point and figure chart,the first of which is called the box size. This is the minimum grid increment thatthe price must move in order to satisfy the plotting of a new X and O. The selection of the box size variable is usually based upon a multiple of the minimumtick size determined by the commodity exchange. If the box size is too small,then the point and figure chart will not filter out white noise, while too large afilter will not present enough detail in the chart to make it useful. We recommend initializing the box size for a FOREX P&F chart with the value of one ortwo pips in the underlying currency pair.The second user-defined parameter necessary to plot a point and figurechart is called the reversal amount. If the price moves in the same direction asthe existing trend, then only one box size is required to plot the continuation ofthe trend. However, in order to filter out small fluctuations in price movements(or lateral congestion), a reversal in trend cannot be plotted until it satisfies thereversal amount constraint. Typically, this value is set at three box sizes, thoughany value between one and seven is a plausible candidate. The daily limitimposed by most commodity exchanges can also influence the trader’s selectionof the reversal amount variable.The algorithm to construct a point and figure chart follows:
100
HOW TO BEAT THE MARKET (MAYBE)
Point and Figure Algorithm
• Upward trends are represented as a vertical column of Xs, while downward trends are displayed as an adjacent column of Os.• New figures (Xs or Os) cannot be added to the current column unlessthe increase (or decrease) in price satisfies the minimum box sizerequirement.• A reversal cannot be plotted in the subsequent column until the pricehas changed by the reversal amount times the box size.
Point and figure charts display the underlying supply and demand ofprices. A column of Xs shows that demand is exceeding supply (a rally); a column of Os shows that supply is exceeding demand (a decline); and a series ofshort columns shows that supply and demand are relatively equal. There are several advantages to using P&F charts instead of the more traditional bar or candlestick charts.P&F charts automatically:
Advantages of P&F Charts
• Eliminate the insignificant price movements that often make barcharts appear “noisy.”• Remove the often misleading effects of time from the analysis process(whipsawing).• Make trend line recognition a “no-brainer.”• Make recognizing support/resistance levels much easier.Nearly all of the pattern formations discussed above have analogouspatterns that appear when using a standard OHLC bar chart.Adjusting the two variables, box size and reversal amount, may causethese patterns to become more recognizable. P&F charts also:• Are a viable online analytical tool in real time. They require only asheet of paper and pencil.• Help you stay focused on the important long-term price developments.
For a more detailed examination of this charting technique, we recommendPoint & Figure Charting by Thomas J. Dorsey (2001: John Wiley & Sons, Inc.).
Technical Analysis
101
Indicators and OscillatorsBeyond charting are various market indicators—calculations using the primaryinformation of open, high, low, or close. Indicators may also be charted orgraphed. Buy and sell signals and complete systems may be generated from abattery of indicators. The most popular indicators are: relative strength, movingaverages, oscillators or momentum analysis (actually a superset of relativestrength), and Bollinger bands.
