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Candlestick chart of EURUSD
A candlestick chart is a style of bar-chart used primarily to describe price movements of a security (finance), derivative, or currency over time.
It is a combination of a line-chart and a bar-chart, in that each bar represents the range of price movement over a given time interval. It is most often used in technical analysis of equity and currency price patterns. They appear superficially similar to error bars, but are unrelated.
Contents
[hide]
• 1 History
• 2 Candlestick chart topics
o 2.1 Candlestick layout
o 2.2 Candlestick simple patterns
o 2.3 Complex Patterns
o 2.4 Use of candlestick charts
• 3 Heiken-Ashi candlesticks
• 4 See also
• 5 References
• 6 External links
History
Candlestick charts are said to have been developed in the 18th century by legendary Japanese rice trader Homma Munehisa. The charts gave Homma and others an overview of open, high, low, and close market prices over a certain period. This style of charting is very popular due to the level of ease in reading and understanding the graphs. Since the 17th century, there has been a lot of effort to relate chart patterns to the ldata points instead of one. The Japanese rice traders also found that the resulting charts would provide a fairly reliable tool to predict future demand.
The method was picked up by Charles Dow around 1900 and remains in common use by today's traders of financial instruments.
Candlestick chart topics
The basic candlestick
Candlestick layout
Candlesticks are usually composed of the body (black or white), and an upper and a lower shadow (wick). The wick illustrates the highest and lowest traded prices of a security during the time interval represented. The body illustrates the opening and closing trades. If the security closed higher than it opened, the body is white or unfilled, with the opening price at the bottom of the body and the closing price at the top. If the security closed lower than it opened, the body is black, with the opening price at the top and the closing price at the bottom. A candlestick need not have either a body or a wick.
To better highlight price movements, modern candlestick charts (especially those displayed digitally) often replace the black or white of the candlestick body with colors such as red (for a lower closing) and blue or green (for a higher closing).
Candlestick simple patterns
There are multiple forms of candlestick chart patterns, with the simplest depicted at right. Here is a quick overview of their names:
1. White candlestick - signals uptrend movement (those occur in different lengths; the longer the body, the more significant the price increase)
2. Black candlestick - signals downtrend movement (those occur in different lengths; the longer the body, the more significant the price decrease)
3. Long lower shadow - bullish signal (the lower wick must be at least the body's size; the longer the lower wick, the more reliable the signal)
4. Long upper shadow - bearish signal (the upper wick must be at least the body's size; the longer the upper wick, the more reliable the signal)
5. Hammer - a bullish pattern during a downtrend (long lower wick and small or no body); Shaven head - a bullish pattern during a downtrend & a bearish pattern during an uptrend (no upper wick); Hanging man - bearish pattern during an uptrend (long lower wick, small or no body; wick has the multiple length of the body.
6. Inverted hammer - signals bottom reversal, however confirmation must be obtained from next trade (may be either a white or black body); Shaven bottom - signaling bottom reversal, however confirmation must be obtained from next trade (no lower wick); Shooting star - a bearish pattern during an uptrend (small body, long upper wick, small or no lower wick)
7. Spinning top white - neutral pattern, meaningful in combination with other candlestick patterns
8. Spinning top black - neutral pattern, meaningful in combination with other candlestick patterns
9. Doji - neutral pattern, meaningful in combination with other candlestick patterns
10. Long legged doji - signals a top reversal
11. Dragonfly doji - signals trend reversal (no upper wick, long lower wick)
12. Gravestone doji - signals trend reversal (no lower wick, long upper wick)
13. Marubozu white - dominant bullish trades, continued bullish trend (no upper, no lower wick)
14. Marubozu black - dominant bearish trades, continued bearish trend (no upper, no lower wick)
Complex Patterns
Itimoku Kinkô Hyô, the applied candlestick chart commonly used in Japan.
In addition to the rather simple patterns depicted in the section above, there are more complex and difficult patterns which have been identified since the charting method's inception.
Candlestick charts also convey more information than other forms of charts, such as bar charts. Just as with bar charts, they display the absolute values of the open, high, low, and closing price for a given period. But they also show how those prices are relative to the prior periods' prices, so one can tell by looking at one bar if the price action is higher or lower than the prior one. They are also visually easier to look at[citation needed], and can be colorized for even better definition.
Use of candlestick charts
Candlestick charts are a visual aid for decision making in stock, forex, commodity, and options trading. For example, when the bar is white and high relative to other time periods, it means buyers are very bullish. The opposite is true for a black bar.
Heiken-Ashi candlesticks
Heiken-Ashi (Japanese for 'average bar') candlesticks are a weighted version of candlesticks calculated with the following formula:
• Open = (open of previous bar+close of previous bar)/2
• Close = (open+high+low+close)/4
• High = maximum of high, open, or close (whichever is highest)
• Low = minimum of low, open, or close (whichever is lowest)
Heiken-Ashi candlesticks must be used with caution with regards to the price as the body doesn't necessarily sync up with the actual open/close. Unlike with regular candlesticks, a long wick shows more strength, whereas the same period on a standard chart might show a long body with little or no wick. Depending on the software or user preference, Heiken-Ashi may be used to chart the price (instead of line, bar, or candlestick), as an indicator overlaid on a regular chart, or an as indicator plotted on a separate window.
Tuesday, January 1, 2008
Technical analysis
Technical analysis is a security analysis discipline for forecasting the future direction of prices through the study of past market data, primarily price and volume.[1]
Contents
[hide]
• 1 History
• 2 General description
• 3 Characteristics
• 4 Principles
o 4.1 Market action discounts everything
o 4.2 Prices move in trends
o 4.3 History tends to repeat itself
• 5 Industry
• 6 Use
• 7 Systematic trading
o 7.1 Neural networks
o 7.2 Rule-based trading
• 8 Combination with other market forecast methods
• 9 Charting terms and indicators
o 9.1 Types of Charts
o 9.2 Concepts
o 9.3 Overlays
o 9.4 Price-based indicators
o 9.5 Volume based indicators
• 10 Empirical evidence
o 10.1 Efficient market hypothesis
10.1.1 Random walk hypothesis
• 11 See also
• 12 Notes
• 13 Books
• 14 External links
History
The principles of technical analysis derive from the observation of financial markets over hundreds of years.[citation needed] The oldest known example of technical analysis was a method developed by Homma Munehisa during early 18th century which evolved into the use of candlestick techniques, and is today a main charting tool.[2][3]
Dow Theory is based on the collected writings of Dow Jones co-founder and editor Charles Dow, and inspired the use and development of modern technical analysis from the end of the 19th century. Other pioneers of analysis techniques include Ralph Nelson Elliott and William Delbert Gann who developed their respective techniques in the early 20th century.
Many more technical tools and theories have been developed and enhanced in recent decades, with an increasing emphasis on computer-assisted techniques.
General description
Technical analysts seek to identify price patterns and trends in financial markets and attempt to exploit those patterns.[4] While technicians use various methods and tools, the study of price charts is primary.
Technicians especially search for archetypal patterns, such as the well-known head and shoulders or double top reversal patterns, study indicators such as moving averages, and look for forms such as lines of support, resistance, channels, and more obscure formations such as flags, pennants or balance days.
Technical analysts also extensively use indicators, which are typically mathematical transformations of price or volume. These indicators are used to help determine whether an asset is trending, and if it is, its price direction. Technicians also look for relationships between price, volume and, in the case of futures, open interest. Examples include the relative strength index, and MACD. Other avenues of study include correlations between changes in options (implied volatility) and put/call ratios with price. Other technicians include sentiment indicators, such as Put/Call ratios and Implied Volatility in their analysis.
Technicians seek to forecast price movements such that large gains from successful trades exceed more numerous but smaller losing trades, producing positive returns in the long run through proper risk control and money management.
There are several schools of technical analysis. Adherents of different schools (for example, candlestick charting, Dow Theory, and Elliott wave theory) may ignore the other approaches, yet many traders combine elements from more than one school. Technical analysts use judgment gained from experience to decide which pattern a particular instrument reflects at a given time, and what the interpretation of that pattern should be.
Technical analysis is frequently contrasted with fundamental analysis, the study of economic factors that influence prices in financial markets. Technical analysis holds that prices already reflect all such influences before investors are aware of them, hence the study of price action alone. Some traders use technical or fundamental analysis exclusively, while others use both types to make trading decisions.
Users of technical analysis are most often called technicians or market technicians. Some prefer the term technical market analyst or simply market analyst. An older term, chartist, is sometimes used, but as the discipline has expanded and modernized the use of the term chartist has become rare.[citation needed]
Characteristics
Technical analysis employs models and trading rules based on price and volume transformations, such as the relative strength index, moving averages, regressions, inter-market and intra-market price correlations, cycles or, classically, through recognition of chart patterns.
Technical analysis stands in contrast to the fundamental analysis approach to security and stock analysis. Technical analysis "ignores" the actual nature of the company, market, currency or commodity and is based solely on "the charts," that is to say price and volume information, whereas fundamental analysis does look at the actual facts of the company, market, currency or commodity. For example, any large brokerage, trading group, or financial institution will typically have both a technical analysis and fundamental analysis team.
Technical analysis is widely used among traders and financial professionals, and is very often used by active day traders, market makers, and pit traders. In the 1960s and 1970s it was widely dismissed by academics. In a recent review, Irwin and Park[5] reported that 56 of 95 modern studies found it produces positive results, but noted that many of the positive results were rendered dubious by issues such as data snooping so that the evidence in support of technical analysis was inconclusive; it is still considered by many academics to be pseudoscience.[6] Academics such as Eugene Fama say the evidence for technical analysis is sparse and is inconsistent with the weak form of the efficient market hypothesis.[7][8] Users hold that even if technical analysis cannot predict the future, it helps to identify trading opportunities.[9]
In the foreign exchange markets, its use may be more widespread than fundamental analysis.[10][11] While some isolated studies have indicated that technical trading rules might lead to consistent returns in the period prior to 1987,[12][13][14][15] most academic work has focused on the nature of the anomalous position of the foreign exchange market.[16] It is speculated that this anomaly is due to central bank intervention.[17] Recent research suggests that combining various trading signals into a Combined Signal Approach may be able to increase profitability and reduce dependence on any single rule.[18].
Principles
Stock chart showing levels of support (4,5,6, 7, and 8) and resistance (1, 2, and 3); levels of resistance tend to become levels of support and vice versa.
Technicians say that a market's price reflects all relevant information, so their analysis looks more at "internals" than at "externals" such as news events. Price action also tends to repeat itself because investors collectively tend toward patterned behavior – hence technicians' focus on identifiable trends and conditions.
Market action discounts everything
Based on the premise that all relevant information is already reflected by prices, pure technical analysts believe it is redundant to do fundamental analysis – they say news and news events do not significantly influence price, and cite supporting research such as the study by Cutler, Poterba, and Summers titled "What Moves Stock Prices?"
On most of the sizable return days [large market moves]...the information that the press cites as the cause of the market move is not particularly important. Press reports on adjacent days also fail to reveal any convincing accounts of why future profits or discount rates might have changed. Our inability to identify the fundamental shocks that accounted for these significant market moves is difficult to reconcile with the view that such shocks account for most of the variation in stock returns.[19]
Prices move in trends
See also: Market trends
Technical analysts believe that prices trend. Technicians say that markets trend up, down, or sideways (flat). This basic definition of price trends is the one put forward by Dow Theory.[4]
An example of a security that had an apparent trend is AOL from November 2001 through August 2002. A technical analyst or trend follower recognizing this trend would look for opportunities to sell this security. AOL consistently moves downward in price. Each time the stock rose, sellers would enter the market and sell the stock; hence the "zig-zag" movement in the price. The series of "lower highs" and "lower lows" is a tell tale sign of a stock in a down trend.[20] In other words, each time the stock edged lower, it fell below its previous relative low price. Each time the stock moved higher, it could not reach the level of its previous relative high price.
Note that the sequence of lower lows and lower highs did not begin until August. Then AOL makes a low price that doesn't pierce the relative low set earlier in the month. Later in the same month, the stock makes a relative high equal to the most recent relative high. In this a technician sees strong indications that the down trend is at least pausing and possibly ending, and would likely stop actively selling the stock at that point.
History tends to repeat itself
Technical analysts believe that investors collectively repeat the behavior of the investors that preceded them. "Everyone wants in on the next Microsoft," "If this stock ever gets to $50 again, I will buy it," "This company's technology will revolutionize its industry, therefore this stock will skyrocket" – these are all examples of investor sentiment repeating itself. To a technician, the emotions in the market may be irrational, but they exist. Because investor behavior repeats itself so often, technicians believe that recognizable (and predictable) price patterns will develop on a chart.[4]
Technical analysis is not limited to charting, but it always considers price trends. For example, many technicians monitor surveys of investor sentiment. These surveys gauge the attitude of market participants, specifically whether they are bearish or bullish. Technicians use these surveys to help determine whether a trend will continue or if a reversal could develop; they are most likely to anticipate a change when the surveys report extreme investor sentiment. Surveys that show overwhelming bullishness, for example, are evidence that an uptrend may reverse – the premise being that if most investors are bullish they have already bought the market (anticipating higher prices). And because most investors are bullish and invested, one assumes that few buyers remain. This leaves more potential sellers than buyers, despite the bullish sentiment. This suggests that prices will trend down, and is an example of contrarian trading.
Industry
Globally, the industry is represented by the International Federation of Technical Analysts (IFTA). In the United States, there are two national organizations: the Market Technicians Association (MTA), and the American Association of Professional Technical Analysts (AAPTA). The United States is also represented by the Technical Security Analysts Association of San Francisco (TSAASF). In the United Kingdom, the industry is represented by the Society of Technical Analysts (STA). In Canada the industry is represented by the Canadian Society of Technical Analysts. Additional major professional technical analysis organizations are noted in the External Links section below.
Professional technical analysis societies have worked on creating a Body of Knowledge that describes the field of Technical Analysis. A Body of Knowledge is central to the field as a way of defining how and why technical analysis may work. It can then be used by academia, as well as regulatory bodies, in developing proper research and standards for the field. The Market Technicians Association (MTA) has published a Body of Knowledge and the International Federation of Technical Analysts and the Nippon Technical Analysis Association are reported to be working on knowledge base projects.
Use
Many traders say that trading in the direction of the trend is the most effective means to be profitable in financial or commodities markets. John W. Henry, Larry Hite, Ed Seykota, Richard Dennis, William Eckhardt, Victor Sperandeo, Michael Marcus and Paul Tudor Jones (some of the so-called Market Wizards in the popular book of the same name by Jack D. Schwager) have each amassed massive fortunes via the use of technical analysis and its concepts. George Lane, a technical analyst, coined one of the most popular phrases on Wall Street, "The trend is your friend!"
Many non-arbitrage algorithmic trading systems rely on the idea of trend-following, as do many hedge funds. A relatively recent trend, both in research and industrial practice, has been the development of increasingly sophisticated automated trading strategies. These often rely on underlying technical analysis principles (see algorithmic trading article for an overview).
Systematic trading
Neural networks
Since the early 1990s when the first practically usable types emerged, artificial neural networks (ANNs) have rapidly grown in popularity. They are artificial intelligence adaptive software systems that have been inspired by how biological neural networks work. They are used because they can learn to detect complex patterns in data. In mathematical terms, they are universal function approximators,[21][22] meaning that given the right data and configured correctly, they can capture and model any input-output relationships. This not only removes the need for human interpretation of charts or the series of rules for generating entry/exit signals, but also provides a bridge to fundamental analysis, as the variables used in fundamental analysis can be used as input.
As ANNs are essentially non-linear statistical models, their accuracy and prediction capabilities can be both mathematically and empirically tested. In various studies, authors have claimed that neural networks used for generating trading signals given various technical and fundamental inputs have significantly outperformed buy-hold strategies as well as traditional linear technical analysis methods when combined with rule-based expert systems.[23][24][25]
While the advanced mathematical nature of such adaptive systems has kept neural networks for financial analysis mostly within academic research circles, in recent years more user friendly neural network software has made the technology more accessible to traders. However, large-scale application is problematic because of the problem of matching the correct neural topology to the market being studied.
Rule-based trading
Rule-based trading is an approach intended to create trading plans using strict and clear-cut rules. Unlike some other technical methods and the approach of fundamental analysis, it defines a set of rules that determine all trades, leaving minimal discretion. The theory behind this approach is that by following a distinct set of trading rules you will reduce the number of poor decisions, which are often emotion based.
For instance, a trader might make a set of rules stating that he will take a long position whenever the price of a particular instrument closes above its 50-day moving average, and shorting it whenever it drops below.
Combination with other market forecast methods
John Murphy says that the principal sources of information available to technicians are price, volume and open interest.[26] Other data, such as indicators and sentiment analysis, are considered secondary.
However, many technical analysts reach outside pure technical analysis, combining other market forecast methods with their technical work. One advocate for this approach is John Bollinger, who coined the term rational analysis in the middle 1980s for the intersection of technical analysis and fundamental analysis.[2] Another such approach, fusion analysis, [3] overlays fundamental analysis with technical, in an attempt to improve portfolio manager performance.
Technical analysis is also often combined with quantitative analysis and economics. For example, neural networks may be used to help identify intermarket relationships.[4] A few market forecasters combine financial astrology with technical analysis. Chris Carolan's article "Autumn Panics and Calendar Phenomenon", which won the Market Technicians Association Dow Award for best technical analysis paper in 1998, demonstrates how technical analysis and lunar cycles can be combined.[5] It is worth noting, however, that some of the calendar related phenomena, such as the January effect in the stock market, have been associated with tax and accounting related reasons.
Investor and newsletter polls, and magazine cover sentiment indicators, are also used by technical analysts.[6]
Charting terms and indicators
Types of Charts
• OHLC - Open High Low Close charts plot the high and low of the price movement vertically and the open and close horizontally. Used to graph range and outliers.
• Candlestick chart - Similar to OHLC, but open and close are filled. Often Black or Red candles represent a close lower than the open. While White, Green or Blue candles represent a close higher than the open.
• Line chart - Connects each closing interval together on a line
Concepts
• Average true range - averaged daily trading range, adjusted for price gaps
• Chart pattern - distinctive pattern created by the movement of security prices on a chart
• Dead cat bounce - the phenomenon whereby a spectacular decline in the price of a stock is immediately followed by a moderate and temporary rise before resuming its downward movement
• Elliott wave principle and the golden ratio to calculate successive price movements and retracements
• Momentum - the rate of price change
• Point and figure charts - charts based on price without time
Overlays
Overlays are generally superimposed over the main price chart.
• Resistance - an area that brings on increased selling
• Support - an area that brings on increased buying
• Breakout - when a price passes through and stays above an area of support or resistance
• Trend line - a sloping line of support or resistance
• Channel - a pair of parallel trend lines
• Moving average - lags behind the price action but filters out short term movements
• Bollinger bands - a range of price volatility
• Pivot point - derived by calculating the numerical average of a particular currency's or stock's high, low and closing prices
Price-based indicators
These indicators are generally shown below or above the main price chart.
• Accumulation/distribution index—based on the close within the day's range
• Advance decline line — a popular indicator of market breadth
• Average Directional Index — a widely used indicator of trend strength
• Commodity Channel Index - identifies cyclical trends
• MACD - moving average convergence/divergence
• Parabolic SAR - Wilder's trailing stop based on prices tending to stay within a parabolic curve during a strong trend
• Relative Strength Index (RSI) - oscillator showing price strength
• Stochastic oscillator, close position within recent trading range
• Trix - an oscillator showing the slope of a triple-smoothed exponential moving average, developed in the 1980s by Jack Hutson
Volume based indicators
• Money Flow - the amount of stock traded on days the price went up
• On-balance volume - the momentum of buying and selling stocks
• PAC charts - two-dimensional method for charting volume by price level
Empirical evidence
Whether technical analysis actually works is a matter of controversy. Methods vary greatly, and different technical analysts can sometimes make contradictory predictions from the same data. Many investors claim that they experience positive returns, but academic appraisals often find that it has little predictive power.[27] Modern studies may be more positive: of 95 modern studies, 56 concluded that technical analysis had positive results, although data-snooping bias and other problems make the analysis difficult.[5] Nonlinear prediction using neural networks occasionally produces statistically significant prediction results.[28] A Federal Reserve working paper[13] regarding support and resistance levels in short-term foreign exchange rates "offers strong evidence that the levels help to predict intraday trend interruptions," although the "predictive power" of those levels was "found to vary across the exchange rates and firms examined".
