In the longrun we are all dead.” The FOREX markets are highly leveraged; this is one oftheir main attractions. You can be correct about a currency pair in the long run,but the leverage may cause a price movement more than ample in degree to takeyou out of the market before you can profit from being correct about the fundamentals. It is discouraging to be correct in your determination of long-termtrend direction—for example, “Interest rates will drive the U.S. dollar loweragainst the euro”—but lose money because volatility and leverage cause so manyshort-term fluctuations that you are never able to board the long-term trendsuccessfully.No one denies that fundamentals such as money supply, labor statistics,political events, and many others drive the currency markets. The problem—and why most traders use technical analysis—is how to interpret them, especially in the short term.Most fundamental information is quantitative but much is not. For example, how does a trader convert an unemployment statistic to a price value?To further complicate matters, there are hundreds of fundamentals that impactprices, and the matrix of possibilities is astronomical. And some fundamentals,such as geopolitical events, are not even quantifiable.The prices in Figure 1.2—tracked hourly for 30 days on EUR/USD—were ultimately driven by a wide range of fundamentals. But how does thetrader discern them in advance?Technical analysis allows you to zoom in as close to the markets as youwant. In fact, an advantage of technical analysis is the ability to visualize themarkets at multiple price levels simultaneously. See Figures 1.3 through 1.5.There is no perfect world, of course. Fundamentalists will counter thatthe prices you use to do technical analysis are already history by the time youdo your calculations, and they have no rational effect on the future prices.But a simple example will show this concept to be incorrect, at least intheory. It is true that after I enter my order to buy or sell, I have had all the
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FIGURE 1.2 Fundamentals—Right and Still Wrong.Source: FXtrekIntelliChart™. Copyright FXtrek.com, Inc.
impact on prices that I will have until I enter the opposite order to exit themarket. Yet every trader has a propensity to exit the market, once entered, onvariable factors of price and time. At what price will I take a profit? At whatprice will I take a loss? How long am I willing to stay in a trade? Thesepropensities vary from trader to trader, but the aggregate of all propensitiescreates a push and pull on the market that should, again in theory, be measurable. See Table 1.1.All traders have access to market prices; the same cannot be said of fundamentals. There are literally millions of fundamental factors in any given currency, and the relationships among them are in the billions. Someone willalmost certainly know a piece of fundamental information before you do. Andhow do you translate a fundamental like gross domestic product (GDP) to aspecific market value or even a specific entry price? To add gasoline to the fire,remember that these relationships are almost certainly nonlinear and are changing rapidly all the time.Fundamental traders conclude that prices have no memory and that onlyraw fundamental information drives the markets. The following is only a partial list of potential fundamentals for the U.S. dollar (USD). Other countrieswill have similar lists. Now, don’t you really want to be a technical trader!
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FIGURE 1.3 Price Level Analysis: 15-Minute Bar Chart.Source: FXtrek IntelliChart™. Copyright 2001–2007 FXtrek.com, Inc.
• ABC/Money magazine Consumer Comfort Index.• Aggregate hours worked.• Atlanta Fed index.• Average hourly earnings.
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FIGURE 1.4 Price Level Analysis: Hourly Bar Chart.Source: FXtrek IntelliChart™. Copyright 2001–2007 FXtrek.com, Inc.
• Average weekly earnings.• Average workweek.• Balance of trade.• Federal Reserve Bank’s Beige Book.
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FIGURE 1.5 Price Level Analysis: Daily Bar Chart.Most of the 15-minute bar chart is contracted into the single right-most barof the daily chart.Source: FXtrek IntelliChart™. Copyright 2001–2007 FXtrek.com, Inc.
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TABLE 1.1 The Technical Market ParadigmThe theory of technical analysis states that all information relevant to the market iscontained in the price data. Even volume and open interest statistics (not available toFOREX traders unless artiﬁcially synthesized from price data) are secondary to pricedata.
Source: www.TradingCharts.com.
