Technical Analysis

What is technical analysis?

Technical analysis is an approach to forecasting commodity prices that examines patterns of price change, rates of change, and changes in volume of trading and open interest, without regard to underlying fundamental market factors. Technical analysis can work consistently only if the theory that price movements are a Random Walk is incorrect. (Source: CFTC)

Technical analysis, also known as charting, is the study of the trading history (the price and volume over time) of any type of traded security (stocks, commodities, etc.) to attempt to predict future prices.

Technical analysis (studying the price and trading history) stands in contrast to fundamental analysis (studying the actual nature of the stock or commodity in question), although some investors combine the two types of analysis in making investment decisions.

Technical analysis is primarily (but not exclusively) conducted by studying charts of past price and trading action. Many different methods and tools are used in technical analysis, but they all rely on the assumption that price patterns and trends exist in markets, and that they can be identified and exploited.

Technical analysis is not, of course, 100% accurate, but attempts to give results that are, simply, correct more often than they are wrong.

Indeed, the central strategy of many active traders is to trade often, terminating trades that prove to be incorrect decisions and "letting run" trades that prove to be correct decisions.

Technical analysis is viewed by many as more art than science; a good proportion of technical and fundamental traders view the other side with derision. Furthermore, within technical analysis, adherents of different technical analyses (say candlestick charting and Dow Theory), often treat each other's approaches with derision.

Some academic studies conclude technical analysis has little, if any, predictive power while other studies show that the practice can produce excess returns. For example, measurable forms of technical analysis, such as non-linear prediction using neural networks, have been shown to occasionally produce statistically significant prediction results.

As an example of the debate regarding the efficacy of technical analysis, Peter Lynch, a very well-known and successful fundamental analyst, once commented, "Charts are great for predicting the past." A Federal Reserve working paper has shown that the statistical properties of intraday foreign exchange prices change near "support and resistance" lines, without showing that this result could be used in a profitable trading strategy.

Technical analysis (studying the price and trading history) stands in contrast to fundamental analysis (studying the actual nature of the stock or commodity in question), although some investors combine the two types of analysis in making investment decisions.

Technical analysis is primarily (but not exclusively) conducted by studying charts of past price and trading action. Many different methods and tools are used in technical analysis, but they all rely on the assumption that price patterns and trends exist in markets, and that they can be identified and exploited.

Technical analysis is not, of course, 100% accurate, but attempts to give results that are, simply, correct more often than they are wrong.

Indeed, the central strategy of many active traders is to trade often, terminating trades that prove to be incorrect decisions and "letting run" trades that prove to be correct decisions.

Technical analysis is viewed by many as more art than science; a good proportion of technical and fundamental traders view the other side with derision. Furthermore, within technical analysis, adherents of different technical analyses (say candlestick charting and Dow Theory), often treat each other's approaches with derision.

Some academic studies conclude technical analysis has little, if any, predictive power while other studies show that the practice can produce excess returns. For example, measurable forms of technical analysis, such as non-linear prediction using neural networks, have been shown to occasionally produce statistically significant prediction results.

As an example of the debate regarding the efficacy of technical analysis, Peter Lynch, a very well-known and successful fundamental analyst, once commented, "Charts are great for predicting the past." A Federal Reserve working paper has shown that the statistical properties of intraday foreign exchange prices change near "support and resistance" lines, without showing that this result could be used in a profitable trading strategy.

History

The premises of technical analysis were derived from observation of financial markets over hundreds of years. The oldest branch of technical analysis is the use of candlestick techniques by Japanese traders at least as early as the 18th century, and now one of the main charting techniques.

Traditionally, "Honno, the God of the markets," a very successful rice trader in early Japan, is said to have invented technical analysis.

Dow Theory, a theory based on the collected writings of Dow Jones co-founder and editor Charles Dow, inspired the use and development of technical analysis from the end of the 19th century. Modern technical analysis considers Dow Theory its cornerstone.

Technical tools and theories have been developed and enhanced in recent decades, with an increasing emphasis on computer-assisted techniques.