Relative Strength IndicatorThe relative strength indicator (RSI) shows whether a currency is overbought oroversold. Overbought indicates an upward market trend, since the financialoperators are buying a currency in the hope of further rate increases. Sooner orlater saturation will occur because the financial operators have already created along position. They show restraint in making additional purchases and try tomake a profit. The profits made can very quickly lead to a change in the trend orat least a consolidation.Oversold indicates that the market is showing downward trend conditions, since the operators are selling a currency in the hope of further rate falls.Over time saturation will occur because the financial operators have createdshort positions. They then limit their sales and try to compensate for the shortpositions with profits. This can rapidly lead to a change in the trend.You cannot determine directly whether the market is overbought or oversold. This would suppose that you knew all of the foreign exchange positions ofall the financial operators. However, experience shows that only speculative buying, which leads to an overbought situation, makes very rapid rate rallies possible.The RSI is a numerical indication of price fluctuations over a givenperiod; it is expressed as a percentage.RSI = sum of price rises / sum of all price fluctuationsTo illustrate this, we have selected the daily closes (multiplied by 10,000)for the EUR/USD currency pair when it first appeared on the FOREX marketin January of 2002. The running time frame in this example is nine days. SeeTable 10.1.An RSI between 30 and 70 percent is considered neutral. Below 25 percentindicates an oversold market, over 75 percent indicates an overbought market.The RSI should never be considered alone but in conjunction with other indicators and charts. Moreover, its interpretation depends largely on the period studied. The example in Table 10.1 is nine days. An RSI over 25 days would show,
HOW TO BEAT THE MARKET (MAYBE)
102
TABLE 10.1Date
Close
Daily Chg
1/01/02
8894
1/02/02
9037
+43
Calculating RSIUps
Downs
Total
Percent
1/03/02
8985
−51
1/04/02
8944
−41
1/07/02
8935
−9
1/08/02
8935
0
1/09/02
8914
−21
1/10/02
8914
0
1/11/02
8925
+11
54
122
176
30.7
1/14/02
8943
+18
72
122
194
37.1
1/15/02
8828
−15
29
137
166
17.5
1/16/02
8821
−7
29
93
122
23.8
1/17/02
8814
−7
29
59
88
33.0
1/18/02
8846
+32
61
50
111
55.0
1/21/02
8836
−10
61
60
121
50.4
1/22/02
8860
+24
85
39
124
68.5
1/23/02
8783
+23
108
39
147
73.5
1/24/02
8782
−1
97
40
137
70.8
1/25/02
8650
–132
79
171
250
31.6
1/28/02
8623
−27
79
183
262
30.2
1/29/02
8656
+33
112
176
288
39.0
1/30/02
8610
−46
112
215
327
34.3
1/31/02
8584
−26
80
232
312
25.6
given a steady evolution of rates, fewer fluctuations. The advantage of obtainingmore rapid signals for selling and buying (by using a smaller number of days) iscounterbalanced by a greater risk of receiving the unconfirmed signals.
Momentum AnalysisLike the RSI, momentum measures the rate of change in trends over a givenperiod. Unlike the RSI, which measures all the rate changes and fluctuationswithin a given period, momentum allows you to analyze only the rate variationsbetween the start and end of the period studied.
Technical Analysis
103
The larger n is, the more the daily fluctuations tend to disappear. Whenmomentum is above zero or its curve is rising, it indicates an uptrend. A signalto buy is given as soon as the momentum exceeds zero, and when it drops belowzero, triggers the signal to sell.Momentum = price on day (X ) − price on day (X − n)where n = number of days in the period studied.The following example in Table 10.2 of momentum analysis uses theEUR/USD currency pair as the underlying security.
TABLE 10.2
Calculating Momentum
Date
Close
1/01/02
8894
1/02/02
9037
1/03/02
8985
1/04/02
8944
1/07/02
8935
1/08/02
8935
1/09/02
8914
1/10/02
8914
1/11/02
8925
1/14/02
8943
9-DayMomentum
+49
1/15/02
8828
−209
1/16/02
8821
−164
1/17/02
8814
−130
1/18/02
8846
−99
1/21/02
8836
−99
1/22/02
8860
−54
1/23/02
8783
−131
1/24/02
8782
−143
1/25/02
8650
−293
1/28/02
8623
−205
1/29/02
8656
−165
1/30/02
8610
−204
1/31/02
8584
−262
104
HOW TO BEAT THE MARKET (MAYBE)
Examination of the nine-day momentum shows a clear downward trend.Momentum analysis should not be used as the sole criterion for market entryand exit timing, but in conjunction with other indicators and chart signals.