• Bridge/Commodity Research Bureau (CRB) indexes.• BTM-UBSW Chain-Store Sales Index.• Building permits.• Business inventories.• Capacity utilization.• Capital flows, per Treasury International Capital System (TIC).• Confederation of British Industry (CBI) report.• Challenger, Gray, and Christmas layoff announcements.• Chicago Purchasing Managers Index (PMI).• Chicago Purchasing Managers Survey.• Chartered Institute of Purchasing and Supply (CIPS) report.• Composite Index of Leading Economic Indicators.• Consumer confidence.• Consumer installment credit.• Consumer price index (CPI).• Consumer sentiment.• Consumer spending.• Corporate profits.
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• Current account (balance of payments).• Durable goods orders.• Employment cost index.• Employment report.• Employment situation.• Existing home sales.• Export prices.• Factory orders.• Federal budget.• Federal government finances.• Federal Reserve Policy disclosures.• Financial account balance.• Federal Open Market Committee (FOMC) minutes andtranscripts.• Foreign trade.• GDP.• GDP advance.• GDP deflator.• GDP final.• GDP provisional (revised).• GNP indicators.• Goldman Sachs Commodity Index.• Goldman Sachs Retail Index for Same-Store Sales.• Help-wanted index.• House prices.• Housing starts.• Humphrey-Hawkins testimony.• German IFO index.• Import prices.• Industrial production.• Industrial Production and Capacity Utilization report from FederalReserve Board.• Initial claims.• International trade.• Institute for Supply Management (ISM) Manufacturing Index.
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• ISM Nonmanufacturing Survey.• ISM Services Index.• Jobless claims.• Kansas City Federal Reserve Bank manufacturing survey.• Lynch, Jones & Ryan (LJR) Redbook report.• Manufacturers’ shipments, inventories, and orders.• Manufacturing and trade inventories.• Michigan Consumer Sentiment Index (MCSI).• Monetary base.• Money supply figures (M1, M2, M3) released monthly by FederalReserve Economic Data (FRED).• Mortgage Bankers Association weekly survey.• National Association of Purchasing Managers (NAPM) index.• National Association of Home Builders (NAHB) survey.• New home sales.• Nonfarm payrolls.• New York’s Empire State Index.• Orders, sectoral production, and inventories.• Payroll employment.• Personal consumption expenditures.• Personal income.• Philadelphia Fed index.• Philadelphia Federal Reserve Bank Business Outlook Survey.• Prices, wages, and productivity.• Producer price index (PPI).• Productivity.• Purchasing Managers Index (PMI).• Real earnings (real average weekly earnings).• Real GDP.• Redbook Index.• Residential construction spending.• Retail sales.• Richmond Federal Reserve Bank Survey.• Trade balance.• Tankan report.
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• Unemployment insurance claims.• Unemployment rate.• Unit auto and Ttuck sales.• Unit labor cost.• U.S. Treasury Borrowing Schedule.• Wholesale inventories.List courtesy of www.FOREXrealm.com.
Econometric AnalysisEconometric analysis attempts to convert fundamental data intopricing forecasts, most typically long-term forecasts. Because of thehigh leverage in FOREX, long-term forecasts may not be of value tomany traders.Econometric analysis typically yields complex mathematical/statistical models. Because of the complexity they are computerbased simulations.The EXPO econometric software (www.lmt-expo.com) attemptsshorter-term price forecasts, incorporating the following factors:
• Data Transformations: Box-Cox Transformations, Differencing,Logit, Seasonal Adjustment, and Periodicity Conversion.
• Statistical Analysis: Autocorrelation and Partial AutocorrelationAnalysis, Q-statistics, Restricted Histogram, Correlation, and Variance/Covariance Matrix.
• Econometric Tests: Additional variables, superﬂuous variables,Dickey-Fuller Unit Root, Engle-Granger Cointegration, GrangerCausality, Multicollinearity, Normality, LM Serial Correlation,GARCH and White Heteroskedasticity, Chow, and Ramsey.