Technical analysis is not concerned with why a price is moving (e.g. poor earnings, difficult business environment, poor management, or other fundamentals) but rather whether it is moving in a particular direction or in a particular chart pattern. Technical analysts believe that profits can be made by "Trend following." In other words if a particular stock price is steadily rising (trending upward) then a technical analyst will look for opportunities to buy this stock.

Until the technical analyst is convinced this uptrend has reversed or ended, all else equal, he will continue to own this security. Additionally, technical analysts look for various price patterns to form on a price chart and will take positions in anticipation of the expected move following that pattern. The tools of technical analysis are believed to assist the technician in determining when trends have formed, ended, etc. and when particular patterns are unfolding.

For example, a popular technical analysis tool is a stock price's 200 day moving average. This is usually defined as the average closing price of a stock over the past 200 trading days (though there are many variations on the moving average used in technical analysis). A stock that has been trending higher will have a history of an increasing daily stock price and an increasing 200 day moving average. Though the daily stock price fluctuates (up 50 cents on day 1, down 20 cents on day 2, up 10 cents on day 3, etc.), the 200 day moving average changes much more slowly and traces a smooth curve that follows the current price on a chart.

When the 200 day moving average is violated by the daily stock price, a technical analyst uses this as strong evidence that a price trend has ended and that possibly a new one has begun to the opposite direction. Suppose IBM's 200 day moving average was 85 and the stock has been trending higher. If IBM closed at 84.50, then a technical analyst would consider selling his IBM holdings and perhaps selling short IBM because the perceived trend is ending.

The above example illustrates a few important characteristics and potential shortfalls of technical analysis. Much of technical analysis is art and open to some varying interpretation. One technical analyst might believe that IBM would need to trade below its moving average for two consecutive days before declaring its trend over. Another might say one day is adequate. To a technician a close below the 200 day moving average is always important, but two technicans might disagree on the best way to act. Still, it is safe to assume that both technicians expect to sell IBM.

The obvious problem in this example is: what if in the near term IBM climbs back above its 200 day moving average after the technician sells his stock? If the technical analyst follows his own rules then he might be buying stock back at a higher price than he just sold plus commissions. This is a substantial component of some of the criticisms of technical analysis. Technical analysis says "false signals" or "whipsaws" are an unavoidable part of using technical analysis. To a technical analyst, the costs of these whipsaws are far outweighed by catching a stock at the beginning of a new long term trend. Some research disputes this assertion however.

Technical analysis may be at odds with fundamental analysis. Fundamental analysis maintains that markets may misprice a security and, through various methods of fundamental analysis, the "correct" price can be calculated. Profits can be made by trading the mispriced security and then waiting for the market to recognize its "mistake" and reprice the security. In contrast, a technical analyst is not interested in a security's "correct" price, only in price movement.

Two well known sayings among technical analysts are, "The trend is your friend," and "Forget the fundamentals and follow the money." An example of the different views of technical and fundamental analysis follows. Suppose a stock was trading at 124.25 pence, and that the consensus fundamental analysis view of the stock was that it was worth 120.00 pence. If the share price rose to 125.00 pence, then to 126.00 pence, and then to 127.00 pence, a technical analyst would likely be a buyer of this stock in order to profit from the perceived trend. In contrast, a fundamental analyst would possibly look to sell the stock as it is moving away from what the fundamental analyst believes is the "correct" price. (Source: Wikipedia)

See also:
Charting and Chartists
Technical Analysis Blog Posts

Short Selling

What is short selling?

A short sale involves selling a futures contract or other instrument with the idea of delivering on it or offsetting it at a later date. (Source: CFTC)

A short sale is generally the sale of a stock you do not own. Investors who sell short believe the price of the stock will fall. If the price drops, you can buy the stock at the lower price and make a profit. If the price of the stock rises and you buy it back later at the higher price, you will incur a loss.

When you sell short, your brokerage firm loans you the stock. The stock you borrow comes from either the firm’s own inventory, the margin account of another of the firm’s clients, or another brokerage firm. The short seller later closes out the position by returning the security to the lender, typically by purchasing securities on the open market. In general, short selling is utilized to profit from an expected downward price movement, to provide liquidity in response to buyer demand, or to hedge the risk of a long position in the same or a related security.