Technical trading strategies were found to be effective in the Chinese marketplace by a recent study that states, "Finally, we find significant positive returns on buy trades generated by the contrarian version of the moving average crossover rule, the channel breakout rule, and the Bollinger band trading rule, after accounting for transaction costs of 0.50 percent." Nauzer J. Balsara, Gary Chen and Lin Zheng The Chinese Stock Market: An Examination of the Random Walk Model and Technical Trading Rules [29]
Critics of technical analysis include well-known fundamental analysts. For example, Peter Lynch once commented, "Charts are great for predicting the past." Warren Buffett has said, "I realized technical analysis didn't work when I turned the charts upside down and didn't get a different answer" and "If past history was all there was to the game, the richest people would be librarians."[7]
An influential 1992 study by Brock et al. which appeared to find support for technical trading rules was tested for data snooping and other problems in 1999;[30] the sample covered by Brock et al. was robust to data snooping.
Subsequently, a comprehensive study of the question by Amsterdam economist Gerwin Griffioen concludes that: "for the U.S., Japanese and most Western European stock market indices the recursive out-of-sample forecasting procedure does not show to be profitable, after implementing little transaction costs. Moreover, for sufficiently high transaction costs it is found, by estimating CAPMs, that technical trading shows no statistically significant risk-corrected out-of-sample forecasting power for almost all of the stock market indices."[8] Transaction costs are particularly applicable to "momentum strategies"; a comprehensive 1996 review of the data and studies concluded that even small transaction costs would lead to an inability to capture any excess from such strategies.[31]
In a paper published in the Journal of Finance Dr. Andrew W. Lo, director MIT Laboratory for Financial Engineering, working with Harry Mamaysky and Jiang Wang found that "Technical analysis, also known as "charting," has been a part of financial practice for many decades, but this discipline has not received the same level of academic scrutiny and acceptance as more traditional approaches such as fundamental analysis. One of the main obstacles is the highly subjective nature of technical analysis---the presence of geometric shapes in historical price charts is often in the eyes of the beholder. In this paper, we propose a systematic and automatic approach to technical pattern recognition using nonparametric kernel regression, and apply this method to a large number of U.S. stocks from 1962 to 1996 to evaluate the effectiveness of technical analysis. By comparing the unconditional empirical distribution of daily stock returns to the conditional distribution---conditioned on specific technical indicators such as head-and-shoulders or double-bottoms---we find that over the 31-year sample period, several technical indicators do provide incremental information and may have some practical value." [32] In that same paper Dr. Lo wrote that "several academic studies suggest that...technical analysis may well be an effective means for extracting useful information from market prices."[33]
Efficient market hypothesis
The efficient market hypothesis (EMH) contradicts the basic tenets of technical analysis by stating that past prices cannot be used to profitably predict future prices. Thus it holds that technical analysis cannot be effective. Economist Eugene Fama published the seminal paper on the EMH in the Journal of Finance in 1970, and said "In short, the evidence in support of the efficient markets model is extensive, and (somewhat uniquely in economics) contradictory evidence is sparse."[34] EMH advocates say that if prices quickly reflect all relevant information, no method (including technical analysis) can "beat the market." Developments which influence prices occur randomly and are unknowable in advance. The vast majority of academic papers find that technical trading rules, after consideration for trading costs, are not profitable.[citation needed]
Technicians say that EMH ignores the way markets work, in that many investors base their expectations on past earnings or track record, for example. Because future stock prices can be strongly influenced by investor expectations, technicians claim it only follows that past prices influence future prices.[35] They also point to research in the field of behavioral finance, specifically that people are not the rational participants EMH makes them out to be. Technicians have long said that irrational human behavior influences stock prices, and that this behavior leads to predictable outcomes.[36] Author David Aronson says that the theory of behavioral finance blends with the practice of technical analysis:
By considering the impact of emotions, cognitive errors, irrational preferences, and the dynamics of group behavior, behavioral finance offers succinct explanations of excess market volatility as well as the excess returns earned by stale information strategies.... cognitive errors may also explain the existence of market inefficiencies that spawn the systematic price movements that allow objective TA [technical analysis] methods to work.[35]
EMH advocates reply that while individual market participants do not always act rationally (or have complete information), their aggregate decisions balance each other, resulting in a rational outcome (optimists who buy stock and bid the price higher are countered by pessimists who sell their stock, which keeps the price in equilibrium).[37] Likewise, complete information is reflected in the price because all market participants bring their own individual, but incomplete, knowledge together in the market.[37]
Random walk hypothesis
The random walk hypothesis may be derived from the weak-form efficient markets hypothesis, which is based on the assumption that market participants take full account of any information contained in past price movements (but not necessarily other public information). In his book A Random Walk Down Wall Street, Princeton economist Burton Malkiel said that technical forecasting tools such as pattern analysis must ultimately be self-defeating: "The problem is that once such a regularity is known to market participants, people will act in such a way that prevents it from happening in the future."[38] In a 1999 response to Malkiel, Andrew Lo and Craig McKinlay collected empirical papers that questioned the hypothesis' applicability[39] that suggested a non-random and possibly predictive component to stock price movement, though they were careful to point out that rejecting random walk does not necessarily invalidate EMH.
Technicians say the EMH and random walk theories both ignore the realities of markets, in that participants are not completely rational and that current price moves are not independent of previous moves.[20][40] Critics reply that one can find virtually any chart pattern after the fact, but that this does not prove that such patterns are predictable. Technicians maintain that both theories would also invalidate numerous other trading strategies such as index arbitrage, statistical arbitrage and many other trading systems.[35]
Contents
[hide]
• 1 History
• 2 General description
• 3 Characteristics
• 4 Principles
o 4.1 Market action discounts everything
o 4.2 Prices move in trends
o 4.3 History tends to repeat itself
• 5 Industry
• 6 Use
• 7 Systematic trading
o 7.1 Neural networks
o 7.2 Rule-based trading
• 8 Combination with other market forecast methods
• 9 Charting terms and indicators
o 9.1 Types of Charts
o 9.2 Concepts
o 9.3 Overlays
o 9.4 Price-based indicators
o 9.5 Volume based indicators
• 10 Empirical evidence
o 10.1 Efficient market hypothesis
10.1.1 Random walk hypothesis
• 11 See also
• 12 Notes
• 13 Books
• 14 External links
History
The principles of technical analysis derive from the observation of financial markets over hundreds of years.[citation needed] The oldest known example of technical analysis was a method developed by Homma Munehisa during early 18th century which evolved into the use of candlestick techniques, and is today a main charting tool.[2][3]
Dow Theory is based on the collected writings of Dow Jones co-founder and editor Charles Dow, and inspired the use and development of modern technical analysis from the end of the 19th century. Other pioneers of analysis techniques include Ralph Nelson Elliott and William Delbert Gann who developed their respective techniques in the early 20th century.
Many more technical tools and theories have been developed and enhanced in recent decades, with an increasing emphasis on computer-assisted techniques.
General description
Technical analysts seek to identify price patterns and trends in financial markets and attempt to exploit those patterns.[4] While technicians use various methods and tools, the study of price charts is primary.
Technicians especially search for archetypal patterns, such as the well-known head and shoulders or double top reversal patterns, study indicators such as moving averages, and look for forms such as lines of support, resistance, channels, and more obscure formations such as flags, pennants or balance days.
Technical analysts also extensively use indicators, which are typically mathematical transformations of price or volume. These indicators are used to help determine whether an asset is trending, and if it is, its price direction. Technicians also look for relationships between price, volume and, in the case of futures, open interest. Examples include the relative strength index, and MACD. Other avenues of study include correlations between changes in options (implied volatility) and put/call ratios with price. Other technicians include sentiment indicators, such as Put/Call ratios and Implied Volatility in their analysis.
Technicians seek to forecast price movements such that large gains from successful trades exceed more numerous but smaller losing trades, producing positive returns in the long run through proper risk control and money management.
There are several schools of technical analysis. Adherents of different schools (for example, candlestick charting, Dow Theory, and Elliott wave theory) may ignore the other approaches, yet many traders combine elements from more than one school. Technical analysts use judgment gained from experience to decide which pattern a particular instrument reflects at a given time, and what the interpretation of that pattern should be.
Technical analysis is frequently contrasted with fundamental analysis, the study of economic factors that influence prices in financial markets. Technical analysis holds that prices already reflect all such influences before investors are aware of them, hence the study of price action alone. Some traders use technical or fundamental analysis exclusively, while others use both types to make trading decisions.
Users of technical analysis are most often called technicians or market technicians. Some prefer the term technical market analyst or simply market analyst. An older term, chartist, is sometimes used, but as the discipline has expanded and modernized the use of the term chartist has become rare.[citation needed]
Characteristics
Technical analysis employs models and trading rules based on price and volume transformations, such as the relative strength index, moving averages, regressions, inter-market and intra-market price correlations, cycles or, classically, through recognition of chart patterns.
Technical analysis stands in contrast to the fundamental analysis approach to security and stock analysis. Technical analysis "ignores" the actual nature of the company, market, currency or commodity and is based solely on "the charts," that is to say price and volume information, whereas fundamental analysis does look at the actual facts of the company, market, currency or commodity. For example, any large brokerage, trading group, or financial institution will typically have both a technical analysis and fundamental analysis team.
Technical analysis is widely used among traders and financial professionals, and is very often used by active day traders, market makers, and pit traders. In the 1960s and 1970s it was widely dismissed by academics. In a recent review, Irwin and Park[5] reported that 56 of 95 modern studies found it produces positive results, but noted that many of the positive results were rendered dubious by issues such as data snooping so that the evidence in support of technical analysis was inconclusive; it is still considered by many academics to be pseudoscience.[6] Academics such as Eugene Fama say the evidence for technical analysis is sparse and is inconsistent with the weak form of the efficient market hypothesis.[7][8] Users hold that even if technical analysis cannot predict the future, it helps to identify trading opportunities.[9]
In the foreign exchange markets, its use may be more widespread than fundamental analysis.[10][11] While some isolated studies have indicated that technical trading rules might lead to consistent returns in the period prior to 1987,[12][13][14][15] most academic work has focused on the nature of the anomalous position of the foreign exchange market.[16] It is speculated that this anomaly is due to central bank intervention.[17] Recent research suggests that combining various trading signals into a Combined Signal Approach may be able to increase profitability and reduce dependence on any single rule.[18].
Principles
Stock chart showing levels of support (4,5,6, 7, and 8) and resistance (1, 2, and 3); levels of resistance tend to become levels of support and vice versa.
Technicians say that a market's price reflects all relevant information, so their analysis looks more at "internals" than at "externals" such as news events. Price action also tends to repeat itself because investors collectively tend toward patterned behavior – hence technicians' focus on identifiable trends and conditions.
Market action discounts everything
Based on the premise that all relevant information is already reflected by prices, pure technical analysts believe it is redundant to do fundamental analysis – they say news and news events do not significantly influence price, and cite supporting research such as the study by Cutler, Poterba, and Summers titled "What Moves Stock Prices?"
On most of the sizable return days [large market moves]...the information that the press cites as the cause of the market move is not particularly important. Press reports on adjacent days also fail to reveal any convincing accounts of why future profits or discount rates might have changed. Our inability to identify the fundamental shocks that accounted for these significant market moves is difficult to reconcile with the view that such shocks account for most of the variation in stock returns.[19]
Prices move in trends
See also: Market trends
Technical analysts believe that prices trend. Technicians say that markets trend up, down, or sideways (flat). This basic definition of price trends is the one put forward by Dow Theory.[4]
An example of a security that had an apparent trend is AOL from November 2001 through August 2002. A technical analyst or trend follower recognizing this trend would look for opportunities to sell this security. AOL consistently moves downward in price. Each time the stock rose, sellers would enter the market and sell the stock; hence the "zig-zag" movement in the price. The series of "lower highs" and "lower lows" is a tell tale sign of a stock in a down trend.[20] In other words, each time the stock edged lower, it fell below its previous relative low price. Each time the stock moved higher, it could not reach the level of its previous relative high price.
Note that the sequence of lower lows and lower highs did not begin until August. Then AOL makes a low price that doesn't pierce the relative low set earlier in the month. Later in the same month, the stock makes a relative high equal to the most recent relative high. In this a technician sees strong indications that the down trend is at least pausing and possibly ending, and would likely stop actively selling the stock at that point.
History tends to repeat itself
Technical analysts believe that investors collectively repeat the behavior of the investors that preceded them. "Everyone wants in on the next Microsoft," "If this stock ever gets to $50 again, I will buy it," "This company's technology will revolutionize its industry, therefore this stock will skyrocket" – these are all examples of investor sentiment repeating itself. To a technician, the emotions in the market may be irrational, but they exist. Because investor behavior repeats itself so often, technicians believe that recognizable (and predictable) price patterns will develop on a chart.[4]
Technical analysis is not limited to charting, but it always considers price trends. For example, many technicians monitor surveys of investor sentiment. These surveys gauge the attitude of market participants, specifically whether they are bearish or bullish. Technicians use these surveys to help determine whether a trend will continue or if a reversal could develop; they are most likely to anticipate a change when the surveys report extreme investor sentiment. Surveys that show overwhelming bullishness, for example, are evidence that an uptrend may reverse – the premise being that if most investors are bullish they have already bought the market (anticipating higher prices). And because most investors are bullish and invested, one assumes that few buyers remain. This leaves more potential sellers than buyers, despite the bullish sentiment. This suggests that prices will trend down, and is an example of contrarian trading.
Industry
Globally, the industry is represented by the International Federation of Technical Analysts (IFTA). In the United States, there are two national organizations: the Market Technicians Association (MTA), and the American Association of Professional Technical Analysts (AAPTA). The United States is also represented by the Technical Security Analysts Association of San Francisco (TSAASF). In the United Kingdom, the industry is represented by the Society of Technical Analysts (STA). In Canada the industry is represented by the Canadian Society of Technical Analysts. Additional major professional technical analysis organizations are noted in the External Links section below.
Professional technical analysis societies have worked on creating a Body of Knowledge that describes the field of Technical Analysis. A Body of Knowledge is central to the field as a way of defining how and why technical analysis may work. It can then be used by academia, as well as regulatory bodies, in developing proper research and standards for the field. The Market Technicians Association (MTA) has published a Body of Knowledge and the International Federation of Technical Analysts and the Nippon Technical Analysis Association are reported to be working on knowledge base projects.
Use
Many traders say that trading in the direction of the trend is the most effective means to be profitable in financial or commodities markets. John W. Henry, Larry Hite, Ed Seykota, Richard Dennis, William Eckhardt, Victor Sperandeo, Michael Marcus and Paul Tudor Jones (some of the so-called Market Wizards in the popular book of the same name by Jack D. Schwager) have each amassed massive fortunes via the use of technical analysis and its concepts. George Lane, a technical analyst, coined one of the most popular phrases on Wall Street, "The trend is your friend!"
Many non-arbitrage algorithmic trading systems rely on the idea of trend-following, as do many hedge funds. A relatively recent trend, both in research and industrial practice, has been the development of increasingly sophisticated automated trading strategies. These often rely on underlying technical analysis principles (see algorithmic trading article for an overview).
Systematic trading
Neural networks
Since the early 1990s when the first practically usable types emerged, artificial neural networks (ANNs) have rapidly grown in popularity. They are artificial intelligence adaptive software systems that have been inspired by how biological neural networks work. They are used because they can learn to detect complex patterns in data. In mathematical terms, they are universal function approximators,[21][22] meaning that given the right data and configured correctly, they can capture and model any input-output relationships. This not only removes the need for human interpretation of charts or the series of rules for generating entry/exit signals, but also provides a bridge to fundamental analysis, as the variables used in fundamental analysis can be used as input.
As ANNs are essentially non-linear statistical models, their accuracy and prediction capabilities can be both mathematically and empirically tested. In various studies, authors have claimed that neural networks used for generating trading signals given various technical and fundamental inputs have significantly outperformed buy-hold strategies as well as traditional linear technical analysis methods when combined with rule-based expert systems.[23][24][25]
While the advanced mathematical nature of such adaptive systems has kept neural networks for financial analysis mostly within academic research circles, in recent years more user friendly neural network software has made the technology more accessible to traders. However, large-scale application is problematic because of the problem of matching the correct neural topology to the market being studied.
Rule-based trading
Rule-based trading is an approach intended to create trading plans using strict and clear-cut rules. Unlike some other technical methods and the approach of fundamental analysis, it defines a set of rules that determine all trades, leaving minimal discretion. The theory behind this approach is that by following a distinct set of trading rules you will reduce the number of poor decisions, which are often emotion based.
For instance, a trader might make a set of rules stating that he will take a long position whenever the price of a particular instrument closes above its 50-day moving average, and shorting it whenever it drops below.
Combination with other market forecast methods
John Murphy says that the principal sources of information available to technicians are price, volume and open interest.[26] Other data, such as indicators and sentiment analysis, are considered secondary.
However, many technical analysts reach outside pure technical analysis, combining other market forecast methods with their technical work. One advocate for this approach is John Bollinger, who coined the term rational analysis in the middle 1980s for the intersection of technical analysis and fundamental analysis.[2] Another such approach, fusion analysis, [3] overlays fundamental analysis with technical, in an attempt to improve portfolio manager performance.
Technical analysis is also often combined with quantitative analysis and economics. For example, neural networks may be used to help identify intermarket relationships.[4] A few market forecasters combine financial astrology with technical analysis. Chris Carolan's article "Autumn Panics and Calendar Phenomenon", which won the Market Technicians Association Dow Award for best technical analysis paper in 1998, demonstrates how technical analysis and lunar cycles can be combined.[5] It is worth noting, however, that some of the calendar related phenomena, such as the January effect in the stock market, have been associated with tax and accounting related reasons.
Investor and newsletter polls, and magazine cover sentiment indicators, are also used by technical analysts.[6]
Charting terms and indicators
Types of Charts
• OHLC - Open High Low Close charts plot the high and low of the price movement vertically and the open and close horizontally. Used to graph range and outliers.
• Candlestick chart - Similar to OHLC, but open and close are filled. Often Black or Red candles represent a close lower than the open. While White, Green or Blue candles represent a close higher than the open.
• Line chart - Connects each closing interval together on a line
Concepts
• Average true range - averaged daily trading range, adjusted for price gaps
• Chart pattern - distinctive pattern created by the movement of security prices on a chart
• Dead cat bounce - the phenomenon whereby a spectacular decline in the price of a stock is immediately followed by a moderate and temporary rise before resuming its downward movement
• Elliott wave principle and the golden ratio to calculate successive price movements and retracements
• Momentum - the rate of price change
• Point and figure charts - charts based on price without time
Overlays
Overlays are generally superimposed over the main price chart.
• Resistance - an area that brings on increased selling
• Support - an area that brings on increased buying
• Breakout - when a price passes through and stays above an area of support or resistance
• Trend line - a sloping line of support or resistance
• Channel - a pair of parallel trend lines
• Moving average - lags behind the price action but filters out short term movements
• Bollinger bands - a range of price volatility
• Pivot point - derived by calculating the numerical average of a particular currency's or stock's high, low and closing prices
Price-based indicators
These indicators are generally shown below or above the main price chart.
• Accumulation/distribution index—based on the close within the day's range
• Advance decline line — a popular indicator of market breadth
• Average Directional Index — a widely used indicator of trend strength
• Commodity Channel Index - identifies cyclical trends
• MACD - moving average convergence/divergence
• Parabolic SAR - Wilder's trailing stop based on prices tending to stay within a parabolic curve during a strong trend
• Relative Strength Index (RSI) - oscillator showing price strength
• Stochastic oscillator, close position within recent trading range
• Trix - an oscillator showing the slope of a triple-smoothed exponential moving average, developed in the 1980s by Jack Hutson
Volume based indicators
• Money Flow - the amount of stock traded on days the price went up
• On-balance volume - the momentum of buying and selling stocks
• PAC charts - two-dimensional method for charting volume by price level
Empirical evidence
Whether technical analysis actually works is a matter of controversy. Methods vary greatly, and different technical analysts can sometimes make contradictory predictions from the same data. Many investors claim that they experience positive returns, but academic appraisals often find that it has little predictive power.[27] Modern studies may be more positive: of 95 modern studies, 56 concluded that technical analysis had positive results, although data-snooping bias and other problems make the analysis difficult.[5] Nonlinear prediction using neural networks occasionally produces statistically significant prediction results.[28] A Federal Reserve working paper[13] regarding support and resistance levels in short-term foreign exchange rates "offers strong evidence that the levels help to predict intraday trend interruptions," although the "predictive power" of those levels was "found to vary across the exchange rates and firms examined".