• Model Estimation and Forecasting: OLS, GARCH, ARIMA, Ridge,rolling/moving regression, instrumental variables, and autoregressive errors.
• Random Number Generation: Using Binomial, Chi-square,Exponential, F, Student-t, Normal, Lognormal, and Poisson Distributions.
• Frequency Analysis: Convolution, Discrete Fourier Transform,Fast Fourier Transform, Inverse Fourier Transforms, impulse(Continued )
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Econometric Analysis (continued )ﬁlters, power spectral density, trigonometric functions generator,digital ﬁlter functions.
• Polynomial Analysis: Cubic spline interpolation, polynomial estimation, and statistics.
• Statistics: Summary statistics, rolling correlation and statistics;Student-t, F, ANOVA, and Chi-square tests.
• Mathematical Functions: An extensive set of advanced functionsfor matrix math and calculus are provided in EXPO’s “Analyze”menu.Courtesy of www.lmt-expo.com.
Why Technical Analysis?Pay your money; take your pick. Technical analysis, despite its faults, hasattracted more traders than fundamental analysis has, for the following reasons:• Technical analysis input (primarily prices in FOREX) is objective,transparent, and available to everyone.• Technical analysis offers a nearly infinite number of possibilities formanipulation and application. Despite the millions of hours of effortexpended on technical analysis, the field is wide open. Who knowswhat you might discover?• Technical analysis allows traders to see the markets at many differentprice levels—of their choosing—at the same time.• Technical analysis lets traders easily time their entries and exits as wellas monitor their trades while they are open and active.If you are right using technical analysis, you will probably make moneyon a trade. If you are right using fundamental analysis, the leverage inherent inthe market may well cause you to get stopped out or exit the trade before youcan collect on your judgment.Despite the fundamentalists’ concept that prices used in technicalanalysis are “instant history,” the technical market paradigm infers that actions in the market of buying and selling obviously have reactions in the markets of selling and buying. Past prices contain information about futureprices. Whether this information can be usefully deciphered is an issue forthe theorists.
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ChartingPrice charts of market behavior have been around for centuries, probablyalmost as long as markets have existed in both the East and West. The mostimportant types of charts used today are bar charts, candlestick charts, pointand figure charts, and swing charts.All charts share the primary characteristic of visually depicting pricebehavior over some period of time. They differ as to their secondary characteristics and type and degree of visual impact.Bar ChartsBar charts are the most popular and enduring for all trading, whether stocks,options, futures, or FOREX. They are time-specific, meaning that they arescaled according to time increments. For FOREX this can be ticks: 5-second,10-second, 30-second, 1-minute, 5-minute, 10-minute, 30-minute, 1-hour,12-hour, daily, or weekly. See Figure 1.6.Time-Speciﬁc versus Price-SpeciﬁcCharts constructed as a function of time units are said to be timespeciﬁc. For example, a bar chart using ﬁve-minute, daily, or weeklyinformation is time speciﬁc. Point and ﬁgure charts are price-speciﬁc;they require only price unit information to construct them. GoodmanSwing Charts are both time- and price-speciﬁc; information for bothtime and price is required.
Candlestick ChartsCandlestick charts, a charting idea from the East, are especially popularin FOREX. Candlestick chart patterns emphasize the technical analysisparadigm—that past prices carry information about future prices. Candlesticksare also time-specific.I used candlestick charts in the 1980s to trade cocoon futures on the Japanese commodity exchange. When in Rome, do as the Romans do! See Figure 1.7.Point and Figure ChartsPoint and figure (P&F) charts have fallen from favor over the past 20 years.Perhaps this is a good reason to give them some extra consideration now. Pointand figure charts are price-specific. Instead of scaling as a function of time,
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FIGURE 1.6 Bar Chart.Source: FXtrek IntelliChart™. Copyright 2001–2007 FXtrek.com, Inc.