Moving AveragesThe moving average (MA) is another instrument used to study trends and generate market entry and exit signals. It is the arithmetic average of closing pricesover a given period. The longer the period studied, the weaker the magnitude ofthe moving average curve. The number of closes in the given period is called themoving average index.Market signals are generated by calculating the residual value:Residual = Price(X) −MA(X)When the residual crosses into the positive area, a buy signal is generated.When the residual drops below zero, a sell signal is generated.A significant refinement to this residual method (also called moving average convergence divergence, or MACD for short) is the use of two movingaverages. When the MA with the shorter MA index (called the oscillatingMA index) crosses above the MA with the longer MA index (called the basis MAindex), a sell signal is generated.Residual = Basis MA(X) − Oscillating MA(X)Again we use the EUR/USD currency pair to illustrate the moving averagemethod (see Table 10.3).The reliability of the moving average residual method depends heavily onthe MA indices chosen. Depending on market conditions, it is the shorter periods or longer periods that give the best results. When an ideal combination ofmoving averages is used, the results are comparatively good. The disadvantage isthat the signals to buy and sell are indicated relatively late, after the maximumand minimum rates have been reached.The residual method can be optimized by simple experimentation or by asoftware program. Keep in mind that when a large sample of daily closes is used,the indices will need to be adjusted as market conditions change.
Bollinger BandsThis indicator was developed by John Bollinger and is explained in detail in hisopus called Bollinger on Bollinger Bands. The technique involves overlaying three
Technical Analysis
TABLE 10.3
105
Calculating Moving Average Residuals
Date
Close
3-Day MA
5-Day MA
Residual
1/01/02
8894
1/02/02
9037
1/03/02
8985
8972
1/04/02
8944
8989
1/07/02
8935
8955
8959
4
1/08/02
8935
8938
8967
29
1/09/02
8914
8928
8943
15
1/10/02
8914
8921
8928
7
1/11/02
8925
8918
8925
7
1/14/02
8943
8927
8926
−1
1/15/02
8828
8899
8905
6
1/16/02
8821
8864
8886
22
1/17/02
8814
8821
8866
45
1/18/02
8846
8827
8850
23
1/21/02
8836
8832
8829
−3
1/22/02
8860
8847
8835
−12
1/23/02
8783
8826
8828
2
1/24/02
8782
8808
8821
13
1/25/02
8650
8738
8782
44
1/28/02
8623
8685
8740
55
1/29/02
8656
8643
8699
56
1/30/02
8610
8630
8664
34
1/31/02
8584
8617
8625
8
bands (lines) on top of an OHLC bar chart (or a candlestick chart) of theunderlying security.The central band is a simple arithmetic moving average of the daily closesusing a trader-selected moving average index. The upper and lower bands arethe running standard deviation above and below the central moving average.Since the standard deviation is a measure of volatility, the bands are selfadjusting, widening during volatile markets and contracting during calmerperiods. Bollinger recommends 10 days for short-term trading, 20 days for
HOW TO BEAT THE MARKET (MAYBE)
106
8707.00
8584.50
8462.00
8339.50
8217.00
FIGURE 10.24
Bollinger bands.
intermediate-term trading, and 50 days for longer-term trading. These valuestypically apply to stocks and bonds, thus shorter time periods will be preferredby commodity traders. See Figure 10.24.Bollinger bands require two trader-selected input variables: the number ofdays in the moving average index and the number of standard deviations to plotabove and below the moving average. Over 95 percent of all the daily closes fallwithin three standard deviations from the mean of the time series. Typical valuesfor the second parameter range from 1.5 to 2.5 standard deviations.As with moving average envelopes, the basic interpretation of Bollingerbands is that prices tend to stay within the upper and lower band. The distinctive characteristic of Bollinger bands is that the spacing between the bandsvaries based on the volatility of the prices. During periods of extreme pricechanges (that is, high volatility), the bands widen to become more forgiving.During periods of stagnant pricing (that is, low volatility), the bands narrow tocontain prices.Bollinger notes the following characteristics of Bollinger bands:• Sharp price changes tend to occur after the bands tighten, as volatilitylessens.• When prices move outside the bands, a continuation of the currenttrend is implied.• Bottoms and tops made outside the bands followed by bottoms andtops made inside the bands call for reversals in the trend.
Technical Analysis
107
• A move that originates at one band tends to go all the way to the otherband. This observation is useful when projecting price targets.Bollinger bands do not generate buy and sell signals alone. They should beused with another indicator, usually the relative strength index. This is becausewhen price touches one of the bands, it could indicate one of two things: a continuation of the trend or it could indicate a reaction the other way. So Bollingerbands used by themselves do not provide all of what technicians need to know,which is when to buy and sell. MACD can be used in conjunction withBollinger bands and RSI.
