acci retracementThis is a popular series based on mathematical ratios arising from natural and artiﬁcial phenomena. It is used to determine how far a price has rebounded or backtracked from its underlyingtrend. The most important retracement levels are 38.2%, 50% and 61.8%.27.2.2 Elliot WaveWith Elliot Wave, technicians classify price movements in patterned waves that can indicatefuture targets and reversals. Waves moving with the trend are called impulse waves, whereasthose moving against the trend are called corrective waves. The Elliot Wave theory actuallybreaks down impulse waves and corrective waves into ﬁve and three primary movements,respectively. The eight movements comprise a complete wave cycle. Time frames can rangefrom 15 minutes to decades.The challenging part of Elliot Wave theory is ﬁguring out the relativity of the wave structure.A corrective wave, for example, could be composed of subimpulsive and corrective waves. Itis, therefore, crucial to determine the role of a wave in relation to the greater wave structure.Thus, the key to Elliot Waves is to be able to identify the wave context in question. Followersalso use Fibonacci retracements to predict the tops and bottoms of future waves.
27.3 WHAT TO LOOK FOR1. Find the trend. Finding the prevailing trend will assist in becoming aware of the overallmarket direction and offer better visibility, especially when shorter term movements tendto clutter the picture. Weekly and monthly charts are most ideally suited for identifying thatlonger term trend. Once the overall trend has been identiﬁed, buy on the dips during risingtrends, and sell the rallies during downward trends.
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2. Support and resistance. These levels are points where a chart experiences recurring upwardor downward pressure. A support level is usually the low point in any chart pattern, whereasa resistance level is the high or the peak of the pattern. These points show a tendency toreappear. It is best to buy near support levels and sell near resistance levels that are unlikelyto be broken. Once these levels are broken, they tend to become the opposite obstacle. Forexample, in a rising market, a resistance level that is broken, could serve as a support forthe upward trend, while, in a falling market, once a support level is broken, it could turninto a resistance.3. Lines and channels. Trend lines are helpful tools in conﬁrming the direction of a markettrend. An upward straight line is drawn by connecting at least two successive lows, withthe second point higher than the ﬁrst. The continuation of the line helps to determine thepath along which the market will move. An upward trend is a concrete method by whichto identify support lines/levels. Conversely, downward lines are charted by connecting twopoints or more. A channel is deﬁned as the price path drawn by two parallel trend lines. Thelines serve as an upward, downward or straight corridor for the price. A familiar property ofa channel for a connecting point of a trend line is to lie between the two connecting pointsof its opposite line.4. Averages. Moving averages tell the average price in a given point of time over a deﬁnedperiod of time. However, a weakness of moving averages is that they lag the market, so theydo not necessarily signal a change in trends. To address this problem, the use of a shorterperiod, such as a 5- or 10-day moving average, would be more reﬂective of the recent priceaction than a 40- or 200-day moving average.
27.4 DRAWING LINESIt is easy to draw a chart by drawing a straight line joining two points, which usually meansjoining the high and the low of the day. In reading a chart, analysts will initially look fortrend lines, where an uptrend is identiﬁed as a higher high and higher low, day after day,and a downtrend is a lower high and lower low, day after day. Secondly, they will lookfor a consolidation pattern, where the chart is characterized by inconsistent highs and lows.Finally, they will look for support and resistance areas, which are valid for both uptrends anddowntrends (see Figure 27.1).A support is a line joining all the bottoms and resistance is a line joining all the tops.
27.5 HEAD-AND-SHOULDERS FORMATIONThe most signiﬁcant reversal formation is the head-and-shoulders formation, which can be atop head-and-shoulders or a bottom head-and-shoulders. Generally, this pattern is most oftenseen in uptrends. To have a head-and-shoulders formation, there has to ﬁve points, as shownin Figure 27.2.A rally to a top to form a left shoulder (point 1) followed by a correction (point 2), a secondrally to form the head (point 3), followed by a correction to somewhere at the same level ofpoint 2 to form point 4. This is then followed by a last rally to point 5 or the right shoulder.The height of the right shoulder should not be above the head. Once the right shoulder starts to
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Figure 27.1 Support and resistance lines. Reproduced by permission of 4CAST LimitedSource: 4castweb.com3
1
5
2
4
Figure 27.2 A head-and-shoulders formation
decline, the chartist will start to identify a head-and-shoulders formation. The ideal head-andshoulders formation has symmetry between the two shoulders and a near horizontal neckline.The neckline will be obtained by joining points 2 and 4.A head-and-shoulders formation tells the analyst that there is a major change in trend. Oncethe price levels break the neckline, the chartist will expect the price to move to an objectivedetermined by the distance from the top of the head to the neckline, measured from the breakof the neckline. Because this is such a major formation, one should expect the price to pullback towards the neckline, before resuming the new trend.
