What is Forex?
The off-exchange retail foreign currency market (“forex”) describes the purchase of a particular currency from an individual or institution and the simultaneous sale of another currency at the equivalent value or current exchange rate. Essentially, the process of exchanging one currency for another is a simple trade based on the current rates of the two currencies involved.
At the core level of the world’s need for money exchange is the international traveler. When traveling from the US to England, for example, you will of course need the local currency to pay for transportation, food, and so on. Upon arrival at the airport you will surrender (sell) your US Dollars in order to receive (buy) the equivalent in British Pounds. In this example, you sold the USD and bought the GBP, conversely the forex counter bought the USD and sold the GBP. The prices at which you buy and sell currencies are known as exchange rates. This rate or price fluctuates based on demand and on political and economic events surrounding each country’s currency.
A Global Market
The example above illustrates foreign currency trading in basic terms as it relates to world travelers. However, the market is also utilized globally by each country’s central bank (i.e., America’s Federal Reserve), investment and commercial banks, fund management firms (mutual funds and hedge funds), major corporations, and individual investors or speculators. Depending on the timing of such transactions, purchasing a currency with the intent of later selling it at a better exchange rate (and vice versa) can potentially yield profits for investors, of course there is a strong potential for loss trading currencies as well.
Utilization by so many parties is why the Forex market is the world’s largest financial market. This mind boggling volume is probably what led you to research the topic.
How do you access the market?
It is important to note that retail traders, such as yourself, will most likely be accessing the off-exchange foreign currency market (or Forex market) via an FCM (Futures Commissions Merchant) or broker. You will not be trading in the actual Interbank market itself. Your access to the total market will be determined by your chosen broker’s limitations.
FCMs or brokers act as a bridge between you and their liquidity partner (sometimes larger global banks) that you would otherwise not have sufficient capital to do business with.
( view figure 1 ) The large majority of off-exchange retail foreign currency brokers act as market makers, meaning that by keeping many trades in house they create their own liquidity. Some retail brokers clear trades directly through to the larger banks that provide their liquidity. If you are new to the Forex market it would wise to research and understand your broker’s particular business model and method of clearing trades.
Forex Market Hours
Unlike other financial markets, the Forex market operates 24 hours a day, 5.5 days a week (6:00 PM EST on Sunday until 4:00 PM EST on Friday). Through an electronic network of banks, corporations and individual traders exchange currencies, though as the market is primarily used as a means for speculative investing, actual physical delivery of currencies is almost never intended. Forex trading begins every day in Sydney, moves to Tokyo, followed by Europe and finally the Americas.
“Bid” vs. “Ask”
Forex prices, or quotes, include a “Bid” and “Ask” similar to other financial products. Bid is the price at which a trader is able to sell a currency pair. The Bid price or sell price of a currency pair is always the lower price in a quote. Ask, sometimes referred to as “Offer”, is then the price at which traders are able to buy a currency pair. In other words, Forex traders always buy at the high and sell at the low of a price quote. The difference between the Bid and Ask is called the “Spread” or “Pip Spread”, which is the Trader’s cost per trade or per transaction. There are typically not additional broker commissions involved in trading the Forex market, as there might be when trading other investment markets.
Reading Price Quotes
Reading a forex quote may seem a bit confusing at first. However, it’s really quite simple if you are able to remember two things:
1. The first currency listed is the base currency
2. The value of the base currency is always 1 (one)
( view figure 1 )
A quote of USD/JPY at 116.04 is to say that 1 US Dollar (USD) = 116.04 Japanese Yen (JPY). When the US dollar is the base unit and a currency pair’s price increases, comparatively the dollar has appreciated and the other currency in the pair (usually known as the cross currency) has weakened. Using the above USD/JPY example as a reference, if the USD/JPY increases from 116.04 to 117.51 (147 pips), the dollar is stronger because it will now buy more yen than before.
There are four currency pairs involving the US dollar in which the US dollar is not the base currency. These exceptions are the Australian dollar (AUD), the British Pound (GBP), the Euro (EUR), and the New Zealand dollar (NZD). A quote on the GBP/USD of 1.7600 would mean that one British Pound is equal to 1.7600 US dollars. If the price of a currency pair increases the value of the base currency in comparison to the cross currency thus increases. Conversely, if the price of a currency pair decreases, such is to say that the value of the base currency in comparison to cross currency has weakened.
What Influences Price?
Forex markets and prices are mainly influenced by international trade and investment flows. The Forex market is also influenced, but to a lesser extent, by the same factors that influence the equity and bond markets: economic and political conditions, especially interest rates, inflation, and political stability, or as if often the case, political instability. Though economic factors do have long term affects, it is often the immediate reaction that causes daily price volatility, which makes Forex trading very attractive to intra-day traders. Currency trading can offer investors another layer of diversification. Trading currencies can be viewed as a means to protect against adverse movements in the equity and bond markets, movements that of course also impact mutual funds. You should bear in mind that trading in the off-exchange foreign currency market is one of the riskiest forms of trading and you should only invest a small portion of your risk capital in this market.
Investors and speculators using the Internet as an investment tool will find that the Forex market offers several advantages over equities trading. ( view figure 1 )
*200:1 is the entry leverage value. Brokerages will have margin calls set at different levels, exact leverage may vary.
**The trader’s cost of doing business is called the Spread. It is the difference between the bid and the ask prices on your chosen currency pair.
Forex is a true 24 hour market, 5.5 days a week, which offers a major advantage over equities trading. Investors are able to trade at odd hours, thus allowing more flexibility for personal, business and social activities. Whether trading at 8am, 2pm, or even 2am, there will always be buyers and sellers actively trading foreign currencies. Such flexibility allows traders to immediately respond to breaking news and other political factors driving the market.
( view figure 2 )
After hours trading in the equities market has several limitations. In the US, for example, equities traders have access to ECNs (Electronic Communications Networks), also known as “matching systems”. These networks are established to provide a method for equities traders to buy and sell amongst each other. Such networks are usually not able to offer as tight of spreads as would be offered during normal market hours, thus most trades are not executed at a fair market price, subsequently there is no guarantee that every trade will be executed.
An investment market with lacking liquidity, or a lack of buyers and sellers at certain times, is often the demise of traders who need in or out of the market without delay. The global network of governments, banks, corporations, hedge funds, and individual traders that collectively drive the Forex market, are in essence, also driving the world’s largest network of liquidity. Such high trade volume works to ensure trade execution and the stability of prices, regardless of the time of day.
Equities traders, on the other hand, are more susceptive to liquidity risk and are subject to potentially wider dealing spreads and larger price movements. Liquidity in the equities market really does pale in comparison to that of the Forex market.
Leverage is the key to understanding the risk associated with trading the Forex Market, and of course, the potential for gain. Many Forex brokers offer leverage as high as 200 – 1, meaning that $50 of margin would control a $10,000 position in the market (this is an example of a mini lot). ( view figure 3 ) Forex trading is often attractive to investors coming from the equities market because Forex trading offers such high leverage. It is important to understand why Forex brokers offer higher leverage, and of course… the dangers associated with such.
To some extent, higher leverage is a necessary evil in the Forex market. It can offer advantages over equities trading, but only if it is properly understood and utilized. Though currency values on a global stage are constantly in a state of flux, high liquidity and market stability translate to relatively small daily price movements. In fact, average daily movement is around 1% on most major pairs. Compare that to the equities market, where average daily movements are closer to 10% and it is not hard to understand why large contracts are needed in order to yield profits on intraday price movements.
Without high leverage most retail investors would not be able to afford trading in the Forex market. However, with increased buying power comes increased risk. Traders who are new to the market often make the mistake of over-trading their account. Because relatively small margin is required to open large positions beginning traders often make the mistake of opening too many positions at one time. A quick market move can then result in substantial losses. IBFX would advise any trader new to the Forex market to trade only a very small percentage of their account at any one time.
Profit Potential in Both Rising and Falling Markets
Like any market, there is always a buyer and a seller the world of currencies. The potential for profit will of course rally between the buyers and sellers, the longs and the shorts. Trading currencies in pairs offers the advantage of speculation from either side, but it is the volatility in combination with excellent liquidity that offers currency investors a true advantage over any other market. Regardless of the time of day, traders in the Forex market can long or short any currency pair of their choice.
Many brokers also offer hedging, meaning that traders can take a long and short position on the same currency pair. The market’s volatility provides the constant potential for gain, and of course, the constant potential for loss as well. Forex trading can be risky, but execution in or out of trades should not be a problem when trading through a reputable broker. Equities traders, on the other hand, may have a much more difficult time liquidating stocks when the market is moving against them.
The off-exchange retail foreign currency market (or Forex market) has many differences, as outlined above. However, one of the most significant factors is the element of risk. The Forex market is the riskiest of all investment vehicles and is suitable only for experienced traders. The higher leverage and volatility found in this market increase the traders risk of loss. There is the potential to lose, all or more, of your original investment.
Investors and speculators using the Internet as an investment tool will find that the Forex market offers several advantages over futures trading. ( view figure 1 )
*200:1 is the entry leverage value. Brokerages will have margin calls set at different levels, exact leverage may vary. **The traders cost of doing business is called the Spread. It is the difference between the bid and the ask price on your chosen currency pair.
Benefits of Spot FX
The benefits of spot Forex (cash market) over futures, and more specifically currency futures, are considerable. The dissimilarities between these investment vehicles range from philosophical – such as the history of each, their target audience, and their relevance in the modern Forex markets, to more tangible issues such as transactions fees, margin requirements, liquidity level, and the technical and educational support offered by the providers of each service.
Higher Volume = Better Liquidity
The spot Forex market, or the cash market, is certainly the most liquid market in the world. Of course, with such incredible volume comes incredible liquidity. To seasoned traders this means one thing: better execution.
After hours trading in the Futures market has several limitations. In the US, for example, equities and futures traders have access to ECNs (Electronic Communications Networks), also known as “matching systems”. These networks are established to provide a method for traders to buy and sell amongst each other. Such networks are usually not able to offer as tight of spreads as would be offered during normal market hours, thus most trades are not executed at a fair market price, subsequently there is no guarantee that every trade will be executed.