As with buying stock on margin, you are subject to the margin rules. Other fees and charges may apply. If the stock you borrow pays a dividend, you must pay the dividend to the person or firm making the loan. (Source: SEC)

In finance, short selling or "shorting" is a way to profit from the decline in price of a security, such as stock or a bond. Most investors "go long" on an investment, hoping that price will rise. To profit from the stock price going down, a short seller can borrow a security and sell it, expecting that it will decrease in value so that they can buy it back at a lower price and keep the difference. For example, assume that shares in XYZ Company currently sell for $10 per share. A short seller would borrow 100 shares of XYZ Company, and then immediately sell those shares for a total of $1000. If the price of XYZ shares later falls to $8 per share, the short seller would then buy 100 shares back for $800, return the shares to their original owner, and make a $200 profit. This practice has the potential for an unlimited loss, for example, if the shares of XYZ that one borrowed and sold in fact went up to $25, the short seller would have to buy back all the shares at $2500, losing $1500.

However, the term "short selling" or "being short" is often used as a blanket term for all those strategies which allow an investor to gain from the decline in price of a security. Those strategies include buying options known as puts. In fact, what is many times labeled short selling is options or futures activity, since this activity greatly magnifies the gain that results from a securities price loss. For example, if the next earnings release of XYZ company is going to show that its profits declined somewhat in some of its divisions, its stock might decline only 5 percent when that information is released. Someone within the company who wants to trade in inside information however would probably not be satisifed with only a 5 percent gain on his short sell and instead would buy put options or other derivatives or futures to gain possibly 20 or more percent on the decline in the stock price of XYZ. (Source: Wikipedia)

Scalpers and Scalping

What is a scalper? What is scalping?

A scalper is a speculator on the trading floor of an exchange who buys and sells rapidly, with small profits or losses, holding his positions for only a short time during a trading session. Typically, a scalper will stand ready to buy at a fraction below the last transaction price and to sell at a fraction above, e.g., to buy at the bid and sell at the offer or ask price, with the intent of capturing the spread between the two, thus creating market liquidity. (Source: CFTC)

Scalping is simply playing the spread. Scalpers attempt to act like traditional market makers or specialists. To make the spread means to simply buy at the Bid price and sell at the Ask price, to gain the bid/ask difference. This procedure allows for profit even when the bid and ask don't move at all, as long as there are traders who are willing to take market prices. It normally involves establishing and liquidating a position quickly, usually within minutes to even seconds.

The role of a scalper is actually the role of market makers or specialists who are to maintain the liquidity and order flow of a product of a market.

A market maker is basically a specialized scalper. The volume it trades are many times more than the average individual scalpers. It has sophisticated trading systems to monitor its trading activity. However it is bound by strict exchange rules while the individual trader is not. For instance, NASDAQ requires each market maker to post at least one bid and one ask at some price level, so as to maintain a two-sided market for each stock it represents.

Due to role overlapping, a scalper is always competing with the market maker for profits. Unfortunately, the low-end scalper is almost always at a disadvantage due to the following market maker's advantages:

1. superior execution speed as an insider
2. a greater knowledge of trading and the actual market situation due to its information gathering capacity
3. huge amount of capital to backup and support market makers
4. the ability to provide false impression to the market by placing a larger/smaller bid or ask to bluff the trader

(Source: Wikipedia)

Hedging

What is hedging?

Hedging involves taking a position in a futures market opposite to a position held in the cash market to minimize the risk of financial loss from an adverse price change; or a purchase or sale of futures as a temporary substitute for a cash transaction that will occur later. One can hedge either a long cash market position (e.g., one owns the cash commodity) or a short cash market position (e.g., one plans on buying the cash commodity in the future). (Source: CFTC)

In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business to profit from an investment activity. Typically, a hedger might invest in a security that he believes is under-priced relative to its "fair value" (for example a mortgage loan that he is then making), and combine this with a short sale of a related security or securities. Thus the hedger doesn't care whether the market as a whole goes up or down in value, only whether the under-priced security appreciates relative to the hedge. Holbrook Working, a pioneer in hedging theory, called this strategy "speculation in the basis," where the basis is the difference between the security's theoretical value and its actual value (or between spot and futures prices in Working's time).

