in terms of total flows at any one time.Generalizing somewhat, one can say that speculative flows dominate short-term exchangerate moves, while non-speculative flows that are attracted by long-term fundamental shifts inthe economy dominate long-term exchange rate moves. This is a nice, cozy definition of thedynamics affecting exchange rates, however there is a problem. Financial bubbles are seenas essentially speculative creations, yet they are generated not by short-term exchange rate orasset market moves but by long-term and increasingly self-perpetuating shifts. The essentiallesson behind this is that it is in fact exceptionally difficult to differentiate the speculative fromthe non-speculative. It is easier to focus on the incentive rather than the result. The primaryincentive behind speculative flow, using our definition of speculation, is that it is mainly drivenby the exchange rate not the interest rate. If it were the latter, neither the Japanese yen northe Swiss franc would ever have risen. Yet, since the 1971–1973 break-up of the BrettonWoods exchange rate system, both have trended higher against the US dollar (and most othercurrencies). Expectations about the exchange rate are the primary motive and incentive behindspeculative capital flow. This is a lesson that many economists have yet to learn, largely becausemany of their theoretical ideas of how exchange rates should behave do not work in practice.Perception and outcome are intrinsically linked in the currency markets; they are both causeand effect. This creates a self-fulfilling and self-reinforcing phenomenon, which becomes morespeculative the longer it lasts, until it becomes unsustainable and the bubble bursts.Free floating exchange rates tend to trade and trend in cycles, and flows are both cause andeffect in this regard. Such currency cycles are not of necessity timed with the economic cycle.It depends why they start. After the bubble bursts, there is usually a period of consolidationand reversal; the longer the initial trend or cycle, the longer in turn the reversal. Thus, we sawa weakening trend for the US dollar in the 1970s, followed by a strengthening in the early1980s, followed by renewed weakening from 1985 to 1987, which again was reversed towardsthe end of that decade. The 1990s saw a similar pattern, with the US dollar weak from 1991 to1995, which was followed by a broad strengthening trend that has lasted from 1995 through2001. This suggests that at some point the US dollar strength cycle will end and be reversed.Trying to determine the top is for the most part impossible. It is more important to be able tounderstand the cyclical nature of the currency markets and to be able to plan accordingly aheadof that cycle ending. To prove the point, towards the end of 2001 the US dollar was continuingto strengthen despite the fact that the Fed funds’ target interest rate was at 1.75%, while theEuropean Central Bank’s repo rate was at 3.25%. Nominal interest rates are not the primary
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incentive for speculative capital flow, never have been and never will be. The exchange rateitself is the incentive. This is an important realization.
3.3 SUMMARYIn this chapter, we have attempted to examine how “flows” interact with price action. Theassumption of the efficient market hypothesis is that flows cannot affect price because ofperfect information availability, yet as we have seen this assumption is clearly and manifestlywrong. Testimony to that fact is the subsequent growth of and interest in flow analysis, whetherof the short-term kind as practiced by commercial and investment banks in looking at theirown client flows, or of a more medium-term kind in the form of the US or Euro area capitalflow reports. Just as flow analysis has become relatively sophisticated in analysing developedmarket exchange rate flow, so it is increasingly becoming so within the emerging markets. Atthis stage, data availability is the only thing holding it back, but this barrier will also fall intime. In sum, flow analysis is a very important and useful tool for currency market practitionersin the making of their currency investment or exposure decisions. The tracking of capital flowsof necessity involves looking for apparent patterns in flow movement. Linked in with this ideais the discipline of tracking patterns in price. This discipline is that of technical analysis, whichwe shall look at in the next chapter.
4Technical Analysis: The Art of ChartingTechnical analysis has much in common with the major principles at work in flow analysis.Both focus on behavioural patterns within financial markets. Both claim that market behaviourcan indeed impact future prices. In addition, both reflect a belief that markets must move andtraders must trade irrespective of whether or not there are changes in economic fundamentals.In this sense, if flow and technical analysis did not exist, they would have to be invented.Demand will eventually result in supply!In this chapter, we take a look at the core ideas behind the fascinating and controversial fieldof technical analysis, its origins, how it works and its main analytical building blocks. For thoselooking to study this field in more depth, I provide useful references in the footnotes. Whereasflow analysis focuses on price trends that are created by order flow, technical analysis focuseson price patterns within those trends. Technical analysis remains a controversial subject formany people. Despite such controversy, its origins are rooted in mathematics and it has beenaround in one form or another for a very long time indeed.