Swing AnalysisSwing analysis is one of those nebulous terms that means different things to different people. It is often associated with swing trading, which also harbors avariety of connotations (the swing trader usually keeps a trade open longer thanthe typical session or day trader).Within the framework of this book, we will define swing analysis as thestudy of the distance between local peaks and troughs in the closing prices forthe purpose of identifying recurring patterns and correlations. The swing chart,like its older sibling the point and figure chart, requires the use of a massagingalgorithm that filters out lateral congestion (whipsawing) during periods of lowvolatility. For this purpose, a minimum box size must be selected. Within currency trading, this is almost always a single pip in the quote (second) currency ofthe currency pair. Additionally, a minimum reversal quantity must be selected.This is simply the number of pips (box sizes) required before a retracement canbe drawn in the opposite direction (the continuation of an existing trendrequires only one box size to plot the next point).Unlike the P&F chart, the swing chart does not distort the time element.That is, swing charts are frequently overlaid directly on top of a vertical barchart since both use the same numerical scaling for the x- and the y-axis. SeeFigure 10.25.In Figure 10.25, it is clear that a swing chart is a sequence of alternatingstraight lines, called waves, which connect each peak with its succeeding troughand vice versa.The swing analyst is particularly interested in retracement percentages.Market behavior is such that when a major trend does break out, there is asequence of impulse waves in the direction of the trend with interceding retracement waves (also called corrective waves). The ratio of the corrective wavedivided by the preceding impulse wave is referred to as the percentage of retrace-
108
FIGURE 10.25
HOW TO BEAT THE MARKET (MAYBE)
Bar chart with swing analysis overlay.
ment. Famous analysts such as William D. Gann and Ralph N. Elliott have dedicated their lives to interpreting these ratios and estimating the length of thenext wave in the time series.Gann believed that market waves moved in patterns based upon, amongother things, the Fibonacci number series, which emphasizes the use of so-calledmagic numbers such as 38.2 percent, 50 percent, and 61.8 percent. Actually,there is no magic involved at all; they are simply proportions derived from theGolden Mean or Divine Ratio. This is a complete study unto itself and hasmany fascinating possibilities. Visit http://www-groups.dcs.st-and.ac.uk/~history/Mathematicians/Fibonacci.html for more details on Fibonacci and his work.In his analysis of stocks in the 1920s and 1930s, Elliott was able to identifyand categorize nine levels of cycles (that is, a sequence of successive waves) over thesame time period for a single bar chart. This entailed increasing the minimumreversal threshold in the filtering algorithm, which creates fewer but longer waveswith each new iteration. He believed each major impulse wave was composed offive smaller waves while major corrective waves were composed of only threesmaller waves. We refer interested readers to the Web site www.elliottwave.com formore details on Elliott and his theories.
Advanced StudiesThis chapter serves as a stepping stone into the realm of technical analysis. Timeseries analysis is a complex and ever-changing discipline. Advanced studies includedeviation analysis, retracement studies, statistical regressions, Fibonacci progressions, Fourier transforms, and the Box-Jenkins method, to name just a few.
Technical Analysis
109
Into the FutureThere are also those using techniques from other disciplines to analyze the markets. Michael Duane Archer, coauthor of this book, has deeply explored the useof Cellular Automata to forecast FOREX prices.Your analysis of the markets is only one component of your trading system. In fact, two other components are more important, in the opinion of theauthors: money management and psychology (discussed in detail in later chapters). Most traders who fail (and most traders do fail) tend to spend all theirenergies on developing a trading system at the expense of money managementand trading psychology. Don’t be like them!