Technical trading strategies were found to be effective in the Chinese marketplace by a recent study that states, "Finally, we find significant positive returns on buy trades generated by the contrarian version of the moving average crossover rule, the channel breakout rule, and the Bollinger band trading rule, after accounting for transaction costs of 0.50 percent." Nauzer J. Balsara, Gary Chen and Lin Zheng The Chinese Stock Market: An Examination of the Random Walk Model and Technical Trading Rules [29]
Critics of technical analysis include well-known fundamental analysts. For example, Peter Lynch once commented, "Charts are great for predicting the past." Warren Buffett has said, "I realized technical analysis didn't work when I turned the charts upside down and didn't get a different answer" and "If past history was all there was to the game, the richest people would be librarians."[7]
An influential 1992 study by Brock et al. which appeared to find support for technical trading rules was tested for data snooping and other problems in 1999;[30] the sample covered by Brock et al. was robust to data snooping.
Subsequently, a comprehensive study of the question by Amsterdam economist Gerwin Griffioen concludes that: "for the U.S., Japanese and most Western European stock market indices the recursive out-of-sample forecasting procedure does not show to be profitable, after implementing little transaction costs. Moreover, for sufficiently high transaction costs it is found, by estimating CAPMs, that technical trading shows no statistically significant risk-corrected out-of-sample forecasting power for almost all of the stock market indices."[8] Transaction costs are particularly applicable to "momentum strategies"; a comprehensive 1996 review of the data and studies concluded that even small transaction costs would lead to an inability to capture any excess from such strategies.[31]
In a paper published in the Journal of Finance Dr. Andrew W. Lo, director MIT Laboratory for Financial Engineering, working with Harry Mamaysky and Jiang Wang found that "Technical analysis, also known as "charting," has been a part of financial practice for many decades, but this discipline has not received the same level of academic scrutiny and acceptance as more traditional approaches such as fundamental analysis. One of the main obstacles is the highly subjective nature of technical analysis---the presence of geometric shapes in historical price charts is often in the eyes of the beholder. In this paper, we propose a systematic and automatic approach to technical pattern recognition using nonparametric kernel regression, and apply this method to a large number of U.S. stocks from 1962 to 1996 to evaluate the effectiveness of technical analysis. By comparing the unconditional empirical distribution of daily stock returns to the conditional distribution---conditioned on specific technical indicators such as head-and-shoulders or double-bottoms---we find that over the 31-year sample period, several technical indicators do provide incremental information and may have some practical value." [32] In that same paper Dr. Lo wrote that "several academic studies suggest that...technical analysis may well be an effective means for extracting useful information from market prices."[33]
Efficient market hypothesis
The efficient market hypothesis (EMH) contradicts the basic tenets of technical analysis by stating that past prices cannot be used to profitably predict future prices. Thus it holds that technical analysis cannot be effective. Economist Eugene Fama published the seminal paper on the EMH in the Journal of Finance in 1970, and said "In short, the evidence in support of the efficient markets model is extensive, and (somewhat uniquely in economics) contradictory evidence is sparse."[34] EMH advocates say that if prices quickly reflect all relevant information, no method (including technical analysis) can "beat the market." Developments which influence prices occur randomly and are unknowable in advance. The vast majority of academic papers find that technical trading rules, after consideration for trading costs, are not profitable.[citation needed]
Technicians say that EMH ignores the way markets work, in that many investors base their expectations on past earnings or track record, for example. Because future stock prices can be strongly influenced by investor expectations, technicians claim it only follows that past prices influence future prices.[35] They also point to research in the field of behavioral finance, specifically that people are not the rational participants EMH makes them out to be. Technicians have long said that irrational human behavior influences stock prices, and that this behavior leads to predictable outcomes.[36] Author David Aronson says that the theory of behavioral finance blends with the practice of technical analysis:
By considering the impact of emotions, cognitive errors, irrational preferences, and the dynamics of group behavior, behavioral finance offers succinct explanations of excess market volatility as well as the excess returns earned by stale information strategies.... cognitive errors may also explain the existence of market inefficiencies that spawn the systematic price movements that allow objective TA [technical analysis] methods to work.[35]
EMH advocates reply that while individual market participants do not always act rationally (or have complete information), their aggregate decisions balance each other, resulting in a rational outcome (optimists who buy stock and bid the price higher are countered by pessimists who sell their stock, which keeps the price in equilibrium).[37] Likewise, complete information is reflected in the price because all market participants bring their own individual, but incomplete, knowledge together in the market.[37]
Random walk hypothesis
The random walk hypothesis may be derived from the weak-form efficient markets hypothesis, which is based on the assumption that market participants take full account of any information contained in past price movements (but not necessarily other public information). In his book A Random Walk Down Wall Street, Princeton economist Burton Malkiel said that technical forecasting tools such as pattern analysis must ultimately be self-defeating: "The problem is that once such a regularity is known to market participants, people will act in such a way that prevents it from happening in the future."[38] In a 1999 response to Malkiel, Andrew Lo and Craig McKinlay collected empirical papers that questioned the hypothesis' applicability[39] that suggested a non-random and possibly predictive component to stock price movement, though they were careful to point out that rejecting random walk does not necessarily invalidate EMH.
Technicians say the EMH and random walk theories both ignore the realities of markets, in that participants are not completely rational and that current price moves are not independent of previous moves.[20][40] Critics reply that one can find virtually any chart pattern after the fact, but that this does not prove that such patterns are predictable. Technicians maintain that both theories would also invalidate numerous other trading strategies such as index arbitrage, statistical arbitrage and many other trading systems.[35]
Foreign exchange market
From Wikipedia, the free encyclopedia
The foreign exchange market (currency, forex, or FX) trades currencies. It lets banks and other institutions easily buy and sell currencies. [1]
The purpose of the foreign exchange market is to help international trade and investment. A foreign exchange market helps businesses convert one currency to another. For example, it permits a U.S. business to import European goods and pay Euros, even though the business's income is in U.S. dollars.
In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market started forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.
The foreign exchange market is unique because of
• its trading volumes,
• the extreme liquidity of the market,
• its geographical dispersion,
• its long trading hours: 24 hours a day except on weekends (from 20:15 UTC on Sunday until 22:00 UTC Friday),
• the variety of factors that affect exchange rates.
• the low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes)
• the use of leverage
As such, it has been referred to as the market closest to the ideal perfect competition, notwithstanding market manipulation by central banks.[citation needed] According to the Bank for International Settlements,[2] average daily turnover in global foreign exchange markets is estimated at $3.98 trillion. Trading in the world's main financial markets accounted for $3.21 trillion of this. This approximately $3.21 trillion in main foreign exchange market turnover was broken down as follows:
• $1.005 trillion in spot transactions
• $362 billion in outright forwards
• $1.714 trillion in foreign exchange swaps
• $129 billion estimated gaps in reporting
Contents
[hide]
• 1 Market size and liquidity
• 2 Market participants
o 2.1 Banks
o 2.2 Commercial companies
o 2.3 Central banks
o 2.4 Hedge funds as speculators
o 2.5 Investment management firms
o 2.6 Retail foreign exchange brokers
o 2.7 Non-bank foreign exchange companies
o 2.8 Money transfer/remittance companies
• 3 Trading characteristics
• 4 Determinants of FX rates
o 4.1 Economic factors
o 4.2 Political conditions
o 4.3 Market psychology
• 5 Algorithmic trading in foreign exchange
• 6 Financial instruments
o 6.1 Spot
o 6.2 Forward
o 6.3 Future
o 6.4 Swap
o 6.5 Option
o 6.6 Exchange-traded fund
• 7 Speculation
• 8 See also
• 9 References
• 10 External links
Market size and liquidity
Main foreign exchange market turnover, 1988 - 2007, measured in billions of USD.
The foreign exchange market is the largest and most liquid financial market in the world. Traders include large banks, central banks, currency speculators, corporations, governments, and other financial institutions. The average daily volume in the global foreign exchange and related markets is continuously growing. Daily turnover was reported to be over US$3.2 trillion in April 2007 by the Bank for International Settlements. [2] Since then, the market has continued to grow. According to Euromoney's annual FX Poll, volumes grew a further 41% between 2007 and 2008.[3]
Of the $3.98 trillion daily global turnover, trading in London accounted for around $1.36 trillion, or 34.1% of the total, making London by far the global center for foreign exchange. In second and third places respectively, trading in New York accounted for 16.6%, and Tokyo accounted for 6.0%.[4] In addition to "traditional" turnover, $2.1 trillion was traded in derivatives.
Exchange-traded FX futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts.
Several other developed countries also permit the trading of FX derivative products (like currency futures and options on currency futures) on their exchanges. All these developed countries already have fully convertible capital accounts. Most emerging countries do not permit FX derivative products on their exchanges in view of prevalent controls on the capital accounts. However, a few select emerging countries (e.g., Korea, South Africa, India—[1]; [2]) have already successfully experimented with the currency futures exchanges, despite having some controls on the capital account.
FX futures volume has grown rapidly in recent years, and accounts for about 7% of the total foreign exchange market volume, according to The Wall Street Journal Europe (5/5/06, p. 20).
Top 10 currency traders [5]
% of overall volume, May 2009
Rank Name Market Share
1 Deutsche Bank
20.96%
2 UBS AG
14.58%
3 Barclays Capital
10.45%
4 Royal Bank of Scotland
8.19%
5 Citi
7.32%
6 JPMorgan
5.43%
7 HSBC
4.09%
8 Goldman Sachs
3.35%
9 Credit Suisse
3.05%
10 BNP Paribas
2.26%
Foreign exchange trading increased by 38% between April 2005 and April 2006 and has more than doubled since 2001. This is largely due to the growing importance of foreign exchange as an asset class and an increase in fund management assets, particularly of hedge funds and pension funds. The diverse selection of execution venues have made it easier for retail traders to trade in the foreign exchange market. In 2006, retail traders constituted over 2% of the whole FX market volumes with an average daily trade volume of over US$50-60 billion (see retail trading platforms).[6] Because foreign exchange is an OTC market where brokers/dealers negotiate directly with one another, there is no central exchange or clearing house. The biggest geographic trading centre is the UK, primarily London, which according to IFSL estimates has increased its share of global turnover in traditional transactions from 31.3% in April 2004 to 34.1% in April 2007. The ten most active traders account for almost 80% of trading volume, according to the 2008 Euromoney FX survey.[3] These large international banks continually provide the market with both bid (buy) and ask (sell) prices. The bid/ask spread is the difference between the price at which a bank or market maker will sell ("ask", or "offer") and the price at which a market taker will buy ("bid") from a wholesale or retail customer. The customer will buy from the market-maker at the higher "ask" price, and will sell at the lower "bid" price, thus giving up the "spread" as the cost of completing the trade. This spread is minimal for actively traded pairs of currencies, usually 0–3 pips. For example, the bid/ask quote of EUR/USD might be 1.2200/1.2203 on a retail broker. Minimum trading size for most deals is usually 100,000 units of base currency, which is a standard "lot".
These spreads might not apply to retail customers at banks, which will routinely mark up the difference to say 1.2100/1.2300 for transfers, or say 1.2000/1.2400 for banknotes or travelers' checks. Spot prices at market makers vary, but on EUR/USD are usually no more than 3 pips wide (i.e., 0.0003). Competition is greatly increased with larger transactions, and pip spreads shrink on the major pairs to as little as 1 to 2 pips.
Market participants
Financial markets
________________________________________
Bond market
Fixed income
Corporate bond
Government bond
Municipal bond
Bond valuation
High-yield debt
Stock market
Stock
Preferred stock
Common stock
Registered share
Voting share
Stock exchange
Foreign exchange market
Derivatives market
Credit derivative
Hybrid security
Options
Futures
Forwards
Swaps
Other Markets
Commodity market
Money market
OTC market
Real estate market
Spot market
________________________________________
Finance series
Financial market
Financial market participants
Corporate finance
Personal finance
Public finance
Banks and Banking
Financial regulation
v • d • e
Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest commercial banks and securities dealers. Within the inter-bank market, spreads, which are the difference between the bid and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle. The difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips for some currencies such as the EUR). This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the "line" (the amount of money with which they are trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there are usually smaller banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail FX-metal market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size” Central banks also participate in the foreign exchange market to align currencies to their economic needs.
Banks
The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account. Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems. The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.
Commercial companies
An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.
Central banks
National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high—that is, to trade for a profit based on their more precise information. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.
The mere expectation or rumor of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank.[7] Several scenarios of this nature were seen in the 1992–93 ERM collapse, and in more recent times in Southeast Asia.
Hedge funds as speculators
About 70% to 90%[citation needed] of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor.
Investment management firms
Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases.
Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades.
Retail foreign exchange brokers
Retail traders (individuals) are an explosively growing part of this market, both in size and importance. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated in the USA by the CFTC and NFA have in the past been subjected to periodic foreign exchange scams.[8][9] To deal with the issue, the NFA and CFTC began (as of 2009) imposing stricter requirements, particularly in relation to the amount of Net Capitalization required of its members. As a result many of the smaller, and perhaps questionable brokers are now gone.
There are two main types of retail FX brokers offering the opportunity for speculative currency trading: Retail brokers who employ the "Agency Broker" model and Market-Makers who employ the "Broker as principal or specialist" model. "Agency Brokers" serve as 'your representative' in the broader FX market, by seeking the best prices for your orders, and then typically pass your orders through to some other market-maker, bank or dealer, after applying a small mark-up. Market-Makers, by contrast, typically play the role of 'final resting stop' for your orders by choosing to simply fill them immediately and then manage the resulting risk themselves. No one model is better than the other, and both have various benefits, advantages and drawbacks.
Nonetheless, it is not widely understood that the "Market-Maker" retail brokers trade 'against' their clients (via the broker as "principal" model rather than the "agency" broker model) and frequently take the other side of their customers' trades (eg: GAIN CAPITAL pursues this model). This may sometimes create a potential conflict of interest and give rise to some of the unpleasant trade-execution experiences some traders & customers have had. A move toward NDD (No Dealing Desk) and STP (Straight Through Processing) has helped to resolve some of these concerns and restore trader confidence, but cautious optimism is still advised.
The earliest Retail FX brokers were CMC Markets, SAXO Bank (Formerly MIDAS), FXCM (formerly Shalish Capital Markets) GFT (Global Forex Trading) MG Forex (AKA "Money Garden"), eForex.com (no longer in existence), and Matchbook FX, which was notable because it was the 1st and only FX broker that pursued a user-price driven ECN model, rather than a Dealer/Market Maker model. Banks have also started to offer their very own retail trading platforms; Deutsche bank offers retail foreign exchange trading under the name DBFX while Citibank (CitiFX pro) has its own offering now too.
Non-bank foreign exchange companies
Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but currency exchange with payments. I.e., there is usually a physical delivery of currency to a bank account. Send Money Home offer an in-depth comparison into the services offered by all the major non-bank foreign exchange companies.
It is estimated that in the UK, 14% of currency transfers/payments[10] are made via Foreign Exchange Companies.[11] These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank. These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services.
Money transfer/remittance companies
Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally followed by UAE Exchange Financial Service Ltd
Send Money Home is an international money transfer price comparison site that allows consumers access to a range of alternative products and rates available when remitting (transferring) money worldwide.
Trading characteristics
Most traded currencies[2]
Currency distribution of reported FX market turnover
Rank Currency ISO 4217 code
(Symbol) % daily share
(April 2007)
1 United States dollar
USD ($) 86.3%
2 Euro
EUR (€) 37.0%
3 Japanese yen
JPY (¥) 17.0%
4 Pound sterling
GBP (£) 15.0%
5 Swiss franc
CHF (Fr) 6.8%
6 Australian dollar
AUD ($) 6.7%
7 Canadian dollar
CAD ($) 4.2%
8-9 Swedish krona
SEK (kr) 2.8%
8-9 Hong Kong dollar
HKD ($) 2.8%
10 Norwegian krone
NOK (kr) 2.2%
11 New Zealand dollar
NZD ($) 1.9%
12 Mexican peso
MXN ($) 1.3%
13 Singapore dollar
SGD ($) 1.2%
14 South Korean won
KRW (₩) 1.1%
Other 14.5%
Total 200%
There is no unified or centrally cleared market for the majority of FX trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currencies instruments are traded. This implies that there is not a single exchange rate but rather a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice the rates are often very close, otherwise they could be exploited by arbitrageurs instantaneously. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. A joint venture of the Chicago Mercantile Exchange and Reuters, called Fxmarketspace opened in 2007 and aspired but failed to the role of a central market clearing mechanism.
The main trading center is London, but New York, Tokyo, Hong Kong and Singapore are all important centers as well. Banks throughout the world participate. Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session, excluding weekends.
Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in gross domestic product (GDP) growth, inflation (purchasing power parity theory), interest rates (interest rate parity, Domestic Fisher effect, International Fisher effect), budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers' order flow.
Currencies are traded against one another. Each pair of currencies thus constitutes an individual product and is traditionally noted XXXYYY or YYY/XXX, where YYY is the ISO 4217 international three-letter code of the currency into which the price of one unit of XXX is expressed (called base currency). For instance, EURUSD or USD/EUR is the price of the euro expressed in US dollars, as in 1 euro = 1.5465 dollar. Out of convention, the first currency in the pair, the "base" currency, was the stronger currency at the creation of the pair. The second currency, counter currency or "term" currency, was the weaker currency at the creation of the pair. Currencies are occasionally incorrectly quoted with the pairs inverted e.g. EUR/USD but this is incorrect. The "/" acts the same as the divide mathematical operator and derives the actual exchange rate. e.g. an amount of $140,000 equates to €100,000. $140,000/€100,000 = $/€ = USD/EUR = a rate of 1.4 hence EURUSD or USD/EUR. See Exchange_rate
The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes positive currency correlation between XXXYYY and XXXZZZ.
On the spot market, according to the BIS study, the most heavily traded products were:
• EURUSD: 27%
• USDJPY: 13%
• GBPUSD (also called cable): 12%
and the US currency was involved in 86.3% of transactions, followed by the euro (37.0%), the yen (17.0%), and sterling (15.0%) (see table). Volume percentages for all individual currencies should add up to 200%, as each transaction involves two currencies.
Trading in the euro has grown considerably since the currency's creation in January 1999, and how long the foreign exchange market will remain dollar-centered is open to debate. Until recently, trading the euro versus a non-European currency ZZZ would have usually involved two trades: EURUSD and USDZZZ. The exception to this is EURJPY, which is an established traded currency pair in the interbank spot market. As the dollar's value has eroded during 2008, interest in using the euro as reference currency for prices in commodities (such as oil), as well as a larger component of foreign reserves by banks, has increased dramatically. Transactions in the currencies of commodity-producing countries, such as AUD, NZD, CAD, have also increased.
Determinants of FX rates
See also: exchange rates
The following theories explain the fluctuations in FX rates in a floating exchange rate regime (In a fixed exchange rate regime, FX rates are decided by its government):
(a) International parity conditions viz; Relative Purchasing Power Parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.
(b) Balance of payments model (see exchange rate). This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit.
(c) Asset market model (see exchange rate) views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.”
None of the models developed so far succeed to explain FX rates levels and volatility in the longer time frames. For shorter time frames (less than a few days) algorithm can be devised to predict prices. Large and small institutions and professional individual traders have made consistent profits from it. It is understood from above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.
Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.
Economic factors
These include: (a)economic policy, disseminated by government agencies and central banks, (b)economic conditions, generally revealed through economic reports, and other economic indicators.
1. Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).
2. Economic conditions include:
Government budget deficits or surpluses
The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.
Balance of trade levels and trends
The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.
Inflation levels and trends
Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.
Economic growth and health
Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.
Productivity of an economy
Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector [3].
Political conditions
Internal, regional, and international political conditions and events can have a profound effect on currency markets.
