estic ProductThe gross domestic product (GDP) is the total market value of all goods and services produced either by domestic or foreign companies within a country’s borders.GDP indicates the pace at which a country’s economy is growing (or shrinking)and is considered the broadest indicator of economic output and growth.GDPs of different countries may be compared (see Table 9.2) by converting their value in national currency according to either (a) exchange rates prevailing on international currency markets, or (b) the purchasing power parity(PPP) of each currency relative to a selected standard (usually the U.S. dollar).
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The relative ranking of countries may differ dramatically depending uponwhich approach is used: Using official exchange rates can routinely understatethe relative effective domestic purchasing power of the average producer or consumer within a less-developed economy by 50 to 60 percent, owing to the weakness of local currencies on world markets.
TABLE 9.2
Gross Domestic Product, PPP BasisPPP total USD(billions)
PPP/capitaUSD
Population2003 est.
1. European Union
10,840
28,600
379,000,000
2. USA
10,400
37,600
290,343,000
3. China
5,700
4,400
1,287,000,000
4. Japan
3,550
28,000
127,215,000
Rank Entity
5. India
2,660
2,540
1,049,701,000
6. Germany
2,180
26,600
82,399,000
7. France
1,540
25,700
60,181,000
8. United Kingdom
1,520
25,300
60,095,000
9. Italy
1,440
25,000
57,998,000
10. Russia
1,350
9,300
144,526,000
11. Brazil
1,340
7,600
182,032,000
12. South Korea
931
19,400
48,249,000
13. Canada
923
29,400
32,207,000
14. Mexico
900
9,000
104,908,000
15. Spain
828
20,700
40,218,000
16. Indonesia
663
3,100
234,894,000
17. Australia
528
27,000
19,732,000
18. Turkey
468
7,000
68,110,000
19. Iran
456
7,000
68,279,000
20. Netherlands
434
26,900
16,151,000
21. South Africa
432
10,000
42,769,000
22. Thailand
429
6,900
70,000,000
23. Taiwan
406
18,000
22,116,000
24. Argentina
391
10,200
38,000,000
25. Poland
368
9,500
38,000,000
Source: CIA World Factbook: PPP, PPP/Capita, Population
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However, comparison based on official exchange rates can offer a betterindication of a country’s purchasing power on the international market forgoods and services.
InterventionAnother important fundamental influence on FOREX currency prices is calledintervention. This occurs when an official regulatory agency or a financial institution with one government directly coerces the exchange rate of its currency,usually by reevaluation, devaluation, or by the manipulation of imports andexports in some way.Such actions may cause broad and erratic changes in the exchange ratewith foreign currencies. However, it is from such anomalies that the FOREXtrader may profit, if the proper stop-loss safeguards are in place.
Other Economic IndicatorsIndustrial ProductionIndustrial production (IP) is a chain-weighted measure of the change in the production of the nation’s factories, mines, and utilities, as well as a measure of theirindustrial capacity and how many available resources among factories, utilities,and mines are being used (commonly known as capacity utilization). The manufacturing sector accounts for one-quarter of the economy. The capacity utilization rate provides an estimate of how much factory capacity is in use.Purchasing Managers IndexThe National Association of Purchasing Managers (NAPM), now called theInstitute for Supply Management, releases a monthly composite index ofnational manufacturing conditions, constructed from data on new orders,production, supplier delivery times, backlogs, inventories, prices, employment,export orders, and import orders. It is divided into manufacturing and nonmanufacturing subindices.Producer Price IndexThe producer price index (PPI) is a measure of price changes in the manufacturing sector. It measures average changes in selling prices received by domesticproducers in the manufacturing, mining, agriculture, and electric utility industries for their output. The PPIs most often used for economic analysis are thosefor finished goods, intermediate goods, and crude goods.
