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Monday, July 30, 2007

Gaps and Gap Analysis

Monday, July 30, 2007
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Have you ever wondered what causes gaps in price charts and what they mean? Well, you've come to the right place. Just in case, a gap is an area on a price chart in which there were no trades. Normally this occurs between the close of the market on one day and the next day's open. Lot's of things can cause this, such as an earnings report coming out after the stock market has closed for the day. If the earnings were significantly higher than expected, many investors might place buy orders for the next day. This could result in the price opening higher than the previous day's close. If the trading that day continues to trade above that point, a gap will exist in the price chart. Gaps can offer evidence that something important has happened to the fundamentals or the psychology of the crowd that accompanies this market movement. Before we get into the different types of gaps, here is a chart showing a gap so you will know what we are talking about.

McDonalds Corp. (MCD) Gap example chart from StockCharts.com

Gaps appear more frequently on daily charts, where every day is an opportunity to create an opening gap. Gaps on weekly or monthly charts are fairly rare: the gap would have to occur between Friday's close and Monday's open for weekly charts and between the last day of the month's close and the first day of the next month's for the monthly charts. Gaps can be subdivided into four basic categories: Common, Breakaway, Runaway, and Exhaustion.

Common Gaps

Sometimes referred to as a trading gap or an area gap, the common gap is usually uneventful. In fact, they can be caused by a stock going ex-dividend when the trading volume is low. These gaps are common (get it?) and usually get filled fairly quickly. "Getting filled" means that the price action at a later time (few days to a few weeks) usually retraces at the least to the last day before the gap. This is also known as closing the gap. Here is a chart of two common gaps that have been filled. Notice that after the gap the prices have come down to at least the beginning of the gap? That is called closing or filling the gap.

Microsoft Corp. (MSFT) Gap example chart from StockCharts.com

A common gap usually appears in a trading range or congestion area, and reinforces the apparent lack of interest in the stock at that time. Many times this is further exacerbated by low trading volume. Being aware of these types of gaps is good, but doubtful that they will produce a trading opportunities.

Breakaway Gaps

Breakaway gaps are the exciting ones. They occur when the price action is breaking out of their trading range or congestion area. To understand gaps, one has to understand the nature of congestion areas in the market. A congestion area is just a price range in which the market has traded for some period of time, usually a few weeks or so. The area near the top of the congestion area is usually resistance when approached from below. Likewise, the area near the bottom of the congestion area is support when approached from above. To break out of these areas requires market enthusiasm and, either, many more buyers than sellers for upside breakouts or more sellers than buyers for downside breakouts.

Volume will (should) pick up significantly, for not only the increased enthusiasm, but many are holding positions on the wrong side of the breakout and need to cover or sell them. It is better if the volume does not happen until the gap occurs. This means that the new change in market direction has a chance of continuing. The point of breakout now becomes the new support (if an upside breakout) or resistance (if a downside breakout). Don't fall into the trap of thinking this type of gap, if associated with good volume, will be filled soon. It might take a long time. Go with the fact that a new trend in the direction of the stock has taken place, and trade accordingly. Notice in the chart below how prices spent over 2 months without going lower than about 41. When they did, it was with increased volume and a downward breakaway gap.

General Motors Corp. (GM) Breakaway Gap example chart from StockCharts.com

A good confirmation for trading gaps is if they are associated with classic chart patterns. For example, if an ascending triangle suddenly has a breakout gap to the upside, this can be a much better trade than a breakaway gap without a good chart pattern associated with it. The chart below shows the normally bullish ascending triangle (flat top and rising, lower trend line) with a breakaway gap to the upside, as you would expect with an ascending triangle.

Ambac Financial Group, Inc. (ABK) Breakaway Gap example chart from StockCharts.com

Runaway Gaps

Runaway gaps are also called measuring gaps, and are best described as gaps that are caused by increased interest in the stock. For runaway gaps to the upside, it usually represents traders who did not get in during the initial move of the up trend and while waiting for a retracement in price, decided it was not going to happen. Increased buying interest happens all of a sudden, and the price gaps above the previous day's close. This type of runaway gap represents an almost panic state in traders. Also, a good uptrend can have runaway gaps caused by significant news events that cause new interest in the stock. In the chart below, note the significant increase in volume during and after the runaway gap.