The Technician’s CreedAll market fundamentals are depicted in the actual market data. So the actualmarket fundamentals need not be studied in detail.History repeats itself and therefore markets move in fairly predictable, orat least quantifiable, patterns. These patterns, generated by price movement, arecalled signals. The goal in technical analysis is to uncover the signals exhibited ina current market by examining past market signals.Prices move in trends. Technicians typically do not believe that price fluctuations are random and unpredictable. Prices can move in one of three directions:up, down, or sideways. Once a trend in any of these directions is established, itusually will continue for some period. Trends occur at all price levels: tick, 5minute, 1-hour, 1-day, weekly. What is a trend at the 1-minute level is obviouslyjust a small blip on the radar on a weekly chart. Curiously, the various prices levelsare interconnected.Never make a trading decision based solely on a single indicator. Theeclectic approach of comparing several indicators and charts at the same time isthe best strategy.As in all other aspects of trading, be very disciplined when using technicalanalysis. Too often, a trader fails to sell or buy into a market even after it hasreached a price that his technical studies have identified as an entry or exitpoint. This is money management and psychology, not technical analysis, andboth are very important!Do you understand the differences between fundamental analysis andtechnical analysis?The basic types of technical analysis tools are charts, moving averages,oscillators, and momentum analysis. In Chapter 12: Trading Tactics we will putforth a suggested program for developing your own technical analysis arsenal.Your analysis of the markets is only one of three components to successful trading—money management and psychology are the others.
4Part
The Businessof Trading
11Chapter
Money Managementand Psychology
The Trading TriangleThere are three components to a trading program: trading method, moneymanagement, and psychology or attitude. The vast majority of traders spendalmost all of their efforts on a trading method. Yet most successful traders willtell you of the three, the trading method is the least important.You do well by allocating significant thought and effort to the other twocomponents. How much you weigh them determines your trading triangle. SeeFigure 11.1.
TradingMethod
MoneyManagement
FIGURE 11.1
Psychology
The trading triangle.
113
114
THE BUSINESS OF TRADING
Money Management FactorsMoney management is obviously about how you manage the money you trade;it includes both your trading capital and how you determine your exit from atrade, as in taking profits or setting stop-losses.Most trading methods determine when you enter a trade, but not whenyou exit. If your trading method does automatically determine such factors, becareful the rules are not too restrictive. Most traders prefer something of a separate ad hoc method of determining trade exits.Allocating your capital is a function of how large a percentage of tradesyou expect to be winners versus losers and the ratio between amount won andamount lost. The higher your percentage of winners and the greater the ratiobetween winners and losers, the less winning trades you need to make.Be realistic. Do not expect to hit 80 percent winning trades with a 10:1ratio between gains and losses. Position traders are happy to hit 30 percent oftheir trades, but expect a ratio of perhaps 5:1 on wins/losses. By contrast, guerillascalpers figure a 1:1 ratio between winning dollars and losing dollars, so theyneed perhaps 60 percent winners to stay in the game. Consider your tradingmethod and what type of trader you are, then construct trading triangles for 25percent, 50 percent, and 100 percent annual returns.
Risk/Reward RatioOne of the most crucial aspects of trading any security is the trader’s propensitytoward the ever-present risk factor. The risk/reward ratio is a nebulous, frequently underestimated component of trading that makes the trade possible.Without risk, there would be no profit or loss, just transaction costs.Paradoxically, in the risk/reward ratio, the reward part is traditionallylisted first. So a 4:1 ratio indicates that the reward is 4 times greater than therisk. Attempting to quantify the risk/reward ratio is a tricky endeavor. Let usassume that the trader has decided upon a 3:1 ratio and wants to initiate a long(buy) position in the EUR/USD currency pair based upon some recentlyacquired fundamental studies.The current price is 1.2500 and the “fundamentals” indicate that there willbe an upward rally to a price of 1.2800 within the next 36 hours (no rolloverrequired). To “enforce” a risk/reward ratio of 3:1, our trader must set a take-profitlimit order at 1.2800 and a stop-loss limit order at 1.2400. It is assumed that thetrader has entered the market at a price of exactly 1.2500.The math looks like this.Take-profit spread: 1.2800 − 1.2500 = 300 pipsStop-loss spread: 1.2500 − 1.2400 = 100 pips
Money Management and Psychology
115
Thus, the risk/reward ratio can be quantified as the quotient of the takeprofit spread divided by the stop-loss spread.Let us also assume our trader had sufficient equity in a margin account toexecute the trade with a unit size of one lot (100k of Euros). The broker offerstwo percent margin trading (50:1 leverage). Each pip in a lot of the EUR/USDpair is worth USD 10.00. Thus, if the targeted price of 1.2800 is triggered first,the trader makes a profit of:USD 10.00 × 50:1 leverage × 300 pips = USD 60,000However, if the stop-loss limit is triggered first, the trader will lose:USD 10.00 × 50:1 leverage × 100 pips = USD 20,000The selection of a risk/reward ratio is highly subjective and is somethingthat the trader must decide carefully after considering many factors includinghis or her trading style and trading methodology.