P&F charts are scaled as a function of price. In the end, it is a half-dozen of oneand six of the other. Prices occur over time, and time is relevant only as itdepicts changing prices.It is said P&F charts were the “secret” of many of the robber barons ofthe nineteenth century who often raided railroad stocks using a tool no one else
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FIGURE 1.7 Candlestick Chart.Source: FXtrek IntelliChart™. Copyright 2001–2007 FXtrek.com, Inc.
used. I don’t know how true that is, but it rings true to me. Trading toolsinvariably are most effective when they are not widely used. After a techniquebecomes popular, it loses much of its effectiveness. The theory is this: The market, never interested in cooperating with traders, essentially immunizes itselfagainst overly popular techniques to prevent the masses from making money.
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To understand the market’s ability to discount and immunize itself, weneed only to consider the commodity spread relationships in grain futures.Useful and effective in the 1950s and 1960s, they have shifted so dramaticallyas to be worthless today. See Figure 1.8.Swing ChartsSwing charts can be either time-specific or price-specific, although most ofthem are price-specific in the manner of P&F charts. I like swing chartsvery much for my close-up view of markets when I am looking to enter orexit. They are also, obviously, useful for detecting swings in the market.When I discuss the FxCodex method of trading, you will see how importantthe information derived from swing charts can be to trading currencies. SeeFigure 1.9.There is no best chart technique. Many traders use more than one forstudying the markets. I use bar charts and swing charts and occasionally refer topoint and figure charts. If you haven’t selected a primary chart tool, look at thesame market over the identical period of time with each type. Which onespeaks to you? If you have already selected a charting technique, feel free to useit to develop your personal codex.I strongly encourage a charting method as your primary tool both forwatching the markets and for deriving buy and sell signals.
FIGURE 1.8 Point and Figure Chart.
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FIGURE 1.9 Swing Charts.
IndicatorsIndicators are popular with traders. The classification and sheer variety of indicators is vast, and a full discussion of them is beyond the scope of this work. Becausemost of us aren’t math and statistics experts, anything that uses dazzling displays ofmathematical pyrotechnics often seems somehow magical and infallible to us.Many traders use an indicator battery (IB), which is a selection of perhapsa dozen or more indicators covering all the technical bases. If you use an IB,you need to have ad hoc rules (or a meta-indicator or indicators) to determinewhat all of its components mean and how to apply them in actually executing atrade.Charts offer traders a transparent one-to-one correspondence with market prices; indicators do not, and that is the primary problem with them. Indicators are second-level techniques. They use the primary market data such asprices but manipulate it to attain a new level, hopefully, of understanding.Information theory tells us that such translations or manipulationsare fraught with some risk and danger. Without being 100 percent certain howthe indicator relates to the underlying data, we can be easily misled. Marketsmove in prices, and using indicators requires that we constantly shift levelsto make trading decisions. Each shift can cause an error, and because the markets move very swiftly, errors compound quickly.
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Indicators also tend to be curve-fit. That is, you must somehow selecttime frames and other parameters to calculate the indicator value. As the markets change, these parameters may need to be constantly altered and updated.Trending markets evolve—sometimes rather quickly—into trading markets,and vice versa. Some indicators do this internally, after a fashion. For others—you guessed it—you need another indicator to make those decisions.Indicators are opaque to varying degrees. The more complex the indicatorthe more difficult it is to determine what it is really measuring. In the meantime,the markets are marching onward and upward or downward. Another consequence of this opaqueness is that it is difficult to develop rational moneymanagement tools using most indicators because the primary-level connection toprices has been severed in the calculation process. Stops, for example, are afunction of prices, and your indicator needs to convert its findings back to pricelevels to determine a stop. Of course, you can always build another indicator to dothat for you. If you’ve guessed that I’m not a big fan of indicators, you are correct.Figures 1.10 through 1.12 provide examples of the three most commontypes of indicators—moving averages, oscillators, and relative strength.