Ford Motor Co. (F) Runaway Gap example chart from StockCharts.com

Runaway gaps can also happen in downtrends. This usually represents increased liquidation of that stock by traders and buyers who are standing on the sidelines. These can become very serious as those who are holding onto the stock will eventually panic and sell – but sell to whom? The price has to continue to drop and gap down to find buyers. Not a good situation.

The term measuring gap is also used for runaway gaps. This is an interpretation that is hard to find examples for, but it is a way of helping one decide how much longer a trend will last. The theory is that the measuring gap will occur in the middle, or half way, through the move.

Sometimes, the futures market will have runaway gaps that are caused by trading limits imposed by the exchanges. Getting caught on the wrong side of the trend when you have these limit moves in futures can be horrifying. The good news is that you can also be on the right side of them. These are not common occurrences in the futures market despite all the wrong information being touted by those who do not understand it, and are only repeating something they read from an uninformed reporter.

Exhaustion Gaps

Exhaustion gaps are those that happen near the end of a good up- or downtrend. They are many times the first signal of the end of that move. They are identified by high volume and large price difference between the previous day's close and the new opening price. They can easily be mistaken for runaway gaps if one does not notice the exceptionally high volume.

It is almost a state of panic if the gap appears during a long down move and pessimism has set in. Selling all positions to liquidate holdings in the market is not uncommon. Exhaustion gaps are quickly filled as prices reverse their trend. Likewise, if they happen during a bull move, some bullish euphoria overcomes trades, and buyers cannot get enough of that stock. The prices gap up with huge volume; then, there is great profit taking and the demand for the stock totally dries up. Prices drop, and a significant change in trend occurs. Exhaustion gaps are probably the easiest to trade and profit from. In the chart, notice that there was one more day of trading to the upside before the stock plunged. The high volume was the giveaway that this was going to be, either, an exhaustion gap or a runaway gap. Because of the size of the gap and the near doubling of volume, an exhaustion gap was in the making here.

Delta Air Lines (DAL) Exhaustion Gap example chart from StockCharts.com

Conclusion

There is an old saying that the market abhors a vacuum and all gaps will be filled. While this may have some merit for common and exhaustion gaps, holding positions waiting for breakout or runaway gaps to be filled can be devastating to your portfolio. Likewise, waiting to get on-board a trend by waiting for prices to fill a gap can cause you to miss the big move. Gaps are a significant technical development in price action and chart analysis, and should not be ignored. Japanese candlestick analysis is filled with patterns that rely on gaps to fulfill their objectives.


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Trend Lines

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Technical analysis is built on the assumption that prices trend. Trend Lines are an important tool in technical analysis for both trend identification and confirmation. A trend line is a straight line that connects two or more price points and then extends into the future to act as a line of support or resistance. Many of the principles applicable to support and resistance levels can be applied to trend lines as well. It is important that you understand all of the concepts presented in our Support and Resistance article before you continue.

Definition

EMC Corp. (EMC) Trend example chart from StockCharts.com

Uptrend Line

An uptrend line has a positive slope and is formed by connecting two or more low points. The second low must be higher than the first for the line to have a positive slope. Uptrend lines act as support and indicate that net-demand (demand less supply) is increasing even as the price rises. A rising price combined with increasing demand is very bullish, and shows a strong determination on the part of the buyers. As long as prices remain above the trend line, the uptrend is considered solid and intact. A break below the uptrend line indicates that net-demand has weakened and a change in trend could be imminent.