All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency.
Market psychology
Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:
Flights to quality
Unsettling international events can lead to a "flight to quality," with investors seeking a "safe haven." There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The Swiss franc and gold have been traditional safe havens during times of political or economic uncertainty.[12]
Long-term trends
Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends. [13]
"Buy the rumor, sell the fact"
This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought".[14] To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices.
Economic numbers
While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.
Technical trading considerations
As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.[15]
Algorithmic trading in foreign exchange
Electronic trading is growing in the FX market, and algorithmic trading is becoming much more common. According to financial consultancy Celent estimates, by 2008 up to 25% of all trades by volume will be executed using algorithm, up from about 18% in 2005.[citation needed]
Financial instruments
Spot
A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. The data for this study come from the spot market. Spot transactions has the second largest turnover by volume after Swap transactions among all FX transactions in the Global FX market. NNM
Forward
See also: forward contract
One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a one day, a few days, months or years. Usually the date is decided by both parties.
Future
Main article: currency future
Foreign currency futures are exchange traded forward transactions with standard contract sizes and maturity dates — for example, $1000 for next November at an agreed rate [4],[5]. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.
Swap
Main article: foreign exchange swap
The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange.
Option
Main article: foreign exchange option
A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world..
Exchange-traded fund
Main article: exchange-traded fund
Exchange-traded funds (or ETFs) are open ended investment companies that can be traded at any time throughout the course of the day. Typically, ETFs try to replicate a stock market index such as the S&P 500 (e.g., SPY), but recently they are now replicating investments in the currency markets with the ETF increasing in value when the US Dollar weakens versus a specific currency, such as the Euro. Certain of these funds track the price movements of world currencies versus the US Dollar, and increase in value directly counter to the US Dollar, allowing for speculation in the US Dollar for US and US Dollar denominated investors and speculators.
Speculation
Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Nevertheless, economists including Milton Friedman have argued that speculators ultimately are a stabilizing influence on the market and perform the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do.[16] Other economists such as Joseph Stiglitz consider this argument to be based more on politics and a free market philosophy than on economics.[17]
Large hedge funds and other well capitalized "position traders" are the main professional speculators. According to some economists, individual traders could act as "noise traders" and have a more destabilizing role than larger and better informed actors [18].
Currency speculation is considered a highly suspect activity in many countries.[where?] While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not; according to this view, it is simply gambling that often interferes with economic policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to devalue the krona.[19] Former Malaysian Prime Minister Mahathir Mohamad is one well known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.
Gregory J. Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit.[20]
In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their national economies, and foreign exchange speculators allegedly made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions. Given that Malaysia recovered quickly after imposing currency controls directly against International Monetary Fund advice, this view is open to doubt.
See also
• Balance of trade
• Bretton Woods system
• Currency pair
• Foreign currency mortgage
• Foreign exchange hedge
• Foreign exchange reserves
• Foreign exchange scam
• Foreign exchange swap
• Nonfarm payrolls
• Retail foreign exchange
• Special Drawing Rights
• Technical analysis
• Tobin Tax
• World currency
• Currency codes
• money market
The foreign exchange market (currency, forex, or FX) trades currencies. It lets banks and other institutions easily buy and sell currencies. [1]
The purpose of the foreign exchange market is to help international trade and investment. A foreign exchange market helps businesses convert one currency to another. For example, it permits a U.S. business to import European goods and pay Euros, even though the business's income is in U.S. dollars.
In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market started forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.
The foreign exchange market is unique because of
• its trading volumes,
• the extreme liquidity of the market,
• its geographical dispersion,
• its long trading hours: 24 hours a day except on weekends (from 20:15 UTC on Sunday until 22:00 UTC Friday),
• the variety of factors that affect exchange rates.
• the low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes)
• the use of leverage
As such, it has been referred to as the market closest to the ideal perfect competition, notwithstanding market manipulation by central banks.[citation needed] According to the Bank for International Settlements,[2] average daily turnover in global foreign exchange markets is estimated at $3.98 trillion. Trading in the world's main financial markets accounted for $3.21 trillion of this. This approximately $3.21 trillion in main foreign exchange market turnover was broken down as follows:
• $1.005 trillion in spot transactions
• $362 billion in outright forwards
• $1.714 trillion in foreign exchange swaps
• $129 billion estimated gaps in reporting
Contents
[hide]
• 1 Market size and liquidity
• 2 Market participants
o 2.1 Banks
o 2.2 Commercial companies
o 2.3 Central banks
o 2.4 Hedge funds as speculators
o 2.5 Investment management firms
o 2.6 Retail foreign exchange brokers
o 2.7 Non-bank foreign exchange companies
o 2.8 Money transfer/remittance companies
• 3 Trading characteristics
• 4 Determinants of FX rates
o 4.1 Economic factors
o 4.2 Political conditions
o 4.3 Market psychology
• 5 Algorithmic trading in foreign exchange
• 6 Financial instruments
o 6.1 Spot
o 6.2 Forward
o 6.3 Future
o 6.4 Swap
o 6.5 Option
o 6.6 Exchange-traded fund
• 7 Speculation
• 8 See also
• 9 References
• 10 External links
Market size and liquidity
Main foreign exchange market turnover, 1988 - 2007, measured in billions of USD.
The foreign exchange market is the largest and most liquid financial market in the world. Traders include large banks, central banks, currency speculators, corporations, governments, and other financial institutions. The average daily volume in the global foreign exchange and related markets is continuously growing. Daily turnover was reported to be over US$3.2 trillion in April 2007 by the Bank for International Settlements. [2] Since then, the market has continued to grow. According to Euromoney's annual FX Poll, volumes grew a further 41% between 2007 and 2008.[3]
Of the $3.98 trillion daily global turnover, trading in London accounted for around $1.36 trillion, or 34.1% of the total, making London by far the global center for foreign exchange. In second and third places respectively, trading in New York accounted for 16.6%, and Tokyo accounted for 6.0%.[4] In addition to "traditional" turnover, $2.1 trillion was traded in derivatives.
Exchange-traded FX futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts.
Several other developed countries also permit the trading of FX derivative products (like currency futures and options on currency futures) on their exchanges. All these developed countries already have fully convertible capital accounts. Most emerging countries do not permit FX derivative products on their exchanges in view of prevalent controls on the capital accounts. However, a few select emerging countries (e.g., Korea, South Africa, India—[1]; [2]) have already successfully experimented with the currency futures exchanges, despite having some controls on the capital account.
FX futures volume has grown rapidly in recent years, and accounts for about 7% of the total foreign exchange market volume, according to The Wall Street Journal Europe (5/5/06, p. 20).
Top 10 currency traders [5]
% of overall volume, May 2009
Rank Name Market Share
1 Deutsche Bank
20.96%
2 UBS AG
14.58%
3 Barclays Capital
10.45%
4 Royal Bank of Scotland
8.19%
5 Citi
7.32%
6 JPMorgan
5.43%
7 HSBC
4.09%
8 Goldman Sachs
3.35%
9 Credit Suisse
3.05%
10 BNP Paribas
2.26%
Foreign exchange trading increased by 38% between April 2005 and April 2006 and has more than doubled since 2001. This is largely due to the growing importance of foreign exchange as an asset class and an increase in fund management assets, particularly of hedge funds and pension funds. The diverse selection of execution venues have made it easier for retail traders to trade in the foreign exchange market. In 2006, retail traders constituted over 2% of the whole FX market volumes with an average daily trade volume of over US$50-60 billion (see retail trading platforms).[6] Because foreign exchange is an OTC market where brokers/dealers negotiate directly with one another, there is no central exchange or clearing house. The biggest geographic trading centre is the UK, primarily London, which according to IFSL estimates has increased its share of global turnover in traditional transactions from 31.3% in April 2004 to 34.1% in April 2007. The ten most active traders account for almost 80% of trading volume, according to the 2008 Euromoney FX survey.[3] These large international banks continually provide the market with both bid (buy) and ask (sell) prices. The bid/ask spread is the difference between the price at which a bank or market maker will sell ("ask", or "offer") and the price at which a market taker will buy ("bid") from a wholesale or retail customer. The customer will buy from the market-maker at the higher "ask" price, and will sell at the lower "bid" price, thus giving up the "spread" as the cost of completing the trade. This spread is minimal for actively traded pairs of currencies, usually 0–3 pips. For example, the bid/ask quote of EUR/USD might be 1.2200/1.2203 on a retail broker. Minimum trading size for most deals is usually 100,000 units of base currency, which is a standard "lot".
These spreads might not apply to retail customers at banks, which will routinely mark up the difference to say 1.2100/1.2300 for transfers, or say 1.2000/1.2400 for banknotes or travelers' checks. Spot prices at market makers vary, but on EUR/USD are usually no more than 3 pips wide (i.e., 0.0003). Competition is greatly increased with larger transactions, and pip spreads shrink on the major pairs to as little as 1 to 2 pips.
Market participants
Financial markets
________________________________________
Bond market
Fixed income
Corporate bond
Government bond
Municipal bond
Bond valuation
High-yield debt
Stock market
Stock
Preferred stock
Common stock
Registered share
Voting share
Stock exchange
Foreign exchange market
Derivatives market
Credit derivative
Hybrid security
Options
Futures
Forwards
Swaps
Other Markets
Commodity market
Money market
OTC market
Real estate market
Spot market
________________________________________
Finance series
Financial market
Financial market participants
Corporate finance
Personal finance
Public finance
Banks and Banking
Financial regulation
v • d • e
Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest commercial banks and securities dealers. Within the inter-bank market, spreads, which are the difference between the bid and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle. The difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips for some currencies such as the EUR). This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the "line" (the amount of money with which they are trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there are usually smaller banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail FX-metal market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size” Central banks also participate in the foreign exchange market to align currencies to their economic needs.
Banks
The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account. Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems. The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.
Commercial companies
An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.
Central banks
National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high—that is, to trade for a profit based on their more precise information. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.
The mere expectation or rumor of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank.[7] Several scenarios of this nature were seen in the 1992–93 ERM collapse, and in more recent times in Southeast Asia.
Hedge funds as speculators
About 70% to 90%[citation needed] of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor.
Investment management firms
Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases.
Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades.
Retail foreign exchange brokers
Retail traders (individuals) are an explosively growing part of this market, both in size and importance. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated in the USA by the CFTC and NFA have in the past been subjected to periodic foreign exchange scams.[8][9] To deal with the issue, the NFA and CFTC began (as of 2009) imposing stricter requirements, particularly in relation to the amount of Net Capitalization required of its members. As a result many of the smaller, and perhaps questionable brokers are now gone.
There are two main types of retail FX brokers offering the opportunity for speculative currency trading: Retail brokers who employ the "Agency Broker" model and Market-Makers who employ the "Broker as principal or specialist" model. "Agency Brokers" serve as 'your representative' in the broader FX market, by seeking the best prices for your orders, and then typically pass your orders through to some other market-maker, bank or dealer, after applying a small mark-up. Market-Makers, by contrast, typically play the role of 'final resting stop' for your orders by choosing to simply fill them immediately and then manage the resulting risk themselves. No one model is better than the other, and both have various benefits, advantages and drawbacks.
Nonetheless, it is not widely understood that the "Market-Maker" retail brokers trade 'against' their clients (via the broker as "principal" model rather than the "agency" broker model) and frequently take the other side of their customers' trades (eg: GAIN CAPITAL pursues this model). This may sometimes create a potential conflict of interest and give rise to some of the unpleasant trade-execution experiences some traders & customers have had. A move toward NDD (No Dealing Desk) and STP (Straight Through Processing) has helped to resolve some of these concerns and restore trader confidence, but cautious optimism is still advised.
The earliest Retail FX brokers were CMC Markets, SAXO Bank (Formerly MIDAS), FXCM (formerly Shalish Capital Markets) GFT (Global Forex Trading) MG Forex (AKA "Money Garden"), eForex.com (no longer in existence), and Matchbook FX, which was notable because it was the 1st and only FX broker that pursued a user-price driven ECN model, rather than a Dealer/Market Maker model. Banks have also started to offer their very own retail trading platforms; Deutsche bank offers retail foreign exchange trading under the name DBFX while Citibank (CitiFX pro) has its own offering now too.
Non-bank foreign exchange companies
Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but currency exchange with payments. I.e., there is usually a physical delivery of currency to a bank account. Send Money Home offer an in-depth comparison into the services offered by all the major non-bank foreign exchange companies.
It is estimated that in the UK, 14% of currency transfers/payments[10] are made via Foreign Exchange Companies.[11] These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank. These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services.
Money transfer/remittance companies
Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally followed by UAE Exchange Financial Service Ltd
Send Money Home is an international money transfer price comparison site that allows consumers access to a range of alternative products and rates available when remitting (transferring) money worldwide.
Trading characteristics
Most traded currencies[2]
Currency distribution of reported FX market turnover
Rank Currency ISO 4217 code
(Symbol) % daily share
(April 2007)
1 United States dollar
USD ($) 86.3%
2 Euro
EUR (€) 37.0%
3 Japanese yen
JPY (¥) 17.0%
4 Pound sterling
GBP (£) 15.0%
5 Swiss franc
CHF (Fr) 6.8%
6 Australian dollar
AUD ($) 6.7%
7 Canadian dollar
CAD ($) 4.2%
8-9 Swedish krona
SEK (kr) 2.8%
8-9 Hong Kong dollar
HKD ($) 2.8%
10 Norwegian krone
NOK (kr) 2.2%
11 New Zealand dollar
NZD ($) 1.9%
12 Mexican peso
MXN ($) 1.3%
13 Singapore dollar
SGD ($) 1.2%
14 South Korean won
KRW (₩) 1.1%
Other 14.5%
Total 200%
There is no unified or centrally cleared market for the majority of FX trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currencies instruments are traded. This implies that there is not a single exchange rate but rather a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice the rates are often very close, otherwise they could be exploited by arbitrageurs instantaneously. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. A joint venture of the Chicago Mercantile Exchange and Reuters, called Fxmarketspace opened in 2007 and aspired but failed to the role of a central market clearing mechanism.
The main trading center is London, but New York, Tokyo, Hong Kong and Singapore are all important centers as well. Banks throughout the world participate. Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session, excluding weekends.
Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in gross domestic product (GDP) growth, inflation (purchasing power parity theory), interest rates (interest rate parity, Domestic Fisher effect, International Fisher effect), budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers' order flow.
Currencies are traded against one another. Each pair of currencies thus constitutes an individual product and is traditionally noted XXXYYY or YYY/XXX, where YYY is the ISO 4217 international three-letter code of the currency into which the price of one unit of XXX is expressed (called base currency). For instance, EURUSD or USD/EUR is the price of the euro expressed in US dollars, as in 1 euro = 1.5465 dollar. Out of convention, the first currency in the pair, the "base" currency, was the stronger currency at the creation of the pair. The second currency, counter currency or "term" currency, was the weaker currency at the creation of the pair. Currencies are occasionally incorrectly quoted with the pairs inverted e.g. EUR/USD but this is incorrect. The "/" acts the same as the divide mathematical operator and derives the actual exchange rate. e.g. an amount of $140,000 equates to €100,000. $140,000/€100,000 = $/€ = USD/EUR = a rate of 1.4 hence EURUSD or USD/EUR. See Exchange_rate
The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes positive currency correlation between XXXYYY and XXXZZZ.
On the spot market, according to the BIS study, the most heavily traded products were:
• EURUSD: 27%
• USDJPY: 13%
• GBPUSD (also called cable): 12%
and the US currency was involved in 86.3% of transactions, followed by the euro (37.0%), the yen (17.0%), and sterling (15.0%) (see table). Volume percentages for all individual currencies should add up to 200%, as each transaction involves two currencies.
Trading in the euro has grown considerably since the currency's creation in January 1999, and how long the foreign exchange market will remain dollar-centered is open to debate. Until recently, trading the euro versus a non-European currency ZZZ would have usually involved two trades: EURUSD and USDZZZ. The exception to this is EURJPY, which is an established traded currency pair in the interbank spot market. As the dollar's value has eroded during 2008, interest in using the euro as reference currency for prices in commodities (such as oil), as well as a larger component of foreign reserves by banks, has increased dramatically. Transactions in the currencies of commodity-producing countries, such as AUD, NZD, CAD, have also increased.
Determinants of FX rates
See also: exchange rates
The following theories explain the fluctuations in FX rates in a floating exchange rate regime (In a fixed exchange rate regime, FX rates are decided by its government):
(a) International parity conditions viz; Relative Purchasing Power Parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.
(b) Balance of payments model (see exchange rate). This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit.
(c) Asset market model (see exchange rate) views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.”
None of the models developed so far succeed to explain FX rates levels and volatility in the longer time frames. For shorter time frames (less than a few days) algorithm can be devised to predict prices. Large and small institutions and professional individual traders have made consistent profits from it. It is understood from above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.
Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.
Economic factors
These include: (a)economic policy, disseminated by government agencies and central banks, (b)economic conditions, generally revealed through economic reports, and other economic indicators.
1. Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).
2. Economic conditions include:
Government budget deficits or surpluses
The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.
Balance of trade levels and trends
The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.
Inflation levels and trends
Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.
Economic growth and health
Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.
Productivity of an economy
Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector [3].
Political conditions
Internal, regional, and international political conditions and events can have a profound effect on currency markets.
All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency.
Market psychology
Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:
Flights to quality
Unsettling international events can lead to a "flight to quality," with investors seeking a "safe haven." There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The Swiss franc and gold have been traditional safe havens during times of political or economic uncertainty.[12]
Long-term trends
Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends. [13]
"Buy the rumor, sell the fact"
This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought".[14] To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices.
Economic numbers
While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.
Technical trading considerations
As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.[15]
Algorithmic trading in foreign exchange
Electronic trading is growing in the FX market, and algorithmic trading is becoming much more common. According to financial consultancy Celent estimates, by 2008 up to 25% of all trades by volume will be executed using algorithm, up from about 18% in 2005.[citation needed]
Financial instruments
Spot
A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. The data for this study come from the spot market. Spot transactions has the second largest turnover by volume after Swap transactions among all FX transactions in the Global FX market. NNM
Forward
See also: forward contract
One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a one day, a few days, months or years. Usually the date is decided by both parties.
Future
Main article: currency future
Foreign currency futures are exchange traded forward transactions with standard contract sizes and maturity dates — for example, $1000 for next November at an agreed rate [4],[5]. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.
Swap
Main article: foreign exchange swap
The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange.
Option
Main article: foreign exchange option
A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world..
Exchange-traded fund
Main article: exchange-traded fund
Exchange-traded funds (or ETFs) are open ended investment companies that can be traded at any time throughout the course of the day. Typically, ETFs try to replicate a stock market index such as the S&P 500 (e.g., SPY), but recently they are now replicating investments in the currency markets with the ETF increasing in value when the US Dollar weakens versus a specific currency, such as the Euro. Certain of these funds track the price movements of world currencies versus the US Dollar, and increase in value directly counter to the US Dollar, allowing for speculation in the US Dollar for US and US Dollar denominated investors and speculators.
Speculation
Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Nevertheless, economists including Milton Friedman have argued that speculators ultimately are a stabilizing influence on the market and perform the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do.[16] Other economists such as Joseph Stiglitz consider this argument to be based more on politics and a free market philosophy than on economics.[17]
Large hedge funds and other well capitalized "position traders" are the main professional speculators. According to some economists, individual traders could act as "noise traders" and have a more destabilizing role than larger and better informed actors [18].
Currency speculation is considered a highly suspect activity in many countries.[where?] While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not; according to this view, it is simply gambling that often interferes with economic policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to devalue the krona.[19] Former Malaysian Prime Minister Mahathir Mohamad is one well known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.
Gregory J. Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit.[20]
In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their national economies, and foreign exchange speculators allegedly made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions. Given that Malaysia recovered quickly after imposing currency controls directly against International Monetary Fund advice, this view is open to doubt.
See also
• Balance of trade
• Bretton Woods system
• Currency pair
• Foreign currency mortgage
• Foreign exchange hedge
• Foreign exchange reserves
• Foreign exchange scam
• Foreign exchange swap
• Nonfarm payrolls
• Retail foreign exchange
• Special Drawing Rights
• Technical analysis
• Tobin Tax
• World currency
• Currency codes
• money market
Gold as an investment
Gold as an investment
From Wikipedia, the free encyclopedia
Jump to: navigation, search
For the physical properties and applications of gold, see gold.