Cycle AnalysisIf the technical market paradigm is correct, then prices have a memory of somesort. Cycle analysis accepts this as an axiom and takes the idea a small stepfurther: Prices behave in cycles. There is certainly logic to this, I think. Butwhether the markets are cyclical in nature or simply exhibit cyclical behaviorfrom time to time is the big question.Components of a CycleAll cycles are deﬁned by four parameters:1. Amplitude—the distance between the maximum or minimumvalue and the mean value of the cycle; half the vertical range.2. Wavelength—the period of the cycle as measured from one peakto the next peak or from one trough to the next trough.3. Phase—the horizontal shift left or right for a cycle.4. Decay/expansion—cycles may decay or expand for the abovevalues over time, either linearly or nonlinearly.
Markets, if they have cyclical aspects, must certainly have multiplecycles. Small cycles represent the shortest-term traders; intermediate cycles
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FIGURE 1.10
Popular Indicators: Exponential Moving Average.
Source: FXtrek IntelliChart™. Copyright 2001–2007 FXtrek.com, Inc.
represent the next level of traders; and large cycles represent long-termtraders—the latter even exist in FOREX. There are perhaps dozens of levelsin between.Theoretically, if you sum all the cycles inherent in a market—again,assuming they are even there—you will get a summed cycle that has the samepeaks and valleys as the underlying market. See Figure 1.13.
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FIGURE 1.11
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Popular Indicators: Oscillator (Bollinger Band).
Source: FXtrek IntelliChart™. Copyright 2001–2007 FXtrek.com, Inc.
Behavior AnalysisBehavior analysis takes another tack in accessing the technical market paradigm. Its central concept is focused on the behavior and propensities of traders.According to the behaviorists, their activities of buying and selling can be profitably measured and monitored. See Figure 1.14.
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FIGURE 1.12
Popular Indicators: Relative Strength (Stochastics)
Source: FXtrek IntelliChart™. Copyright 2001–2007 FXtrek.com, Inc.
Much of the data for behavior studies derives from trading volume andopen interest. Trading volume is the gross number of trades made over some period of time. Open interest is the total number of buyers and sellers in the market as a function of whether they are new buyers and sellers over some period orold buyers and sellers already in the market.
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FIGURE 1.13 Summed Cycles.The three cycles in the middle of the chart are summed to create the cyclejust below it.Source: Expert Cycle System (www.FxPraxis.com).
Volume and Open InterestBecause there is no central clearinghouse for currency trading,there are no aggregate volume or open interest statistics. In theory,this information could be synthesized from price data.Volume is the total number of transactions (buy/sell) over aperiod of time. Open interest is the total number of trades open andactive at a given time in a speciﬁc quantity unit.Volume and open interest in futures are classically interpreted asshown in the following table:Price
Volume
Open Interest
Interpretation
Rising
Rising
Rising
Market is strong.
Rising
Falling
Falling
Market is weakening.
Falling
Rising
Rising
Market is weak.
Falling
Falling
Falling
Market is strengthening.
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PRICE
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TIMEFIGURE 1.14 The Ultimate Trading Paradigm.Every trader in the market has a propensity to exit the market at somecombination of price and time. Every trader contemplating enteringthe market has a propensity for some price and time. The sum total ofthese propensities or decisions constitutes the ﬂow of prices over time.
Behavior analysis is less useful in FOREX than in futures or options.There is no centralized exchange or clearinghouse and thus no reporting of total volume or tracking of open interest.Because I have a high opinion of behavior analysis, I have spent aconsiderable amount of effort devising synthetic volume and synthetic openinterest to provide analogous data for currency behavior analysis studies.For more information on this research, you may want to visit my web site,www.FxPraxis.com.