4.1 ORIGINS AND BASIC CONCEPTSAt least in its modern version, technical analysis is generally seen as emanating from the“Dow Theory” established by Charles Dow at the start of the twentieth century. The coreoriginal ideas of technical analysis focused on the trending nature of prices, the idea of supportand resistance and the concept of volume mirroring changes in price. Though we only touchon it here, the contribution of Charles Dow to modern-day technical analysis should not beunderestimated. His focus on the basics of security price movement helped to give rise to acompletely new method of analysing financial markets in general.The basic premise behind this is that the price of a security represents a consensus. At theindividual level, it is the price at which one person is willing to buy and another to sell. Atthe market level, it is the price at which the sum of market participants is willing to transact.The willingness to buy or sell depends on the price expectations of individual market participants. Because human expectations are relatively unpredictable, so the same must be said fortheir price expectations. If we were all totally logical and could separate our emotions fromour investment decisions, one should assume that classic fundamental analysis would be abetter predictor of future prices than it currently is. Prices would only reflect fundamentalvaluations. The fact that this is not the case suggests that other forces may be at work. Indeed,investor expectations also play a part, both at the individual level and also as a group.Technical analysis is the process of analysing a currency or financial security’s historicalprice in an attempt to determine its future price direction. It is founded in the belief that there areconsistent patterns within price action, which in turn have predictable results in terms of futureprice action. In contrast to economics, technical analysis requires that financial markets arenot perfectly efficient, that there is no such thing as perfect knowledge or perfect informationavailability or usage, and also that in the absence of other information market participants
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will look to past price action as a determinant of future prices. For precisely this reason, theeconomics profession generally has dismissed technical analysis as irrational. However, justas we have already seen that financial markets are not perfectly efficient, so substantial researchhas shown conclusively both that technical analysis is widely practiced by market participantsand perhaps more importantly that it has yielded substantially positive results. Traders who haveused technical analysis have frequently made consistently high excess returns. Furthermore,in the context of the currency markets, technical analysis has a particularly good track recordin predicting short-term exchange rate moves. How can this be so? Simply put, nature abhorsa vacuum and thus in the vacuum left by classic economic analysis, in its inability to predictexchange rates over the short term, came technical analysis.
4.2 THE CHALLENGE OF TECHNICAL ANALYSISTechnical analysis has posed a challenge to economic analysis in its ability to predict exchangerates. As a result, considerable research has been undertaken by the economic community onhow technical analysis works, both in practice and in theory. It is not for here to go through thisresearch or literature in detail. Rather, we look at one such study as symptomatic of a generalenquiry by the economics profession into the workings of technical analysis. More specifically,no less than the Federal Reserve undertook to examine this phenomenon, apparent confirmationof an ongoing change in the way both private and public institutions are approaching the field oftechnical analysis. Indeed, the reader can find no more useful and detailed investigation of thesubject matter, starting from a macroeconomic perspective, than two reports by Carol L. Osler ofthe Federal Reserve Bank of New York, which examine how technical analysis is able to predictexchange rates.1 These papers go a substantial way in explaining how technical analysis worksand are particularly useful as they undertake this investigation from an economic perspective.In line with work done on studying order flow, which we looked at in Chapter 3, they suggestcustomer orders “cluster” around certain price levels and that such “clustering” creates specificprice patterns depending on whether or not those levels hold. To a technician, this makes perfectsense given that a price represents the consensus of market supply and demand at any one time.Below the price, there should be “support” levels at which demand is expected to exceed supplyand conversely above the price there may be “resistance” levels, where supply may exceeddemand. From my perspective, I would suggest the following reasons why technical analysishas gradually taken on a more prominent and important role in predicting exchange rates:
r Over the short term, the currency market is essentially trend following.r The majority of market participants are speculative, that is they undertake currency transactions that have no underlying trade or investment transaction behind them.
r Nature abhors a vacuum – currency market participants have to trade off something whetheror not there has been any change in macroeconomic fundamentals.
r Traditional exchange rate models have had relatively poor results, therefore another analytical discipline was needed that was able to achieve better results.
r Exchange rate supply and demand create price patterns, which in the absence of otherstimulus may provide clues for future exchange rate moves.1Carol L. Osler, Currency Orders and Exchange Rate Dynamics: Explaining the Success of Technical Analysis, Federal ReserveBank of NewYork Staff Report No. 125, April 2001; “Support for resistance: technical analysis and intraday exchange rates”, EconomicPolicy Review, 6(2) (July 2000).