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The above formations can sometimes be inverted, and is typically seen in downtrends.What is noteworthy about the inverted head-and-shoulders is the volume aspect. Normally,the inverted left shoulder should be accompanied by an increase in volume. The inverted headshould be made on lighter volume. The rally from the head, however, should show greatervolume than the rally from the left shoulder.Ultimately, the inverted right shoulder should register the lightest volume of all. Finally,when the currency then rallies through the neckline, a large increase in volume should beseen.
27.6 FORMATION PATTERNS27.6.1 The symmetrical triangleAnother formation or pattern is a symmetrical triangle formation, which must have four reversals of minor trend, as there has to be two top points and two bottom points in order to draw thetwo straight lines forming the triangle. In fact, symmetrical triangles can be characterized asareas of indecision. A market pauses and future direction is questioned. Typically, the forcesof supply and demand at that moment are considered to be almost equal.Prices may break out of a symmetrical triangle either up or down. It is important to waituntil the breakout has started, as it is very difﬁcult to determine the direction in which thebreakout will occur. Once the breakout is conﬁrmed, the price movement is requested to havean objective equal to the height of the triangle measured from point 2 (Figure 27.3).
27.6.2 The descending triangleThis formation is also a variation of the symmetrical triangle. It is generally considered to bebearish and is usually found in downtrends. Unlike the ascending triangle, the bottom part ofthis triangle appears ﬂat. The top part triangle has a downward slant. Prices drop to a pointwhere they are oversold. Tentative buying comes in at the lows, and prices pick up. The higherprice, however, attracts more sellers and process retests the old lows. Buyers then once againtentatively re-enter the market. The better prices, however, again attract even more selling.
24
31
Figure 27.3 A symmetrical triangle formation
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2
4
31
Figure 27.4 A right-angle triangle formation
Thus, sellers are in control and push through the old lows, while the previous buyers rush todump their positions.27.6.3 The right-angle triangleTwo other formations of importance are a right-angle triangle, which can either be ascendingor descending and is, respectively, a bullish or bearish sign. The ascending right-angle triangleis shown in Figure 27.4. It is a variation on the symmetrical triangle. Ascending triangles aregenerally most reliable when found in an uptrend. The top part of the triangle appears ﬂat,while the bottom part of the triangle has an upward slant.27.6.4 The WedgeThe wedge formation is also similar to a symmetrical triangle in appearance, in that it hasconverging trend lines that come together at an apex. However, wedges are distinguished by anoticeable slant, either to the upside or to the downside. A falling wedge is generally consideredbullish and is usually found in uptrends. This pattern is marked by a series of lower tops andlower bottoms. On the other hand, a rising wedge is generally considered bearish and is usuallyfound in downtrends. They can also be found in uptrends, but would still generally be regardedas bearish. Rising wedges put in a series of higher tops and higher bottoms.27.6.5 The ChannelGenerally, channel formations should be considered as continuation patterns. They are indecision areas that are usually resolved in the direction of the trend and the trend lines run parallelin a rectangle. Supply and demand appears evenly balanced with buyers and sellers equallymatched. The same highs are constantly tested, as are the same lows. With this formation,volume does not seem to suffer as it might do with other patterns. However, like other chartformations, volume in the market should noticeably increase on a breakout.27.6.6 Flags and pennantsFlags and pennants are small consolidations in trend lines and appear to be ‘breathing spaces’before the trend continues. A ﬂag in an uptrend is shown in Figure 27.5.