This article's citation style may be unclear. The references used may be made clearer with a different or consistent style of citation, footnoting, or external linking. (November 2008)
Reserves of foreign exchange and gold
Of all the precious metals, gold is the most popular as an investment. Investors generally buy gold as a hedge or safe haven against any economic, political, social or currency-based crises. These crises include investment market declines, burgeoning national debt, currency failure, inflation, war and social unrest. Investors also buy gold early in a bull market and aim to sell it before a bear market begins, in an attempt to gain financially.
Contents
[hide]
• 1 Gold price
• 2 Factors influencing the gold price
• 3 Methods of investing in gold
• 4 Investment strategies
o 4.1 Fundamental analysis
o 4.2 Gold versus stocks
o 4.3 Technical analysis
o 4.4 Using leverage
o 4.5 Price speculation
• 5 See also
• 6 References
• 7 External links
[edit] Gold price
Price of one troy ounce of gold in US Dollars 1968–2008. (Note that this graph in nominal USD terms may mislead. In real terms, the peak value was 1981 by some margin).
Gold has been used throughout history as a form of payment and has been a relative standard for currency equivalents specific to economic regions or countries. Many European countries implemented gold standards in latter part of the 19th century until these were dismantled in the financial crises involving World War I. After World War II, the Bretton Woods system pegged the United States dollar to gold at a rate of US$35 per troy ounce. The system existed until the 1971 Nixon Shock, when the US unilaterally suspended the direct convertibility of the United States dollar to gold.
Since 1919 the most common benchmark for the price of gold has been the London gold fixing, a twice-daily telephone meeting of representatives from five bullion-trading firms of the London bullion market. Furthermore, gold is traded continuously throughout the world based on the intra-day spot price, derived from over-the-counter gold-trading markets around the world. The following table sets forth the gold price versus various assets and key statistics:
Year Gold, USD/ozt[1]
Silver, USD/ozt[2]
DJIA, USD[3]
World GDP, USD tn[4]
US Debt, USD bn[5]
Trade Weighted US dollar Index[6]
1970 37.4 1.6 838.9 3.3 370.1
1975 140.3 4.2 852.4 6.4 533.2 33.0442
1980 589.5 15.5 964.0 11.8 907.7 35.6922
1985 327.0 5.8 1,546.7 13.0 1,823.1 68.2042
1990 353.4 4.2 2,633.7 22.2 3,233.3 73.2249
1995 369.6 5.1 5,117.1 29.8 4,974.0 90.3097
2000 272.7 4.6 10,786.9 31.9 5,662.2 118.6013
2005 513.0 8.8 10,717.5 45.1 8,170.4 111.5580
2008 865.0 10.8 8,776.4 54.6 10,699.8 96.0884
In March 2008, the gold price exceeded US$1,000,[7] achieving a nominal high of US$1,004.38. In real terms, actual value was still well below the US$599 peak in 1981 (equivalent to $1417 in U.S. 2008 dollar value). After the March 2008 spike, gold prices declined to a low of US$712.30 per ounce in November. Pricing soon resumed on upward momentum by temporarily breaking the US$1000 barrier again in late February 2009 but regressed moderately later in the quarter.
After fluctuation returned near the US$1,000.00 mark in mid-September 2009, international gold markets peaked at US$1,023.30. Pricing later declined moderately again in late September 2009, falling back to US$991.70 for the week ending on September 25, 2009.
Later in 2009, the March 2008 intra-day spot price record of US$1,033.90 was broken several times in October, as the price of gold entered parabolic stages of successively new highs when a spike reversal to $1226 initiated a retrace of the price to the mid-October levels.
Financial commentator Jim Rogers predicts that gold will reach US$2000 per troy ounce without citing a time frame.[8] Some analysts attribute this to central banks diverting their reserves away from US dollars.[9] However, economics professor Nouriel Roubini sees another investment bubble that will burst spectacularly.[10]
[edit] Factors influencing the gold price
Today, like all investments and commodities, the price of gold is ultimately driven by supply and demand. Unlike most other commodities, the hoarding and disposal plays a much bigger role in affecting the price, because most of the gold ever mined still exists and is potentially able to come on to the market for the right price.[11][12] At the end of 2006, it was estimated that all the gold ever mined totaled 158,000 tonnes.[13] This can be represented by a cube with an edge length of just 20.2 meters.
Given the huge quantity of stored gold, compared to the annual production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production.[14] According to the World Gold Council, annual mine production of gold over the last few years has been close to 2,500 tonnes.[15] About 2,000 tonnes goes into jewellery or industrial/dental production, and around 500 tonnes goes to retail investors and exchange traded gold funds.[15] This translates to an annual demand for gold to be 1,000 tonnes in excess over mine production which has come from central bank sales and other disposal.[15]
Central banks and the International Monetary Fund play an important role in the gold price. At the end of 2004 central banks and official organizations held 19 percent of all above-ground gold as official gold reserves.[16] The Washington Agreement on Gold (WAG), which dates from September 1999, limits gold sales by its members (Europe, United States, Japan, Australia, Bank for International Settlements and the International Monetary Fund) to less than 400 tonnes a year.[17] European central banks, such as the Bank of England and Swiss National Bank, have been key sellers of gold over this period.[18] Although central banks do not generally announce gold purchases in advance, some, such as Russia, have expressed interest in growing their gold reserves again as of late 2005.[19] In early 2006, China, which only holds 1.3% of its reserves in gold,[20] announced that it was looking for ways to improve the returns on its official reserves. Some bulls hope that this signals that China might reposition more of its holdings into gold in line with other Central Banks. India has recently purchased over 200 tons of gold which has led to a surge in prices.[21]
Bank failures
When dollars were fully convertible into gold, both were regarded as money. However, most people preferred to carry around paper banknotes rather than the somewhat heavier and less divisible gold coins. If people feared their bank would fail, a bank run might have been the result. This is what happened in the USA during the Great Depression of the 1930s, leading President Roosevelt to impose a national emergency and to outlaw the ownership of gold by US citizens.[22]
Low or negative real interest rates
If the return on bonds, equities and real estate is not adequately compensating for risk and inflation then the demand for gold and other alternative investments such as commodities increases. An example of this is the period of Stagflation that occurred during the 1970s and which led to an economic bubble forming in precious metals.[23][24]
War, invasion, looting, crisis
In times of national crisis, people fear that their assets may be seized and that the currency may become worthless. They see gold as a solid asset which will always buy food or transportation. Thus in times of great uncertainty, particularly when war is feared, the demand for gold rises.[25][26]
[edit] Methods of investing in gold
Main article: Methods of investing in gold
Investment in gold can be done directly through bullion or coin ownership, or indirectly through gold exchange-traded funds, certificates, accounts, spread betting, derivatives or shares.
[edit] Investment strategies
[edit] Fundamental analysis
One troy ounce along with the certificate
Investors using fundamental analysis analyze the macroeconomic situation, which includes international economic indicators, such as GDP growth rates, inflation, interest rates, productivity and energy prices. They would also analyze the yearly global gold supply versus demand. Over 2005 the World Gold Council estimated yearly global gold supply to be 3,859 tonnes and demand to be 3,754 tonnes, giving a surplus of 105 tonnes.[27] While gold production is unlikely to change in the near future, supply and demand due to private ownership is highly liquid and subject to rapid changes. This makes gold very different from almost every other commodity.[11][12]
[edit] Gold versus stocks
Dow/Gold Ratio 1968-2008
The ratio of the Dow Jones Industrial Average index divided by the price of an ounce of gold. A surrogate index was used to generate all points before 1897. Note: The vertical scale of this chart is logarithmic.
The performance of gold bullion is often compared to stocks. They are fundamentally different asset classes. Gold is regarded by some as a store of value (without growth) whereas stocks are regarded as a return on value (i.e., growth from anticipated real price increase plus dividends). Stocks and bonds perform best in a stable political climate with strong property rights and little turmoil. The attached graph shows the value of Dow Jones Industrial Average divided by the price of an ounce of gold. Since 1800, stocks have consistently gained value in comparison to gold in part because of the stability of the American political system.[28] This appreciation has been cyclical with long periods of stock outperformance followed by long periods of gold outperformance. The Dow Industrials bottomed out a ratio of 1:1 with gold during 1980 (the end of the 1970s bear market) and proceeded to post gains throughout the 1980s and 1990s. The gold price peak of 1980 also coincided with the Soviet Union's invasion of Afghanistan and the threat of the global expansion of communism. The ratio peaked on January 14, 2000 a value of 41.3 and has fallen sharply since.
In November 2005, Rick Munarriz of Motley Fool.com posed the question of which represented a better investment: a share of Google or an ounce of gold. The specific comparison between these two very different investments seems to have captured the imagination of many in the investment community and is serving to crystallize the broader debate.[29][30] At the time of writing, a share of Google's stock and an ounce of gold were both near $700. On January 4, 2008 23:58 New York Time, it was reported that an ounce of gold outpaced the share price of Google by 30.77%, with gold closing at $859.19 per ounce and a share of Google closing at $657 on U.S. market exchanges.
On January 24, 2008, the gold price broke the $900 mark per ounce for the first time. The price of gold topped $1,000 an ounce for the first time ever on March 13, 2008 amid recession fears in the United States.[31] Google closed 2008 at $307.65 while gold closed the year at $866.
The cost of holding onto tangible gold yields risk. Because of gold's value, that risk must be hedged by secure protection. Because of this additional cost and security risk, some opt for mutual funds.[32]
[edit] Technical analysis
As with stocks, gold investors may base their investment decision partly on, or solely on, technical analysis. Typically, this involves analyzing chart patterns, moving averages, market trends and/or the economic cycle in order to speculate on the future price.
[edit] Using leverage
Bullish investors may choose to leverage their position by borrowing money against their existing [gold] assets and then purchasing [more] gold on account with the loaned funds. This technique is referred to as a carry trade. Leverage is also an integral part of buying gold derivatives and unhedged gold mining company shares (see gold mining companies). Leverage via carry trades or derivatives may increase investment gains but also increases the corresponding risk of capital loss if/when the trend reverses.
[edit] Price speculation
Since April 2001 the gold price has more than tripled in value against the US dollar, prompting speculation that the long secular bear market has ended and a bull market has returned[33]. A World Gold Council report released on February 18, 2009 showed physical gold demand rose sharply in the second half of 2008.
Identifiable investment demand for gold, which includes gold exchange-traded funds, bars and coins, was up 64 percent in 2008 over the year before.[34]
In the last century, major economic crises (such as the Great Depression, World War II, the first and second oil crisis) lowered the Dow/Gold ratio, an indicator of how bad a recession is and whether the outlook is deteriorating or improving, to a value well below 4. The ratio fell on February 18, 2009 to below 8.[34] During these difficult times, many investors tried to preserve their assets by investing in precious metals, most notably gold and silver.
From Wikipedia, the free encyclopedia
Jump to: navigation, search
For the physical properties and applications of gold, see gold.
This article's citation style may be unclear. The references used may be made clearer with a different or consistent style of citation, footnoting, or external linking. (November 2008)
Reserves of foreign exchange and gold
Of all the precious metals, gold is the most popular as an investment. Investors generally buy gold as a hedge or safe haven against any economic, political, social or currency-based crises. These crises include investment market declines, burgeoning national debt, currency failure, inflation, war and social unrest. Investors also buy gold early in a bull market and aim to sell it before a bear market begins, in an attempt to gain financially.
Contents
[hide]
• 1 Gold price
• 2 Factors influencing the gold price
• 3 Methods of investing in gold
• 4 Investment strategies
o 4.1 Fundamental analysis
o 4.2 Gold versus stocks
o 4.3 Technical analysis
o 4.4 Using leverage
o 4.5 Price speculation
• 5 See also
• 6 References
• 7 External links
[edit] Gold price
Price of one troy ounce of gold in US Dollars 1968–2008. (Note that this graph in nominal USD terms may mislead. In real terms, the peak value was 1981 by some margin).
Gold has been used throughout history as a form of payment and has been a relative standard for currency equivalents specific to economic regions or countries. Many European countries implemented gold standards in latter part of the 19th century until these were dismantled in the financial crises involving World War I. After World War II, the Bretton Woods system pegged the United States dollar to gold at a rate of US$35 per troy ounce. The system existed until the 1971 Nixon Shock, when the US unilaterally suspended the direct convertibility of the United States dollar to gold.
Since 1919 the most common benchmark for the price of gold has been the London gold fixing, a twice-daily telephone meeting of representatives from five bullion-trading firms of the London bullion market. Furthermore, gold is traded continuously throughout the world based on the intra-day spot price, derived from over-the-counter gold-trading markets around the world. The following table sets forth the gold price versus various assets and key statistics:
Year Gold, USD/ozt[1]
Silver, USD/ozt[2]
DJIA, USD[3]
World GDP, USD tn[4]
US Debt, USD bn[5]
Trade Weighted US dollar Index[6]
1970 37.4 1.6 838.9 3.3 370.1
1975 140.3 4.2 852.4 6.4 533.2 33.0442
1980 589.5 15.5 964.0 11.8 907.7 35.6922
1985 327.0 5.8 1,546.7 13.0 1,823.1 68.2042
1990 353.4 4.2 2,633.7 22.2 3,233.3 73.2249
1995 369.6 5.1 5,117.1 29.8 4,974.0 90.3097
2000 272.7 4.6 10,786.9 31.9 5,662.2 118.6013
2005 513.0 8.8 10,717.5 45.1 8,170.4 111.5580
2008 865.0 10.8 8,776.4 54.6 10,699.8 96.0884
In March 2008, the gold price exceeded US$1,000,[7] achieving a nominal high of US$1,004.38. In real terms, actual value was still well below the US$599 peak in 1981 (equivalent to $1417 in U.S. 2008 dollar value). After the March 2008 spike, gold prices declined to a low of US$712.30 per ounce in November. Pricing soon resumed on upward momentum by temporarily breaking the US$1000 barrier again in late February 2009 but regressed moderately later in the quarter.
After fluctuation returned near the US$1,000.00 mark in mid-September 2009, international gold markets peaked at US$1,023.30. Pricing later declined moderately again in late September 2009, falling back to US$991.70 for the week ending on September 25, 2009.
Later in 2009, the March 2008 intra-day spot price record of US$1,033.90 was broken several times in October, as the price of gold entered parabolic stages of successively new highs when a spike reversal to $1226 initiated a retrace of the price to the mid-October levels.
Financial commentator Jim Rogers predicts that gold will reach US$2000 per troy ounce without citing a time frame.[8] Some analysts attribute this to central banks diverting their reserves away from US dollars.[9] However, economics professor Nouriel Roubini sees another investment bubble that will burst spectacularly.[10]
[edit] Factors influencing the gold price
Today, like all investments and commodities, the price of gold is ultimately driven by supply and demand. Unlike most other commodities, the hoarding and disposal plays a much bigger role in affecting the price, because most of the gold ever mined still exists and is potentially able to come on to the market for the right price.[11][12] At the end of 2006, it was estimated that all the gold ever mined totaled 158,000 tonnes.[13] This can be represented by a cube with an edge length of just 20.2 meters.
Given the huge quantity of stored gold, compared to the annual production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production.[14] According to the World Gold Council, annual mine production of gold over the last few years has been close to 2,500 tonnes.[15] About 2,000 tonnes goes into jewellery or industrial/dental production, and around 500 tonnes goes to retail investors and exchange traded gold funds.[15] This translates to an annual demand for gold to be 1,000 tonnes in excess over mine production which has come from central bank sales and other disposal.[15]
Central banks and the International Monetary Fund play an important role in the gold price. At the end of 2004 central banks and official organizations held 19 percent of all above-ground gold as official gold reserves.[16] The Washington Agreement on Gold (WAG), which dates from September 1999, limits gold sales by its members (Europe, United States, Japan, Australia, Bank for International Settlements and the International Monetary Fund) to less than 400 tonnes a year.[17] European central banks, such as the Bank of England and Swiss National Bank, have been key sellers of gold over this period.[18] Although central banks do not generally announce gold purchases in advance, some, such as Russia, have expressed interest in growing their gold reserves again as of late 2005.[19] In early 2006, China, which only holds 1.3% of its reserves in gold,[20] announced that it was looking for ways to improve the returns on its official reserves. Some bulls hope that this signals that China might reposition more of its holdings into gold in line with other Central Banks. India has recently purchased over 200 tons of gold which has led to a surge in prices.[21]
Bank failures
When dollars were fully convertible into gold, both were regarded as money. However, most people preferred to carry around paper banknotes rather than the somewhat heavier and less divisible gold coins. If people feared their bank would fail, a bank run might have been the result. This is what happened in the USA during the Great Depression of the 1930s, leading President Roosevelt to impose a national emergency and to outlaw the ownership of gold by US citizens.[22]
Low or negative real interest rates
If the return on bonds, equities and real estate is not adequately compensating for risk and inflation then the demand for gold and other alternative investments such as commodities increases. An example of this is the period of Stagflation that occurred during the 1970s and which led to an economic bubble forming in precious metals.[23][24]
War, invasion, looting, crisis
In times of national crisis, people fear that their assets may be seized and that the currency may become worthless. They see gold as a solid asset which will always buy food or transportation. Thus in times of great uncertainty, particularly when war is feared, the demand for gold rises.[25][26]
[edit] Methods of investing in gold
Main article: Methods of investing in gold
Investment in gold can be done directly through bullion or coin ownership, or indirectly through gold exchange-traded funds, certificates, accounts, spread betting, derivatives or shares.
[edit] Investment strategies
[edit] Fundamental analysis
One troy ounce along with the certificate
Investors using fundamental analysis analyze the macroeconomic situation, which includes international economic indicators, such as GDP growth rates, inflation, interest rates, productivity and energy prices. They would also analyze the yearly global gold supply versus demand. Over 2005 the World Gold Council estimated yearly global gold supply to be 3,859 tonnes and demand to be 3,754 tonnes, giving a surplus of 105 tonnes.[27] While gold production is unlikely to change in the near future, supply and demand due to private ownership is highly liquid and subject to rapid changes. This makes gold very different from almost every other commodity.[11][12]
[edit] Gold versus stocks
Dow/Gold Ratio 1968-2008
The ratio of the Dow Jones Industrial Average index divided by the price of an ounce of gold. A surrogate index was used to generate all points before 1897. Note: The vertical scale of this chart is logarithmic.
The performance of gold bullion is often compared to stocks. They are fundamentally different asset classes. Gold is regarded by some as a store of value (without growth) whereas stocks are regarded as a return on value (i.e., growth from anticipated real price increase plus dividends). Stocks and bonds perform best in a stable political climate with strong property rights and little turmoil. The attached graph shows the value of Dow Jones Industrial Average divided by the price of an ounce of gold. Since 1800, stocks have consistently gained value in comparison to gold in part because of the stability of the American political system.[28] This appreciation has been cyclical with long periods of stock outperformance followed by long periods of gold outperformance. The Dow Industrials bottomed out a ratio of 1:1 with gold during 1980 (the end of the 1970s bear market) and proceeded to post gains throughout the 1980s and 1990s. The gold price peak of 1980 also coincided with the Soviet Union's invasion of Afghanistan and the threat of the global expansion of communism. The ratio peaked on January 14, 2000 a value of 41.3 and has fallen sharply since.
In November 2005, Rick Munarriz of Motley Fool.com posed the question of which represented a better investment: a share of Google or an ounce of gold. The specific comparison between these two very different investments seems to have captured the imagination of many in the investment community and is serving to crystallize the broader debate.[29][30] At the time of writing, a share of Google's stock and an ounce of gold were both near $700. On January 4, 2008 23:58 New York Time, it was reported that an ounce of gold outpaced the share price of Google by 30.77%, with gold closing at $859.19 per ounce and a share of Google closing at $657 on U.S. market exchanges.
On January 24, 2008, the gold price broke the $900 mark per ounce for the first time. The price of gold topped $1,000 an ounce for the first time ever on March 13, 2008 amid recession fears in the United States.[31] Google closed 2008 at $307.65 while gold closed the year at $866.