Some form of risk taking is inherent to any business activity. Some risks are considered to be "natural" to specific businesses, such as the risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other forms of risk are not wanted, but cannot be avoided without hedging. Someone who has a shop, for example, can take care of natural risks such as the risk of competition, of poor or unpopular products, and so on. The risk of the shopkeeper's inventory being destroyed by fire is unwanted, however, and can be hedged via a fire insurance contract. Not all hedges are financial instruments: a producer that exports to another country, for example, may hedge its currency risk when selling by linking its expenses to the desired currency.

Many hedges do not involve exotic financial instruments or derivatives. A natural hedge is an investment that reduces the undesired risk by matching cash flows, (for example) revenues and expenses. For example, an exporter to the United States faces a risk of changes in the value of the U.S. dollar, and could choose to open a production facility in that market to match its expected sales revenue to its cost structure. Another example is a company that opens a subsidiary in another country and borrows in the local currency to finance its operations, even though the local interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the local currency, the parent company has reduced its foreign currency exposure.

Similarly, an oil producer may expect to receive its revenues in U.S. dollars, but face costs in a different currency; it would be applying a natural hedge if it agreed to, for example, pay bonuses to employees in U.S. dollars.

Currency hedging is used both by financial investors to parse out the risks they encounter when investing overseas, as well as by non-financial actors in the global economy for whom multi-currency activities is a necessary evil rather than a desired state of exposure.

For example, cost of labor variables dictate that much of the simple commoditized manufacturing in the global economy today goes on in China and south-east Asia (Taiwan, Philippines, Vietnam, Indonesia, etc.). The cost benefit of moving manufacturing to outsource providers outweighs the uncertainties of never having done business in foreign countries, so many businesses are jumping into the fray and becoming part of the globalization trend of moving manufacturing operations overseas. The benefits of doing this however, come with numerous risks that were never a problem when manufacturing was done at home--among them currency risk.

If your cost of manufacturing goods in another country is denominated in a currency other than the one that you sell the finished goods in, there is the risk that the currency "volatility" alone may destroy the margin between what you pay to produce your product, and what you collect when you sell it (note you may be selling your product in a foreign country too, so you can hedge against the currency risk on this side as well!). So when you convert all costs on the production side, and all sales receipts from the retail side, back into your home currency, you may be alarmed to find that your profits have diminished significantly, or disappeared altogether. That's currency risk-- it is germane to doing business globally, but entirely independent of your specific business or products. Currency hedging then, is the insurance you can purchase to limit the impact this unpredictable risk has on your business, the same way Fire or Hurricane insurance protects your physical premises from unexpected events beyond your control.

Currency hedging is not always available, but is readily found at least in the major currencies of the world economy, the growing list of which qualify as major liquid markets beginning with the "Major Eight" (USD, GBP, EUR, JPY, CHF, HKD, AUD, CAD), which are also called the "Benchmark Currencies", and expands to include several others by virtue of liquidity. The currencies beyond the Major 8 can most reliably be identified by checking to see which are included within the "Continuous-Linked Settlement Bank" "(CLS Bank)", which handles a growing percentage of the globe's daily settlement volume between currencies.

Currency hedging, like many other forms of financial hedging, can be done in two primary ways, with standardized contracts, or with customized contracts (also known as over-the-counter or OTC).

The financial investor application may be that a hedge fund (let's say, based in New York) finds a great company to invest in, but doesn't want to necessarily be investing in the currency of the country this company resides in (let's say, Brazil for example). So, the hedge fund can separate out the credit risk (eg the Company, which it wants to take a position in), from the currency risk (eg the Brazilian Real, which it doesn't want to take a position in) by "hedging" out the currency risk. In effect, this means that the investment the hedge fund makes into the company is effectively a USD investment, in Brazil. Hedging product allows the investor to transfer the currency risk to someone else who does want to take a position in the currency. The New York based hedge fund has to pay this other investor to take on the currency exposure, the same way you pay any insurance company to provide insurance against an unknown outcome. The "gamble" the insurance provider takes is that the ultimate outcome during the period insured will not exceed the amount the buyer paid; the insurance provider may, however, be hedging their own risk on a similar (mirror image) transaction. In this way, the global economy becomes more efficient, because two investors are able to take positions they both want. (Source: Wikipedia)

See also:
Hedge Fund

Fundamental Analysis

What is fundamental analysis?