Market FiltersMarket filters, in general, are statistical tools indicating possible high-risk trading areas or times. Because of the leverage and pace in FOREX trading, filterscan be extremely useful. If a filter prevents you from making a single bad trade,it has paid the cost of having it in your toolbox.Here is a simple example of a useful filter: The Federal Reserve makesroutine (and sometimes not so routine) pronouncements at 8:30 A.M. Eastern
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Standard Time. The markets—those involving the USD—often react very violently just after such announcements (as you will see in Figure 1.16). Pull upsome charts of this time of day and see for yourself. Observe how often themarket feints in one direction right after the announcement and then proceedsin the opposite direction soon thereafter. Don’t enter a trade just before a Fedannouncement. Do watch the action after an announcement. See Figures 1.15and 1.16.After you decide which pairs and crosses you will trade, it is important todevelop and keep a calendar of relevant events and announcements for thecountry in question. Serious traders will also follow general events in thatcountry for clues to news that may impact its currency.Your daily trade plan should include a calendar showing any such scheduled announcements. Not stepping in doo-doo is more important than findingthe pot of gold at the end of the rainbow. The pot of gold is always there, but ifyou lose too much money you will no longer be in the race to find it.Whereas fundamentals may be difficult to use, news is not. News provides important feedback about the market. A market’s reaction to news mayyield valuable clues as to the underlying strength or weakness of a currency. Isay more about using news in Part 3.
The Toolbox ApproachA typical toolbox takes tools from several categories:• Charts, including:• Bar Charts• Swing Charts• Point & Figure Charts• Candlestick Charts• Indicators—the list is long, but most can be reduced to these categories:• Moving averages• Oscillators• Bands• Stochastics• Cycles• Market filtersThe traditional trader will generally pull techniques from all these categories. That is both good and bad. It is good because more information formaking intelligent trading decisions is at your fingertips. It is bad because themore techniques you use, the more opaque your trading strategy becomes.The more opaque your strategy—the further away you get from the actual
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FIGURE 1.15 Fed Announcements.For those trading the USD versus any other currency, the announcements bythe Federal Reserve are critical. These announcements very often elicit highvolatility and extreme price movements, at least for a few minutes of trading.Most broker/dealer trading platforms have an economic calendar with all important news and announcements listed. One excellent resource iswww.ForexEconomicCalendar.com.Source: www.global-view.com.
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FIGURE 1.16
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Shockwaves
prices going by on your trading platform screen—the more difficult it is toknow what you are actually seeing and measuring. Consequently, it becomesmore difficult to convert that plethora of information to an actual trade. Themarkets move quickly and it is very easy to get lost in your own toolbox. Bythe time you find your hammer, some other trader has driven the nail home.Select tools that complement and supplement each other. If you use indicators, don’t use four different oscillators and no moving average; if you do,you’ve left out a good trending market tool. If you use charts, don’t use bothpoint and figure and swing charts—they overlap too much.Toolbox ConﬁgurationA no-nonsense, classical toolbox conﬁguration might look like this:ChartsBar chartsIndicatorsMoving averagesOscillatorsMarket FiltersTime-of-day studiesAnnouncements and news
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SummaryThis chapter is intended to give you a very brief overview of traditional tradingtechniques as a trading element—their pluses and minuses individually and collectively. The field of technical analysis is vast and enormously interesting. Thisis certainly one reason that most traders spend most of their time and efforthere. The resources of technical analysis are staggering, and the possibilities—for better or for worse—are endless.More specific information is presented in Parts 2 and 3 for those tools selected for the FxCodex method. The codex approach folds trading techniquesinto an analytical process and they become less important individually than theyare to the traditional trader.Don’t let the sheer quantity of information confuse or mislead you. Trading tools are only one-third of the successful trader’s set of elements. Moneymanagement and the soft elements are just as important, perhaps more so. Thealluring siren song of trading techniques has been the ruin of many, manytraders.Let the trader beware!
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The Soft Elementsof StyleIf it looks like a fish, be sure it can swim.—Charles B. Goodman
y soft elements I mean those elements less subject to objective criteria andmore dependent on a trader’s own personal and subjective likes and