Market Analysis
In trading, as in life, no two traders are exactly the same. What makes the market so fascinating and indeed challenging, is that two traders can approach the market with apparently contradictory styles yet both can be equally successful or unsuccessful.
Though traders do use a multitude of styles and approaches, their trading approach can generally be classified into one of two categories - Fundamental or Technical. Listed below is a general description of each approach.
Fundamental Analysis
Fundamental analysis involves the interpretation of various economic and political factors which may have an impact on the value of a stock, commodity or financial instrument. By analysing the cause and effect relationship of market behaviour, the fundamental analyst may seek answers to questions such as; What is happening to inflation in major world economies? Are inflationary trends likely to lead to an increase in overseas interest rates? What effect could this have on Australian interest rates and interest rate futures?
The fundamental analyst may analyse economic data such as balance of payments, level of overseas debt, the unemployment rate, capital expenditure levels, the consumer price index, housing approvals, retail sales etc, with a view to determining the implications of any changes in these economic indicators to that of share prices, interest rates, foreign exchange rates or the price of an instrument or product traded in the financial markets. A fundamental analyst will also consider weather patterns when trading commodities, such as wheat, corn, wool etc.
Unlike the technical analyst, who is principally concerned with the study of patterns, the fundamental analyst is concerned with forecasting short term and medium term trends in the Australian and overseas economies, again with a view to forecasting the direction of movements in financial asset prices, such as the physical prices of 90-day bank bills, 3-year and 10-year Commonwealth Treasury Bonds and their derivatives in the futures markets.
Of interest to the fundamental analyst will also be the impact of economic policy decisions made by the government and/or its agencies especially the Reserve Bank of Australia. These may include Government revenue policies, capital expenditure programmes, stated public sector borrowing requirements or anything announced within the Federal Budget. This process also includes anticipating future government policy responses to forecast trends or individual data releases, which in recent times has focused mainly on inflation and unemployment.
While fundamental analysis should not be overlooked, the majority of private traders also use technical analysis in their trading strategies. A description of technical analysis is given below.
Recommended reading
- Schwager on Futures: Fundamental Analysis by Jack D Schwager
- Study Guide to Accompany Schwager on Futures: Fundamental Analysis by Steven C Turner and Jack D Schwager
- Understanding Futures Trading in Australia by Christopher Tate
- Getting Started in Futures by Todd Lofton
Technical Analysis
Technical Analysis is the study of market action (movement in the price of a commodity or instrument), primarily through the use of charts for the purpose of forecasting future price trends. The actual history of trading in the commodity or instrument is recorded (charted), the records of which include the changes in price, volume and so on.
Advocates of Technical Analysis believe that all market information is expressed in the market price of a commodity or financial instrument. The market price therefore reflects the value as well as all the actions and reactions of the market players. Technical analysts therefore believe that past chart patterns are the most reliable tools for predicting the future price movements of a commodity or financial instrument.
Technical Analysis is built on the basis that fundamental factors are only relevant in the way that they show up in market action. The patterns of market action, and the psychology and responses of the market participants to this action are observed and compared with historical patterns that are known to have indicated a particular future trend. It is generally assumed that the formation of similar patterns in the marketplace is a sign that the same trend is likely to develop. The most important information that technical analysts use in their charts consists of prices, volumes of trading and open positions.
Basically Technical Analysis assumes:
- Price discounts all known information and expectations: all public or privately known factors that will impact price have impacted price, including expectations about these factors.
- Prices are correlated and move in trends - price is not random.
- History repeats itself - price formation is an interplay between optimistic buyers (bulls) and pessimistic sellers (bears) and crowds are led by price: Group Psychology.
- Technical Analysis improves the probability of profitable trading (it is not mere forecasting or 'gut feeling'). The identification of a trend or trend reversal is essential for maximising trading profits.
Technical analysis terms:
Open
Starting price for the period.
High
Highest price traded during the period.
Low
Lowest price traded during the period.
Close
Ending price for the period.