Easy to Read Price Quotes
Currency futures quotes are inversions of the cash price. For example, if the cash price for USD/CHF is 1.7100/1.7105, the futures equivalent is .5894/ .5897 (a format only familiar to future’s traders). Spot prices, on the other hand, offer a simpler look at the market. The bid price is always shown on the left and the ask price on the right. The value of the base currency is always 1 (one). In the example above 1 US Dollar (USD) = 1.7100 CHF.
Currency futures’ prices also have the added complication a forward Forex component that takes into account a time factor that is not necessary in the cash Forex Market.
The off-exchange retail foreign currency market (or Forex market) has many differences, as outlined above. However, one of the most significant factors is the element of risk. The Forex market is the riskiest of all investment vehicles and is suitable only for experienced traders. The higher leverage and volatility found in this market increase the traders risk of loss. There is the potential to lose, all or more, of your original investment.
Most currency transactions involve the “Majors” consisting of the British Pound (GBP), Euro (EUR), Japanese Yen (JPY), Swiss Franc (CHF) and the US Dollar (USD). Many traders are beginning to add the Canadian Dollar (CAD) and the Australian Dollar (AUD) to this category as well.
( view figure 1 )
Currencies in Pairs?
Often new traders struggle to grasp the concept of trading currencies in pairs, why not just buy the Euro they might ask? Why does it have to be paired with the US Dollar? Simple, the currency on the right side of the pair is there to establish a comparative value, without it how could the base currency (currency on the left side of the pair) have any certain value? In other words, if currencies were not paired what would a single currency gain or lose value against? By pairing two currencies against each other a fluctuating value can be established for the one versus the other. So, how is the Euro doing against the Dollar, or how many Dollars does it take to buy one Euro? Thus the need for currencies in pairs.
( view figure 2 )
Cross Currency Pairs
Currency pairs that do not include the US dollar are referred to as Cross Currency Pairs. Cross Currency trading can open a completely new aspect of the Forex market to speculators. Some cross currencies move very slowly and trend very well, ideal for beginning traders. Other cross currency pairs move very quickly and are extremely volatile; with daily average movements exceeding 100 pips.
Speculators might utilize cross pairs as a means of portfolio diversification. An example would be an investor whose portfolio is primarily comprised of US based stocks and bonds who wants to diversify into foreign markets. Holding carry trades in cross currencies might be a good option for this type of investor. Many of these cross currencies also offer greater return potential with enhanced interest (also referred to as swap, rollover interest or carry forward interest) that can be paid on open positions. Swap is a credit or debit as a result of daily interest rates. When traders hold positions over night, they are either credited or debited interest based on the rates at the time. Often, cross currencies yield higher interest rates than do major currencies and are traded for the purpose of collecting said interest.
What is Margin?
In the Forex market the term margin is most often referring to the amount of money required to open a leveraged position, or a contract in the market. It may also be used to describe the type of account, i.e. margin account; meaning that an account is being traded on borrowed funds. It is generally safe to assume that all off-exchange retail foreign currency (or Forex) traders are trading within margined accounts.
Without leverage, or the ability to trade on borrowed funds, a trader placing a standard lot trade in the market would need to post the full contract value of $100,000 in order to have his or her trade executed. Trading with a margined account allows traders to utilize leverage, meaning that the same $100,000 contract can be placed for an amount of margin determined by the set level of leverage. An account at 100:1 leverage would require $1,000 of margin to place a $100,000 trade.
The table shown in figure 1 illustrates the amount of margin required to open standard, mini and micro contracts, also referred to as lots. As can be seen, at 1:1 leverage (no leverage at all) the full value of a contract is required. The table illustrates the required amount of equity on margin per lot traded. ( view figure 1 )
Default leverage levels for new accounts are set at 200:1 for Mini accounts and 100:1 for Standard accounts. * These levels have been set by IBFX, and will likely vary from broker to broker within the retail Forex industry.
* 200:1 is the entry leverage value. Since most brokerages will have margin calls set at different level, exact leverage may vary.
Simply stated, trading Forex on margin increases your buying power. As an example: a trader with $10,000 in a margin account that allows 100:1 leverage, would be able to purchase a maximum of $1,000,000 in currency contracts (10 standard lots). At 100:1 leverage 1% of the contract value is required as collateral.
By trading on margin, traders can potentially increase their total return on investment with less cash outlay. Trading on margin should be used wisely as it magnifies both your potential profits AND potential losses. A good rule of thumb to follow is the higher the margin, the greater the risk.
Margin Trading Example
A trader with a $10,000 account balance decides that the US Dollar (USD) is undervalued against the Euro (EUR). The current bid/ask price for EUR/USD is 1.2348/1.2350 – meaning a trader can buy 1 EUR for $1.2350 USD or sell 1 EUR for $1.2348 USD. The trader decides to sell EUR (buy dollars) by selling 1 standard lot. With leverage at 100:1 or 1%, initial margin deposit for this trade is $1,000, leaving the account balance at $9,000. As anticipated, the EUR/USD drops 48 pips to 1.2298/1.2300. To exit the position the trader would close 1 lot at 1.2300 In this scenario the trader has realized a profit of 48 pips or $480 US Dollars.
Trading with a heavily margined account is a double-edged sword. Trading utilizing high leveraged accounts can potentially increase profits, but it increases your risk of potential losses. Most brokers have standard leverage levels – 100:1, 200:1 or even 400:1. Remember, the higher the leverage, the higher the risk. Traders in the Forex market are subject to the margin rules set by their chosen brokers. In order to protect themselves and their traders, brokers in the Forex market set margin requirements and levels at which traders are subject to margin calls. A margin call would occur when a trader is utilizing too much of their available margin (cash deposit towards an open position). Spread across too many loosing trades, an over margined account can give a broker the right to close a trader’s open positions.
Managing a Margin Account
It is important that traders new to the Forex market take the time to understand the risk associated with trading in a margined account.
Every trader should be clear on the parameters of their own account, i.e. at what level does their broker consider them subject to a margin call. Be sure to read the margin agreement in the account application when opening a live account.
The positions in a trading account could be partially or totally liquidated should the available margin (“Free Margin”) in the account fall to the predetermined threshold of 50% margin level. * This is a level set by IBFX, other brokers may have margin call levels set differently.
Traders should monitor margin balance on a regular basis and utilize stop-loss orders to limit downside risk. However, due to the extreme volatility that can be found in the Forex market, stop-loss orders are not always an effective measure in limited downside risk. There is still the possibility of losing all, or more, of your original investment.
Calculating Your Margin Capability
The maximum available margin is 1% (100:1 leverage) for standard accounts and 0.5% (200:1) for mini accounts. Traders always have the option of setting a lower level of leverage. Doing such may help some traders manage their risk, but bear in mind that a lower level of leverage will of course mean that larger margin deposits will need to be made in order to control the same size contracts.
Margin = (Contract size / Leverage)
The requirements for leverage may vary with account size or market conditions, and may be changed from time to time at the sole discretion of IBFX. Please refer to your trading agreement for details.
If maximum leverage is employed, traders must maintain the minimum margin requirement on their open positions at all times. It is the customer’s responsibility to monitor his/her margin account balance. IBFX has the right to liquidate any or all open positions whenever a trader’s minimum margin requirement is not maintained. This is an important risk management feature designed to strictly limit trading losses in your account.
To calculate the margin required to execute 4 mini lots of USD/JPY (40,000 USD) at 200:1 leverage in a $500 mini account, simply divide the deal size by the leverage amount e.g. (40,000 / 200 = 200). $200 margin will be required to place this trade, leaving an additional $300 marginable balance in the trading account.
The trading platform automatically calculates margin requirements and checks available funds before allowing a trader to successfully enter a new position. If there are not adequate funds available to enter a new position, traders will receive a “Not Enough Money” message when attempting to place the trade.
*For a further explanation on calculating margin percentages and the potential for a margin call, please see the following course.
Understanding Contract Sizes
Understanding contract sizes (lots) is a necessary precursor to understanding the need for high leverage in the Forex market. Each standard lot traded in the Forex market is a $100,000 contract. In other words, when trading one lot in a standard account, a trader is essentially placing a $100,000 trade in the market. Without leverage, most investors would not be able to afford such a transaction. Leverage of 100 – 1 would allow a trader to place the same one lot ($100,000) trade with the post of $1,000 in margin. $100,000 divided by 100 equals $1,000, thus 100 – 1 leverage means that $1,000 of margin is able to control a $100,000 position.
Many retail Forex traders today begin their trading in a Mini account. Because standard contracts in the Forex market are rather large, even with 100 – 1 leverage, $1,000 of margin per contract traded is still a bit expensive for some investors. For this reason most retail brokers offer the option of a mini account.
Mini accounts are essentially 10% the value of standard accounts, meaning that mini contracts are $10,000. A trade of one mini lot would be a $10,000 trade, whereas a standard lot is of course a $100,000 trade. It is not unusual for brokers to offer higher leverage in mini accounts, 200 – 1 is very common. Trading with 200 – 1 leverage would mean that $50 of margin would control a $10,000 contract.
Margin is calculated 2 ways: Used Margin and Free Margin. Used margin is the amount of money used to hold open positions. Free margin is the amount of funds available to place additional positions. ( view figure 1 )
As seen in figure 1, $250 is used to hold their current positions, totaling 5 mini lots. $4,736.00 is available for the trader to open additional positions.
Calculating a Margin Call
Because institutions are loaning 99% of the value of a contract to a trader, fail-safes have been put in place to help prevent a trader from going into the negative and owing the institution additional funds. This is commonly referred to as a Margin Call, where typically a client is called upon to send additional funds or the position(s) will be closed at market price. At 50% margin level the trader will be subject to a margin call, the automatic close of open positions so as to bring the margin level back to a suitable percentage.
The margin level is calculated by dividing the current equity in an account by the current amount of margin in use (used margin). ( view figure 2 ) After dividing the equity by the margin move the decimal two places to the right. A trader whose equity is at $1,000 and who is using a $500 of margin would divide 1,000 by 500 which of course equals 2. Then move the decimal two places to the right; this trader’s current margin level or percentage is thus 200%. At 100% margin level a trader is essentially using their entire available margin. When this level drops to 50% trades will automatically be closed to help ensure that a trader is not subject to losing more money than is held in their account.
ISO (International Organization for Standardization)
Established in 1947, ISO established a standard for country and currency pair abbreviations. Since foreign currencies are quoted in terms of value of one currency against another, a currency pair consists of an acronym for both currencies, separated by a slash “/”.
