often this pattern is formed, where the second bottom is higher than the first, though the difference between the two bottoms should not exceed 10% counting from the resistance break (green horizontal line in example below).

Example:

In this pattern the market forms one bottom and later forms a corrective movement, after which another bottom is formed. On the maximum of the top formed (correction), we should draw a horizontal line which will be called the resistance break. If the market breaks the resistance break then we could open a long position. In this price pattern we can obviously also expect how far the market will increase. This distance is counted as follows:

X (distance) = Bottom 1 – Resistance Break

More Examples:

An interesting fact in double tops and bottoms is that when making a prognosis to where the market may move to, we automatically find a significant level of resistance or support for the next few weeks and sometimes even months. So keep in mind that the eventual range of both formations could be relevant information for making decisions in the future.

Conclusion:

Double tops and bottoms are not only easy to find, but they are also very effective. Many investors stray away from them stating that they are just too simple to make money on. That is only half true. They are simple but as mentioned before, they are also very effective if managed well. Managing your transactions is very important, sometimes even more important then the position you choose to take. More about capital management will still be mentioned in further materials where we will once more come back to double bottoms and tops and explain how to open a position well and not worry what the market does.

Moving Average Convergence Divergence (MACD)

MACD is an acronym for Moving Average Convergence Divergence. This tool is used to identify moving averages that are indicating a new trend, whether it's bullish or bearish. After all, our top priority in trading is being able to find a trend, because that is where the most money is made.

With an MACD chart, you will usually see three numbers that are used for its settings.

• The first is the number of periods that is used to calculate the faster moving average.
• The second is the number of periods that is used in the slower moving average.
• And the third is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.

For example, if you were to see "12, 26, 9" as the MACD parameters (which is usually the default setting for most charting packages), this is how you would interpret it:

• The 12 represents the previous 12 bars of the faster moving average.
• The 26 represents the previous 26 bars of the slower moving average.
• The 9 represents the previous 9 bars of the difference between the two moving averages. This is plotted by vertical lines called a histogram (the green lines in the chart above).

There is a common misconception when it comes to the lines of the MACD. The two lines that are drawn are NOT moving averages of the price. Instead, they are the moving averages of the DIFFERENCE between two moving averages.

In our example above, the faster moving average is the moving average of the difference between the 12 and 26-period moving averages. The slower moving average plots the average of the previous MACD line. Once again, from our example above, this would be a 9-period moving average.

This means that we are taking the average of the last 9 periods of the faster MACD line and plotting it as our slower moving average. This smoothens out the original line even more, which gives us a more accurate line.

The histogram simply plots the difference between the fast and slow moving average. If you look at our original chart, you can see that, as the two moving averages separate, the histogram gets bigger.

This is called divergence because the faster moving average is "diverging" or moving away from the slower moving average.

As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average is "converging" or getting closer to the slower moving average.

And that, my friend, is how you get the name, Moving Average Convergence Divergence! Whew, we need to crack our knuckles after that one!

Ok, so now you know what MACD does. Now we'll show you what MACD can do for YOU.

How to Trade Using MACD

Because there are two moving averages with different "speeds", the faster one will obviously be quicker to react to price movement than the slower one.

When a new trend occurs, the fast line will react first and eventually cross the slower line. When this "crossover" occurs, and the fast line starts to "diverge" or move away from the slower line, it often indicates that a new trend has formed.

From the chart above, you can see that the fast line crossed under the slow line and correctly identified a new downtrend. Notice that when the lines crossed, the histogram temporarily disappears.

This is because the difference between the lines at the time of the cross is 0. As the downtrend begins and the fast line diverges away from the slow line, the histogram gets bigger, which is good indication of a strong trend.

Let's take a look at an example.

In EUR/USD's 1-hour chart above, the fast line crossed above the slow line while the histogram disappeared. This suggested that the brief downtrend would eventually reverse.

From then, EUR/USD began shooting up as it started a new uptrend. Imagine if you went long after the crossover, you would've gained almost 200 pips!

There is one drawback to MACD. Naturally, moving averages tend to lag behind price. After all, it's just an average of historical prices.

Since the MACD represents moving averages of other moving averages and is smoothed out by another moving average, you can imagine that there is quite a bit of lag. However, MACD is still one of the most favored tools by many traders.