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There does appear to be a crucial self-fulfilling aspect to technical analysis, which is tosay that because a large number of people see a particular price level as important, thereforede facto it becomes important. Needless to say, this is an aspect that critics of technical analysisregularly seize on. While this may be the case to an extent, it does not answer the obviousquestion of why such a number of people find those levels important in the first place. Technicalanalysis is the discovery of patterns within price action, patterns, which can be used to predictfuture prices. The predictive results of technical analysis consistently exceed those suggestedby a random walk theory.2 Indeed, such have been the results achieved that there is now asizeable and ever growing community of traders and leveraged funds that trade solely onthe back of technical analysis signals. In short, technical analysis “works” to the extent thatit produces results consistently for market participants who are trying to predict short-termexchange rate moves. If this is the case, what precisely is technical analysis and how can oneuse it?
4.3 THE ART OF CHARTINGTechnical analysis is founded on the principle of “charting”, which relates to creating chartsto reflect price patterns. Once again, this is best explained by the use of a chart. In Figure 4.1,we are looking at the Euro–dollar exchange rate from April 1998 to October 2001. At thismost basic stage, there are few clear patterns, apart from the one dominant pattern, which isthat the Euro has been in a downtrend for some time! Clearly, in order to try and interpret thischart, we have to have a set of tools at our disposal, which provide some degree of unbiased,objective analysis as to likely trends and direction. To start this off, we look at the two mostimportant building blocks of technical analysis:
r Supportr Resistance
4.3.1 Currency Order Dynamics and Technical LevelsSceptics may suggest that support or resistance levels can just as easily be randomly picked.The evidence however does not support such scepticism. Indeed, on the contrary, both academicand institutional research suggests exchange rate trends are interrupted or reversed at publishedsupport and resistance levels much more frequently than is the case at randomly picked levels.Such levels are therefore seen as statistically important, most likely because of the clusteringeffect mentioned earlier. Customer orders are placed just above or just below previous highsor lows. As a result, this clustering can have the effect either of pausing or accelerating theshort-term price trend at any one time. This link between capital flows and technical chartlevels can be expressed in the following way:
r “Support” reflects a concentration of demand sufficient to pause the prevailing trendr “Resistance” equally reflects a similar concentration of supply
2While there are a number of studies on the results achieved through technical analysis, readers may find particularly useful thatdone by Richard M. Levich and Lee R. Thomas, “The significance of technical trading-rule profits in the foreign exchange market:a bootstrap approach”, as published in the Journal of International Money and Finance, October 1993 and also in Andrew W. Gitlin(editor), Strategic Currency Investing: Trading and Hedging in the Foreign Exchange Market, Probus Publishing Company, 1993.
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Figure 4.1 Example of a chartSource: Reuters. Copyright Reuters Limited, 1999, 2002.