Amazon.com, Inc. (AMZN) Trend example chart from StockCharts.com

Downtrend Line

A downtrend line has a negative slope and is formed by connecting two or more high points. The second high must be lower than the first for the line to have a negative slope. Downtrend lines act as resistance, and indicate that net-supply (supply less demand) is increasing even as the price declines. A declining price combined with increasing supply is very bearish, and shows the strong resolve of the sellers. As long as prices remain below the downtrend line, the downtrend is solid and intact. A break above the downtrend line indicates that net-supply is decreasing and that a change of trend could be imminent.

For a detailed explanation of trend changes, which are different than just trend line breaks, please see our article on the Dow Theory.

Scale Settings

High points and low points appear to line up better for trend lines when prices are displayed using a semi-log scale. This is especially true when long-term trend lines are being drawn or when there is a large change in price. Most charting programs allow users to set the scale as arithmetic or semi-log. An arithmetic scale displays incremental values (5,10,15,20,25,30) evenly as they move up the y-axis. A $10 movement in price will look the same from $10 to $20 or from $100 to $110. A semi-log scale displays incremental values in percentage terms as they move up the y-axis. A move from $10 to $20 is a 100% gain, and would appear to be a much larger than a move from $100 to $110, which is only a 10% gain.

EMC Corp. (EMC) Trend example chart from StockCharts.com

In the case of EMC[Emc], there was a large price change over a long period of time. While there were not any false breaks below the uptrend line on the arithmetic scale, the rate of ascent appears smoother on the semi-log scale. EMC doubled three times in less than two years. On the semi-log scale, the trend line fits all the way up. On the arithmetic scale, three different trend lines were required to keep pace with the advance.

Amazon.com, Inc. (AMZN) Trend example chart from StockCharts.com

In the case of Amazon.com (AMZN)[Amzn], there were two false breaks above the downtrend line as the stock declined during 2000 and 2001. These false break outs could have led to premature buying as the stock continued to decline after each one. The stock lost 60% of its value three times over a two year period. The semi-log scale reflects the percentage loss evenly, and the downtrend line was never broken.

Validation

It takes two or more points to draw a trend line The more points used to draw the trend line, the more validity attached to the support or resistance level represented by the trend line. It can sometimes be difficult to find more than 2 points from which to construct a trend line Even though trend lines are an important aspect of technical analysis, it is not always possible to draw trend lines on every price chart. Sometimes the lows or highs just don't match up, and it is best not to force the issue. The general rule in technical analysis is that it takes two points to draw a trend line and the third point confirms the validity.

Microsoft Corp. (MSFT) Trend example chart from StockCharts.com

The chart of Microsoft (MSFT)[Msft] shows an uptrend line that has been touched 4 times. After the third touch in Nov-99, the trend line was considered a valid line of support. Now that the stock has bounced off of this level a fourth time, the soundness of the support level is enhanced even more. As long as the stock remains above the trend line (support), the trend will remain in control of the bulls. A break below would signal that net-supply was increasing and that a change in trend could be imminent.

Spacing of Points

The lows used to form an uptrend line and the highs used to form a downtrend line should not be too far apart, or too close together. The most suitable distance apart will depend on the time frame, the degree of price movement, and personal preferences. If the lows (highs) are too close together, the validity of the reaction low (high) may be in question. If the lows are too far apart, the relationship between the two points could be suspect. An ideal trend line is made up of relatively evenly spaced lows (or highs). The trend line in the above MSFT example represents well-spaced low points.

Wal-Mart Stores, Inc. (WMT) Trend example chart from StockCharts.com

On the Wal-Mart (WMT)[Wmt] example, the second high point appears to be too close to the first high point for a valid trend line; however, it would be feasible to draw a trend line beginning at point 2 and extending down to the February reaction high.

Angles

As the steepness of a trend line increases, the validity of the support or resistance level decreases. A steep trend line results from a sharp advance (or decline) over a brief period of time. The angle of a trend line created from such sharp moves is unlikely to offer a meaningful support or resistance level. Even if the trend line is formed with three seemingly valid points, attempting to play a trend line break or to use the support and resistance level established it will often prove difficult.