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Consumer Price IndexThe consumer price index (CPI) is a measure of the average price level paid byurban consumers (80 percent of the population) for a fixed basket of goods andservices. It reports price changes in over 200 categories. The CPI also includesvarious user fees and taxes directly associated with the prices of specific goodsand services.Durable GoodsThe durable goods orders indicator measures new orders placed with domesticmanufacturers for immediate and future delivery of factory hard goods. Adurable good is defined as a good that lasts an extended period of time (overthree years) during which its services are extended.Employment Cost IndexPayroll employment is a measure of the number of jobs in more than 500industries in all 50 states and 255 metropolitan areas. The employment estimates are based on a survey of larger businesses and count the number of paidemployees working part-time or full-time in the nation’s business and government establishments.Retail SalesThe retail sales report is a measure of the total receipts of retail stores from samples representing all sizes and kinds of business in retail trade throughout thenation. It is the timeliest indicator of broad consumer spending patterns and isadjusted for normal seasonal variation, holidays, and trading-day differences.Retail sales include durable and nondurable merchandise sold, and services andexcise taxes incidental to the sale of merchandise. Excluded are sales taxes collected directly from the customer.Housing StartsThe housing starts report measures the number of residential units on whichconstruction is begun each month. A start in construction is defined as thebeginning of excavation of the foundation for the building and is comprised primarily of residential housing. Housing is very interest rate–sensitive and is oneof the first sectors to react to changes in interest rates. Significant reaction ofstarts/permits to changing interest rates signals that interest rates are nearing atrough or a peak. To analyze the data, focus on the percentage change in levelsfrom the previous month. The report is released around the middle of the following month.
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ForecastingFundamental analysis refers to the study of the core underlying elements thatinfluence the economy of a particular entity. It is a method of study that attemptsto predict price action and market trends by analyzing economic indicators, government policy, and societal factors (to name just a few elements) within a business cycle framework. If you think of the financial markets as a big clock, thefundamentals are the gears and springs that move the hands around the face.Anyone walking down the street can look at this clock and tell you what time itis now, but the fundamentalist can tell you how it came to be this time and moreimportantly, what time (or more precisely, what price) it will be in the future.There is a tendency to pigeonhole traders into two distinct schools of market analysis—fundamental and technical. Indeed, the first question posed toyou after you tell someone that you are a trader is generally “Are you a technician or a fundamentalist?” The reality is that it has become increasingly difficultto be a purist of either persuasion. Fundamentalists need to keep an eye on thevarious signals derived from the price action on charts, while few technicianscan afford to completely ignore impending economic data, critical politicaldecisions, or the myriad of societal issues that influence prices.Bearing in mind that the financial underpinnings of any country, tradingbloc, or multinational industry take into account many factors, including social,political, and economic influences, staying on top of an extremely fluid fundamental picture can be challenging. At the same time, you’ll find that yourknowledge and understanding of a dynamic global market will increase immeasurably as you delve further and further into the complexities and subtleties ofthe fundamentals of the markets.Fundamental analysis is a very effective way to forecast economic conditions, but not necessarily exact market prices. For example, when analyzing aneconomist’s forecast of the upcoming GDP or employment report, you begin toget a fairly clear picture of the general health of the economy and the forces atwork behind it. However, you’ll need to come up with a precise method as tohow best to translate this information into entry and exit points for a particulartrading strategy.A trader who studies the markets using fundamental analysis generally creates models to formulate a trading strategy. These models typically utilize a hostof empirical data and attempt to forecast market behavior and estimate futurevalues or prices by using past values of core economic indicators. These forecastsare then used to derive specific trades that best exploit this information.Forecasting models are as numerous and varied as the traders and marketbuffs that create them. Two people can look at the same data and come up withtwo completely different conclusions about how the market will be influencedby it. Therefore it is important that before casting yourself into a particular
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mold regarding any aspect of market analysis, you study the fundamentals andsee how they best fit your trading style and expectations.Do not succumb to “paralysis by analysis.” Given the multitude of factorsthat fall under the heading of “The Fundamentals,” there is a distinct danger ofinformation overload. Sometimes traders fall into this trap and are unable to pullthe trigger on a trade. This is one of the reasons why many traders turn to technical analysis. To some, technical analysis is seen as a way to transform all of thefundamental factors that influence the markets into one simple tool: prices. However, trading a particular market without knowing a great deal about the exactnature of its underlying elements is like fishing without bait. You might get luckyand snare a few on occasion, but it’s not the best approach over the long haul.For FOREX traders, the fundamentals are everything that makes a country tick. From interest rates and central bank policy to natural