GBP = Great British Pound
EUR = Euro
CHF = Confoederatio Helvetica Franc (Swiss Franc)
USD = United States Dollar
CAD = Canadian Dollar
JPY = Japanese Yen
AUD = Australian Dollar
NZD = New Zealand Dollar
Currencies are always traded in pairs, for example EUR/USD, USD/JPY. Every position requires the buying of one currency and selling of another. When someone says they are “buying the EUR/USD”, they are buying Euros and selling Dollars.
There are many other currency pairs available to trade, such as the Danish Krone, Mexican Peso, and Russian Ruble. However, these pairs are generally traded less, and for these pairs, it is harder to find buyers and sellers. Such currency pairs are called “exotics”. Because they have less volume and involve a higher risk for the broker, they typically have a wider PIP spread.
Market increments are measured in PIPs, or Percentage in Point. A pip is the last digit in the value of a currency pair; 1.3294, 115.13 etc. All currency pairs, except for the Japanese Yen, have 4 decimal places. The Yen crosses only have 2 decimal places.
( view figure 1 )
For example, let’s assume a trader buys 1 standard lot of GBP/USD. The current market rate is 1.9615. Essentially this trader is buying £100,000 in exchange for $196,150. Again, for examples sake, assume the market rate rose 15 PIPs to 1.9630 and the trader liquidates the position. The same £100,000 is now worth $196,300, the trader realizing a $150 profit.
Some currency pairs are traded more heavily than others. The currency pairs that have the most volume consist of the “majors”. While it can be debated which currency pairs are considered a major, it can be widely agreed upon that the following 6 pairs are:
Nicknames are sometimes used for currency pairs. Here is a list of currency pairs and commonly used nicknames for each:
GBP – Pound, Cable, or Sterling
EUR – Euro
CHF – Swissy, or Franc
USD – Greenback
CAD – Loonie
AUD – Aussie
NZD – Kiwi
JPY – Yen
Most modern nations have central banks that perform similar functions. Usually a branch of government, a central bank is responsible for setting interest rates, stabilizing the economy and reporting to the general public on economic conditions. Typically, central banks will loan funds to commercial banks at a certain set interest rate. Commercial banks then base their lending rates accordingly. Key central banks to the global economy include: The Federal Reserve (USA), The Bank of Japan, the Bank of Canada, The European Central Bank, The Bank of England, etc. etc.
When examining currency pairs one must understand what is meant by ‘exchange rate’. Obviously, the exchange rate refers to the rate, or price at which one currency can be exchanged for another. However, many traders look at a currency pair, EUR/USD for example, without understanding a very basic concept: A price quote of 1.4760 is to say that 1.4760 US Dollars (currency on the right) will purchase 1 Euro (currency on the left).
A liquid market refers to a market that is cash heavy, and liquidity refers to substantial level of capital or funds existing within a market or bank. Markets with high trading volume and substantial money flow are considered liquid markets. Banks and brokerages that clear trades are considered liquidity providers, as they are providing the funds necessary to support the execution of trades.
The idea of market expectations should seem simple enough; essentially, the point is this: Forex traders must be educated! The mass of well educated traders generally have simialar expectations in terms of where prices will head. For example, given a poor showing in Nonfarm payroll, the mass of traders are going to expect the Dollar to weaken on the first friday of the month. A trader focused on nothing but moving averages and who is ignorant to obvious market expectations will have very limited success. Do your homework, read the commentary of market analysts, prep your daily trading; in short – know what the market is expecting!
Off – Exchange
The term off-exchange is often used to describe the Forex Market place. Because the Forex market has no central exchange, or physical location wherein trading is facilitated, it is considered an off-exchange market place. The NYSE (New York Stock Exchange) and CME (Chicago Mercantile Exchange) are examples of physical exchanges. The Forex market is essentially a network of banks and brokerages all of which are connected globally to one another, but not through any one physical exchange.
In any market, trading volume refers to the amount of trades in and out of the market in correlation with their contract size. A market with high trading volume (high amount of transactions and high level of money exchanging hands) will substantially impact the overall economy of a nation. Trading markets with high volume will also impact the individual trader, as increased trade volume ensures that traders can easily enter and exit trades as there is an adequate supply of buyers and sellers.
What is Technical Analysis?
“Technical analysis” is an industry term that more often than not sounds much more complicated than the actual process is. Really, it ought to be referred to as “price analysis”, as this would be a more accurate description. Through the use of charted data traders around the world analyze their market of choice. The objective: determine future price movement. The means: understanding price movement patterns of the past.
The charting of price movements creates a visual tug-of-war between buyers and sellers. The large majority of Technical traders in the Forex market focus their attention on candlestick data, a method of charting that offers a visual interpretation of the high, low, open and close of a currency price within a certain time frame.
Combined with various forms of pattern recognition (which will be covered later in the course) candlestick charting offers traders a visual look at the market’s past prices and trends. Analyzing this historical data in order to predict the movements of future prices is the process known as “technical analysis”. Notice how price patterns formed on the following chart tend to repeat; technical traders attempt to identify patterns of these nature, and base their trades accordingly. ( view figure 1 )
Why Does Technical Analysis Work?
Technical analysis is often dispelled as a myth, even a fool’s errand. There are those who believe that price movement is completely random and completely unpredictable. True, technical analysis is never an exact science (predicting the future never is). However, the true fool would be he or she that ignores the power of technical analysis, particularly in the Forex market.
Analyzing price patterns is actually very similar to analyzing human behavior. While humans can at times be unpredictable in nature, humans are typically considered to be creatures of habit. The average human adheres to certain paradigms, paradigms that are rarely broken. Do you brush your teeth or shower first? Do you comb your hair before or after you shave? The point: if one were to observe an average person’s daily routine before leaving the house for work their behavior may seem random or without purpose. However, if one were to observe the same human day after day, within a relatively short amount of time it would not be hard to outline that person’s morning routine. In fact, nine times out of ten you would probably be able to predict with impressive accuracy how your observed creature would prepare for their day, perhaps even down to the minute.
The Forex market is also a creature of habit. Analyzing price movement is effective because the past can teach us how human beings (the real living and breathing organism of this market) will react to certain situations. History does repeat itself. Technical analysis offers the Forex trader a certain level of expectancy when considering future price movements. In a sense, accurate technical analysis is a trader’s true edge. There is no crystal ball for predicting the future of the market, though there are keys to understanding patterns, past, present and future.
When Does Technical Analysis Fail?
Technical analysis fails when traders fail to consider the fundamentals. Why mention fundamental analysis when explaining technical analysis? Simple, the one just doesn’t work without the other. Fundamental factors such as political events, a hike in interest rates, unemployment rates and so on will impact the Forex market more substantially than perhaps any other market. Fundamental factors are often the driving force of major price movements. A trader focused on technical analysis cannot ignore Nonfarm Payroll on the first Friday of the month and expect his or her technical indications to be as accurate as the day prior. Notice the price movement shown in the following image; shortly after Nonfarm Payroll price reactions were wild; during such times technical analysis cannot be counted on. ( view figure 2 ) Purely technical traders understand that certain political factors throw all other price forecasts out the window.
Charting & Charting Styles
‘Charting’ is essentially the most basic component of technical analysis. As such, some would argue that the more raw and basic data plotted on a chart is of little use to the technical trader. Instead, they might argue that a technical trader needs more advanced indicators as a means of determining price direction. Indicators such as moving averages, momentum indicators, oscillators and so on… will, ultimately be of grand use to the technical trader, but not without first learning the basics!
There is nothing more basic than a line chart. A simple visual representation of data, the Line Chart plots the closing price of a single day and over the course of weeks and months connects the dots. The following image shows an example of a basic line chart:( view figure 1 )
The line chart’s simplicity is often seen as its strength. Or so it may be in other markets. In the Forex market the line chart offers very little insight into the market’s volatility or movement within the time frame of a single day. As most Forex traders are ‘day traders’ (often in and out of positions in a 24 hour period) a line chart, even if plotted by the hour, would still leave much to be desired. As we continue to explain other charting methods, the previous point will make more sense!
Bar charts are in essence the less visually appealing version of Candlestick charts. Candlestick charting is the most popular method used by today’s Forex traders. However, it might be important to understand the one before the other. A Bar Chart displays a price’s open, high, low and closing prices. As shown in the following image the top of the bar chart represents the highest price of the period, and the bottom of the bar represents the lowest price of the period. To the left and right side of the bar are “ticks”, the left tick represents the open price of the period and the right tick represents the close price of the period. ( view figure 2 )
Really the only choice for today’s Forex traders, the candlestick chart offers the same information as does a bar chart, but does so in a much more ascetically pleasing manner. As is illustrated in the following image the candlestick is comprised of a “body” and an upper and lower “wick”. The body of the candle is typically a dark color when the close is at a lower price than was the open (a bearish candle). Conversely, if the close is at a higher price than was the open the candle will be a light color (a bullish candle). The wick of the candle represents the entire range of price for that period. The top of wick of course represents the price at its highest point, while the bottom of the wick represents the price at its lowest point.
A quick glance at a candlestick will tell a trained eye literally everything they might want to know about a price within a certain time frame, i.e. what was the high and low price, was it bullish or bearish, where was the open and close. A trader can also quickly glance at a series of candles and with little thought note how many consecutive candles have been bullish or bearish; which in conjunction with other technical analysis often serves as an appropriate timing method to enter a trade. ( view figure 3 )
What am I looking for?
More often than not, traders in the Forex market doom their own technical analysis. The reason is simple; they look at a chart and try to remember everything that they have ever studied about technical analysis. Before long it seems that one philosophy only contradicts another, an obvious entry becomes a source of confusion and so on. Some of the best traders in world have a bit of a mental check list that is always considered when analyzing a chart. However, they also know that too many technical indicators used in conjunction with one another is a fast track to a certain demise.
There are certainly a few things that you are going to want to consider when looking at a chart. As the course continues you will be better prepared to compile your own trading style. For the time being, consider the following a check list for the novice. Ask yourself what the chart on your screen is telling you, and which of the following considerations are worth considering:
Is there an obvious trend or direction of the market within the time frame that you are viewing?
Are there any basic chart formations such as triangles, wedges, pennants, double tops or bottoms or otherwise that might suggest a pending breakout or trend reversal?
Is the market trading within the walls of any obvious support and resistance levels, or is the market trading within a channel?
Have you considered at least two technical indicators, i.e. two technical indicators that complement each other well?