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CB
A
Figure 27.5 Flags and pennants formation
Flags and pennants can be categorized as continuation patterns as they usually representonly brief pauses in a dynamic currency. They are typically seen immediately after a large,quick move. The currency then usually takes off again in the same direction. Past experiencehas shown that these formations are some of the most reliable continuation patterns. In general,lower tops and lower bottoms characterize bullish ﬂags, with the formation slanting againstthe trend. However, unlike wedges, their trend lines run parallel. On the other hand, bearishﬂags comprise higher tops and higher bottoms. The trend lines of bear ﬂags run parallel, butalso have a tendency to slope against the trend.
27.7 EXAMPLES‘Reaction/consolidation seen soon, but higher again to follow’4Cast M/T View – USD/JPY – Tuesday 24 September 2002 Recovery from 115 nearing strongerresistance, but clearance over the next 2–3 months now seen more likely. (Ref. rate 123.25)Over the past month USD has been rallying above 115.00, the bottom of the 2001 range. This isnow nearing an area of stronger resistance, and a reaction and consolidation of gains is thereforelikely over the next few weeks. However, the extent of the recovery, which has cut initial downtrends, suggests that a signiﬁcant low can already be in place. We would therefore now expectrenewed gains to follow into the latter half of the next 2–3 months, conﬁrmed above 126.00/127.00resistance. (See Figure 27.6.)While rates are still ﬁrm in a shorter-term up trend, resistance is now close at hand towards theupper end of previous congestion at 125.80/90, the June peak area. Just above is 126.36/77, theMarch and early May lows and the beginning of the December/May top. This is not seen clearedwithout more consolidation, but a breakup is now anticipated after this. Look then for a moveto 129.05, 9 May high. Above here would signal scope to challenge 132.38, 13 April high, and133.83, 1 April high. Beyond is the 135.00/15 January/February peak area, then 140.00 historiccongestion. (See Figure 27.7.)Meanwhile support during the expected consolidation phase is now at 120.86, 19 September low,ahead of 120.00/119.40, congestion and the 13 Sep low. If this holds, an earlier resumption of gainswill be in focus. More likely is a deeper reaction into the stronger congestion down to 116.80/26, 3
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Figure 27.6 Reproduced by permission of 4CAST LimitedSource: 4castweb.com
Figure 27.7 Reproduced by permission of 4CAST LimitedSource: 4castweb.comSeptember and 14 August lows. These should hold. Failure, not currently anticipated, would retest115.34, 16 July low. Clearance of this, now seen unlikely, would be needed to reinstate scopefor a longer downswing, targeting next 110.00, the top of the large 1999/2000 base. (Beneathis 105.00, the mid area; this is the maximum downside seen and should hold any test.) (SeeFigure 27.8.)In the next few weeks we expect the dollar’s rally to give way to a reaction and consolidationphase. However, a more extensive retracement of the 2000/02 gains below 115.00 is no longer
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Figure 27.8 Reproduced by permission of 4CAST LimitedSource: 4castweb.com
Figure 27.9 Reproduced by permission of 4CAST LimitedSource: 4castweb.comseen as likely. We rather expect higher support levels to hold, and be followed by renewed gainsinto the second half of the quarter. (See Figure 27.9.)
27.8 TECHNICAL INDICATORSBelow is the description of some of the most popular technical indicators used in the analysisof charts in the foreign exchange market today.