Yahoo!, Inc. (YHOO) Trend example chart from StockCharts.com

The trend line for Yahoo! (YHOO)[Yhoo] was touched four times over a 5-month period. The spacing between the points appears OK, but the steepness of the trend line is unsustainable, and the price is more likely than not to drop below the trend line. However, trying to time this drop or make a play after the trend line is broken is a difficult task. The amount of data displayed and the size of the chart can also affect the angle of a trend line. Short and wide charts are less likely to have steep trend lines than long and narrow charts. Keep that in mind when assessing the validity and sustainability of a trend line.

Internal Trend Lines

Sometimes there appears to be the possibility for drawing a trend line, but the exact points do not match up cleanly. The highs or lows might be out of whack, the angle might be too steep or the points might be too close together. If one or two points could be ignored, then a fitted trend line could be formed. With the volatility present in the market, prices can over-react, and produce spikes that distort the highs and lows. One method for dealing with over-reactions is to draw internal trend lines. Even though an internal trend line ignores price spikes, the ignoring should be within reason.

S&P 500 ($SPX) Trend example chart from StockCharts.com

The long-term trend line for the S&P 500 ($SPX)[$spx] extends up from the end of 1994, and passes through low points in Jul-96, Sept-98 and Oct-98. These lows were formed with selling climaxes, and represented extreme price movements that protrude beneath the trend line. By drawing the trend line through the lows, the line appears to be at a reasonable angle, and the other lows match up extremely well.

Coca Cola Co. (KO) Trend example chart from StockCharts.com

Sometimes, there is a price cluster with a high or low spike sticking out. A price cluster is an area where prices are grouped within a tight range over a period of time. The price cluster can be used to draw the trend line, and the spike can be ignored. The Coca Cola (KO)[Ko] chart shows an internal trend line that is formed by ignoring price spikes and using the price clusters, instead. In October and November 1998, Coke formed a peak, with the November peak just higher than the October peak (1). If the November peak had been used to draw a trend line, then the slope would have been more negative, and there would have appeared to be a breakout in Dec-98 (gray line). However, this would have only been a two-point trend line, because the May-June highs are too close together (black arrows). Once the Dec-99 peak formed (green arrow), it would have been possible to draw an internal trend line based on the price clusters around the Oct/Nov-98 and the Dec-99 peaks (blue line). This trend line is based on three solid touches, and it accurately forecasts resistance in Jan-00 (blue arrow).

Conclusion

Trend lines can offer great insight, but if used improperly, they can also produce false signals. Other items - such as horizontal support and resistance levels or peak-and-trough analysis - should be employed to validate trend line breaks. While trend lines have become a very popular aspect of technical analysis, they are merely one tool for establishing, analyzing, and confirming a trend. Trend lines should not be the final arbiter, but should serve merely as a warning that a change in trend may be imminent. By using trend line breaks for warnings, investors and traders can pay closer attention to other confirming signals for a potential change in trend.

Verisign, Inc. (VRSN) Trend example chart from StockCharts.com

The uptrend line for VeriSign (VRSN)[Vrsn] was touched 4 times, and seemed to be a valid support level. Even though the trend line was broken in Jan-00, the previous reaction low held, and did not confirm the trend line break. In addition, the stock recorded a new higher high prior to the trend line break.


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Support and Resistance

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Support and resistance represent key junctures where the forces of supply and demand meet. In the financial markets, prices are driven by excessive supply (down) and demand (up). Supply is synonymous with bearish, bears and selling. Demand is synonymous with bullish, bulls and buying. These terms are used interchangeably throughout this and other articles. As demand increases, prices advance and as supply increases, prices decline. When supply and demand are equal, prices move sideways as bulls and bears slug it out for control.

What Is Support?

Support is the price level at which demand is thought to be strong enough to prevent the price from declining further. The logic dictates that as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support.