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However, this clustering effect on prices can be further broken down into two specific typesof customer order:
r Take profitr Stop loss
There are important differences in the way that these two specific types of customer ordertend to cluster. For instance, take profit orders tend to cluster in front of important support orresistance levels and thus tend to have the habit of causing the trend to reverse – thus reinforcingthat support or resistance – if they are sufficient in number. By contrast, stop loss orders tend tobe clustered behind important support or resistance levels, thus accelerating and intensifyingthe prevailing trend if triggered. Academic research has found that take profit and stop losscustomer orders, which impose some degree of conditionality on the order, can make upbetween 10 and 15% of total order flow. As a result, they can have an important effect on tradingconditions and therefore on price patterns. During calm market conditions, they can furtherrestrict price action. Conversely, during volatile market conditions, they can exacerbate pricevolatility when such orders are triggered. Thus, both in calm and volatile market conditions,they re-emphasize the original importance of the support and resistance levels.So far, we have been looking at “spot” foreign exchange orders, that is conditional customerorders to be executed for spot (T + 2) delivery. However, conditional orders left in the optionsmarket can also impact spot currency price action. More specifically, “knock-in” and “knockout” levels for exotic options, allowing a client to be knocked-in to the underlying structure orconversely knocked-out of it, can and do trigger specific spot currency price activity. Knock-inand knock-out levels are usually chosen based on previously important highs and lows. In otherwords, they are chosen based on technical support or resistance levels. As a result, there canbe – and frequently is – both spot and option customer order clustering around such levels,further impacting price action.It is not only customers that place conditional orders in the market. In order to limit a bank’sbalance sheet exposure to overnight price swings in exchange rates, interbank dealers eitherclose out their positions at the end of the day or alternatively themselves leave take profit orstop loss orders with their dealing counterparts within the bank in the next time zone. Thus,a dealer in Singapore may pass on their customers’ conditional orders as well as their own toLondon and London may in turn pass on such orders to New York and so on round the timezones, either until such orders are filled or conversely are cancelled. If there is a self-fulfillingaspect to this whole idea, it concerns therefore the very microstructure of the currency marketitself. Broadly speaking, currency interbank dealers follow technical analysis more closelythan the customer base of the bank, in part because they have a much shorter time frame thantheir customers and in part because they have to trade in order to make a living irrespective ofwhether or not there have been changes in economic fundamentals. Currency interbank dealersand short-term traders follow technical analysis, and because they make up the majority ofcurrency market participants the levels and types of analysis that they follow automaticallybecome important. Thus, structural aspects within the currency market may help explain tosome degree the success of technical analysis. What it does not explain however is the superiordegree of that success relative to classic economic analysis or alternatively to random walktheory in predicting short-term exchange rate moves. Given that take profit orders cause pricetrends to pause, while stop loss orders extend such trends, the logical conclusion is that thebalance between such orders in the market place is an important real-time determinant ofexchange rates.
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4.3.2 The Study of TrendsAt its heart, technical analysis represents the study of price trends (or anticipated trends). Inprice terms, at their most basic, these can be divided into uptrends and downtrends. Within suchtrends, we see points where little price action occurs and conversely other points reflectingsubstantial price action and market tension. The idea behind support and resistance is that ifthe price action fails to exceed a certain level, then that level becomes important. Thus, if aprice fails to exceed a high and falls back, we call that high a resistance. Equally, if the priceaction fails to get below a low price level, then that low price level becomes support. Pricetrends reflecting a number of support and resistance levels are reflected by trend-lines (seeFigure 4.2).Resistance or support can be formed around such a trend-line. Note that at the bottom rightof Figure 4.2, the price of the Euro–dollar exchange rate breaks up through the trend-line.From this, we can say that it has broken trend-line resistance. Thus, we can describe supportand resistance levels as levels where a trend may be interrupted or reversed. Because suchlevels can determine the continuation or the cessation of a trend, they are seen as important bymarket participants. In this example, market participants may well have left stop loss orders tobuy Euro and sell dollars above the trend-line resistance on the view that if such a level brokeit would signal a short-term end to the downtrend. Of course, if enough people leave ordersto buy (sell) above (below) trend-line resistance (support), then the reversal of the previoustrend could well be accelerated. Furthermore, speculative elements could discover such ordersand try to target them in order to cause what might become a self-fulfilling move, allowing forpotential profits.To identify support and resistance levels, technical analysts use a variety of informationinputs, including but not exclusive to chart analysis and numerical rules based on previousprice performance. The rule with support and resistance is that they are important until theyare broken. This may seem like just stating the obvious, but the key thing to note is that thereis no particular time limit to their importance.
4.3.3 Psychological LevelsIn addition to the types of support and resistance that are identified by previous price actionand thus previous lows and highs, there are also other sorts that focus instead on psychologicalfactors or instead on flow dynamics specific to that particular exchange rate. In the first, marketparticipants frequently focus on round numbers – such as 0.9400 for the Euro–dollar exchangerate – hence such levels are termed psychological support or resistance. They are importantnot because they represent of necessity a previous low or high, but instead because they reflectthe expectation of a future move if they are breached. In the second, there can exist withinspecific exchange rates support or resistance levels reflecting anticipated flow dynamics. Forinstance, in the dollar–yen exchange rate, some Japanese exporters may prefer also to sell theirreceivables forward (selling dollars and buying yen) to achieve a round number. Thus, oneanticipates this by adding the forward points. For instance, if the spot dollar–yen exchangerate is 120.45/55 and the three-month forward points are −73/−72.5, one might expect someexporter sales to occur at 120.73 (which would allow an outright level of 120.00 to be achieved).Consequently, one might see 120.73 as one type of resistance. Of course, the difficulty withthis particular type of approach is that as the spot exchange rate and the interest rate differentialmove, so the forward resistance point moves.