disasters, thefundamentals are a dynamic mix of distinct plans, erratic behaviors, and unforeseen events. Therefore, it is easier to get a handle on the most influentialcontributors to this diverse mix than it is to formulate a comprehensive list ofall the fundamentals.Economic indicators are snippets of financial and economic data published by various agencies of the government or private sector. These statistics,which are made public on a regularly scheduled basis, help market observersmonitor the pulse of the economy. Therefore, they are religiously followed byalmost everyone in the financial markets. With so many people poised to reactto the same information, economic indicators in general have tremendouspotential to generate volume and to move prices in the markets. While on thesurface it might seem that an advanced degree in economics would come inhandy to analyze and then trade on the glut of information contained in theseeconomic indicators, a few simple guidelines are all that is necessary to track,organize, and make trading decisions based on the data.Know exactly when each economic indicator is due to be released. Keep acalendar on your desk or trading station that contains the date and time wheneach statistic will be made public. You can find these calendars on the N.Y.Federal Reserve Bank Web site using this link: http://www.ny.frb.org/. Then searchfor “economic indicators.” The same information is also available from manyother sources on the Web or from the company you use to execute your trades.Keeping track of the calendar of economic indicators will also help youmake sense out of otherwise unanticipated price action in the market. Considerthis scenario: It’s Monday morning and the U.S. dollar has been in a tailspin forthree weeks. As such, it is safe to assume that many traders are holding largeshort USD positions. However, the employment data for the United States isdue to be released on Friday. It is very likely that with this key piece of economicinformation soon to be made public, the USD could experience a short-termrally leading up to the data on Friday as traders pare down their short positions.
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HOW TO BEAT THE MARKET (MAYBE)
The point here is that economic indicators can affect prices directly (followingtheir release to the public) or indirectly (as traders massage their positions inanticipation of the data).Understand which particular aspect of the economy is being revealed inthe data. For example, you should know which indicators measure the growthof the economy (GDP) versus those that measure inflation (PPI, CPI) oremployment (non-farm payrolls). After you follow the data for a while, you willbecome very familiar with the nuances of each economic indicator and whichpart of the economy it measures.Not all economic indicators are created equal. Well, they might havebeen created with equal importance but along the way, some have acquiredmuch greater potential to move the markets than others. Market participantswill place higher regard on one statistic versus another depending on the stateof the economy.Know which indicators the markets are keying on. For example, if prices(inflation) are not a crucial issue for a particular country, the markets will probably not as keenly anticipate or react to inflation data. However, if economicgrowth is a vexing problem, changes in employment data or GDP will be eagerlyanticipated and could precipitate tremendous volatility following its release.The data itself is not as important as whether or not it falls within marketexpectations. Besides knowing when all the data will hit the wires, it is vitallyimportant that you know what economists and other market pundits are forecasting for each indicator. For example, knowing the economic consequencesof an unexpected monthly rise of 0.3 percent in the producer price index (PPI)is not nearly as vital to your short-term trading decisions as it is to know thatthis month the market was looking for PPI to fall by 0.1 percent. As mentioned, you should know that PPI measures prices and that an unexpected risecould be a sign of inflation. But analyzing the longer-term ramifications of thisunexpected monthly rise in prices can wait until after you have taken advantage of the trading opportunities presented by the data. Once again, marketexpectations for all economic releases are published on various sources on theWeb and you should post these expectations on your calendar along withthe release date of the indicator.Do not get caught up in the headlines, however. Part of getting a handleon what the market is forecasting for various economic indicators is knowingthe key aspects of each indicator. While your macroeconomics professor mighthave drilled the significance of the unemployment rate into your head, evenjunior traders can tell you that the headline figure is for amateurs and that themost closely watched detail in the payroll data is the non-farm payrolls figure.Other economic indicators are similar in that the headline figure is not nearly asclosely watched as the finer points of the data. PPI, for example, measureschanges in producer prices. But the statistic most closely watched by the mar-
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kets is PPI, minus food and energy price changes. Traders know that the foodand energy component of the data is much too volatile and subject to revisionson a month-to-month basis to provide an accurate reading on the changes inproducer prices.Speaking of revisions, do not be too quick to pull that trigger should a particular economic indicator fall outside of market expectations. Contained ineach new economic indicator released to the public are revisions to previouslyreleased data. For example, if durable goods should rise by 0.5 percent in thecurrent month, while the market is anticipating them to fall, the unexpected risecould be the result of a downward revision to the prior month. Look at revisionsto older data because in this case, the previous month’s durable goods figuremight have been originally reported as a rise of 0.5 percent but now, along withthe new figures, it is being revised to indicate a rise of only 0.1 percent.Therefore, the unexpected rise in the current month is