Amazon.com, Inc. (AMZN) Support and Resistance example chart from StockCharts.com

Support does not always hold and a break below support signals that the bears have won out over the bulls. A decline below support indicates a new willingness to sell and/or a lack of incentive to buy. Support breaks and new lows signal that sellers have reduced their expectations and are willing sell at even lower prices. In addition, buyers could not be coerced into buying until prices declined below support or below the previous low. Once support is broken, another support level will have to be established at a lower level.

Where Is Support Established?

Support levels are usually below the current price, but it is not uncommon for a security to trade at or near support. Technical analysis is not an exact science and it is sometimes difficult to set exact support levels. In addition, price movements can be volatile and dip below support briefly. Sometimes it does not seem logical to consider a support level broken if the price closes 1/8 below the established support level. For this reason, some traders and investors establish support zones.

What Is Resistance?

Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further. The logic dictates that as the price advances towards resistance, sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance.

Lilly Eli & Co. (LLY) Support and Resistance example chart from StockCharts.com

Resistance does not always hold and a break above resistance signals that the bulls have won out over the bears. A break above resistance shows a new willingness to buy and/or a lack of incentive to sell. Resistance breaks and new highs indicate buyers have increased their expectations and are willing to buy at even higher prices. In addition, sellers could not be coerced into selling until prices rose above resistance or above the previous high. Once resistance is broken, another resistance level will have to be established at a higher level.

Where Is Resistance Established?

Resistance levels are usually above the current price, but it is not uncommon for a security to trade at or near resistance. In addition, price movements can be volatile and rise above resistance briefly. Sometimes it does not seem logical to consider a resistance level broken if the price closes 1/8 above the established resistance level. For this reason, some traders and investors establish resistance zones.

Methods to Establish Support and Resistance?

Support and resistance are like mirror images and have many common characteristics.

Highs and Lows

Support can be established with the previous reaction lows. Resistance can be established by using the previous reaction highs.

Halliburton Co. (HAL) Support and Resistance example chart from StockCharts.com

The above chart for Halliburton (HAL)[HAL] shows a large trading range between Dec-99 and Mar-00. Support was established with the October low around 33. In December, the stock returned to support in the mid-thirties and formed a low around 34. Finally, in February the stock again returned to the support scene and formed a low around 33 1/2.

After each bounce off support, the stock traded all the way up to resistance. Resistance was first established by the September support break at 42.5. After a support level is broken, it can turn into a resistance level. From the October lows, the stock advanced to the new support-turned-resistance level around 42.5. When the stock failed to advance past 42.5, the resistance level was confirmed. The stock subsequently traded up to 42.5 two more times after that and failed to surpass resistance both times.

Support Equals Resistance

Another principle of technical analysis stipulates that support can turn into resistance and visa versa. Once the price breaks below a support level, the broken support level can turn into resistance. The break of support signals that the forces of supply have overcome the forces of demand. Therefore, if the price returns to this level, there is likely to be an increase in supply, and hence resistance.

The other turn of the coin is resistance turning into support. As the price advances above resistance, it signals changes in supply and demand. The breakout above resistance proves that the forces of demand have overwhelmed the forces of supply. If the price returns to this level, there is likely to be an increase in demand and support will be found.

NASDAQ ($NDX) Support and Resistance example chart from StockCharts.com

In this example of the NASDAQ 100 Index ($NDX)[$NDX], the stock broke resistance at 935 in May-97 and traded just above this resistance level for over a month. The ability to remain above resistance established 935 as a new support level. The stock subsequently rose to 1150, but then fell back to test support at 935. After the second test of support at 935, this level is well established.

PeopleSoft, Inc. (PSFT) Support and Resistance example chart from StockCharts.com

From the PeopleSoft (PSFT)[PSFT] example, we can see that support can turn into resistance and then back into support. PeopleSoft found support at 18 from Oct-98 to Jan-99 (green oval), but broke below support in Mar-99 as the bears overpowered the bulls. When the stock rebounded (red oval), there was still overhead supply at 18 and resistance was met from Jun-99 to Oct-99.