The cost of holding onto tangible gold yields risk. Because of gold's value, that risk must be hedged by secure protection. Because of this additional cost and security risk, some opt for mutual funds.[32]
[edit] Technical analysis
As with stocks, gold investors may base their investment decision partly on, or solely on, technical analysis. Typically, this involves analyzing chart patterns, moving averages, market trends and/or the economic cycle in order to speculate on the future price.
[edit] Using leverage
Bullish investors may choose to leverage their position by borrowing money against their existing [gold] assets and then purchasing [more] gold on account with the loaned funds. This technique is referred to as a carry trade. Leverage is also an integral part of buying gold derivatives and unhedged gold mining company shares (see gold mining companies). Leverage via carry trades or derivatives may increase investment gains but also increases the corresponding risk of capital loss if/when the trend reverses.
[edit] Price speculation
Since April 2001 the gold price has more than tripled in value against the US dollar, prompting speculation that the long secular bear market has ended and a bull market has returned[33]. A World Gold Council report released on February 18, 2009 showed physical gold demand rose sharply in the second half of 2008.
Identifiable investment demand for gold, which includes gold exchange-traded funds, bars and coins, was up 64 percent in 2008 over the year before.[34]
In the last century, major economic crises (such as the Great Depression, World War II, the first and second oil crisis) lowered the Dow/Gold ratio, an indicator of how bad a recession is and whether the outlook is deteriorating or improving, to a value well below 4. The ratio fell on February 18, 2009 to below 8.[34] During these difficult times, many investors tried to preserve their assets by investing in precious metals, most notably gold and silver.
Market Analysis - Dow theory
Market Analysis - Dow theory
Table of Contents
• Dow Theory
o Introduction
o Background
o Assumptions
Manipulation
Averages Discount Everything
Theory Not Perfect
o Market Movements
Primary Movement
Secondary Movements
Dow Theory Note
Daily Fluctuations
o The Three Stages of Primary Bull Markets and Primary Bear Markets
Primary Bull Market - Stage 1 - Accumulation
Primary Bull Market - Stage 2 - Big Move
Primary Bull Market - Stage 3 - Excess
Primary Bear Market - Stage 1 - Distribution
Primary Bear Market - Stage 2 - Big Move
Primary Bear Market - Stage 3 - Despair
o Signals
o Identification of the Trend
o Averages Must Confirm
Why the Rails?
How Averages Confirm
o Volume
Volume Confirmation
Volume and Reversals
o Trading Ranges a.k.a. Lines
o Performance of the Dow Theory
o Criticisms of Dow Theory
o Conclusions
Dow Theory
Introduction
The Dow theory has been around for almost 100 years, yet even in today's volatile and technology-driven markets, the basic components of Dow theory still remain valid. Developed by Charles Dow, refined by William Hamilton and articulated by Robert Rhea, the Dow theory addresses not only technical analysis and price action, but also market philosophy. Many of the ideas and comments put forth by Dow and Hamilton became axioms of Wall Street. While there are those who may think that it is different this time, a read through The Dow Theory will attest that the stock market behaves the same today as it did almost 100 years ago.
The Dow theory presented below has been taken from Robert Rhea's book, The Dow Theory. Although Dow theory is attributed to Charles Dow, it is William Hamilton's writings that serve as the corner stone for this book and the development of the theory. Also, it should be noted that most of the theory was developed with the Dow Jones Rail and Industrial averages in mind. Even though many concepts can be applied to individual stocks, please keep in mind that these are broad concepts and best applied to stocks as a group or index. When possible, we have also attempted to link some of the realities of today's market with the Dow theory as explained by Dow, Hamilton and Rhea.
Background
Charles Dow developed the Dow theory from his analysis of market price action in the late 19th century. Until his death in 1902, Dow was part owner as well as editor of The Wall Street Journal. Although he never wrote a book on the subject, he did write some editorials that reflected his views on speculation and the role of the rail and industrial averages.
Even though Charles Dow is credited with developing the Dow theory, it was S.A. Nelson and William Hamilton who later refined the theory into what it is today. Nelson wrote The ABC of Stock Speculation and was the first to actually use the term "Dow theory." Hamilton further refined the theory through a series of articles in The Wall Street Journal from 1902 to 1929. Hamilton also wrote The Stock Market Barometer in 1922, which sought to explain the theory in detail.
In 1932, Robert Rhea further refined the analysis of Dow and Hamilton in The Dow Theory. Rhea read, studied and deciphered some 252 editorials through which Dow (1900-1902) and Hamilton (1902-1929) conveyed their thoughts on the market. Rhea also referred to Hamilton's The Stock Market Barometer. The Dow Theory presents the Dow theory as a set of assumptions and theorems.
Assumptions
Before one can begin to accept the Dow theory, there are a number of assumptions that must be accepted. Rhea stated that for the successful application of the Dow theory, these assumptions must be accepted without reservation.
Manipulation
The first assumption is: The manipulation of the primary trend is not possible. When large amounts of money are at stake, the temptation to manipulate is bound to be present. Hamilton did not argue against the possibility that speculators, specialists or anyone else involved in the markets could manipulate the prices. He qualified his assumption by asserting that it was not possible to manipulate the primary trend. Intraday, day-to-day and possibly even secondary movements could be prone to manipulation. These short movements, from a few hours to a few weeks, could be subject to manipulation by large institutions, speculators, breaking news or rumors. Today, Hamilton would likely add message boards and day-traders to this list.
Hamilton went on to say that individual shares could be manipulated. Examples of manipulation usually end the same way: the security runs up and then falls back and continues the primary trend. Examples include:
• PairGain Technology rose sharply due to a hoax posted on a fake Bloomberg site. However, once the hoax was revealed, the stock immediately fell back and returned to its primary trend.
• Books-A-Million rose from 3 to 47 after announcing an improved web site. Three weeks later, the stock settled around 10 and drifted lower from there.
• In 1979/80, there was an attempt to manipulate the price of silver by the Hunt brothers. Silver skyrocketed to over 50$ per ounce, only to come back down to earth and resume its long bear market after the plot to corner the market was unveiled.
While these shares were manipulated over the short term, the long-term trends prevailed after about a month. Hamilton also pointed out that even if individual shares were being manipulated, it would be virtually impossible to manipulate the market as a whole. The market was simply too big for this to occur.
Averages Discount Everything
The market reflects all available information. Everything there is to know is already reflected in the markets through the price. Prices represent the sum total of all the hopes, fears and expectations of all participants. Interest rate movements, earnings expectations, revenue projections, presidential elections, product initiatives and all else are already priced into the market. The unexpected will occur, but usually this will affect the short-term trend. The primary trend will remain unaffected.
The chart below of Coca-Cola (KO) is a recent example of the primary trend remaining intact. The downtrend for Coca-Cola began with the sharp fall from above 90. The stock rallied with the market in October and November 1998, but by December started to decline again. According to Dow theory, the October/November rally would be called a secondary move (against the primary trend). It is likely that the stock was caught up in the general market advance at the time. However, when the major indices were hitting new highs in December, Coca-Cola was starting to flounder and resume its primary trend.
Hamilton noted that sometimes the market would react negatively to good news. For Hamilton, the reasoning was simple: the market looks ahead. By the time the news hits the street, it is already reflected in the price. This explains the old Wall Street axiom, "buy the rumor, sell the news". As the rumor begins to filter down, buyers step in and bid the price up. By the time the news hits, the price has been bid up to fully reflect the news. Yahoo! (YHOO) and the run up to earnings is a classic example. For the past three quarters, Yahoo! has been bid up leading right up to the earnings report. Even though earnings have exceeded expectations each time, the stock has fallen by about 20%.
Theory Not Perfect
Hamilton and Dow readily admit that the Dow theory is not a sure-fire means of beating the market. It is looked upon as a set of guidelines and principles to assist investors and traders with their own study of the market. The Dow theory provides a mechanism for investors to use that will help remove some of the emotion. Hamilton warns that investors should not be influenced by their own wishes. When analyzing the market, make sure you are objective and see what is there, not what you want to see. If an investor is long, he or she may want to see only the bullish signs and ignore any bearish signals. Conversely, if an investor is out of the market or short, he or she may be apt to focus on the negative aspects of the price action and ignore any bullish developments. Dow theory provides a mechanism to help make decisions less ambiguous. The methods for identifying the primary trend are clear-cut and not open to interpretation.
Even though the theory is not meant for short-term trading, it can still add value for traders. No matter what your time frame, it always helps to be able to identify the primary trend. According to Hamilton (writing in the early part of the 20th century), those who successfully applied the Dow theory rarely traded more than four or five times a year. Remember that intraday, day-to-day and possibly even secondary movements can be prone to manipulation, but the primary trend is immune from manipulation. Hamilton and Dow sought a means to filter out the noise associated with daily fluctuations. They were not worried about a couple of points, or getting the exact top or bottom. Their main concern was catching the large moves. Both Hamilton and Dow recommended close study of the markets on a daily basis, but they also sought to minimize the effects of random movements and concentrate on the primary trend. It is easy to get caught up in the madness of the moment and forget the primary trend. After the October low, the primary trend for Coca-Cola remained bearish. Even though there were some sharp advances, the stock never forged a higher high.
Market Movements
Dow and Hamilton identified three types of price movements for the Dow Jones Industrial and Rail averages: primary movements, secondary movements and daily fluctuations. Primary moves last from a few months to many years and represent the broad underlying trend of the market. Secondary (or reaction) movements last from a few weeks to a few months and move counter to the primary trend. Daily fluctuations can move with or against the primary trend and last from a few hours to a few days, but usually not more than a week.
Primary Movement
Primary movements represent the broad underlying trend of the market and can last from a few months to many years. These movements are typically referred to as bull and bear markets. Once the primary trend has been identified, it will remain in effect until proved otherwise. (We will address the methods for identifying the primary trend later in this article.) Hamilton believed that the length and the duration of the trend were largely indeterminable. Hamilton did study the averages and came up with some general guidelines for length and duration, but warned against attempting to apply these as rules for forecasting.
Many traders and investors get hung up on price and time targets. The reality of the situation is that nobody knows where and when the primary trend will end. The objective of Dow theory is to utilize what we do know, not to haphazardly guess about what we don't know. Through a set of guidelines, Dow theory enables investors to identify the primary trend and invest accordingly. Trying to predict the length and the duration of the trend is an exercise in futility. Hamilton and Dow were mainly interested in catching the big moves of the primary trend. Success, according to Hamilton and Dow, is measured by the ability to identify the primary trend and stay with it.
Secondary Movements
Secondary movements run counter to the primary trend and are reactionary in nature. In a bull market a secondary move is considered a correction. In a bear market, secondary moves are sometimes called reaction rallies. Earlier in this article, a chart of Coca-Cola was used to illustrate reaction rallies (or secondary movements) within the confines of a primary bear trend. Below is a chart illustrating a correction within the confines of a primary bull trend.
In Sept-96, the DJIA ($INDU) recorded a new high, thereby establishing the primary trend as bullish. From trough to peak, the primary advance rose 1988 points. During the advance from Sept-96 to Mar-97, the DJIA never declined for more than two consecutive weeks. By the end of March, after three consecutive weeks of decline, it became apparent that this move was not in the category of daily fluctuations and could be considered a secondary move. Hamilton noted some characteristics that were common to many secondary moves in both bull and bear markets. These characteristics should not be construed as rules, but rather as loose guidelines to be used in conjunction with other analysis techniques. The first three characteristics have been applied to the example above.
1. Based on historical observation, Hamilton estimated that secondary movements retrace 1/3 to 2/3 of the primary move, with 50% being the typical amount. In actuality, the secondary move in early 1997 retraced about 42% of the primary move. (7158 - 5170 = 1988; 7158 - 6316 = 842, 842/1988 = 42.35%).
2. Hamilton also noted that secondary moves tend to be faster and sharper than the preceding primary move. Just with a visual comparison, we can see that the secondary move was sharper that the preceding primary advance. The primary move advanced 38% (1988/5170 = 38%) and lasted from Jul-96 to Mar-97, about 8 months. The secondary move witnessed a correction of 11.7% (842/7158 = 11.7%) and lasted a mere five weeks.
3. At the end of the secondary move, there is usually a dull period just before the turnaround. Little price movement, a decline in volume, or a combination of the two can mark this dullness. Below is a daily chart focusing on the Apr-97 low for the secondary move outlined above.
April 7 through 10 marked the dull point (red line on volume). There was little price movement and volume was the lowest since the decline began. The DJIA ($INDU) then gapped down on an increase in volume. After the down gap, there was a reversal day and then the DJIA proceeded with a gap up and breakout to a reaction high on increasing volume (green line on volume). The new reaction high combined with the increase in volume indicated that the secondary move was over and the primary trend had resumed.
4. Lows are sometimes accompanied by a high-volume washout day. The September/October lows in 1998 were accompanied by record volume levels. At the time, the low on Sept-1 witnessed the highest volume ever recorded and the Oct-8 low recorded the second highest volume ever. Although these high-volume lows were not a signal in and of themselves, they helped form a pattern that preceded a historical advance. This advance took the DJIA ($INDU) from below 8000 to over 11000 in less than one year. Further confirmation of a change in trend came in the form of a new reaction high with high volume on Oct-15.
Dow Theory Note
There is still debate as to whether the crash of 1998 was a bear market or merely a secondary move within the confines of a larger bull market. In hindsight, it would appear to be a secondary move. Even though the DJIA recorded a lower low on August 4 and had lost just over 20% by September 4, the two-month time frame makes it difficult to justify as a bear market.
Hamilton characterized secondary moves as a necessary phenomenon to combat excessive speculation. Corrections and counter moves kept speculators in check and added a healthy dose of guesswork to market movements. Because of their complexity and deceptive nature, secondary movements require extra careful study and analysis. Investors often mistake a secondary move for the beginning of a new primary trend. How far does a secondary move have to go before the primary trend is affected? This issue will be addressed in Part 3 of this article, when we analyze the various signals based on Dow theory.
Daily Fluctuations
Daily fluctuations, while important when viewed as a group, can be dangerous and unreliable individually. Due to the randomness of the movements from day to day, the forecasting value of daily fluctuations is limited at best. At worst, too much emphasis on daily fluctuation will lead to forecasting errors and possibly losses. Getting too caught up in the movement of one or two days can lead to hasty decisions that are based on emotion. It is vitally important to keep the whole picture in mind when analyzing daily price movements. Think of the pieces of a puzzle. Individually, a few pieces are meaningless, yet at the same time they are essential to complete the picture. Daily price movements are important, but only when grouped with other days to form a pattern for analysis. Hamilton did not disregard daily fluctuations, quite to the contrary. The study of daily price action can add valuable insight, but only when taken in context of the larger picture. There is little structure in one, two or even three days' worth of price action. However, when a series of days is combined, a structure will start to emerge and analysis becomes better grounded.
The Three Stages of Primary Bull Markets and Primary Bear Markets
Hamilton identified three stages to both primary bull markets and primary bear markets. These stages relate as much to the psychological state of the market as to the movement of prices. A primary bull market is defined as a long sustained advance marked by improving business conditions that elicit increased speculation and demand for stocks. A primary bear market is defined as a long sustained decline marked by deteriorating business conditions and subsequent decrease in demand for stocks. In both primary bull markets and primary bear markets, there will be secondary movements that run counter to the major trend.
Primary Bull Market - Stage 1 - Accumulation
Hamilton noted that the first stage of a bull market was largely indistinguishable from the last reaction rally of a bear market. Pessimism, which was excessive at the end of the bear market, still reigns at the beginning of a bull market. It is a period when the public is out of stocks, the news from corporate America is bad and valuations are usually at historical lows. However, it is at this stage that the so-called "smart money" begins to accumulate stocks. This is the stage of the market when those with patience see value in owning stocks for the long haul. Stocks are cheap, but nobody seems to want them. This is the stage where Warren Buffet stated in the summer of 1974 that now was the time to buy stocks and become rich. Everyone else thought he was crazy.
In the first stage of a bull market, stocks begin to find a bottom and quietly firm up. When the market starts to rise, there is widespread disbelief that a bull market has begun. After the first leg peaks and starts to head back down, the bears come out proclaiming that the bear market is not over. It is at this stage that careful analysis is warranted to determine if the decline is a secondary movement (a correction of the first leg up). If it is a secondary move, then the low forms above the previous low, a quiet period will ensue as the market firms and then an advance will begin. When the previous peak is surpassed, the beginning of the second leg and a primary bull will be confirmed.
Primary Bull Market - Stage 2 - Big Move
The second stage of a primary bull market is usually the longest, and sees the largest advance in prices. It is a period marked by improving business conditions and increased valuations in stocks. Earnings begin to rise again and confidence starts to mend. This is considered the easiest stage to make money as participation is broad and the trend followers begin to participate.
Primary Bull Market - Stage 3 - Excess
The third stage of a primary bull market is marked by excessive speculation and the appearance of inflationary pressures. (Dow formed these theorems about 100 years ago, but this scenario is certainly familiar.) During the third and final stage, the public is fully involved in the market, valuations are excessive and confidence is extraordinarily high. This is the mirror image to the first stage of the bull market. A Wall Street axiom: When the taxi cab drivers begin to offer tips, the top cannot be far off.
Primary Bear Market - Stage 1 - Distribution
Just as accumulation is the hallmark of the first stage of a primary bull market, distribution marks the beginning of a bear market. As the "smart money" begins to realize that business conditions are not quite as good as once thought, they start to sell stocks. The public is still involved in the market at this stage and become willing buyers. There is little in the headlines to indicate a bear market is at hand and general business conditions remain good. However, stocks begin to lose a bit of their luster and the decline begins to take hold.
While the market declines, there is little belief that a bear market has started and most forecasters remain bullish. After a moderate decline, there is a reaction rally (secondary move) that retraces a portion of the decline. Hamilton noted that reaction rallies during bear markets were quite swift and sharp. As with his analysis of secondary moves in general, Hamilton noted that a large percentage of the losses would be recouped in a matter of days or perhaps weeks. This quick and sudden movement would invigorate the bulls to proclaim the bull market alive and well. However, the reaction high of the secondary move would form and be lower than the previous high. After making a lower high, a break below the previous low would confirm that this was the second stage of a bear market.
Primary Bear Market - Stage 2 - Big Move
As with the primary bull market, stage two of a primary bear market provides the largest move. This is when the trend has been identified as down and business conditions begin to deteriorate. Earnings estimates are reduced, shortfalls occur, profit margins shrink and revenues fall. As business conditions worsen, the sell-off continues.
Primary Bear Market - Stage 3 - Despair
At the top of a primary bull market, hope springs eternal and excess is the order of the day. By the final stage of a bear market, all hope is lost and stocks are frowned upon. Valuations are low, but the selling continues as participants seek to sell no matter what. The news from corporate America is bad, the economic outlook bleak and not a buyer is to be found. The market will continue to decline until all the bad news is fully priced into stocks. Once stocks fully reflect the worst possible outcome, the cycle begins again.
Signals
Through the writings of Dow and Hamilton, Rhea identified 4 separate theorems that addressed trend identification, buy and sell signals, volume, and trading ranges. The first two were deemed the most important and serve to identify the primary trend as bullish or bearish. The second two theorems, dealing with volume and trading ranges, were not considered instrumental in primary trend identification by Hamilton. Volume was looked upon as a confirming statistic and trading ranges were thought to identify periods of accumulation and distribution.
Identification of the Trend
The first step in identifying the primary trend is to identify the individual trend of the Dow Jones Industrial Average (DJIA), and Dow Jones Transportation Average (DJTA), individually. Hamilton used peak and trough analysis in order to ascertain the identity of the trend. An uptrend is defined by prices that form a series of rising peaks and rising troughs (higher highs and higher lows). In contrast, a downtrend is defined by prices that form a series of declining peaks and declining troughs (lower highs and lower lows).
Once the trend has been identified, it is assumed valid until proved otherwise. A downtrend is considered valid until a higher low forms and the ensuing advance off of the higher low surpasses the previous reaction high. Below is a chart of the Dow Jones Transportation Average in 1992. Even though Hamilton and Dow did not make specific references to trend lines, a line has been drawn to emphasize the downward trajectory of the trend. Since the peak in February, a series of lower lows and lower highs formed to make a downtrend. There was a secondary rally in April and May (green circle), but the March high was not surpassed.