Fundamental analysis is the sudy of basic, underlying factors that will affect the supply and demand, and thus the price, of a financial instrument such as a stock, commodity, or currency. (Source: CFTC)

Fundamental analysis maintains that markets may misprice a security in the short run but that the "correct" price will eventually be reached. Profits can be made by trading the mispriced security and then waiting for the market to recognize its "mistake" and reprice the security. Even if the investor believes he cannot beat the market index, he may still pick stock for the challenge, for the fun of trying, and for the ego rush when he does beat the market. (Source: Wikipedia)

Day Traders and Day Trading

What is a day trader? What is day trading?

A day trader is a trader, often a person with exchange trading privileges, who takes positions and then offsets them during the same trading session prior to the close of trading. (Source: CFTC)

Day traders rapidly buy and sell stocks, commodities, or currencies throughout the day in the hope that they will continue climbing or falling in value for the seconds to minutes they own them, allowing them to lock in quick profits. Day trading is extremely risky and can result in substantial financial losses in a very short period of time. (Source: SEC)

Day trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions will usually (not necessarily always) be closed before the market close of the trading day. Traders performing day trading are called day traders.

Some of the more commonly day-traded financial instruments are stocks, stock options, currencies, and a host of futures contracts such as equity index futures, interest rate futures, and commodity futures.

Due to the nature of leverage and rapid returns, day trading can be extremely profitable and high-risk profile traders can generate huge percentage returns. Some day traders can manage to earn millions per year solely by day trading.

Nevertheless day trading can become very risky, especially if one has poor discipline, risk or money management. The common use of buying on margin (using borrowed funds) amplifies gains and losses, such that substantial losses or gains can occur in a very short period of time. In addition, a broker usually allow more margins for daytraders. Where overnight margin required to hold a stock position is normally 50% of the stock's value, many brokers allow pattern day trader accounts to use levels as low as 25% for intraday purchases. That means even a day trader with the minimum $25,000 in his account can buy $100,000 worth of stock during the day, as long as half of those positions are exited before the market close. Thus a day trader has to admit mistakes quickly and cut losses fast when the market goes against a position. Even when a position is in profit the day-trader needs to be careful since the profit plus any dividend has to offset the transaction costs and the interest on the margin. (Source: Wikipedia)

Charting and Chartists

What is charting? What is a chartist?

Charting is the use of graphs and charts in the technical analysis of markets to plot trends of price movements, average movements of price, volume of trading, and open interest.

A chartist is a technical trader who reacts to signals derived from graphs of price movements. Other terms for chartist are technical analyst or technical trader.

Charts are a key component of technical analysis of market behavior.

(Source: CFTC)

See also:
Technical Analysis

Arbitrage

What is arbitrage?

A strategy involving the simultaneous purchase and sale of identical or equivalent commodity futures contracts or other instruments across two or more markets in order to benefit from a discrepancy in their price relationship. In a theoretical efficient market, there is a lack of opportunity for profitable arbitrage. (Source: CFTC)

In economics, arbitrage is the practice of taking advantage of a price differential between two or more markets: a combination of matching deals are struck that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, a risk-free profit. A person who engages in arbitrage is called an arbitrageur. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives and currencies.

If the market prices do not allow for profitable arbitrage, the prices are said to constitute an arbitrage equilibrium or arbitrage free market. An arbitrage equilibrium is a precondition for a general economic equilibrium.

Arbitrage is possible when one of three conditions is met:

1. The same asset does not trade at the same price on all markets ("the law of one price").
2. Two assets with identical cash flows do not trade at the same price.
3. An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securities).

Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency exchange rates, the price of commodities, and the price of securities in different markets tend to converge to the same prices, in all markets, in each category. The speed at which prices converge is a measure of market efficiency. Arbitrage tends to reduce price discrimination by encouraging people to buy an item where the price is low and resell it where the price is high, as long as the buyers are not prohibited from reselling and the transactions cost of buying, holding and reselling are small relative to the difference in prices in the different markets. (Source: Wikipedia)