likely the result of adownward revision to the previous month’s data.Do not forget that there are two sides to a trade in the foreign exchangemarket. So, while you might have a handle on the complete package of economic indicators published in the United States or Europe, most other countries also publish similar economic data. The important thing to remember hereis that not all countries are as efficient as the G8 in releasing this information.Once again, if you are going to trade the currency of a particular country, youneed to find out the particulars about that country’s economic indicators. Asmentioned earlier, not all of these indicators carry the same weight in the markets and not all of them are as accurate as others. Do your homework so youwon’t be caught off guard.When it comes to focusing exclusively on the impact that economic indicators have on price action in a particular market, the foreign exchange marketsare the most challenging. Therefore, they have the greatest potential for profitsof any market. Obviously, factors other than economic indicators move pricesand as such make other markets more or less potentially profitable. But since acurrency is a proxy for the country it represents, the economic health of thatcountry is priced into the currency. One very important way to measure thehealth of an economy is through economic indicators. The challenge comes indiligently keeping track of the nuts and bolts of each country’s particular economic information package. Here are a few general comments about economicindicators and some of the more closely watched data.Most economic indicators can be divided into leading and lagging indicators. Leading indicators are economic factors that change before the economy starts to follow a particular pattern or trend. Leading indicators are usedto predict changes in the economy. Lagging indicators are economic factorsthat change after the economy has already begun to follow a particular patternor trend.
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The problem with fundamental analysis is that it is difficult to convert the“qualitative” information into a specific price prediction. With FOREX leveragebeing what it is, it is seldom enough to know that a report is “bullish” for a currency without being able to attach specific values.Even if you opt for a technical analysis trading approach, as most tradersdo, do not completely ignore the fundamentals. Use a new service to do a dailytake on what’s happening. Remember: Be aware of pending reports, statisticalreleases, and so on, as they often will cause a violent market reaction one way orthe other.The authors consulted numerous sources while compiling the current chapter. We wish to acknowledge specifically http://www.sbfx.net/fundamental_analysis.aspx for their informative Web site. Fundamental analysis is a very deep well. Itis important to understand the basic fundamentals that drive currency prices,even though most traders use technical analysis to make specific day-to-daytrading decisions.
10Chapter
Technical Analysis
OverviewProbably the most successful and most utilized means of making decisions andanalyzing FOREX markets is technical analysis. The difference between technical and fundamental analyses is that technical analysis ignores fundamentalfactors and is applied only to the price action of the market. While fundamental data can often provide only a long-term forecast of exchange rate movements, technical analysis has become the primary tool to successfully analyzeand trade shorter-term price movements, as well as to set profit targets andstop-loss safeguards because of its ability to generate price-specific informationand forecasts.Historically, technical analysis in the futures markets has focused on thesix price fields available during any given period of time: open, high, low, close,volume, and open interest. Since the FOREX market has no central exchange, itis very difficult to estimate the latter two fields, volume and open interest. Inthis chapter, we therefore limit our analysis to the first four price fields.Technical analysis consists primarily of a variety of technical studies,each of which can be interpreted to predict market direction or to generatebuy and sell signals. Many technical studies share one common importanttool: a price-time chart that emphasizes selected characteristics in the pricemotion of the underlying security. One great advantage of technical analysisis its “visualness.”87
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Bar ChartsBar charts are the most widely used type of chart in security market technicalanalysis and date back to the last decade of the nineteenth century. They arepopular because they are easy to construct and understand. These charts are constructed by representing intra-day, daily, weekly, or monthly activity as a verticalbar. Opening and closing prices are represented by horizontal marks to the leftand right of the vertical bar respectively. Spotting both patterns and the trend ofa market, two of the essentials of chart reading, is often easiest using bar charts.Bar charts present the data individually, without linking prices to neighboringprices. Each set of price fields is a single “island.”Each vertical bar has the components shown in Figure 10.1.Figure 10.2 shows a daily bar chart for the EUR/USD currency pair forthe month of June 2003. The vertical scale on the right represents the cost ofone Euro in terms of U.S. dollars. The horizontal legend at the bottom of thechart represents the day of week.A common method of classifying the vertical bars is to show the relationships between the opening and closing prices within a single time interval, asseen in Figure 10.3.Graphically, an open/high/low/close (OHLC) bar chart is defined usingthe following algorithm:OHLC Bar Chart Algorithm
• Step 1—One vertical rectangle whose upper boundary represents thehigh for the day and whose lower boundary represents the low for thegiven time period.• Step 2—One horizontal rectangle to the left of the high-low rectanglewhose central value represents the opening price for the given period.• Step 3—One horizontal rectangle to the right of the high-low rectanglewhose central value represents the closing price for the given period.