Have you ignored the impulse to consider every technical indicator that you have ever read a paragraph or two on?
You should now understand at least the basics of what a technical trader is looking for when analyzing a chart and the market. As we continue to dissect various technical indicators and forms of pattern recognition your skills will be refined, for the time being it is enough to know, if nothing else, what it is that you will ultimately be looking for.
Support & Resistance Trends
Fortunately for traders in the Forex market, dealing in this market is often about dealing in trends. It is often said that ‘the trend is your friend’; there is truth to this, but only when a trader understands why the market trends and the underlining factors that can often disassemble a forming trend (these factors will be covered throughout the course as we further analyze technical analysis). ( view figure 4 )
The image above shows an example of an upwards trend. Notice that the trend line was drawn by identifying the lowest low of the trend and connecting the line to the following low preceding a new high. A solid trend line should continue in this manner until at least four lows followed by new highs are plotted. This trend line can also be referred to as a support level. In other words, think of this line as if it were the roof of a house. During this trend period the price range is going to crawl along the roof of the house. In an upwards trend we are obviously looking for an opportunity to buy. It is generally taught that a trader’s best buy entry point during an upwards trend would be at the lowest low of the candle on the third touch of the support level, as is shown in the following image: ( view figure 5 )
Just the opposite of an upwards trend, in a downwards trend our trend line can be referred to as a resistance level. Now as opposed to trading along the outside of a roof we are trading along the top of the ceiling. During this trend a trader can assume that the price is often going to reach the ceiling, but never push through it. A trader following a well developed downwards trend is looking for an opportunity to sell on the third touch of the resistance line at the highest possible point of the candle, as is shown in the following image: ( view figure 6 )
Timing an entry point within a trend is as key as recognizing a trend, as obviously they will not last forever. First consider the time frame of the chart that you are viewing in relation to the likely continuance of the trend. As mentioned earlier, we are usually looking to buy or sell on the third touch of a support or resistance level within a trend. Using historical data in your charts, you will notice that the average trend will not provide more than 3 to 4 additional touches of the support or resistance after the first 3 that would have inspired you to note the trend to begin with. Thus, depending upon whether you are viewing a 1 minute chart, a 5 minute chart, or so on you will need to gage an estimated time frame within which you will trade.
Double Tops & Double Bottoms
Double Tops do not only provide technical traders with a firm indication of a beginning downward trend; they also prove that price movement is not random, but rather is a clear indication of market sentiment. Double Tops occur when a new high is plotted, raising the resistance level. The price then retraces and declines, only to rise again and reach the same high or resistance level.
( view figure 1 )
As can be seen in figure 1 Double Tops can be thought of as true market sentiment. Traders around the globe push the price to a new high; because the new high is a tad extreme the price is subsequently brought back down. Again traders push up to the same level, testing it just one more time; again the price feels too extreme. The market has decided that an upwards trend is just not in the cards, twice a new high was tested and twice the market sold to push it back down. After noticing a Double Top a trader is generally safe to assume that for the time being the market will move in a downwards trend, thus affording an opportunity to sell, or exit a soon to be falling long position.
Of course, Double Bottoms are just the opposite of Double Tops. Twice the market will test a new low, and twice the market will refuse the idea of pushing beyond that point. The buyers will rally and an uptrend will follow.
There are three types of triangles that technical traders focus on:
( view figure 2 )
Ascending triangles are considered bullish pattern formations, though depending on whether they are formed during an up-trend or a down-trend they may have different implications towards future price movement. Spotted within an up-trend an ascending triangle is typically considered an indication that the upwards trend will continue. Just the opposite, if an ascending triangle forms during a downwards trend it is considered an indication of a trend reversal. Essentially, ascending triangles are comprised of a series of candles that, in accordance with the pattern’s name, form the shape of a triangle. The term ascending triangle refers to the fact that the triangle’s two trend lines are not created equally; the top line of the triangle will represent a fairly even level of high prices, while the lower level of the triangle will represent a continued series of higher lows.
The consolidation between buyers and sellers at an upward slant suggests pressure from the buyers. The resistance line can typically only hold for so long before the buyers get the best of the sellers and the price breaks out in an upwards trend, at which point the resistance level often becomes the new support level; or for a seasoned trader, a wise level to place a stop loss. Figure 3 shows an example of an ascending triangle. As can be seen, it is generally safe to assume that the triangle will break out at least five candles before the actual point of the triangle would form. ( view figure 3 )
Descending triangles, naturally, are just the opposite of ascending triangles. In a downwards trend the triangle forms as an indication that the trend will continue downwards. In an upwards trend the triangle forms as an indication of a trend reversal. Descending triangles are formed when there is a series of progressively lower highs and relatively even lows. As can be seen in the image below the top line or resistance line of the triangle will be angled down, while the lower line or support level will appear as a level horizontal line.
Symmetrical triangles are most often considered a continuation pattern. Symmetrical triangles can be seen as a series of lower highs and higher lows develop forming the shape of a triangle. This pattern represents a struggle between buyers and sellers, as is usually the case with price consolidation; more often than not symmetrical triangles precede a price breakout. Though it is generally safe to assume that symmetrical triangles will only present themselves as an indication that the current trend either upwards or downwards will continue, this may not always be the case. ( view figure 4 )
The good news for seasoned traders is that one need not really know ahead of time where the market will head, the true key is simply to spot the symmetrical triangle developing. As can be seen in the example below once the support or resistance line of the triangle has been penetrated by two to three consecutive candles the trend will more than likely continue in that direction, thus offering traders an excellent entry point.
Wedges are often considered a difficult pattern to recognize, and or are often confused with triangles. The distinction between wedges and triangles is actually quite clear to the trained eye. The key to spotting the difference is found in the slant or the angle of the support or resistance line. When observing triangles notice that ascending triangles show a flat or even resistance line, conversely descending triangles show a flat or even support line. Symmetrical triangles, as their name suggests, are neither slanted downwards or upwards. Wedges on the other hand, are represented by support and resistance lines that both slant in the same direction, be it up or down. ( view figure 5 )
There are two types of wedges; rising wedges and falling wedges.
Falling wedges are considered bullish pattern formations. When found in a downwards trend the falling wedge suggests a reversal of that trend. When found in an upwards trend the falling wedge suggests a continuation of the upwards trend. The falling wedge is formed by a series of lower highs and lower lows. Notice that both the support and resistance levels of the wedge are slanted downwards, setting the wedge aside from what might be mistaken as a triangle pattern formation. Prices within the falling wedge will continue to tighten until the resistance line is finally penetrated and the breakout upwards begins. Timing a falling wedge is much like timing a triangle formation; one can generally assume that after two to three candlesticks have pushed through the resistance line it is then time to consider hoping on the bandwagon with the rest of the buyers.
Rising wedges, just the opposite of falling wedges, are considered bearish pattern formations and are represented by a series of continued higher highs and higher lows which are narrowing or consolidating. The rising wedge suggests to the trained eye that though the buyers are reaching new highs, these highs a progressively tighter and tighter. These progressively tighter highs indicate that the upwards trend is losing steam. Thus, a rising wedge found in an upwards trend would suggest a trend reversal and a rising wedge found in a downwards trend would suggest a short rally from the buyers, but ultimately a continuation of the downwards trend.
( view figure 6 )
Flags & Pennants
Flags and pennants are perhaps the most common of continuation patterns. Spotting a flag or a pennant usually begins with noticing the flag pole, or for more practical purposes, the trend line. Flags and pennants typically form after a substantial trend up or down as an indication that the price is consolidating, or being tested before continuing in the initial direction of the trend. Often the consolidation period (the flag or pennant) is slanted in a direction opposite of the initial trend, this demonstrates the market’s hesitation to continue upwards or downwards, but ultimately it is nothing more than a brief hesitation and an indication to the trained eye that there is safety in staying with the initial trend.
Though both flags and pennants indicate a continuation of the current trend, there is a distinct visual difference between the two. The flag will be represented by a more rectangular consolidation period, ( view figure 7 ) both support and resistance levels will be about an equal distance from one another. A pennant on the other hand will be represented by support and resistance levels that are moving towards one another in the shape of an asymmetrical triangle. Both the flag and the pennant are always spotted at the end of the flag pole, or at the end of a sharp directional trend.
Head & Shoulders / Reverse Head & Shoulders
Usually found after a long trend either up or down, as its name suggests head and shoulders are named after the human form. Consisting of three peaks, one of which (the head) is centered and higher than the two lower and relatively equal peaks (the shoulders). Head and Shoulders is perhaps the most well known reversal pattern within technical analysis. Formed after a long upwards trend the left shoulder begins to form while still in the upwards trend. Essentially the left shoulder forms as prices rally up and quickly thereafter retrace, typically the upwards trend line, or resistance level will not be broken as this happens. Notice that the left shoulder seen alone can also be viewed as a forming flag. As the left shoulder finds its end, prices again rally, this time to a new high which will become the head of the pattern. After the high peak or head of the pattern is formed and prices have retraced back down, again prices will rally to near the same level as the left shoulder to form the right shoulder.
Essentially, within an upwards trend prices have attempted to rally three times and each rally has seen limited success, or in other words has been rejected by the sellers. Once the right shoulder breaks through the imaginary support line equal with the right shoulder (the neck line) the reversal of the trend has officially begun. Buyers have tried to continue the upwards trend, and three times have lost their battle to the sellers. A trader who has spotted a forming head and shoulders pattern can usually be quite sure that he or she has seen the end or a long upwards trend. It’s time to cut your losses, secure your profits, or short the market. ( view figure 8 )
Every pattern within technical analysis seems to have its opposite, head and shoulders is no exception to this rule. Reverse head and shoulders represent essentially the same situation as normal head and shoulders, but of course are found in long term downwards trends as opposed to long term upwards trends. Instead of the head and shoulders represented by new peak highs they are represented by new peak lows. The reverse head and shoulders tips the trader that the downwards trend is losing steam as three new lows have been tested and each time bested by the buyers in the market. Again, it’s time to cut your losses, secure your profits, or this time, long the market.
TA 1030 | Support & Resistance – Clif Droke
The concept of support and resistance in the charts is basic to the understanding of price patterns and their implications.