Range
Difference between high and low: indicates price volatility.
Support
Corresponds with buying which is strong enough (with sufficient volume) to stop a downtrend for a significant period of time. Buyer pressure overcomes seller pressure.
Resistance
Corresponds with selling which is strong enough (with sufficient volume) to stop an up-trend for a significant period of time. Seller pressure overcomes buyer pressure.
Technical analysis methods
Candlestick Charts
Method of drawing stock (or commodity) charts which originated in Japan. Required the presence of Open, High, Low and Close price data to be drawn. There are two basic types of candies, the white body and the black body. As with regular bar charts, a vertical line is used to indicate the periods (normally daily) high to low. When prices close higher than they opened a white rectangle is drawn on top of the high-low line. This rectangle originates at the opening price level and extends up towards the closing price. A down day is drawn in black.
The combination of several candies results in patterns (with names like 'two crows' or 'bullish engulfing pattern') which give insight into future price activity. For other Japanese charting approaches also see Renko and Kagi charts.
Elliott Wave
The Elliott Wave Principle basically states that the stock market follows a repetitive rhythm of a five-wave advance followed by a three-wave decline.
Waves 1, 3 & 5 = rising waves (impulse waves)
Waves 2 & 4 = corrective waves
Waves A, B & C = declining waves
There are three important aspects of Elliott Wave Principle - pattern, ratio and time.
- Patterns refer to the wave patterns which are the most important part of the theory.
- Ratio analysis measures the relationship between the different waves and is used to determine retracement points and price objectives.
- Time relationship can be used to confirm the wave patterns and ratios.
Fibonacci Ratios and Retracements
Fibonacci numbers can be applied both to price and time, although it is more common to use them on prices. The most common levels used in retracement analysis are 61.8%, 38% and 50%. When a move starts to reverse, the three price levels are calculated (and drawn using horizontal lines) using a movement's low to high. These retracement levels are then interpreted as likely levels where counter moves will stop. It is interesting to note that the Fibonacci ratios were also known to Greek and Egyptian mathematicians. The ratio was known as the Golden Mean and was applied in music and architecture. A Fibonacci spiral is a logarithmic spiral that tracks natural growth patterns.
Gann Square
The Gann Square is a mathematical system for finding support and resistance based upon a commodity or stock's extreme low or high price for a given period. Attainment of a particular price level in a square tells you the next probable price peak or valley of future movement. The probable price levels tend to be more reliable if they are extrapolated from Gann Square values along one of the major axes of the Gann Square. The Gann Square is generated from a central value, normally an all-time or cyclical high or low. If a low is used, the numbers are incremented by a constant amount to generate the Gann Square. If a high is used, the numbers are decremented during the square generation.
Moving Averages
The moving average is probably the best known, and most versatile, indicator in the analysts tool chest. It can be used with the price of your choice (i.e. highs, closes) and can also be applied to other indicators, helping to smooth out volatility. As the name implies, the Moving Average is the average of a given amount of data. For example, a 14 day average of closing prices is calculated by adding the last 14 closes and dividing by 14. The result is noted on a chart. The next day the same calculations are performed with the new result being connected (using a solid or dotted line) to yesterday's. And so forth. Variations of the basic Moving Average are the Weighted and Exponential moving averages.
Parabolic (SAR)
The Parabolic is a Time/Price system for the automatic setting of stops. The stop is both a function of price and of time. The system allows a few days for market reaction after a trade is initiated after which stops begin to move in more rapid incremental daily amounts in the direction the trade was initiated. For example, when a long position is taken the stop will move up regardless of price direction. However, the distance that the stop moves up is determined by the favourable distance the price has moved. If the price fails to move favourably within a certain period of time, the stop reverses the position and begins a new time period.