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27.8.1 Relative Strength IndexRSI is a momentum indicator, which measures a currency’s price relative to itself. It is pastperformance and is also front weighted. This means it gives a better velocity reading than otherindicators. RSI is also less affected by sharp rises or drops in a currency pair’s performance.The RSI absolute levels are 1 and 100. Traditionally, buy signals are triggered at 30 andsell signals are triggered at 70. However, today, many seasoned campaigners are using 20and 80 as the relevant buy and sell signals. In effect, the RSI is like a rubber band, in thatit can be stretched just so far. After a certain point, unless it breaks, the band is forced tocontract. It is also an indicator, which lends itself to trend lines, support and resistance lines anddivergence.27.8.2 Moving averageThis is one of the oldest and most useful of the technical indicators. In its simplest form, amoving average is the average price of a currency at a speciﬁc point in time. Hence, it showsa trend and the purpose is to show the trend in a smoothed fashion. A user will specify thetime span, with the most common time period being 10-, 30-, 50-, 100- and 200-day movingaverages. There really is not just one ‘right’ time frame. Each technician will have his or herown favourite. It should be noted that moving averages with different time spans will tell adifferent story, in that the shorter the time span, the more sensitive the moving average will beto price changes. The longer the time span, the less sensitive or the more smoothed the movingaverage will be.27.8.3 Bollinger bandsThese are envelopes which surround the price bars on a chart. They are plotted two standarddeviations away from a simple moving average. The envelopes are plotted at a ﬁxed percentageabove and below a moving average. Because the standard deviation is a measure of volatility,the Bollinger Bands adjust themselves to the market conditions. In fact, they widen duringvolatile market periods and contract during less volatile periods. Sometimes, Bollinger Bandsare displayed with a third line, which is the simple moving average line. The time period forthis moving average can vary, but it is recognized in the market as 10 days for short-termtrading, 20 days for intermediate term trading, and 50 days for longer term trading. Pleasenote, however, that Bollinger Bands do not generate buy and sell signals alone. In theory, theyshould be used in conjunction with RSI or MACD (see below).27.8.4 Moving Average Convergence DivergenceMACD is an oscillator, which is derived by dividing one moving average by another. With thecapabilities of modern computers, the moving averages are usually exponentially weighted,thus giving more weight to the more recent data. The MACD is plotted in a chart with ahorizontal equilibrium line. This line is quite important, because when the two moving averagescross below the equilibrium line, it implies that the shorter EMA is at a value less than thelonger EMA. This is a bearish signal. When the EMAs are above the equilibrium line, itimplies that the shorter EMA has a value greater than the longer EMA, and is thus a bullishsignal.
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27.8.5 StochasticsOscillator compares where a currency’s price has closed relative to its price range over aspeciﬁcally identiﬁed period of time. The theory is that in an upward trending market, pricestend to close near their high, while in a downward trending market, prices tend to close neartheir low. Also, as an upward trend matures, price tends to close further away from its high, andas a downward trend matures, price tends to close away from its low. This indicator attemptsto determine when prices start to cluster around their low of the day for an uptrending marketand when the trend to cluster around their high in a downtrending market. Thus, these are theconditions that indicate a trend reversal is starting to occur.
CONCLUDING REMARKSTechnical analysis is an art in which quasi-statistical techniques and formal statistics are usedto determine the existence and strength of trends in ﬁnancial time series and to identify turningpoints in these trends. It is concerned with the ‘when’ and the ‘how’ of trading foreign exchange.It determines the optimal timing for a position, and its conclusions about how long to stay in aparticular trade have signiﬁcant importance. The market loves to announce, ‘the trend is yourfriend’, but timing is everything.
Glossary of Terms for Chapters 24 to 27Activity Economic effect.Consumer Price Index rises Indicates rising inﬂation.Durable Goods Orders rises Pick up in business activity usually leads to increased creditdemand.Fed buys bills Fed permanently adds to banking system reserves, which may cause interestrates to drop.Fed does repurchase agreements Fed puts money into the banking system by purchasingcollateral and agreeing to resell later. This helps bring down rates.Fed does reverses of matched sales Fed takes money from the system by selling collateraland agreeing to repurchase them at a later date. This decrease in money supply generallyraises interest rates.Fed raises discount rate An increase in the borrowing rate for banks from the Fed usually results in increased rates for clients of banks. This action is used to slow creditexpansion.Gross National Product falls Reﬂects a slowing economy. Fed may loosen money supply,prompting a decline in interest rates.Housing Starts rises Shows growth in the economy and increased credit demand. Fed lessaccommodating and may attempt a tightening by allowing rates to rise.Industrial production falls Indicates slowing economic growth. Fed may be more accommodating in allowing interest rates to fall to stimulate the economy.Inventories up Indicates a slowing economy since sales are not keeping up with production.Leading indicators up Signals strength in the economy leading to greater creditdemand.Money supply increases Excess money supply growth potentially can cause inﬂation andgenerate fears the Fed may tighten money growth by allowing the Fed Funds rate to rise,which in turn, lowers futures prices.Oil prices fall Reduces upward pressure on interest rates, thereby enhancing prices of debtsecurities.Personal income rises The higher one’s income, the more is consumed, prompting increaseddemand and higher prices for consumer goods.Precious metal price falls Reﬂects decreased inﬂation. Demand for inﬂation hedgesabates.