Edwards & Magee defined support as the “buying, actual or potential, sufficient in volume to halt a downtrend in prices for an Appreciable period.” Resistance, of course, is the antithesis of this and consists of selling, actual or potential, in sufficient volume to keep prices from rising for a time. “Support and resistance, as thus defined, are nearly but not quite synonymous with demand and supply, respectively.”
Further expounding this concept, Edwards & Magee tell us:
“A support level is a price level at which sufficient demand for a stock appears to hold a downtrend temporarily at least, and possibly reverse it. i.e., start prices moving up again. A resistance zone by the same token, is a price level at which sufficient supply of stock is forthcoming to stop, and possibly turn back, its uptrend. There is, theoretically, a certain amount of supply and a certain amount of demand at any given price level… But a support range represents a concentration of demand, and a resistance range represents a concentration of supply.”
Support and resistance – in their basic forms – are represented on the charts as follows:
In a trending market, especially one in which prices travel within the confines of a clearly defined channel, the support and resistance lines will tend to keep prices within the channel, bouncing from support to resistance in an alternating “zigzag” pattern.
Support and resistance are more than just an upward trending or downward trending channel lines. They may be encountered from a variety of chart patterns and other places of price congestion on the charts.
One rule of thumb for determining where a market or security will meet with either support or resistance on the charts is to find previous chart areas where consolidation has occurred. If, for example, a particular stock has stalled out in a net sideways or other congestion pattern at a certain level in the recent past before falling to a lower level, it is all but likely that the stock will encounter difficulty in penetrating that same level later on as it rallies and tries to overcome it. This, of course, does not necessarily mean the former area of consolidation (in this case, resistance) will prove impenetrable; to the contrary, it will probably be overcome eventually. But not without considerable effort on behalf of the buyers. The greater the congestion, the greater the effort required to overcome that congestion, whether it is in the form of support or resistance. Thus support and resistance serve as checks in the development of a trend (be it a rising or a falling trend) to keep the trend from moving too far, too fast and thus getting out of hand and eliciting violent reactions. (This does not apply, of course, in market crashes or “buying panics,” in which case support and resistance levels become meaningless. But such instances are fortunately quite rare.
This leads us to the next related principle of support and resistance which Edwards & Magee elucidate for us:
“…here is the interesting and the important fact which, curiously enough, many casual chart observers appear never to grasp: These critical price levels constantly switch their roles from support to resistance and from resistance to support. A former top, once it has been surpassed, becomes a bottom zone in a subsequent downtrend; and an old bottom, once it has been penetrated, becomes a top zone in a later advancing phase.”
Thus, if a certain security breaks through an overhead resistance level at, say $50, then the moment prices are above the$50 level, it automatically becomes a support. Conversely, if the $50 in our hypothetical security had been a support checking prices from moving below it and the $50 level is suddenly penetrated then $50 automatically becomes resistance. This principle, which we call the “principle of interchangeability”, hold true for older levels of support and resistance as well, not just recent levels.
Other instances of support and resistance can be found not only in areas of chart congestion but in geometric chart patterns as well. The symmetrical triangle affords just such an example. Throughout the formation of the triangle, the upper and lower boundary lines serve as resistance and support, respectively. However, an even stronger level of support level of support and resistance (depending on which direction prices take upon breaking out from the triangle) is provided by the apex of the triangle. By drawing a horizontal line from the apex and extending it across the chart an analyst will be provided with a reliable support/resistance level. However, such levels usually become weak as time passes. Thus, a chartist will want to regard this as a strong support/resistance only in the days/weeks immediately following a price breakout from the triangle.
Concerning volume, it is sufficient merely to point out that the power of a resistance (or support) range is estimated by using the criterion of volume. In other words, the greater the amount of volume was recorded at the making of a top (resistance) or bottom (support) in a given market or security, the greater the strength of that top or bottom will be and the more effort will be necessary to penetrate it in the future. As Edwards & Magee put it:
“In brief, a single, sharp, high-volume bottom offers somewhat more resistance than a series of bottoms with the same volume spread out in time and with intervening rallies.”
Another criterion Edward & Magee discuss that is worth noting here is the extent of the subsequent decline from a resistance zone. Or, to phrase it differently, how far will prices have to climb before they encounter the old bottom zone whose resistance potential the analyst attempt to appraise? “Generally speaking,” Edwards & Magee write, “the greater the distance, the greater the resistance.”
In other words, the higher that prices must travel before breaking the previous top, the stronger the resistance that top is likely to hold.
Finally, in answer to the oft-asked question as to what exactly constitutes a legitimate “break” of either support or resistance, we would refer the analyst back to the old Edwards & Magee “three percent rule,” which states that a break above a support or resistance level (or through a corresponding chart pattern) by distance of at least 3 percent, and accompanied by increased trading volume, should be viewed as the start of a new trend and therefore followed.
TA1040 | Moving Averages
Most literature written on technical analysis, more specifically technical indicators, begins with Moving Averages. The reason for this is simple; they are considered by most analysts the most basic and core trend identifying indicators. As its name would suggest a moving average calculates an average of price range over a specified period. For example, a 10 day moving average gathers the closing prices of each day within the 10 day period, adds the 10 prices together and then of course divides by 10. The term moving implies that as a new day’s closing price is added to the equation, the day that is now 11 days back is dropped from the equation. Figure 1 shows an example of a simple moving average line placed on a candlestick chart.
( view figure 1 )
The example above outlines what would be considered a Simple Moving Average. There are at least 7 varieties of moving averages, but generally the average Forex trader is focused on just one of the following three:
Simple Moving Averages
Exponential Moving Averages
Weighted Moving Averages
What are moving averages trying to tell us?
Before examining the various calculations and types of moving averages it is essential that we as traders understand what a moving average is trying to tell us. Its message is really quite simple, and is primarily focused on market expectations. A moving average calculating the last 30 days of prices in the market essentially represents a consensus of price expectations over that 30 day period.
Understanding a moving average is at times as simple as comparing the market’s current price expectations to that of the market’s average price expectations over the time frame that you are viewing. The average gives us a bit of safe zone, or a range that traders globally are comfortable trading within.
When prices stray from this safe zone, or from the moving average line a trader should begin to consider potential entry points into the market. For example, a price that has risen above the moving average line typically implies a market that is becoming more bullish, traders are on the up, and with such will come good opportunities to buy. ( view figure 2 ) Just the opposite, when prices begin to fall below moving average lines the market is becoming visibly bearish; traders should thus be looking for opportunities to sell.
Notice the angle of the moving average shown above at various points across the chart. Moving averages not only give traders a much smoother look at the true trend of the market, they also offer keen directional insight found in the angle of the moving average line. Erratic sideways markets tend to be represented by moving average lines that are flat or sideways, whereas markets that are beginning to trend strongly in one direction or another will begin that trend with a very angled moving average line.
Remember, it is one thing to look at a completed moving average line and determine at what point would have been an excellent entry into the market, it is another thing to spot the angle of the line as it is developing and at that point wisely enter the market. A true technical analyst is after what the moving average can tell him or her about the coming hours or days of the market, not what the moving average can prove about what should have been done in the past. That said, look for angles! ( view figure 3 )
Simple Moving Averages
Calculating simple moving averages is really quite simple (no pun intended). As was outlined in the beginning of this section the sum of all closing prices is divided by the number of days in the equation. With each new day the now oldest day that is no longer a part of the time frame is subsequently dropped from the equation. A simple moving average is considered a lagging indicator. In fact, the simple moving average perhaps epitomizes the meaning of lagging indicator in that its visual data often comes a bit after the fact, and can be hard to act on. Nevertheless, simple moving averages are key to understanding the markets general feel of where the price rage should be trading at, or the safe zone that we referred to earlier. When prices begin to break away from the moving average line in conjunction with a sharply angled moving average line – basic mathematics is predicting a move up or down in the market. The notable down side is that when observing lagging indicators, this prediction often comes too late; thus the reasons for other types of moving averages, averages that more heavily weigh recent data and can offer quicker predictions:
Exponential Moving Averages
Exponential and weighted moving averages attempt to resolve the issue of lagging directional forecasts. In other words, they often cut to the chase faster, allowing traders to better time the market. This is done by placing greater emphasis on more recent price data. Instead of evenly distributing plotted points of a moving average across all candles in the period, a weighted or exponential moving average puts more emphasis on the most recent data; allowing the angle of the moving average to react more quickly.
Theorizing that most recent price data is more important to the immediate future of the market than is older price data is often true, but can certainly be a trader’s demise if he or she is not careful. Trading a heavily weighted 10 day EMA (exponential moving average) and jumping the gun on an initial angle up on the EMA when just 10 to 12 days prior a very strong and long down trend occurred might be a bit naïve. Why? It is simple, Your 10 day EMA is over looking data that is an accurate reflection of recent market sentiment, or price direction. Remember, reading moving averages is about comparing an average view of the market’s recent trends to an actual view of recent price data. In other words, is the market trading within its safe zone, or where its average has been lately? If not, it may be an indication of a new direction or trend, but before you pull the trigger cross check your SMA (simple moving average) and gage an evenly weighted average of the market’s recent history. Notice in figure 4 that the exponential average reacts more quickly to price chance than does this simple moving average; which can be good or bad, but traders should form the habit of cross checking the two. ( view figure 4 )
Whether using exponential moving averages, weighted moving averages or simple moving averages the objective does not change. You are looking for an average in which the market has been trading. When new candles push significantly through this average in conjunction with a sharply angled moving average line it is time to consider an entry point. History has proved itself; when prices begin trading above the moving average line the market is becoming bullish and traders should be looking for buy entry points. When prices begin trading below the moving average line the market is becoming bearish and traders should look for an opportunity to sell.
20 Days & the Moving Average Cross
There are those who pretend that they understand why the 20 day moving average is such a popular choice of today’s Forex traders. The answer may simply be that the average charting software offers this time frame as a default setting, or it may be that minus the weekends this time frame represents about a month of market activity.
Whatever the case may be, an increased number of traders around the world follow this number, and thus theory becomes reality. In other words, why do technical indicators often work as well as they do? Well, market sentiment is everything; remember human beings drive any financial market. If enough human beings believe in the same indicator and the same time frame for that indicator, often there is no better way to go than with the crowd.