HighCloseOpenLow
FIGURE 10.1
Anatomy of single vertical bar.
Technical Analysis
FIGURE 10.2
89
Vertical bar chart.
One interesting variation to the standard OHLC bar chart was developedby author/trader Burton Pugh is the 1930s. His model involved connecting theprevious set of quotes to the current set of quotes, which generates a continuousline representation of price movements. There are four basic formationsbetween two adjacent vertical bars in Burton’s system. (see Figure 10.4)Bar chart interpretation is one of the most fascinating and well-studied topics in the realm of technical analysis. Recurring bar chart formations have beenlabeled, categorized, and analyzed in detail. Common formations like tops, bottoms, head-and-shoulders, inverted head-and-shoulders, lines of support andresistance, reversals, and so forth, are examined in the following sections.
Close
Open
Open
CloseBull Bar
FIGURE 10.3
Anatomy of bull and bear bars.
Bear Bar
HOW TO BEAT THE MARKET (MAYBE)
90A
B
A
BullHigher Highs, Higher Lows
A
B
FIGURE 10.4
BearLower Highs, Lower Lows
A
OutsideHigher Highs, Lower Lows
B
B
InsideLower Highs, Higher Lows
Continuous line bar chart.
Trend LinesA trend can be up, down, or lateral and is represented by drawing a straight lineabove the daily highs in a downward trend and a straight line below the dailylows in an upward trend. See Figure 10.5A common trading technique involves the intersection of the trend linewith the most recent prices. If the trend line for a downward trend crosses
Trend lineTrend line
Trend line
FIGURE 10.5
Bar chart with trend lines.
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91
through the most recent prices, a buy signal is generated. Conversely, if thetrend line for an upward trend passes through the most recent prices, then a sellsignal is generated.
Support and ResistanceSupport levels indicate the price at which most traders feel that prices will movehigher. There is sufficient demand for a security to cause a halt in a downwardtrend and turn the trend up. You can spot support levels on the bar charts bylooking for a sequence of daily lows that fluctuate only slightly along a horizontal line. When a support level is penetrated (the price drops below the supportlevel) it often becomes a resistance level; this is because traders want to limittheir losses and will sell later, when prices approach the former level.Like support levels, resistance levels are horizontal lines on the bar chart.They mark the upper level for trading, or a price at which sellers typically outnumber buyers. When resistance levels are broken, the price moves above theresistance level, and often does so decisively. See Figure 10.6.Many traders find lines of support and resistance useful in determiningthe placement of stop-loss and take-profit limit orders.
Recognizing Chart PatternsProper identification of an ongoing trend can be a tremendous asset to the trader.However, the trader must also learn to recognize recurring chart patterns thatdisrupt the continuity of trend lines. Broadly speaking, these chart patterns canbe categorized as reversal patterns and continuation patterns.
Resistance
Support
FIGURE 10.6
Bar chart with support and resistance lines.
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Reversal PatternsReversal patterns are important because they inform the trader that a marketentry point is unfolding or that it may be time to liquidate an open position.Figures 10.7 through 10.10 illustrate the most common reversal patterns.
FIGURE 10.7
Double top.
FIGURE 10.8
Double bottom.
HeadRight Shoulder
Left Shoulder
Neckline
FIGURE 10.9
Head-and-shoulders top.
Technical Analysis
FIGURE 10.10
93
Head-and-shoulders bottom.
Continuation PatternsA continuation pattern implies that while a visible trend was in progress, it wastemporarily interrupted, and then continued in the direction of the originaltrend. The most common continuation patterns are shown in Figure 10.11through 10.15.The proper identification of a continuation pattern may prevent the traderfrom prematurely liquidating an open position that still has profit potential.