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Producer Price Index rises Indicates rising inﬂation. Demand for goods rises as well asprices. Investors require higher rates, pushing rates up.Retail sales rises Indicates stronger economic growth. Fed may have to tighten.Unemployment rises Indicates slow economic growth. Fed may ease credit, causing ratesto drop.
28Final RemarksOn the foreign exchange markets, major currencies are traded like commodities. Althoughthere is no centralized exchange, individuals are linked to one another through sophisticatedcommunications and information systems. Trading occurs in the prominent ﬁnancial centres ofthe world, so that a foreign exchange market is active somewhere in the world every minute ofthe day. Hence it is a decentralized marketplace. The main players are corporations, individuals,major banks and central banks.Participants transact in foreign currency not only for immediate delivery (spot transactions)but also for settlement at speciﬁc times in the future (forward transactions). The marketparticipants on the other side of any trade must either have exactly opposite needs or be willingto take a speculative position. Typical transactions in the bank market range from $5 millionto $50 million plus, although banks will handle smaller sizes but generally at slightly lessfavourable prices.Besides the spot and forward markets, over the years, other markets have been developed thatare gaining acceptance. Foreign currency futures contracts, which provide an alternative tothe forward market, have been designed for a few major currencies. The advantages of thesecontracts are smaller contract size and the high degree of liquidity for small transactions. Thedisadvantages include the inﬂexibility of both standardized contract sizes and maturities andthe higher costs on large transactions. Options on both currency futures and spot currencyare also available and are growing in statue every day. Foreign currency swaps form anotherinstrument that is used to provide long-dated forward cover of foreign currency exposure,especially against the ﬂow of foreign currency debt.Participants in the foreign exchange market need to keep abreast of their fundamentalknowledge as well as learn how to use basic technical tools. Currency prices often reﬂectthe underlying strength or weakness of the country’s economy. For example, the strength ofthe dollar reﬂected the boom of the American economy over the past decade. If Americaneconomic growth is declining or is expected to decline, the expected return on Americanassets will fall, and the dollar may be pressured relative to other currencies. Also, a knowledgeof macroeconomic fundamentals is critical for trading any currency. For example, Japanhas suffered a no-growth economy for years and its nominal interest rates have hovered nearzero percent. A trader needs to know that a strong Japanese yen is not a solution to theseproblems. Thus, in periods where the yen strengthens, traders should be wary of an ofﬁcialpolicy response to drive the yen lower. Hence, if a currency is very strong, the trader needs toknow who is hurt and who is helped by that condition. A strong yen hurts the Japanese exporterwho has to sell to America, but it helps the American carmakers in competition with Japaneseexports.Also, any currency trader needs to develop a global perspective and a feel for intermarketrelationships. Interest rate trends are the most important external information source. If theAmerican Federal Reserve cuts rates, the dollar should weaken. However, if the EuropeanCentral Bank is expected to follow suit, interest rate trends will converge and the value of
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the currency may not change at all. A trader will need to follow not only the Chairman ofthe Federal Reserve, but also his counterparts in the European Central Bank and the Bank ofJapan.Currencies tend to be trendier than either stocks or commodities, and it is important tounderstand the trend from both a fundamental and a technical point of view. Currencies cannotreverse trends very easily because economies do not reverse quickly relative to one another.However, a successful trader will recognize how fundamentals and technicals combine toindicate a trend reversal. Of course, ﬁnding the trend reversal before it happens is the ‘HolyGrail’ of trading. No one can be expected to be successful all the time.