Market sentiment when shared by the masses most often becomes market reality. That is why an untrained trader often finds him or herself baffled by a price move that does not make any logical sense. But, perhaps this trader was unaware of the fact that after a large and intense move up in the market technical analysts around the world were all looking at the same Fibonacci retracement levels (material for a later course, no need to fret). As such, everyone believes that the market will retrace at the same Fib levels and so everyone begins to sell at the same level, thus pushing the market down; sentiment becomes reality. For this very reason it is imperative that anyone serious about trading the Forex market, or any market for that matter, must first learn the basics of technical analysis. Often technical analysis and market sentiment are one in the same.
The moving average cross is a tool that should not be overlooked. As can be seen in figure 5
( view figure 5 ) there are two moving average lines plotted on this chart. The idea is to combine a short term moving average with a long term moving average. For example, a 10 day moving average on top of a 20 day moving average. Of course the shorter moving average period will react more quickly to price direction, whereas the longer moving average period will be represented by a smoother less volatile line. When the two lines cross this is considered an indication of a quickly approaching trend reversal or change in price direction. As always, watch for the angle of the moving average line, particularly the shorter time frame (in this case the 10 day moving average). When lines cross with a sharp angle and an obvious separation from one another nine times out of ten a trader can count on a change in price direction. Do not trust moving average crosses that are represented by lines on top of one another. The two periods might have crossed, but if there is not a sharp angle and a good degree of separation after the cross expect a sideways market for the time being.
When trading moving average crosses follow these rules: when your shorter moving average period crosses the line representing your longer period from the bottom – look for an opportunity to buy. In other words, the market in this situation is most likely poised for a trend upwards. When your shorter moving average period crosses the line representing your longer period from the top – look for an opportunity to sell. The market in this situation is most likely poised for a trend downwards. Take a look at the following chart; notice that the angle of the cross and the separation of the cross are the keys to large changes in direction. ( view figure 6 )
Don’t jump the gun!
Don’t jump the gun! Often inexperienced traders assume that a moving average cross is a perfect entry at the exact point of lines intersecting. This is usually not the case. Do not be fooled by what may become nothing more than a sideways market. Again, look for sharp angles and an obvious degree of separation between the two lines. Looking back at the image above, notice that the solid trends all have two things in common; the shorter period line has a sharp angle up or down, and the two lines are separated by what would be at least 2 or 3 numbers on a clock. Once this separation is obvious and a few candles have opened higher than the previous (lower than the previous in the case of a downwards trend) the market has shown its true colors. At this point, you should be looking to pull the trigger.
What They are and How to Use Them for High-Impact Results:
Using two moving averages – one of shorter length and one of longer length – to generate trading signals is commonly used among traders today. This method, known as the “double crossover method,” is especially suited for securities that happen to be in trending, as opposed to range-bound markets. (Trending markets are characterized by steady upward price movement in bull markets and steady downward price movement in bear markets. Prolonged sideways movement with little sustained progress up or down is characteristic of “range bound” markets.)
There are many different ways in which this double crossover method may be used. The combination possibilities are endless. The two moving averages can be daily or weekly, but one must always be of a shorter time frame than the other. For example, you might consider using a 12- and 24- day moving average in conjunction with security’s price chart. Or a 10- and 30- day, or a 30-day and 60-day average. The shorter moving average measures the short-term trend, while the longer MA measures the longer-term trend. Buying and selling signals are given whenever the two cross over or under one another.
Trading rules for the double crossover method are quite simple: whenever the shorter-term moving average crosses above the longer-term moving average – and the longer-term MA happens to be rising – a buy signal is generated. Conversely, whenever the shorter-term average falls beneath the longer-term average – and the longer-term average happens to be falling – a sell signal is generated.
BigCharts.com provides a free charting service through its internet site (www.bigcharts.com), which contains charting tools for constructing several varieties of moving averages. The daily and weekly bar charts on the BigCharts.com Web site can be modified to the time frame that best suites the trader. Included in this chapter are a number of BigCharts.com stock charts, and the buy or sell signals they generated based on the crossover method using the 30-day 60-day moving average. Bear in mind that the same rules that apply for interpreting the 30-day and 60-day moving average combo apply for all types of double series moving averages; and can be used for all time frames, including daily, weekly and monthly charts.
J.P. Morgan (JPM)
Here is a fine example of how the double crossover system of moving averages works in J.P. Morgan. Here, the daily chart provides a buy signal when the shorter 30-day moving average crosses over the longer 60-day moving average. Conversely, a sell signal is flashed when the longer of the two averages (60-day) crosses over and remains on top of the shorter average (30-day). This basic rule of thumb applies for moving averages of any size and not just the 30-day and 60-day functions. Notice in March 1999 that the first buy signal was given as the 30-day average (light colored line) crossed on top of the darker 60-day line. So long as the price bars were rising and remained on top of the averages, the buy signal remained intact. This was the case from March through June 1999, at which point the priceline dropped underneath the averages and the averages started turning down, indicating a loss of momentum. In August 1999 the 60-day average crossed on top of the 30-day average, flashing a sell signal. This continued until November, when another buy signal occurred. However, since the two moving averages got so far out of synch with one another, it warned the trader to avoid making a commitment to the stock until the averages got back in line. The next “in-line” buy signal occurred In August 2000 (note how the two averages interacted at this time on the chart). Because the two averages became widely spaced apart shortly after this signal, it indicated that an over-bought condition was developing in J.P. Morgan. Therefore, the prudent trader would have been right to look for exit signals. The first such signal came in October, at which time the 30-day average turned down and failed to support the priceline. Even though a crossover did not occur until one month later, it would have been wise to sell out when the first 30-day moving average turned down. The rules for interpreting single line moving averages still apply when interpreting double line moving averages, even when the two lines have not crossed over yet.
Standard & Poor’s Depository Receipt (SPY)
A buy signal in the Standard &Poor’s Depository Receipts (SPY) remained in place throughout 1999 until August of that year until the two moving averages started rounding off and turning down. Shortly thereafter, a bearish crossover occurred, though it would have been wise to exit long positions as soon as the moving averages – particularly the 30-day average – starting curving over, reflecting waning momentum. Another strong buy signal was given in November 1999, when the 30-day average crossed the 60-day average. It soon starting curving over, however, and the priceline began a prolonged sideways movement into the year 2000. The next formal sell signal was flashed in September, at which time the 60-day average crossed over the 30-day average. The sell signal remained in place through the remainder of the year.
General Motors (GM)
General Motors provides a clear sell signal in its daily chart In May 1999 (note crossover and downward curve of moving averages and their relation to the priceline). A buy signal was given in October 1999 (note bowl-shaped bottoming pattern of moving averages, the rising priceline in relation to the rising averages and the crossover of the shorter average (30-day) on top of the longer average (60-day). The next sign of trouble came in May 2000, when the two averages got out of line with both curving over. The priceline plunged through both of them before bouncing higher. This should have been the trader’s signal to exit all long positions in GM and sell the stock short. Remember, when trading using two moving averages, you do not necessarily have to await a crossover before making a trading commitment – a simple curve of one or both of the moving averages, or a failure of the moving averages to contain the priceline is all the signal that is required. The crossover serves more or less as a confirmation to the preliminary buy or sell signal.
Here is a daily chart of DuPont (DD), a leading industrial stock and a component of the Dow Jones Industrial Average. A strong buy signal was given in April 1999, when both moving averages were close together and moved up at the same time while the price bar were also rising. A separation of the two averages occurred between May and June of that year, followed by a curving over of the shorter (30-day) moving average in June. This provided a preliminary sell signal to the alert trader. An all-out sell signal was given in September when the 30-day average fell below the falling 60-day average. This was followed by falling prices and then a short-term buy signal in December 1999. However notice that in the month between December 1999 and January 2000, even as DuPont’s priceline was moving higher, the 30-day moving average ascended while the 60-day average never followed suit. Instead, the 60-day moving average, after a short rise in December, quickly turned back down and continued to curve lower even as the 30-day average was rising. This is what is known as divergence, and it is typically bearish. In cases like these where one moving average gives a buy signal while the other give a sell signal, it is best to exit long positions and either await a clearer signal before re-establishing trading positions or else sell short (if you are an aggressive trader). The longer of the two averages holds more significance, so in this case the fact that the 60-day average was falling implied that the longer-term trend was still down; therefore, short positions were justified. The sell-off continued throughout the year 2000; however, notice how the two averages had moved close together and were starting to round off in bowl fashion. This provides a clue that the sell-off likely has halted and that accumulation could be underway. The trader should watch this chart carefully in anticipation of the next buy signal.
Cisco Systems (CSCO)
A bullish buy signal continued throughout 1999 and into the early part of 2000. Notice, however, that the moving averages began moving apart in early 2000 and continued to spread apart into April, at which time the 30-day moving average started to curve over with the 60-day average soon following suit. The first sell signal was given in April when the priceline for Cisco Systems fell through both averages. Although there was quick bounce back, the curvature of the averages plus the fact that the priceline had previously plunged through them, was strong evidence that Cisco’s bull market had ended and that further weakness could be expected.
Chinadotcom Corp. (China)
The chart provided on the next page for Chinadotcom Corp (CHINA) is a great example of how a moving average system can serve to protect traders from adverse moves in the stock market. After an extraordinary advance from its initial public offering in July 1999, CHINA proceeded to rise to a price of nearly $80 a share in March 2000. The large gap between the priceline and the moving averages that occurred in March 2000 (just before the crash) was a preliminary warning that the stock was due a significant pullback. Although there is no hard-and-fast rule as to just how far the distance between the priceline and moving average should be before a sell signal is given, it is up to the trader to use discretion based on the “average” distance between the two over the long-term. Whenever it becomes plainly evident that there is a wide separation between the moving average and the priceline, the trader should prepare to either sell or sell short. Notice also how both averages – particularly the 60-day average – began losing momentum and curving over just before the sell-off occurred. This was yet another advance warning that a plunge was imminent. After the initial crash, CHINA continued to trade below the two moving averages for the rest of the year, indicating that selling pressure was intense throughout.
Boston Properties (BXP)
The chart for Boston Properties (BXP) served as a wonderful guide for making profits over a two-year period. Using the double moving average system, a trader, after initially buying in April 1999, knew to sell short between May and June of that year as the gap between the 30-day and the 60-day moving averages widened conspicuously. The sell signal was confirmed in July as the averages crossed over. The trend remained down until December 1999, at which time a preliminary buy signal was flashed as the two averages bottomed and turned up together (the crossover occurred the next month). After a rocky start in the initial months of 200, a firm buy signal was flashed in March, and from there prices headed higher. A preliminary sell signal was given in September 2000, as both averages lost momentum and curved over. Although the next firm buy signal had not been given as of December, it was beginning to look like a distinct possibility. Note how both averages are very close together and appear to be turning up with the priceline moving higher. However, as a clear-cut buy signal has not yet been flashed it is safest to remain on the sidelines awaiting a clear signal. Both averages must turn higher before a long position can be safely established.