The DJTA ($TRAN) continued down until the high volume washout day (red arrow). As discussed in this article, high volume days signal that a possible change is looming. Alone, a high volume washout day is not a buy signal, but rather an indication to monitor price action a little closer. After this high volume day, the DJTA dipped again and then moved above 1250, creating a higher low (green arrow). Even after the higher low is in place, it is still too early to call for a change in trend. The change of trend is not confirmed until the previous reaction high is surpassed (blue arrow).
Conversely, an uptrend is considered in place until a lower low forms and the ensuing decline exceeds the previous low. Below is a line chart of the closing prices for the DJIA. An uptrend began with the Oct-98 lows and the DJIA formed a series of higher highs and higher lows over the next 11 months. Twice, in Dec-98 (red circle) and Jun-99 (blue arrows), the validity of the uptrend came into question, but the uptrend prevailed until late September. (The Dec-98 price action is addressed below.) There were lower highs in Jun-99, but there were never any lower lows to confirm these lower highs and support held. Any bears that jumped the gun in June were made to sit through two more all-time highs in July and August. The change in trend occurred on September 23 when the June lows were violated. Some traders may have concluded that the trend changed when the late August lows were violated. This may indeed be the case, but it is worth noting that the June lows represented a more convincing support area. Keep in mind that the Dow theory is not a science and Hamilton points this out numerous times. The Dow theory is meant to offer insights and guidelines from which to begin careful study of the market movements and price action.
Looking at the line chart above (DJIA ($INDU) 1998/1999 daily close semi-log scale), it may be difficult to distinguish between a valid change in trend and a simple correction. For instance: Was a change in trend warranted when the December low penetrated the November low? (red circle) After the November peak, a lower high formed in December and then the November reaction low was broken. In order to eliminate false signals, Hamilton suggested excluding moves of less than 3%. This was not meant to be a hard and fast rule, but the idea is worth noting. With the increased volatility of today's markets comes the need to smooth the daily fluctuations and avoid false readings.
Hamilton and Dow were interested in catching the big moves and would have been apt to use weekly charts to establish reaction highs and lows. However, in today's fast moving markets, weekly charts may not portray the detail that investors need. One possible solution is to apply a short moving average to the price plot. Although not mentioned by Hamilton and Dow, a 5-day moving average could be applied to smooth the price series and still allow for detail. The chart below (DJIA ($INDU) 1998/1999 daily close 5-EMA) uses a 5-day exponential moving average to smooth the price plot. Notice that the November reaction low now appears quite immaterial. Also, the September reaction high (red arrow) still shows up.
Averages Must Confirm
When the Dow theory was being developed at the turn of the century, the railroads were a vital link in the economy. Hamilton argued that many times activity would begin in the Rail Average before the Industrial Average. He attributed this to the fact that before economic activity began, raw materials would have to be moved from the suppliers to manufacturers. Before General Motors could increase production, more steel would need to be transported. Therefore, an increase in activity among the rail stocks would foreshadow an increase in business activity for the industrial stocks.
Why the Rails?
There is no doubt that today's economy is much different and the makeup of the DJTA has changed to favor the airlines. However, there is still some credibility in using the DJTA to confirm movements in the DJIA. Transport stocks are much more dependent on the economic environment than the average stock and will likely foreshadow economic growth.
• The airline business is cyclical and revenues are highly susceptible to economic changes.
• Airline companies typically carry above average levels of debt and will be more vulnerable to changes in interest rates.
• Energy and Labor costs form a large portion of expenses.
To reflect the added risks above, airline stocks have traditionally sold significantly below market multiples. If the PE for the S&P 500 is 28, the average airline might sell for only 8-10 times earnings.
Even though we are possibly entering into a "new economy," the majority of businesses will somehow be affected by changes in economic activity, interest rates, energy costs and labor costs. Airline companies, bearing the burden of all of the above, are still likely to act as a leading indicator of the general economic environment.
However, one caveat must be added as well. Possibly the greatest fear of the airlines is that people will stop flying in airplanes. Business travel accounts for a large portion of airline revenues, especially the high margin revenues. With the development of the Internet and networking, the need for business travel could be greatly reduced in the future. Federal Express has already experienced a slowdown in the quantity of business documents being shipped. This could ultimately spill over into the business of the airlines.
How Averages Confirm
Hamilton and Dow stressed that for a primary trend buy or sell signal to be valid, both the Industrial Average and the Rail Average must confirm each other. If one average records a new high or new low, then the other must soon follow for a Dow theory signal to be considered valid.
Combining the guidelines set forth for trend identification with the theorem on confirmation, it is now possible to classify the primary trend of the market. The chart above shows an array of signals that occurred during a 7-month period in 1998.
1. In April, both the DJIA ($INDU) and DJTA ($TRAN) recorded new all-time highs (blue line). The primary trend was already bullish, but this confirmation validated the primary trend as bullish.
2. In July, trouble began to surface when the DJTA failed to confirm the new high set by the DJIA. This served as a warning sign, but did not change the trend. Remember, the trend is assumed to be in force until proved otherwise.
3. On July 31, the DJTA recorded a new reaction low. Two days later, the DJIA recorded a new reaction low and confirmed a change in the primary trend from bullish to bearish (red line). After this signal, both averages went on to record new reaction lows.
4. In October, the DJIA formed a higher low while the DJTA recorded a new low. This was another non-confirmation and served notice to be on guard for a possible change in trend.
5. After the higher low, the DJIA followed through with a higher high later that month. This effectively changes the trend for the average from down to up.
6. It was not until early November that the DJTA went on to better its previous reaction high. However, at the same time the DJIA was also advancing higher and the primary trend had changed from bearish to bullish.
Volume
The importance of volume was alluded to above with the chart of the Apr-97 bottom in the DJIA. Rhea notes that while Hamilton did analyze volume statistics, price action was the ultimate determinant. Volume is more important when confirming the strength of advances and can also help to identify potential reversals.
Volume Confirmation
Hamilton thought that volume should increase in the direction of the primary trend. In a primary bull market, volume should be heavier on advances than during corrections. Not only should volume decline on corrections, but participation should also decrease. As Hamilton put it, the market should become "dull and narrow" on corrections, "narrow" meaning that the number of declining issues should not be expanding dramatically. The opposite is true in a primary bear market. Volume should increase on the declines and decrease during the reaction rallies. The reaction rallies should also be narrow and reflect poor participation of the broader market. By analyzing the reaction rallies and corrections, it is possible to judge the underlying strength of the primary trend.
Volume and Reversals
Hamilton noted that high volume levels could be indicative of an impending reversal. A high volume day after a long advance may signal that the trend is about to change or that a reaction high may form soon. In his StockCharts.com commentary on 25-Jun-99, Rex Takasugi discusses the correlation between volume and peaks in the market. Even though his analysis reveals a lag time between volume peaks and market reversals, the relationship still exists. Takasugi's analysis reveals that since 1900 there have been 14 cycles and volume peaked on average 5.6 months ahead of the market. He also notes that the most recent volume peak occurred in Apr-99.
Trading Ranges a.k.a. Lines
In his commentaries over the years, Hamilton referred many times to "lines." Lines are horizontal lines that form trading ranges. Trading ranges develop when the averages move sideways over a period of time and make it possible to draw horizontal lines connecting the tops and bottoms. These trading ranges indicate either accumulation or distribution, but it was virtually impossible to tell which until there was a break to the upside or the downside. If there were a break to the upside, then the trading range would be considered an area of accumulation. If there were a break to the downside, then the trading range would be considered an area of distribution. Hamilton considered the trading range neutral until a breakout occurred. He also warned against attempting to anticipate the breakout.
Performance of the Dow Theory
Mark Hulbert, writing in the New York Times - 6-Sept-98, notes a study that was published in the Journal of Finance by Stephen Brown of New York University and William Goetzmann and Alok Kumar of Yale. They developed a neural network that incorporated the rules for identifying the primary trend. The Dow theory system was tested against buy-and-hold for the period from 1929 to Sept-98. When the system identified the primary trend as bullish, a long position was initiated in a hypothetical index fund. When the system signaled a bearish primary trend, stocks were sold and the money was placed in fixed income instruments. By taking money out of stocks after bear signals, the risk (volatility) of the portfolio is significantly reduced. This is a very important aspect of the Dow theory system and portfolio management. In the past few years, the concept of risk in stocks has diminished, but it is still a fact that stocks carry more risk than bonds.
Over the 70-year period, the Dow theory system outperformed a buy-and-hold strategy by about 2% per year. In addition, the portfolio carried significantly less risk. If compared as risk-adjusted returns, the margin of out-performance would increase. Over the past 18 years, the Dow theory system has under-performed the market by about 2.6% per year. However, when adjusted for risk, the Dow theory system outperformed buy-and-hold over the past 18 years. Keep in mind that 18 years is not a long time in the history of the market. The Dow theory system was found to under-perform during bull markets and outperform during bear markets.
Criticisms of Dow Theory
The first criticism of the Dow theory is that it is really not a theory. Neither Dow nor Hamilton wrote proper academic papers outlining the theory and testing the theorems. The ideas of Dow and Hamilton were put forth through their editorials in the Wall Street Journal. Robert Rhea stitched the theory together by poring over these writings.
Secondly, the Dow theory is criticized for being too late. The trend does not change from bearish to bullish until the previous reaction high has been surpassed. Many traders feel that this is simply too late and misses much of the move. Dow and Hamilton sought to catch the meat of the move and enter during the second leg. Even though this is where the bulk of the move will take place, it is also after the first leg and part way into the second leg. And, if one has to wait for confirmation from the other average, it could even be later in the move.
Thirdly, because it uses the DJIA and DJTA, the Dow theory is criticized as being outdated and no longer an accurate reflection of the economy. This may be a valid point, but as outlined earlier, the DJTA is one of the most economically sensitive indices. The stock market has always been seen as a great predictor of economic growth. To at least keep the industrials up to speed, Home Depot, Intel, Microsoft and SBC Corp have been added to the average to replace Chevron, Goodyear, Sears and Union Carbide, as of 1-Nov-99.
Conclusions
The goal of Dow and Hamilton was to identify the primary trend and catch the big moves. They understood that the market was influenced by emotion and prone to over-reaction both up and down. With this in mind, they concentrated on identification and following: identify the trend and then follow the trend. The trend is in place until proved otherwise. That is when the trend will end, when it is proved otherwise.
Dow theory helps investors identify facts, not make assumptions or forecast. It can be dangerous when investors and traders begin to assume. Predicting the market is a difficult, if not impossible, game. Hamilton readily admitted that the Dow theory was not infallible. While Dow theory may be able to form the foundation for analysis, it is meant as a starting point for investors and traders to develop analysis guidelines that they are comfortable with and understand.
Reading the markets is an empirical science. As such there will be exceptions to the theorems put forth by Hamilton and Dow. They believed that success in the markets required serious study and analysis that would be fraught with successes and failures. Success is a great thing, but don't get too smug about it. Failures, while painful, should be looked upon as learning experiences. Technical analysis is an art form and the eye grows keener with practice. Study both successes and failures with an eye to the future.
Table of Contents
• Dow Theory
o Introduction
o Background
o Assumptions
Manipulation
Averages Discount Everything
Theory Not Perfect
o Market Movements
Primary Movement
Secondary Movements
Dow Theory Note
Daily Fluctuations
o The Three Stages of Primary Bull Markets and Primary Bear Markets
Primary Bull Market - Stage 1 - Accumulation
Primary Bull Market - Stage 2 - Big Move
Primary Bull Market - Stage 3 - Excess
Primary Bear Market - Stage 1 - Distribution
Primary Bear Market - Stage 2 - Big Move
Primary Bear Market - Stage 3 - Despair
o Signals
o Identification of the Trend
o Averages Must Confirm
Why the Rails?
How Averages Confirm
o Volume
Volume Confirmation
Volume and Reversals
o Trading Ranges a.k.a. Lines
o Performance of the Dow Theory
o Criticisms of Dow Theory
o Conclusions
Dow Theory
Introduction
The Dow theory has been around for almost 100 years, yet even in today's volatile and technology-driven markets, the basic components of Dow theory still remain valid. Developed by Charles Dow, refined by William Hamilton and articulated by Robert Rhea, the Dow theory addresses not only technical analysis and price action, but also market philosophy. Many of the ideas and comments put forth by Dow and Hamilton became axioms of Wall Street. While there are those who may think that it is different this time, a read through The Dow Theory will attest that the stock market behaves the same today as it did almost 100 years ago.
The Dow theory presented below has been taken from Robert Rhea's book, The Dow Theory. Although Dow theory is attributed to Charles Dow, it is William Hamilton's writings that serve as the corner stone for this book and the development of the theory. Also, it should be noted that most of the theory was developed with the Dow Jones Rail and Industrial averages in mind. Even though many concepts can be applied to individual stocks, please keep in mind that these are broad concepts and best applied to stocks as a group or index. When possible, we have also attempted to link some of the realities of today's market with the Dow theory as explained by Dow, Hamilton and Rhea.
Background
Charles Dow developed the Dow theory from his analysis of market price action in the late 19th century. Until his death in 1902, Dow was part owner as well as editor of The Wall Street Journal. Although he never wrote a book on the subject, he did write some editorials that reflected his views on speculation and the role of the rail and industrial averages.
Even though Charles Dow is credited with developing the Dow theory, it was S.A. Nelson and William Hamilton who later refined the theory into what it is today. Nelson wrote The ABC of Stock Speculation and was the first to actually use the term "Dow theory." Hamilton further refined the theory through a series of articles in The Wall Street Journal from 1902 to 1929. Hamilton also wrote The Stock Market Barometer in 1922, which sought to explain the theory in detail.
In 1932, Robert Rhea further refined the analysis of Dow and Hamilton in The Dow Theory. Rhea read, studied and deciphered some 252 editorials through which Dow (1900-1902) and Hamilton (1902-1929) conveyed their thoughts on the market. Rhea also referred to Hamilton's The Stock Market Barometer. The Dow Theory presents the Dow theory as a set of assumptions and theorems.
Assumptions
Before one can begin to accept the Dow theory, there are a number of assumptions that must be accepted. Rhea stated that for the successful application of the Dow theory, these assumptions must be accepted without reservation.
Manipulation
The first assumption is: The manipulation of the primary trend is not possible. When large amounts of money are at stake, the temptation to manipulate is bound to be present. Hamilton did not argue against the possibility that speculators, specialists or anyone else involved in the markets could manipulate the prices. He qualified his assumption by asserting that it was not possible to manipulate the primary trend. Intraday, day-to-day and possibly even secondary movements could be prone to manipulation. These short movements, from a few hours to a few weeks, could be subject to manipulation by large institutions, speculators, breaking news or rumors. Today, Hamilton would likely add message boards and day-traders to this list.
Hamilton went on to say that individual shares could be manipulated. Examples of manipulation usually end the same way: the security runs up and then falls back and continues the primary trend. Examples include:
• PairGain Technology rose sharply due to a hoax posted on a fake Bloomberg site. However, once the hoax was revealed, the stock immediately fell back and returned to its primary trend.
• Books-A-Million rose from 3 to 47 after announcing an improved web site. Three weeks later, the stock settled around 10 and drifted lower from there.
• In 1979/80, there was an attempt to manipulate the price of silver by the Hunt brothers. Silver skyrocketed to over 50$ per ounce, only to come back down to earth and resume its long bear market after the plot to corner the market was unveiled.
While these shares were manipulated over the short term, the long-term trends prevailed after about a month. Hamilton also pointed out that even if individual shares were being manipulated, it would be virtually impossible to manipulate the market as a whole. The market was simply too big for this to occur.
Averages Discount Everything
The market reflects all available information. Everything there is to know is already reflected in the markets through the price. Prices represent the sum total of all the hopes, fears and expectations of all participants. Interest rate movements, earnings expectations, revenue projections, presidential elections, product initiatives and all else are already priced into the market. The unexpected will occur, but usually this will affect the short-term trend. The primary trend will remain unaffected.
The chart below of Coca-Cola (KO) is a recent example of the primary trend remaining intact. The downtrend for Coca-Cola began with the sharp fall from above 90. The stock rallied with the market in October and November 1998, but by December started to decline again. According to Dow theory, the October/November rally would be called a secondary move (against the primary trend). It is likely that the stock was caught up in the general market advance at the time. However, when the major indices were hitting new highs in December, Coca-Cola was starting to flounder and resume its primary trend.
Hamilton noted that sometimes the market would react negatively to good news. For Hamilton, the reasoning was simple: the market looks ahead. By the time the news hits the street, it is already reflected in the price. This explains the old Wall Street axiom, "buy the rumor, sell the news". As the rumor begins to filter down, buyers step in and bid the price up. By the time the news hits, the price has been bid up to fully reflect the news. Yahoo! (YHOO) and the run up to earnings is a classic example. For the past three quarters, Yahoo! has been bid up leading right up to the earnings report. Even though earnings have exceeded expectations each time, the stock has fallen by about 20%.
Theory Not Perfect
Hamilton and Dow readily admit that the Dow theory is not a sure-fire means of beating the market. It is looked upon as a set of guidelines and principles to assist investors and traders with their own study of the market. The Dow theory provides a mechanism for investors to use that will help remove some of the emotion. Hamilton warns that investors should not be influenced by their own wishes. When analyzing the market, make sure you are objective and see what is there, not what you want to see. If an investor is long, he or she may want to see only the bullish signs and ignore any bearish signals. Conversely, if an investor is out of the market or short, he or she may be apt to focus on the negative aspects of the price action and ignore any bullish developments. Dow theory provides a mechanism to help make decisions less ambiguous. The methods for identifying the primary trend are clear-cut and not open to interpretation.
Even though the theory is not meant for short-term trading, it can still add value for traders. No matter what your time frame, it always helps to be able to identify the primary trend. According to Hamilton (writing in the early part of the 20th century), those who successfully applied the Dow theory rarely traded more than four or five times a year. Remember that intraday, day-to-day and possibly even secondary movements can be prone to manipulation, but the primary trend is immune from manipulation. Hamilton and Dow sought a means to filter out the noise associated with daily fluctuations. They were not worried about a couple of points, or getting the exact top or bottom. Their main concern was catching the large moves. Both Hamilton and Dow recommended close study of the markets on a daily basis, but they also sought to minimize the effects of random movements and concentrate on the primary trend. It is easy to get caught up in the madness of the moment and forget the primary trend. After the October low, the primary trend for Coca-Cola remained bearish. Even though there were some sharp advances, the stock never forged a higher high.
Market Movements
Dow and Hamilton identified three types of price movements for the Dow Jones Industrial and Rail averages: primary movements, secondary movements and daily fluctuations. Primary moves last from a few months to many years and represent the broad underlying trend of the market. Secondary (or reaction) movements last from a few weeks to a few months and move counter to the primary trend. Daily fluctuations can move with or against the primary trend and last from a few hours to a few days, but usually not more than a week.
Primary Movement
Primary movements represent the broad underlying trend of the market and can last from a few months to many years. These movements are typically referred to as bull and bear markets. Once the primary trend has been identified, it will remain in effect until proved otherwise. (We will address the methods for identifying the primary trend later in this article.) Hamilton believed that the length and the duration of the trend were largely indeterminable. Hamilton did study the averages and came up with some general guidelines for length and duration, but warned against attempting to apply these as rules for forecasting.
Many traders and investors get hung up on price and time targets. The reality of the situation is that nobody knows where and when the primary trend will end. The objective of Dow theory is to utilize what we do know, not to haphazardly guess about what we don't know. Through a set of guidelines, Dow theory enables investors to identify the primary trend and invest accordingly. Trying to predict the length and the duration of the trend is an exercise in futility. Hamilton and Dow were mainly interested in catching the big moves of the primary trend. Success, according to Hamilton and Dow, is measured by the ability to identify the primary trend and stay with it.
Secondary Movements
Secondary movements run counter to the primary trend and are reactionary in nature. In a bull market a secondary move is considered a correction. In a bear market, secondary moves are sometimes called reaction rallies. Earlier in this article, a chart of Coca-Cola was used to illustrate reaction rallies (or secondary movements) within the confines of a primary bear trend. Below is a chart illustrating a correction within the confines of a primary bull trend.