Ad Hoc Adjustment of Limit OrdersThe notion of losing 20,000 dollars on one trade (as in the previous example)should make all traders cringe. However, the trader can limit his or her potentiallosses by “tightening the reins” of the trade, that is, moving both the take-profitand the stop-loss limit orders closer to the market entry price.The trader can cut the loss potential to one-fourth the loss potential in theexample by raising the stop-loss to 1.2475 and lowering the take-profit to 1.2600.If the price direction begins to react adversely, the trader may even elect to exitearly by manually liquidating the trade.However, if the price direction moves favorably, then the trader shouldraise both limit orders accordingly. At some point, he or she may even move thestop-loss limit order above the market entry price, thus “locking in” guaranteedprofits. At the time, the trader still has the potential to hit the originally targetedprice of 1.2800.
Early LiquidationWhen dealing with long (buy) positions, the trader should hesitate lowering astop-loss limit order. Accept the small loss and examine a different currency pairfor market entry possibilities. A take-profit limit in a long position shouldonly be lowered if the trader is fairly certain a period of lateral congestion or a
116
THE BUSINESS OF TRADING
reversal is about to occur. It may even be better to simply liquidate. The converse is true for short (sell) positions. But the road to large losses usually startswith moving or removing a stop-loss order!If at any point the trader becomes overrun with uncertainty (a polite wordfor fear), doubt, and confusion, it is better to manually liquidate the trade witha small profit or loss than to hang on dismally waiting for a large loss.
More Ideas on Setting StopsDon’t put stops where everyone else does!Stop-losses are typically placed below or above a previous low or high. We preferto set stops as a function of market volatility. Look at some recent charts for thepairs you trade and the data and time frame you will use to actually execute atrade. Average the subtrends in the major trend direction and average the subtrends in the minor trend direction. Redo these averages occasionally to also getan idea of how volatility is shifting. Use the information to set price objectivesand also stops. The technique may also be utilized for entry point purposes.
Trade Capital AllocationNever allocate more than 10 percent of your trading capital to a single trade,either as margin or risk. Never start trading until you have funds for at least 30,and preferably 50 or more, trades.Suppose your starting capital or grubstake is $3,000.00. Break it into threeportions of $1,000.00 each. Then, break each of those down into 10 trades of$100 each. If you lose the first $1,000.00, take a deep breath and maybe a fewdays off. If you lose the second $1,000.00, spend some time analyzing yourapproach to the markets and making minor adjustments—resist the temptationto completely retool every time you have a bad trade or a losing streak.Obviously you must consider your trading method and your trading type.You can be a scalper on small lots risking $50 a trade, but you cannot be a position trader on large lots with the same risk. Consider all factors in proportion.Trade logical transaction sizes. Margin trading allows the FOREX trader avery large amount of leverage; trading at full margin capacity can make for somevery large profits or losses on an account. Scaling your trades so that you mayreenter the market or make transactions on other currencies is generally wiser.In short, do not trade amounts that can potentially wipe you out and do not putall your eggs in one basket. See Figure 11.2.
Money Management and Psychology1 × $3,000
FIGURE 11.2
3 × $1,000
117
3 × 10 × $100
Sample allocation