28.1 AND WHAT OF THE FUTURE?The foreign exchange trading market is changing dramatically with the arrival of electronictrading. Today’s electronic environment means that participants are looking for faster andtighter pricing with faster relevant news ﬂows than ever before. Also, market participants arelooking for trading platforms, which are Internet enabled, scalable across regions, reliableand safeguarded against crashes, and which can be integrated with various risk managementsystems. The future lies largely in the ability of market makers to deliver a better service totheir clients, whether it is offering transaction, deal capture, trade history facilities or riskmanagement capabilities. At the end of the day, it is all about the value chain and how it isdelivered to clients. Internet trading might be here to stay, but the foreign exchange marketshould not expect volumes to increase signiﬁcantly. At the end of the day, the foreign exchangemarket will always be a people-to-people marketplace.So, in conclusion, foreign exchange is both a science and an art. Risk can be quantiﬁedand alternatives identiﬁed to reduce or eliminate it. But judgement, personal attitudes towardsrisk, as well as other personal and corporate orientations, are required for consistent positionmanagement. I repeat again, proﬁt opportunities and potential loss are equal and opposite.
Indexabsolute prices, 147actual volatility, 89alternative markets, 3American style option, 79, 89, 91, 109American terms, 42, 44assignment, 109at-best orders, 133at-the-money, 88, 91, 109averages, 165, 172balance of payments, 151Bank of England (BoE), 158Bank of Japan (BoJ), 155, 178banks, 2, 25, 33, 85barriers, 107, 108bartering, 1, 7bear spread, 102, 109bid-buy price, 27, 33, 42, 50, 61big ﬁgures, 44, 129Black–Scholes model, 90Bollinger bands, 172break-even point, 109Bretton Woods, 9, 11broken date, 47, 59–60, 61brokered dealing, 44brokers, 2, 25, 28, 33bull spread, 101, 109butterﬂy, 102, 103, 109calendar spread, 109call option, 79, 95, 96, 109call ratio spread, 105cash, 61cash ﬂows, 75, 83cash management, 71cash settlement, 68, 113channel, 168charting, 149, 163Clearing Corporation, 109, 114
click ‘n’ deal, 138coffee houses, 1, 8coinage, 7collateral, 3, 113, 141combination, 109common monetary policy, 15condor, 104, 105, 109consolidation patterns, 165consumer price index (CPI), 152, 175contingent orders, 134contingent risk, 66, 83conversion arbitrage, 109convertibility, 9corrective waves, 164country risk, 46, 54, 93covered write, 109credit premium, 109credit risk, 46, 54, 80, 85, 93, 113cross rate, 44, 51cross-currency swap, 75cross-rate effect, 156, 158, 159, 160currency option, 3, 21, 35, 37, 79–93, 95–107, 177currency swap, 3, 21, 75–77, 177dealer, 33, 121dealing room, 121–123dealings, 129–131debit premium, 109default risk, 113delivery date, 92, 115delta, 87, 92, 109, 110descending triangle, 167direct dealing, 44direct terms, 42, 110discount, 47, 50, 61discount rate, 159, 175discretionary price order, 134Dow theory, 164downside protection, 110
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downtrend, 165durable goods orders, 152, 175economic data, 155, 156, 157, 158, 160, 177economic exposure, 37, 81Economic Planning Agency (EPA), 155economic reform, 14electronic trading, 137–139, 178Elliot Wave theory, 164end/end, 61European Central Bank (ECB), 13, 16, 157, 177European currency unit (ECU), 12European monetary system (EMS), 12, 15European monetary union (EMU), 13, 15European rate mechanism (ERM), 12, 16European style option, 79, 89, 90, 110European terms, 42exchange, 80, 110, 114exchange for physical (EFP), 117–118exercise, 79, 93, 110exercise rate, 79, 110expiration cycle, 110expiry date, 79, 92, 110ex-pit transaction, 117factual considerations, 147fair value, 110Fed funds rate, 159Federal Open Market Committee (FOMC), 159Federal Reserve Bank (Fed), 159, 177Fibanacci theory, 164ﬁll or kill order (FOK), 135Finex, 118, 139ﬁrm, 61ﬁscal policy, 148ﬁxed currency, 42ﬁxings, 19, 63ﬂags and pennants, 168ﬂoating exchange rate mechanism, 23for indication, 61foreign exchange, 1, 35foreign exchange dealings, 129–131foreign exchange exposure, 36, 83foreign exchange market, 1, 19, 20foreign exchange