Fundamental Analysis

Economic indicators

GDP (Gross Domestic Product) – measures summary value of goods and services generated in a relevant country. All economic activity is taken into consideration while calculating the index, regardless of nationality of the owner of any given production factor. The level of GDP can be calculated in actual prices, asserting actual market production value, as well as in static prices, allowing estimation of the dynamics in the economic growth rate.

Financial markets analyze carefully changes in GDP published each quarter. Higher then expected economic growth rate can contribute to strengthening the local currency on the international market.

CPI (Consumer Price Index) – reflects the price of consumer goods adjusted by seasonal factor. Investors tend to avoid currencies with increasing inflation. The rise of the CPI index leads to an increase in interest rates, that results in a lowering of bond prices, nominated in a given currency. Panic amongst foreign investors selling the bonds with the perspective of an interest rate rise may result in increased supply and weakening of the currency.

PPI (Production Price Index) – the dynamics of changes in the prices of goods offered by farmers and manufacturers. Financial markets follow changes in final goods prices, published monthly. As a result of seasonal food prices and high instability of energy prices the PPI index may be subjected to frequent revisions. Large increase in PPI together with high inflation expectations can negatively affect market sentiment towards the currency.

Industrial Production – specifies momentum of aggregated growth of the physical level of economic production. High dynamics of the indicator signifies the good condition of an economy and can positively influence the sentiment towards the local currency. Low dynamics of industrial production reflects an unhealthy condition in the local economy.

Trade balance – compares the value of exported and imported goods and services. The difference between the value of export and import for the given country represents the trade balance. Its positive value - advantage of export over import illustrates the status of economic capacity of a country. High competitiveness of economy can interest investors in local currency.

ISM – index takes into account five factors: new orders, production, deliveries, stockpiles and employment. A value greater then 50% indicates the development of production and the whole economy. Reading 45%-50% indicates stagnation of industrial production, and an index value below 40% signifies stagnation in production and the entire economy.

Financial markets place great importance in ISM on account of its decisive influence on Federal Reserve’s monetary policy.

Current Account – includes all capital flow in and out of the country. Positive current account balance indicates that capital is flowing into the country, which may strengthen the demand for the local currency.

Unemployment rate – the level of unemployment is one of the most important indicators representing the condition of the economy. The published level of unemployment includes natural - voluntary unemployment as well as real unemployment – resulting from unsuitable qualifications of the workforce to the market requirement, lack of demand.. The steady rise in unemployment indicates an aggravation in the economic situation of the country, and negatively impacts financial markets, leading to a weakening of the given currency.

University of Michigan Consumer Sentiment Index – published monthly, represents an important indicator of consumers’ sentiment and perspective of future economic growth in the USA. Its value is influenced by the assessment of the current situation and anticipation of the future economic condition. The survey is carried out by phone among 700 households. Consumer expenditures represent one of the most significant factors, having an impact on the level of Gross Domestic Product. Positive Index data - surpassing expectations of the market - may influence the demand for the US dollar.

IFO Business Sentiment – developed by Munich Institute of Economics represents sentiment of German industrial entrepreneurs. The survey is carried out among 7000 business entities. Financial market analysts regard the Index as an important indicator for the state of the economy in the whole Euro zone. Growing IFO Index may signify a healthy economic condition and stimulate the rise of the euro.

Durable Goods Orders – measures the value of orders for durable goods (amortization above 3 years). The Index is fairly volatile and subject to frequent revisions; nevertheless the publications can have a considerable impact on financial markets, resulting in significant currency price changes.

New Home Sales - stands for the number of houses sold and for sale. Changes in dynamics represent the condition of the American real estate market. High dynamics is characteristic for a boom period, while low dynamics indicates a potential stagnation of the economy.

Housing Starts and Building Permits – published monthly, represents relative increment in building investments and building permits on the US real estate market. The Index is influenced by the level of mortgage interest rates. Prosperity in the real estate market characterizes a boom economy.

Conference Board Consumer Confidence – similar to the Michigan Index. As the sentiment of consumers reflects the state of the economy – optimism during a boom period, pessimism during a recession. Good sentiments of American consumers signify higher demand, higher business sector income and a potential demand for the US dollar.

Non-farm Payrolls – reflects the condition of the US economy. Ongoing increases in employment represents improvement of the economic climate, a boost in household income and in long-term value of enterprises. High Index values may result in increased demand for the US dollar.