Resource Asset Investment Trust (RAS)
Resource Asset Investment Trust (RAS) is a dynamic stock that can be traded with wonderful results using a double moving average trading system. Note here the interplay between its 30-day and 60-day moving averages. Note especially how the two lines cross through each other at critical turning points along the timeline. Whenever the 30-day moving averages crosses through and above the rising 60-day average, it always precedes a big run-up in share price. Note also how well the averages tend to act as support and resistance for the priceline. The first significant buy signal came in May 1999 when the 30-day MA crossed through and above the 60-day MA. Both curved over in August, at which point the trader should have sold short. A ”rounding” process occurred between November 1999 and July 2000 during which time both the priceline and the averages produced a bowl-shaped curve, implying accumulation was taking place. The next buy signal was finally flashed in July 2000, which saw RAS rocket from its low near $10.50 to a high of nearly $13 in three months – a hefty percentage gain. After a prompt sell-off from the October high, the averages curved over and failed to support the falling priceline, at which time the trader should have sold. By December, however, the 30-day moving average appeared to be ready to cross through the 60-day average, which would send another buy s
MACD (Moving Average Convergence / Divergence)
After delving into the world of moving averages there is no better place to go next than into the world of MACD. Why? Simple, the MACD is comprised of two moving averages. Some traders argue that there is no better technical indicator than that of the MACD, more often than not, this author tends to agree. The theory behind MACD is really the same theory behind trading any other form of a moving average cross. Generally a technical analyst can learn more from the interaction of two moving averages than he or she can learn from a single moving average in and of itself.
The MACD uses two exponential moving averages, more specifically a 12 day EMA and a 26 day EMA. The 12 day EMA is of course going to react to the market more quickly than will the 26 day EMA. When prices in the market begin to rise or trend upwards the 12 EMA will of course increase faster than will the 26 day. Visually this results in a MACD that is slanted upwards. Conversely when prices fall or trend downwards the opposite will occur and the 12 day EMA will decrease faster than will the 26 day, creating an obvious visual slant downwards. The MACD does oscillate at what would be considered a zero line. In other words, the MACD is either above or below the level that can be considered the third part of the equation. Some analysts refer to this line as the signal line, or the trigger line. Essentially this line is usually a 9 day exponential moving average of the actual MACD itself.
Whether you are a mathematician or not is hardly the point. One need not really understand the complexities of the calculations within a MACD, but rather it is only crucial to understand the basics of the math and what the MACD is trying to tell us as technical traders. For that reason, we will not further dissect the math. Instead, let us get to the point; how does a MACD forecast successful trades?
As is the case with trading moving average crosses, buy and sell signals derived from a MACD will come from the crossing of two lines. However, these two lines are not your two EMA lines, rather one is the combined level of the two EMA lines and the second is the signal, or trigger line (the 9 day exponential moving average of the actual MACD itself). The MACD crossing signal line from above would indicate a sell order and conversely the MACD crossing the signal line from below would indicate a buy order ( view figure 1 )
MACD as a Histogram
The lines plotted on the bottom of the MACD are trying to tell a story as well, and traders had better listen up! Moving Average Convergence Divergence was not randomly chosen as this indicator’s name. Through the histogram we can visually gauge convergence (moving average lines of MACD moving towards one another) and divergence (moving average lines of MACD moving away from one another). ( view figure 2 )
Notice – as the moving average lines cross the histogram will show no lines whatsoever, indicating to traders that lines (prices) should now start in a new direction. ( view figure 3 ) Very rarely does the histogram reach the point of a cross (two lines crossing and no line plotted on the histogram) and then plot lines in the same direction as the previous section of the histogram. In other words, if there is a legitimate cross, the histogram should begin indicating a new price direction.
Consider the following strategy: watch the histogram for points where no lines or very small lines are drawn (indicating a cross), then look for strong lines up or down from that point. If after a cross, the histogram begins to plot lines at a sharp angle up or down, such should be considered an indication of a strong directional change in the market. ( view figure 4 ) If the MACD crosses, but the histogram plots a series of lines at a weak angle, perhaps the market it momentarily retracing, but overall trends may not be changing. ( view figure 5 )
Now take a look at the complete picture, figure 6 ( view figure 6 ) shows an example of two trades that should have been avoided on the MACD and one opportunity that shouldn’t have been overlooked. The first directional change is weak, lines essentially move sideways. The second directional change is strong, prices dive immediately and just three lines into the histogram a trader wise enough to short the market still has 70 pips left in this downward move. The third directional change is again weak, and is nothing more than a retracement… and indication to the trader that shorted the second move that he or she might want to secure profits… but not enter a new trade.
Understanding Fundamental Analysis
Fundamental analysis is the study of the core underlying elements that influence the economy of a particular currency. This method of study attempts to predict price action and market trends by analyzing economic indicators, government policy and societal factors. Imagine financial markets as a large clock, the gears inside this clock that move the hands, or drive the clock would be these “fundamentals”. Although you can look at the clock and know what time it is, only by looking at the fundamentals can you truly understand how it became the time it is now. By knowing this, you might better understand the movement of time and be better able to predict what time it will be in the future. As a Forex investor you can better understand why the market is where it is today and where it might be tomorrow (or at a future point) based on studying these fundamentals.
Keep in mind that Fundamental analysis is a very effective resource to forecast economic conditions, but not exact currency prices. For example, you might get a clear understanding of the health of the US economy by studying an economist’s forecast of an upcoming Employment Cost Index (ECI), but how does that translate into entry and exit points? You need to develop a method that you use to decipher this raw data into usable entry and exit points based on your personal unique trading strategy. These methods are known as forecasting models. Forecasting models are like fingerprints – unique to every trader. Every trader may look at the exact same data, yet conclude completely different scenarios on how the market will react. It is important to analyze the fundamentals and apply your findings to your model.
Fundamentals for each currency might include, but not limited to; interest rates, central bank policy, political figures/events, unemployment/employment reports, and Gross Domestic Product (GDP). These economic indicators are snippets of financial and economic data published by various agencies of the government or private sectors for each country. These statistics, which are made public on a regularly scheduled basis, help market observers monitor the pulse of the economy. Therefore, almost everyone in the financial markets religiously follows them.
With so many people poised to react to the same information, economic indicators in general have tremendous potential to generate volume and to move prices in the markets. While on the surface it might seem that an advanced degree in economics would come in handy to analyze and then trade on the glut of information contained in these economic indicators, a few simple guidelines are all that is necessary to track, organize and make trading decisions based on the data.
The Business Cycle
Economic indicators are classified according to how they related to the business cycle. An economic indicator will do one of the following:
- Reflect the current state of the economy as coincident
- Predict future conditions are leading
- Confirm a turning occurred and conditions are lagging
The organization responsible for an indicator generally distributes its reports about an hour before the official release time to the financial news outlets (Reuters, CNBC, Dow Jones Newswires, Bloomberg).
The reporters, who are literally locked in a room and not permitted to have contact with anyone outside, ask questions of the agency officials and prepare headlines and analyses of the report contents. These stories are embargoed until the official release, at which time they are transmitted over the newswires to be dissected by the Wall Street community. Most Wall Street firms employ economists to provide live broadcasts of the numbers as they run across the newswires, together with interpretation and commentary regarding likely market reaction. This is known as the hoot and “holler” or tape reading. The more an indicator deviates from Street expectations, the greater its effect on the financial markets.
What is the Central Bank?
The central bank (also sometimes referred to as the reserve bank or monetary authority) is the entity responsible for the monetary policy of a country or of a group of member states. Its primary responsibility is to maintain the stability of the national currency and money supply, but more active duties include controlling subsidized-loan interest rates, and acting as a “bailout” lender of last resort to the banking sector during times of financial crisis. Most wealthy countries today have an “independent” central bank-that is, one which operates under rules designed to prevent political interference.
Central Bank Responsibilities
- Implementation of monetary policy
- Controls the nation’s money supply
- Acts as the government’s banker as well as the bankers’ bank (“lender of last resort”)
- Manages the country’s forex and gold reserves, as well as the government’s stock register
- Sets the official interest rate, used to manage both inflation and the country’s exchange rate
Why Study by Currency or Region?
In continuing your journey through the world of fundamental analysis, consider the approach taken when outlining the entire fundamental analysis section of this university; a strong emphasis on the US economy followed by a very close look at the following currencies – and the countries that impact their place in the market:
GBP – Great Britain Pound
JPY – Japanese Yen
EUR – European Dollar
CHF – Swiss Franc
NZD – New Zealand Dollar
AUD – Australian Dollar
CAD – Canadian Dollar
The key to understanding global economics can perhaps be found within the core economic indicators that drive market sentiment. Often, these indicators are not exclusive to the US economy. Many economic indicators are used by multiple countries, while others are specific only to certain economies. Most currency traders are aware of indicators key to the US, but even more traders probably haven’t the slightest clue or education concerning economic indicators specific to other economies. Such a view of fundamental analysis is tunnel vision at best.
A Global Economic Game Plan
The truth of the matter is that without a game plan attempting to master global economics would exhaust the most brilliant of minds. So, instead, look at it in the following manner: Every currency that you trade is paired with another currency for the purpose of establishing a comparative value. Consider it a battle of economies if you like, but however you choose to look at it, the point is that if trading the GBP/USD you had better know about not only the economic indicators that move the Dollar, but also of the key indicators that move the Pound. The dollar might be gathering strength across the board, but perhaps the Brits just released a Trade Balance report showing an increase in exports. As most economists know, increased exports tend to precede an increased demand for a nation’s currency.
The following is an excerpt from ‘FA1036 – Economics of the GBP’:
An increased number of exports translate to an increase in the demand for said nation’s currency, as other countries will be forced to exchange currency in order to purchase the exports. GDP (Gross Domestic Product) is also largely impacted by the trade balance, as an increase in the demand for exports will increase the work load of domestic factories, thus increasing employment levels.