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Figure 4.2 Example of a trend-lineSource: Reuters. Copyright Reuters Limited, 1999, 2002.
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A further complication within technical analysis is that there are various ways in whichcharts can be drawn. In Figures 4.3–4.5, we look at the three main types:
r Liner Candlestickr BarThe basic chart, which is a simple line chart (Figure 4.3), is as the title suggests formedfrom a single line. Of necessity that line must be formed by a series of highs, lows, open orclosing levels. Thus, it is an approximation of the price action over a given time, reflectingmore the overall trend rather than the intraday price action. Yet, highs and lows can be just asimportant as that trend, hence the bar chart (Figure 4.4) is also useful. Sometimes, for thesame instrument, security or exchange rate, the line and bar charts can show quite differentsupport and resistance levels. Yet, it can also be important when precisely those highs and lowsoccurred. For instance, the implication of price action on any given day may be quite differentif the high in price action occurs at the start or at the end of a move. For this reason, analysisusing a candlestick chart (Figure 4.5) can be useful.These are the three most basic types of chart. For all three, we can use a number of technicaltools and schools of thought to try and develop predictive knowledge from past price patterns.Before we go on to some of the more complex tools, it is probably worth having anotherlook at support and resistance, accompanied by another building block – the moving average.As the name suggests, this is the average of the exchange rate values over a set time period.Because that exchange rate is constantly moving, so is the average rate of necessity. Movingaverages can be studied according to periods of any length, but the most widely used and thusmost important are the 20-, 55- and 200-day and the 55- and 200-week moving averages. Thusarmed with the initial building blocks of support, resistance and moving averages, let’s try todo some technical analysis, using the chart of the Euro–dollar exchange rate in Figure 4.6.Here, we have our Euro–dollar exchange rate with the following technical tools:
r A trend-liner A trend-channel (two parallel trend-lines)r 55-day moving averager 200-day moving averageSo, what can we tell from this chart? A layman might not be able to tell much apart fromthe fact that Euro–dollar has been in a downtrend. Sometimes, such basic observations, madeeither by a layman or by a practicing technical analyst, are the most important ones. However,a “technician” should be armed with a skill set that at least allows for the possibility of a morecomplex and sophisticated analysis. Looking at the chart again, we can identify the followingpoints accordingly:
r Euro–dollar has traded within a long-term downward sloping trend-channel.r It has only broken that channel on a sustained basis to the downside up until July of 2001when it broke through and held above channel resistance.
r Before that, in December 2000, Euro–dollar briefly managed to exceed that trend-channelresistance and made a major high of 0.9595. Major highs and lows usually reflect theultimate extension of a trend reversal. Thus, 0.9595 needs to be exceeded for the mediumterm downward trend to be negated.
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Figure 4.3 Simple line chartSource: Reuters. Copyright Reuters Limited, 1999, 2002.
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Figure 4.4 Candlestick chartSource: Reuters. Copyright Reuters Limited, 1999, 2002.
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Figure 4.5 Bar chartSource: Reuters. Copyright Reuters Limited, 1999, 2002.
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Figure 4.6 Trend-lines and moving averagesSource: Reuters. Copyright Reuters Limited, 1999, 2002.
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r The fact that a shorter-term moving average has broken up through the longer-term counterpart would appear to validate the view that Euro–dollar trades higher in the short term,whether or not it actually manages to breach that level of 0.9595.r More specifically, however, the fact that the 55-day moving average has broken up throughthe 200-day moving average is potentially very significant. Why? As we noted above, certainmoving averages are seen as more equal than others. Notably, the break of a 200-day by a55-day MA usually can potentially lead to impulsive moves and signal a short-term trendreversal. Here, the 55-day MA has broken up through the 200-day MA, which we call a“golden cross”, arguing for potentially dramatic gains. Conversely, if the 55-day MA wereto break down through the 200-day MA, that would be termed a “death cross” and becorrespondingly bearish as the name might suggest.One could go on