In Sept-96, the DJIA ($INDU) recorded a new high, thereby establishing the primary trend as bullish. From trough to peak, the primary advance rose 1988 points. During the advance from Sept-96 to Mar-97, the DJIA never declined for more than two consecutive weeks. By the end of March, after three consecutive weeks of decline, it became apparent that this move was not in the category of daily fluctuations and could be considered a secondary move. Hamilton noted some characteristics that were common to many secondary moves in both bull and bear markets. These characteristics should not be construed as rules, but rather as loose guidelines to be used in conjunction with other analysis techniques. The first three characteristics have been applied to the example above.
1. Based on historical observation, Hamilton estimated that secondary movements retrace 1/3 to 2/3 of the primary move, with 50% being the typical amount. In actuality, the secondary move in early 1997 retraced about 42% of the primary move. (7158 - 5170 = 1988; 7158 - 6316 = 842, 842/1988 = 42.35%).
2. Hamilton also noted that secondary moves tend to be faster and sharper than the preceding primary move. Just with a visual comparison, we can see that the secondary move was sharper that the preceding primary advance. The primary move advanced 38% (1988/5170 = 38%) and lasted from Jul-96 to Mar-97, about 8 months. The secondary move witnessed a correction of 11.7% (842/7158 = 11.7%) and lasted a mere five weeks.
3. At the end of the secondary move, there is usually a dull period just before the turnaround. Little price movement, a decline in volume, or a combination of the two can mark this dullness. Below is a daily chart focusing on the Apr-97 low for the secondary move outlined above.
April 7 through 10 marked the dull point (red line on volume). There was little price movement and volume was the lowest since the decline began. The DJIA ($INDU) then gapped down on an increase in volume. After the down gap, there was a reversal day and then the DJIA proceeded with a gap up and breakout to a reaction high on increasing volume (green line on volume). The new reaction high combined with the increase in volume indicated that the secondary move was over and the primary trend had resumed.
4. Lows are sometimes accompanied by a high-volume washout day. The September/October lows in 1998 were accompanied by record volume levels. At the time, the low on Sept-1 witnessed the highest volume ever recorded and the Oct-8 low recorded the second highest volume ever. Although these high-volume lows were not a signal in and of themselves, they helped form a pattern that preceded a historical advance. This advance took the DJIA ($INDU) from below 8000 to over 11000 in less than one year. Further confirmation of a change in trend came in the form of a new reaction high with high volume on Oct-15.
Dow Theory Note
There is still debate as to whether the crash of 1998 was a bear market or merely a secondary move within the confines of a larger bull market. In hindsight, it would appear to be a secondary move. Even though the DJIA recorded a lower low on August 4 and had lost just over 20% by September 4, the two-month time frame makes it difficult to justify as a bear market.
Hamilton characterized secondary moves as a necessary phenomenon to combat excessive speculation. Corrections and counter moves kept speculators in check and added a healthy dose of guesswork to market movements. Because of their complexity and deceptive nature, secondary movements require extra careful study and analysis. Investors often mistake a secondary move for the beginning of a new primary trend. How far does a secondary move have to go before the primary trend is affected? This issue will be addressed in Part 3 of this article, when we analyze the various signals based on Dow theory.
Daily Fluctuations
Daily fluctuations, while important when viewed as a group, can be dangerous and unreliable individually. Due to the randomness of the movements from day to day, the forecasting value of daily fluctuations is limited at best. At worst, too much emphasis on daily fluctuation will lead to forecasting errors and possibly losses. Getting too caught up in the movement of one or two days can lead to hasty decisions that are based on emotion. It is vitally important to keep the whole picture in mind when analyzing daily price movements. Think of the pieces of a puzzle. Individually, a few pieces are meaningless, yet at the same time they are essential to complete the picture. Daily price movements are important, but only when grouped with other days to form a pattern for analysis. Hamilton did not disregard daily fluctuations, quite to the contrary. The study of daily price action can add valuable insight, but only when taken in context of the larger picture. There is little structure in one, two or even three days' worth of price action. However, when a series of days is combined, a structure will start to emerge and analysis becomes better grounded.
The Three Stages of Primary Bull Markets and Primary Bear Markets
Hamilton identified three stages to both primary bull markets and primary bear markets. These stages relate as much to the psychological state of the market as to the movement of prices. A primary bull market is defined as a long sustained advance marked by improving business conditions that elicit increased speculation and demand for stocks. A primary bear market is defined as a long sustained decline marked by deteriorating business conditions and subsequent decrease in demand for stocks. In both primary bull markets and primary bear markets, there will be secondary movements that run counter to the major trend.
Primary Bull Market - Stage 1 - Accumulation
Hamilton noted that the first stage of a bull market was largely indistinguishable from the last reaction rally of a bear market. Pessimism, which was excessive at the end of the bear market, still reigns at the beginning of a bull market. It is a period when the public is out of stocks, the news from corporate America is bad and valuations are usually at historical lows. However, it is at this stage that the so-called "smart money" begins to accumulate stocks. This is the stage of the market when those with patience see value in owning stocks for the long haul. Stocks are cheap, but nobody seems to want them. This is the stage where Warren Buffet stated in the summer of 1974 that now was the time to buy stocks and become rich. Everyone else thought he was crazy.
In the first stage of a bull market, stocks begin to find a bottom and quietly firm up. When the market starts to rise, there is widespread disbelief that a bull market has begun. After the first leg peaks and starts to head back down, the bears come out proclaiming that the bear market is not over. It is at this stage that careful analysis is warranted to determine if the decline is a secondary movement (a correction of the first leg up). If it is a secondary move, then the low forms above the previous low, a quiet period will ensue as the market firms and then an advance will begin. When the previous peak is surpassed, the beginning of the second leg and a primary bull will be confirmed.
Primary Bull Market - Stage 2 - Big Move
The second stage of a primary bull market is usually the longest, and sees the largest advance in prices. It is a period marked by improving business conditions and increased valuations in stocks. Earnings begin to rise again and confidence starts to mend. This is considered the easiest stage to make money as participation is broad and the trend followers begin to participate.
Primary Bull Market - Stage 3 - Excess
The third stage of a primary bull market is marked by excessive speculation and the appearance of inflationary pressures. (Dow formed these theorems about 100 years ago, but this scenario is certainly familiar.) During the third and final stage, the public is fully involved in the market, valuations are excessive and confidence is extraordinarily high. This is the mirror image to the first stage of the bull market. A Wall Street axiom: When the taxi cab drivers begin to offer tips, the top cannot be far off.
Primary Bear Market - Stage 1 - Distribution
Just as accumulation is the hallmark of the first stage of a primary bull market, distribution marks the beginning of a bear market. As the "smart money" begins to realize that business conditions are not quite as good as once thought, they start to sell stocks. The public is still involved in the market at this stage and become willing buyers. There is little in the headlines to indicate a bear market is at hand and general business conditions remain good. However, stocks begin to lose a bit of their luster and the decline begins to take hold.
While the market declines, there is little belief that a bear market has started and most forecasters remain bullish. After a moderate decline, there is a reaction rally (secondary move) that retraces a portion of the decline. Hamilton noted that reaction rallies during bear markets were quite swift and sharp. As with his analysis of secondary moves in general, Hamilton noted that a large percentage of the losses would be recouped in a matter of days or perhaps weeks. This quick and sudden movement would invigorate the bulls to proclaim the bull market alive and well. However, the reaction high of the secondary move would form and be lower than the previous high. After making a lower high, a break below the previous low would confirm that this was the second stage of a bear market.
Primary Bear Market - Stage 2 - Big Move
As with the primary bull market, stage two of a primary bear market provides the largest move. This is when the trend has been identified as down and business conditions begin to deteriorate. Earnings estimates are reduced, shortfalls occur, profit margins shrink and revenues fall. As business conditions worsen, the sell-off continues.
Primary Bear Market - Stage 3 - Despair
At the top of a primary bull market, hope springs eternal and excess is the order of the day. By the final stage of a bear market, all hope is lost and stocks are frowned upon. Valuations are low, but the selling continues as participants seek to sell no matter what. The news from corporate America is bad, the economic outlook bleak and not a buyer is to be found. The market will continue to decline until all the bad news is fully priced into stocks. Once stocks fully reflect the worst possible outcome, the cycle begins again.
Signals
Through the writings of Dow and Hamilton, Rhea identified 4 separate theorems that addressed trend identification, buy and sell signals, volume, and trading ranges. The first two were deemed the most important and serve to identify the primary trend as bullish or bearish. The second two theorems, dealing with volume and trading ranges, were not considered instrumental in primary trend identification by Hamilton. Volume was looked upon as a confirming statistic and trading ranges were thought to identify periods of accumulation and distribution.
Identification of the Trend
The first step in identifying the primary trend is to identify the individual trend of the Dow Jones Industrial Average (DJIA), and Dow Jones Transportation Average (DJTA), individually. Hamilton used peak and trough analysis in order to ascertain the identity of the trend. An uptrend is defined by prices that form a series of rising peaks and rising troughs (higher highs and higher lows). In contrast, a downtrend is defined by prices that form a series of declining peaks and declining troughs (lower highs and lower lows).
Once the trend has been identified, it is assumed valid until proved otherwise. A downtrend is considered valid until a higher low forms and the ensuing advance off of the higher low surpasses the previous reaction high. Below is a chart of the Dow Jones Transportation Average in 1992. Even though Hamilton and Dow did not make specific references to trend lines, a line has been drawn to emphasize the downward trajectory of the trend. Since the peak in February, a series of lower lows and lower highs formed to make a downtrend. There was a secondary rally in April and May (green circle), but the March high was not surpassed.
The DJTA ($TRAN) continued down until the high volume washout day (red arrow). As discussed in this article, high volume days signal that a possible change is looming. Alone, a high volume washout day is not a buy signal, but rather an indication to monitor price action a little closer. After this high volume day, the DJTA dipped again and then moved above 1250, creating a higher low (green arrow). Even after the higher low is in place, it is still too early to call for a change in trend. The change of trend is not confirmed until the previous reaction high is surpassed (blue arrow).
Conversely, an uptrend is considered in place until a lower low forms and the ensuing decline exceeds the previous low. Below is a line chart of the closing prices for the DJIA. An uptrend began with the Oct-98 lows and the DJIA formed a series of higher highs and higher lows over the next 11 months. Twice, in Dec-98 (red circle) and Jun-99 (blue arrows), the validity of the uptrend came into question, but the uptrend prevailed until late September. (The Dec-98 price action is addressed below.) There were lower highs in Jun-99, but there were never any lower lows to confirm these lower highs and support held. Any bears that jumped the gun in June were made to sit through two more all-time highs in July and August. The change in trend occurred on September 23 when the June lows were violated. Some traders may have concluded that the trend changed when the late August lows were violated. This may indeed be the case, but it is worth noting that the June lows represented a more convincing support area. Keep in mind that the Dow theory is not a science and Hamilton points this out numerous times. The Dow theory is meant to offer insights and guidelines from which to begin careful study of the market movements and price action.
Looking at the line chart above (DJIA ($INDU) 1998/1999 daily close semi-log scale), it may be difficult to distinguish between a valid change in trend and a simple correction. For instance: Was a change in trend warranted when the December low penetrated the November low? (red circle) After the November peak, a lower high formed in December and then the November reaction low was broken. In order to eliminate false signals, Hamilton suggested excluding moves of less than 3%. This was not meant to be a hard and fast rule, but the idea is worth noting. With the increased volatility of today's markets comes the need to smooth the daily fluctuations and avoid false readings.
Hamilton and Dow were interested in catching the big moves and would have been apt to use weekly charts to establish reaction highs and lows. However, in today's fast moving markets, weekly charts may not portray the detail that investors need. One possible solution is to apply a short moving average to the price plot. Although not mentioned by Hamilton and Dow, a 5-day moving average could be applied to smooth the price series and still allow for detail. The chart below (DJIA ($INDU) 1998/1999 daily close 5-EMA) uses a 5-day exponential moving average to smooth the price plot. Notice that the November reaction low now appears quite immaterial. Also, the September reaction high (red arrow) still shows up.
Averages Must Confirm
When the Dow theory was being developed at the turn of the century, the railroads were a vital link in the economy. Hamilton argued that many times activity would begin in the Rail Average before the Industrial Average. He attributed this to the fact that before economic activity began, raw materials would have to be moved from the suppliers to manufacturers. Before General Motors could increase production, more steel would need to be transported. Therefore, an increase in activity among the rail stocks would foreshadow an increase in business activity for the industrial stocks.
Why the Rails?
There is no doubt that today's economy is much different and the makeup of the DJTA has changed to favor the airlines. However, there is still some credibility in using the DJTA to confirm movements in the DJIA. Transport stocks are much more dependent on the economic environment than the average stock and will likely foreshadow economic growth.
• The airline business is cyclical and revenues are highly susceptible to economic changes.
• Airline companies typically carry above average levels of debt and will be more vulnerable to changes in interest rates.
• Energy and Labor costs form a large portion of expenses.
To reflect the added risks above, airline stocks have traditionally sold significantly below market multiples. If the PE for the S&P 500 is 28, the average airline might sell for only 8-10 times earnings.
Even though we are possibly entering into a "new economy," the majority of businesses will somehow be affected by changes in economic activity, interest rates, energy costs and labor costs. Airline companies, bearing the burden of all of the above, are still likely to act as a leading indicator of the general economic environment.
However, one caveat must be added as well. Possibly the greatest fear of the airlines is that people will stop flying in airplanes. Business travel accounts for a large portion of airline revenues, especially the high margin revenues. With the development of the Internet and networking, the need for business travel could be greatly reduced in the future. Federal Express has already experienced a slowdown in the quantity of business documents being shipped. This could ultimately spill over into the business of the airlines.
How Averages Confirm
Hamilton and Dow stressed that for a primary trend buy or sell signal to be valid, both the Industrial Average and the Rail Average must confirm each other. If one average records a new high or new low, then the other must soon follow for a Dow theory signal to be considered valid.
Combining the guidelines set forth for trend identification with the theorem on confirmation, it is now possible to classify the primary trend of the market. The chart above shows an array of signals that occurred during a 7-month period in 1998.
1. In April, both the DJIA ($INDU) and DJTA ($TRAN) recorded new all-time highs (blue line). The primary trend was already bullish, but this confirmation validated the primary trend as bullish.
2. In July, trouble began to surface when the DJTA failed to confirm the new high set by the DJIA. This served as a warning sign, but did not change the trend. Remember, the trend is assumed to be in force until proved otherwise.
3. On July 31, the DJTA recorded a new reaction low. Two days later, the DJIA recorded a new reaction low and confirmed a change in the primary trend from bullish to bearish (red line). After this signal, both averages went on to record new reaction lows.
4. In October, the DJIA formed a higher low while the DJTA recorded a new low. This was another non-confirmation and served notice to be on guard for a possible change in trend.
5. After the higher low, the DJIA followed through with a higher high later that month. This effectively changes the trend for the average from down to up.
6. It was not until early November that the DJTA went on to better its previous reaction high. However, at the same time the DJIA was also advancing higher and the primary trend had changed from bearish to bullish.
Volume
The importance of volume was alluded to above with the chart of the Apr-97 bottom in the DJIA. Rhea notes that while Hamilton did analyze volume statistics, price action was the ultimate determinant. Volume is more important when confirming the strength of advances and can also help to identify potential reversals.
Volume Confirmation
Hamilton thought that volume should increase in the direction of the primary trend. In a primary bull market, volume should be heavier on advances than during corrections. Not only should volume decline on corrections, but participation should also decrease. As Hamilton put it, the market should become "dull and narrow" on corrections, "narrow" meaning that the number of declining issues should not be expanding dramatically. The opposite is true in a primary bear market. Volume should increase on the declines and decrease during the reaction rallies. The reaction rallies should also be narrow and reflect poor participation of the broader market. By analyzing the reaction rallies and corrections, it is possible to judge the underlying strength of the primary trend.
Volume and Reversals
Hamilton noted that high volume levels could be indicative of an impending reversal. A high volume day after a long advance may signal that the trend is about to change or that a reaction high may form soon. In his StockCharts.com commentary on 25-Jun-99, Rex Takasugi discusses the correlation between volume and peaks in the market. Even though his analysis reveals a lag time between volume peaks and market reversals, the relationship still exists. Takasugi's analysis reveals that since 1900 there have been 14 cycles and volume peaked on average 5.6 months ahead of the market. He also notes that the most recent volume peak occurred in Apr-99.
Trading Ranges a.k.a. Lines
In his commentaries over the years, Hamilton referred many times to "lines." Lines are horizontal lines that form trading ranges. Trading ranges develop when the averages move sideways over a period of time and make it possible to draw horizontal lines connecting the tops and bottoms. These trading ranges indicate either accumulation or distribution, but it was virtually impossible to tell which until there was a break to the upside or the downside. If there were a break to the upside, then the trading range would be considered an area of accumulation. If there were a break to the downside, then the trading range would be considered an area of distribution. Hamilton considered the trading range neutral until a breakout occurred. He also warned against attempting to anticipate the breakout.
Performance of the Dow Theory
Mark Hulbert, writing in the New York Times - 6-Sept-98, notes a study that was published in the Journal of Finance by Stephen Brown of New York University and William Goetzmann and Alok Kumar of Yale. They developed a neural network that incorporated the rules for identifying the primary trend. The Dow theory system was tested against buy-and-hold for the period from 1929 to Sept-98. When the system identified the primary trend as bullish, a long position was initiated in a hypothetical index fund. When the system signaled a bearish primary trend, stocks were sold and the money was placed in fixed income instruments. By taking money out of stocks after bear signals, the risk (volatility) of the portfolio is significantly reduced. This is a very important aspect of the Dow theory system and portfolio management. In the past few years, the concept of risk in stocks has diminished, but it is still a fact that stocks carry more risk than bonds.
Over the 70-year period, the Dow theory system outperformed a buy-and-hold strategy by about 2% per year. In addition, the portfolio carried significantly less risk. If compared as risk-adjusted returns, the margin of out-performance would increase. Over the past 18 years, the Dow theory system has under-performed the market by about 2.6% per year. However, when adjusted for risk, the Dow theory system outperformed buy-and-hold over the past 18 years. Keep in mind that 18 years is not a long time in the history of the market. The Dow theory system was found to under-perform during bull markets and outperform during bear markets.
Criticisms of Dow Theory
The first criticism of the Dow theory is that it is really not a theory. Neither Dow nor Hamilton wrote proper academic papers outlining the theory and testing the theorems. The ideas of Dow and Hamilton were put forth through their editorials in the Wall Street Journal. Robert Rhea stitched the theory together by poring over these writings.
Secondly, the Dow theory is criticized for being too late. The trend does not change from bearish to bullish until the previous reaction high has been surpassed. Many traders feel that this is simply too late and misses much of the move. Dow and Hamilton sought to catch the meat of the move and enter during the second leg. Even though this is where the bulk of the move will take place, it is also after the first leg and part way into the second leg. And, if one has to wait for confirmation from the other average, it could even be later in the move.
Thirdly, because it uses the DJIA and DJTA, the Dow theory is criticized as being outdated and no longer an accurate reflection of the economy. This may be a valid point, but as outlined earlier, the DJTA is one of the most economically sensitive indices. The stock market has always been seen as a great predictor of economic growth. To at least keep the industrials up to speed, Home Depot, Intel, Microsoft and SBC Corp have been added to the average to replace Chevron, Goodyear, Sears and Union Carbide, as of 1-Nov-99.
Conclusions
The goal of Dow and Hamilton was to identify the primary trend and catch the big moves. They understood that the market was influenced by emotion and prone to over-reaction both up and down. With this in mind, they concentrated on identification and following: identify the trend and then follow the trend. The trend is in place until proved otherwise. That is when the trend will end, when it is proved otherwise.
Dow theory helps investors identify facts, not make assumptions or forecast. It can be dangerous when investors and traders begin to assume. Predicting the market is a difficult, if not impossible, game. Hamilton readily admitted that the Dow theory was not infallible. While Dow theory may be able to form the foundation for analysis, it is meant as a starting point for investors and traders to develop analysis guidelines that they are comfortable with and understand.
Reading the markets is an empirical science. As such there will be exceptions to the theorems put forth by Hamilton and Dow. They believed that success in the markets required serious study and analysis that would be fraught with successes and failures. Success is a great thing, but don't get too smug about it. Failures, while painful, should be looked upon as learning experiences. Technical analysis is an art form and the eye grows keener with practice. Study both successes and failures with an eye to the future.
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