Point & Figure Charts
The Point and Figure (PF) charting method is a technique that has been used for many years in analysing the variations in prices of stocks and commodities. There are several types of PF charting methods. Some employ trend lines, resistance levels, and various other additions to the chart. This example shows only daily reversal type charts. The principal advantage of a PF chart is that it is much easier to read and interpret than other types of charts. All the small, and often confusing, price movements are eliminated and only the most important features of the price action remain. It would be reasonable to think of this method as a filter that (hopefully) allows only meaningful information to enter the chart and ultimately the decision process. Two basic symbols are used:
- X - Denotes the continuance of an increase in price and is always 'stacked' in the vertical direction.
- 0 - Denotes the continuance of a decrease in price and is always 'stacked' in the vertical direction.
While prices are rising X's are used. When falling, O's are used. They are always plotted on rectangular grid graph paper such that columns of X's and O's alternate. A Point and Figure chart is characterised by the specification of two parameters: box size and reversal number. The box size dictates the price range associated with a particular box (cubical area within the grid), while the reversal number specifies the conditions which terminate a column of X's and begin a column of O's and vice-versa.
RSI - Relative Strength Index
This indicator was developed by Welles Wilder Jr. Relative Strength is often used to identify price tops and bottoms by keying on specific levels (usually '30'and 70') on the RSI chart which is scaled from 0-100. The study is also useful to detect the following:
- Movement which might not be as readily apparent on the bar chart
- Failure swings above 70 or below 30 which can warn of coming reversals
- Support and resistance levels
- Divergence between the RSI and price which is often a useful reversal indicator
The Relative Strength Index requires a certain amount of lead-up time in order to operate successfully. The formula for calculating the RSI is:
* rsi =100-(100/1-rs)
* rs = average of x day's up closes divided by average of x day's down closes
Stochastic
The Stochastic Indicator is based on the observation that as prices increase, closing prices tend to accumulate ever closer to the highs for the period. Conversely, as prices decrease, closing prices tend to accumulate ever closer to the lows for the period. Trading decisions are made with respect to divergence between % of 'D' (one of the two lines generated by the study) and the item's price.
For example, when a commodity or stock makes a high, reacts, and subsequently moves to a higher high while corresponding peaks on the % of 'D' line make a high and then a lower high, a bearish divergence is indicated. When a commodity or stock has established a new low, reacts, and moves to a lower low while the corresponding low points on the % of 'D' line make a low and then a higher low, a bullish divergence is indicated. Traders act upon this divergence when the other line generated by the study (K) crosses on the right-hand side of the peak of the % of 'D' line in the case of a top, or on the right-hand side of the low point of the % of 'D' line in the case of a bottom.
Two variations of the Stochastic Indicator are in use: Regular and Slow. When the Regular plot of the Stochastic too choppy, the 'Slow' version can often clarify the results by reducing the sensitivity of the calculations. The formula is: %K=100 {(C-L5)/(H5-L5)} Note: 5 Days is the most commonly used value for %K
The %D line is a 3 day smoothed version of the %K line %D=100(H3/L3) where H3 is the 3 day sum of (C-L5) and L3 is the 3 day sum of (H5-L5)
Recommended Reading
- Technical Analysis of the Financial Markets, by John H Murphy
- An Introduction to Technical Analysis, The Reuters Financial Training Series
- Schwager on Futures: Technical Analysis, by Jack D Schwager
- Getting Started in Technical Analysis, by Jack D Schwager
Trading techniques
Money Management
Money management tells you "how many?" or "how much?" to trade. How much risk should you be willing to take? This is the most crucial concern a trader faces; it determines your risk and profit and is often a technique that is neglected by traders.
Like all aspects of trading, there are no hard and fast money management rules. Strict control of trading capital is possible, however, with the application of basic common sense principles.
- What are my trading goals?
- How much money am 1 prepared to risk on individual trades and how much of overall equity will be put on the line?
- How and where will 1 set stop loss orders?
- What is an acceptable risk/reward ratio?
- What markets will 1 trade to diversify my portfolio?
Successful futures traders work according to probabilities, aiming to win more on average than they lose. Whatever the approach, money management reduces the need to find the perfect trading system.