The point is to have an eye on both of the economies, or currencies, that you are dealing in. A trader looking at only the economic indicators pertinent to the USD might have assumed that the Dollar would strengthen versus the Pound, as in our example it had been strengthening versus other currencies. But, given the announcement of increased exports in Britain, the dollar may in fact weaken versus the Pound simply as a result of the Pound’s reaction to the GBP Trade Balance report. Had a trader been focused solely on the US economy, and solely on US economic indicators, this key fact would have been overlooked.
Continuing Your Fundamental Analysis Education
As the Fundamental Analysis section of the university continues you will notice heavy emphasis is placed on the US economy. This is not an issue of pride, but rather is the case because of the position of the US economy globally; few can argue its place as an economic world super-power. Also, note that the Dollar is either the Base or the Cross currency in 7 major pairs:
USD/CHF ~ USD/JPY ~ EUR/USD ~ GBP/USD ~ USD/CAD ~ AUD/USD ~ NZD/USD
However, one should of course never focus on just the US economy. After a very close look at the USD the rest of fundamental analysis section of the university dissects (one course at a time) the economies that drive the currencies already listed above (GBP, JPY, EUR, CHF, NZD, AUD, CAD). Each currency has a very unique place in the global market, and moreover, each currency is impacted by various economic indicators. In the case of the EUR, many countries can potentially impact the standing of the EUR, meaning that traders should be aware of the economic indicators released by each of these nations.
Taken from ‘FA1038 – Economics of the EUR’ consider the below:
Listed in alphabetical order the Euro is the official currency of the following countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Slovenia and Spain – these countries comprise what is known as the Eurozone. The economic standing of any of the aforementioned countries can potentially impact the stability and price direction of the Euro.
Traders need to be aware of major economic indicators around the entire globe… no other approach to fundamental analysis is completely sound. That said; push forward with your study of fundamental analysis; begin with the US economy, and then take a look at economics of each currency or region as they are outlined in this university!
What type of Economic Data is Important?
Most major economies around the globe collect and measure very similar forms of economic data. Sifting through this data can be a bit daunting if you are not well prepared with an understanding of what to look for. Furthermore, traders need to understand which economic indicators carry the most weight, in terms of potential to impact the market. Many economic indicators are considered of lesser importance to the immediate price volatility of a currency. However, these same indicators pooled together can collectively make their mark.
In other words, one large indicator can in and of itself impact a currency’s value. On the flip side, one lower-end economic indicator is unlikely to impact the market alone. Unfortunately, many traders understand this concept without understanding the following: though one lower-end or less significant economic indicator is unlikely to in and of itself move the market, a group of smaller indicators can certainly impact a currency… given that their collective sentiment negatively or positively reflects a nation’s economy.
A serious fundamental trader will first and foremost monitor the numbers and data of every major economic indicator. As a secondary objective, the same fundamental analyst would note the correlation of smaller or lower-end economic indicators, i.e. in a given week is their collective data all negative or positive?
12 Major US Indicators
As a general guide, consider the following 12 US economic indicators of key importance to the value of the US dollar and the overall economic sentiment in the United States. Each indicator is further broken down and described as you continue your reading of further courses within this section of the university. Remember, various countries around the globe will use some of these same economic indicators, perhaps titled slightly differently, and of course will also have their own key indicators, or means of measuring economic data.
1. GDP (Gross Domestic Product)
2. Indices of Leading, Lagging, and Coincident Indicators
3. The Employment Situation
4. Industrial Production and Capacity Utilization
5. Institute for Supply Management Indices
6. Manufacturers’ Shipments, Inventories, and Orders
7. Manufacturing and Trade Inventories and Sales
8. New Residential Construction
9. Conference Board Consumers Confidence and University of Michigan Consumer Sentiment
10. Advance Monthly Sales for Retail Trade and Food Services
11. Personal Income and Outlays
12. Consumer and Producer Price Indices
Combination of Economics & Accounting
GDP is the broadest, most comprehensive barometer of a country’s overall economic condition. Sum of all the market values of all final goods and services produced in a country (domestically) during a specific period using that country’s resources, regardless of the ownership of the resources.
GDP is calculated and reported on a quarterly basis as part of the National Income and Product Accounts (NIPAs). NIPAs were developed and are maintained today by the Commerce Department’s Bureau of Economic Analysis (BEA). NIPAs are the most comprehensive set of data available regarding US national output, production, and the distribution of income. Each GDP report contains data on the following:
- personal income & consumption expenditures
- corporate profits
- national income
To calculate GDP, the BEA uses the aggregate expenditure equation:
C – is personal consumption expenditures
I – is gross private domestic investment
G – is government consumption expenditures & gross investment
X-M – is the net export value of goods and services (exports – imports
C (Personal Consumption Expenditures)
The total market value of household purchases during the accounting term, including items such as beer, telephone service, golf clubs, CDs, gasoline, musical instruments and taxicab rides.
These fall into 3 categories; durable goods, nondurable goods, and services.
- Durable goods have shelf lives of three or more years
– Non durable goods are food, clothing, energy products, and items like tobacco, cosmetics, prescription drugs, and magazines.
I (Gross Private Domestic Investment)
Spending by businesses, expenditures on residential housing and apartments, and inventories. Inventories are valued by the BEA at the prevailing market price.
G (Government Consumption Expenditures & Gross Investment)
All money laid out by federal, state and local governments for goods and services.
X-M (Net Exports of Goods & Services)
The difference between the dollar value of the goods and services sent abroad and those it takes in across its borders.
The GDP report is a mother lode of information about a nations economy. The GDP is released on a quarterly basis. One commonly used strategy is calculating the output gap of the GDP. The output gap is the difference between the economy’s actual and potential levels of production. This difference yields insight into important economic conditions, such as employment and inflation.
The economy’s potential output is the amount of goods and services it would produce if it utilized all its resources. Economists estimate the rate at which the economy can expand without sparking a rise in inflation. It is not an easy calculation, and it yields as many different answers as the economists who calculate it. Luckily, a widely accepted estimate of potential output is reported relatively frequently by the Congressional Budget Office (www.cbo.gov). This website has information about methodology, underlying assumptions in computing the trend level as well as a detailed historical data.
Index of Leading Economic Indicators
Compiled by the Conference Board and published in its monthly Business Cycle Indicators report. Released to public at 10:00 am ET four to five weeks after the end of the record month. http://www.conference-board.org has historical data and explanations of the methodology behind the indices.
Because the indices’ components are all released earlier than the indices themselves, the markets generally don’t react strongly to the indicator report.
(1) Nonfarm Payrolls: obtained from a survey of about 160,000 businesses, conducted by the Bureau of Labor Statistics.
(2) Personal Income Less Transfer Payments: Derived from the Personal Income and Outlays report, produced by the Bureau of Economic Analysis (BEA). The largest source is wages and salaries, transfer payments – government disbursements and food stamps.
(3) Total Industrial Production Index: published by the Federal Reserve and constructed of 295 components that are weighted according to the value they add during the production process.
(4) Manufacturing & Retail Trade Sales: Collected as part of the National Income and Product Accounts calculations. Found in the Manufacturing and Trade Inventories and Sales (MTIS) report published by the Department of Commerce.
Leading Economic Index
(1) Average weekly hours worked in manufacturing
(2) Average weekly initial claims for unemployment insurance
(3) Manufacturers’ new orders for consumer goods and materials
(4) Slower deliveries diffusion index of vendor performance
(5) Manufacturers’ new orders for nondefense capital goods
(6) Monthly building permits for new private housing
(7) Stock prices, 500 common stocks
(8) The M2 money supply (in 1996 dollars)
(9) The interest rate spread between the 10-year Treasury bond and the federal funds rate
(10) The Index of Consumer Expectations
The individual indicators composing the Leading Economic Index differ considerably in their abilities to predict economic turning points. Some are very far seeing, others relatively near sighted. The composite index combines in such a way that the whole is designed to outperform any of its parts.
Laggin Economic Index
(1) Average duration of unemployment
(2) Ratio of manufacturing and trade inventories to sales
(3) Manufacturing labor cost per unit of output
(4) Average prime rate
(5) Commercial and industrial loans outstanding
(6) Ratio of consumer installment credit to personal income
(7) Change in the consumer price index for services
The Lagging Economic Index follows downturns in the business cycles by about three months and expansions by about fifteen. This index was designed to confirm turning points in economic activity that were identified by the leading and coincident indices have actually occurred, thus preventing the transmission of false signals.
One of the most key economic indicators:
The most important economic indicator in terms of market and price impact is the monthly Employment Situation published by the Bureau of Labor Statistics (BLS). No other report has the potential to move the forex market like employment and no other indicator is more revealing of general economic conditions than the labor market data. Employment data is important because it reveals how firms, corporations, and others responsible for hiring decisions view the current and upcoming economic environment.
The monthly employment report is based on two separate surveys: the Current Population Survey (CPS), aka the household survey, and the Current Employment Statistics survey (CES), aka the establishment, or payrolls, survey. Supplemental to each release, the commissioner of the Bureau of Labor Statistics provides a statement to the Joint Economic Committee of the U.S. Congress. The statement, generally three pages long, highlights significant strengths and weaknesses in the monthly employment statistics.
Top billing on the employment report is generally shared by two figures; the unemployment rate and the monthly change in nonfarm payrolls. Average hourly earnings, hours worked, overtime hours worked and the monthly change in manufacturing jobs also command a great deal of traders attention.
The surveys include:
In the employment surveys, the BLS includes only persons older than sixteen. Excluded from surveys are people in mental or penal institutions and members of the armed forces. People qualify as employed in two ways. First are those who, during a given period, have worked as paid employees in someone else’s company or in their own businesses or on their own farms or have done fifteen hours or more of unpaid labor in a family-operated enterprise. Second are those with jobs or in businesses from which they have take temporary leave, paid or unpaid, because of illness, bad weather, vacation, child-care problems, labor disputes, maternity or paternity leave or other family or personal obligations.
Unemployed people are those not working during the period in question, whether because they voluntarily terminated their employment, in which case they are classified as job leavers, or because they were involuntarily laid off, making them job losers.
Strong relationships exist between the employment data and virtually every other indicator. The growth rate of non farm payrolls is generally strongly correlated with the growth rate of GDP, industrial production and capacity utilization, consumer confidence, spending, and income.
Central Banks of “The Majors”
Below is a list of central banks for several of the world’s major currencies:
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