FIGURE 10.11
Flag or pennant.
FIGURE 10.12
Symmetrical triangle.
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FIGURE 10.13
Ascending triangle.
FIGURE 10.14
Descending triangle.
FIGURE 10.15
Rectangle.
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95
GapsA gap occurs when the trading range on a given day lies outside the trading rangeof the previous day. Often the result of an emotional response to overnight news,a gap can be an indication of a new price trend. See Figures 10.16.through 10.19.The authors’ research indicates that gaps are of special importance inFOREX.
FIGURE 10.16
Breakaway gap.
FIGURE 10.17
Runaway gap.
FIGURE 10.18
Exhaustion gap.
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FIGURE 10.19
HOW TO BEAT THE MARKET (MAYBE)
Island reversal gap.
Candlestick ChartsCandlestick charting is usually credited to the Japanese rice trader MunehisaHomma in the early eighteenth century, though many references indicate thatthis method of technical analysis probably existed as early as the 1600s. StevenNison of Merrill Lynch is credited with popularizing candlestick charting inWestern markets and has become recognized as the leading expert on their interpretation. See Figure 10.20.
FIGURE 10.20
Candlestick chart.
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97
The candlestick is the graphic representation of the price bar: the open,high, low, and closing price of the period. The algorithm to construct a candlestick chart follows:Candlestick Chart Algorithm
• Step 1—The candlestick is made up of a body and two shadows.• Step 2—The body is depicted as a vertical column bounded by theopening price and the closing price.• Step 3—The shadows are just vertical lines—a line above the body tothe high of the day (the upper shadow) and a line below the body tothe low of the day (the lower shadow).• Step 4—It is customary for the body to be empty if the close washigher than the open (a bull day) and filled if the close was lower thanthe open (a bear day).
The elements of a candlestick bar are shown in Figure 10.21.The nomenclature used to identify individual or consecutive combinations of candlesticks is rich in imagery: Hammer, hanging man, dark cloudcover, morning star, three black crows, three mountains, three advanced whitesoldiers, and spinning tops are only a few of the candlestick patterns that havebeen categorized and used in technical analysis.
HighUpper shadowClose
Close
Real body
Open
Open
Lower shadowLow
FIGURE 10.21
Anatomy of candlestick bar.
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A thorough description of how to interpret candlestick charts is given inSteven Nison’s books: Japanese Candlestick Charting Techniques, Hall, 1991, andBeyond Candlesticks: More Japanese Charting Techniques Revealed, Wiley, 1994. Asummary of the different candlestick patterns can also be found at www.hotcandle.com/candle.htm.
Point and Figure ChartsThe modern point and figure (P&F) chart was created in the late nineteenthcentury and is roughly 15 years older than the standard OHLC bar chart. Thistechnique, also called the three-box reversal method, is probably the oldestWestern method of charting prices still around today.Its roots date back into trading lore, as it has been intimated that thismethod was successfully used by the legendary trader James R. Keene during themerger of U.S. Steel in 1901. Mr. Keene was employed by Andrew Carnegie todistribute the company shares, as Carnegie refused to take stock as payment forhis equity interest in the company. Keene, using point and figure charting andtape readings, managed to promote the stock and get rid of Carnegie’s sizeablestake without causing the price to crash. This simple method of charting hasstood the test of time and requires less time to construct and maintain than thetraditional bar chart. See Figure 10.22.The point and figure method derives its name from the fact that price isrecorded using figures (Xs and O s) to represent a point, hence the name “Point
FIGURE 10.22
Point and figure chart.
Technical Analysis
Upward Trends
XXOXXO XOXO XO
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One Box Size
XOXStarting Point
FIGURE 10.23
Downward Trends
Anatomy of point and figure columns.
and Figure.” Charles Dow, the original founder of the Wall Street Journal andthe inventor of stock indexes, was rumored to be a point and figure user. Indeed,the practice of point and figure charting is alive and well today on the floor of allfutures exchanges. The method’s simplicity in identifying price trends and support and resistance levels, as well as its ease of upkeep, has allowed it to endurethe test of time, even in the age of Web pages, personal computers, and theinformation explosion.The elements of the point and figure anatomy are shown on Figure 10.23.Two user-defined variables are required to plot a