There are numerous approaches to money management. Some simple techniques include:
Pyramiding (inverted and conventional and reflecting)
Pyramiding generally involves adding or compounding contracts during the length of a profitable trade.
For example:
- Inverted pyramiding involves commitments of equal (or larger) positions being added as the trade progresses,
- Conventional pyramiding involves adding half of the prior position as the market moves in the traders anticipated direction,
- And reflecting pyramiding involves closing positions when an average profit is reached.
Fixed percentage
Fixed percentage determines the position size as a percentage of risk capital by using a mathematical formula. It is calculated by dividing the largest loss by the percentage of capital risked.
Z score
The z score technique enables traders to determine what system/trading profile type they belong to, and whether to increase, decrease or hold the position size of a trade on any given trade. A negative z score is associated with winners followed by winners, and visa versa, losers followed by losers. A positive z score is associated with a random approach of winning to losing trades.
Optimal F
The optimal f technique enables traders to determine what amount to allocate on any given trade based on their risk capital size and largest loss. For example, if optimal f is calculated at 0.65 and the largest loss is $400, then the number of contracts to trade is two on a $5,000 account. Optimal f is aggressive and drawdowns can be volatile but the returns can be large.
Effective money management allows a trader to juggle the risks associated with futures markets and maintain the right balance between winning and losing trades. Without money management, there is a risk of possible lower returns and increased risk, and more importantly money management gives you the key to becoming a long-term trader.
Recommended Reading
- Mathematics of Money Management, by Ralph Vince
- New Commodity Trading Systems Methods, by Perry Kaufman
- Technical Analysis of Stocks, Options and Futures, by Williarn F Eng
Trading psychology
For many traders, learning how to control their emotions is their key to trading success.
Your feelings have an immediate impact on your account equity. You may have a brilliant trading system, but if you feel frightened, arrogant, or upset, your account is sure to suffer. When you recognise that it is your emotions rather than your mind is influencing your trading decisions, then it is time to stop trading. Remember, when you trade, you compete against the sharpest minds in the world.
Many traders lose in the markets because they are not psychologically prepared.
Listed below is a brief outline of how psychology can impact on your trading:
Fear: "The market is going to crash tonight so I had better stay out"
Result: Paralysis incapable of making a trade
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Fear: "I can't afford to lose any money"
Result: Trader will place stop loss orders where the prices are too close together. The result is that the trader will continually be stopped out
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Overconfidence:"I know it all"
Result: Will tend to have an undisciplined approach to trading. Always cursing the market because it didn't do what was expected. i.e. The trader refuses to accept responsibility for his/her own actions.
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Greed:"I've got $10,000 and I'm going to turn it into $60,000 within three months"
Result: Overtrading trying to meet unrealistic expectations. The trader will tend to take larger risks than are prudent with the result usually being that the trader loses all the capital quickly
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Timid/indecisive:"Buy me ten contracts at market "No I mean SELL, No Buy - I don't know - you tell me what to do"
Result:Trader will be in the market without really knowing why. The result is that they will tend to rely on the advice of others, not stick to their trading plan and will fritter away the proceeds of their account.
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Angry:"You advised me to sell this morning and it was a buy. Can't you tell what's going on with the screen in front of you?".
Result: Poor relationship development with broker and frustration. Such a response usually comes from a failure to accept responsibility for the trader's own decisions.
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Trading Psychology is a very broad subject, however, here are some principles to keep in mind:
- You must be emotionally detached from the markets
- You must use stops
- You must have a trading plan
- You need to be capitalised correctly
- Do not over trade
- Don't panic - execute your plan
- Maintain discipline
- Proper money management
- Do your analysis
Recommended reading
- Trading for a Living, by Dr Alexander Elder
- Study Guide to Trading for a Living, by Dr Alexander Elder
- Trading to Win, by Arl Keiv
- The Disciplined Trader, by Mark Douglas
- Trading for a Living, Dr Alexander Elder
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