Where does this overhead supply come from? Demand was obviously increasing around 18 from Oct-98 to Mar-99 (green oval). Therefore, there were a lot of buyers in the stock around 18. When the price declined past 18 and to around 14, many of these buyers were probably still holding the stock. This left a supply overhang (commonly known as resistance) around 18. When the stock rebounded to 18, many of the green-oval-buyers (who bought around 18) probably took the opportunity to sell. When this supply was exhausted, the demand was able to overpower supply and advance above resistance at 18.

Trading Range

Trading ranges can play an important role in determining support and resistance as turning points or as continuation patterns. A trading range is a period of time when prices move within a relatively tight range. This signals that the forces of supply and demand are evenly balanced. When the price breaks out of the trading range, above or below, it signals that a winner has emerged. A break above is a victory for the bulls (demand) and a break below is a victory for the bears (supply).

WorldCom Group (WCOEQ) Support and Resistance example chart from StockCharts.com

After an extended advance from 27 to 64, WorldCom (WCOM)[WCOM] entered into a trading range between 55 and 63 for about 5 months. There was a false breakout in mid-June when the stock briefly poked its head above 62 (red oval). This did not last long and a gap down a few days later nullified the breakout (black arrow). The stock then proceeded to break support at 55 in Aug-99 and trade as low as 50. Here is another example of support turned resistance as the stock bounced off 55 two more times before heading lower. While this does not always happen, a return to the new resistance level offers a second chance for longs to get out and shorts to enter the fray.

Lucent Technologies, Inc. (LU) Support and Resistance example chart from StockCharts.com

In Nov/Dec-99, Lucent Technologies (LU)[Lu] formed a trading range that resembled a head and shoulders pattern (red oval). When the stock broke support at 60, there was little or no time to exit. Even though the there is a long black candlestick indicating an open at 59, the stock fell so fast that it was impossible to exit above 44. In hindsight, the support line could have been drawn as an upward sloping neckline (blue line), and the support break would have come at 61. This is only 1 point higher and a trader would have had to take action immediately to avoid a sharp fall. However, the lows match up rather nicely on the neckline, and it is something to consider when drawing support lines.

After Lucent declined, a trading range was established between 40.5 and 47.5 for almost two months (green oval). The resistance level of the trading range was well marked by three reaction peaks at 47.5. The support level was not as clearly marked, but appeared to be between 40 and 41. Some buying interest began to become evident around 44 in mid- to late-February. Notice the array of candlesticks with long lower shadows, or hammers, as they are known. The stock then proceeded to form two up gaps on 24-Feb and 25-Feb, and finally closed above resistance at 48. This was a clear indication of demand winning out over supply. There were still two more opportunities (days) to get in on the action. On the third day after the breakout, the stock gapped up and moved above 56.

Support and Resistance Zones

Because technical analysis is not an exact science, it is useful to create support and resistance zones. This is contrary to the strategy mapped out for Lucent Technologies (LU), but it is sometimes the case. Each security has its own characteristics, and analysis should reflect the intricacies of the security. Sometimes, exact support and resistance levels are best, and, sometimes, zones work better. Generally, the tighter the range, the more exact the level. If the trading range spans less than 2 months and the price range is relatively tight, then more exact support and resistance levels are best suited. If a trading range spans many months and the price range is relatively large, then it is best to use support and resistance zones. These are only meant as general guidelines, and each trading range should be judged on its own merits.

Halliburton Co. (HAL) Support and Resistance example chart from StockCharts.com

Returning to the analysis of Halliburton (HAL)[Hal], we can see that the November high of the trading range (33 to 44) extended more than 20% past the low, making the range quite large relative to the price. Because the September support break forms our first resistance level, we are ready to set up a resistance zone after the November high is formed, probably around early December. At this point though, we are still unsure if a large trading range will develop. The subsequent low in December, which was just higher than the October low, offers evidence that a trading range is forming, and we are ready to set the support zone. As long as the stock trades within the boundaries set by the support and resistance zone, we will consider the trading range to be valid. Support may be looked upon as an opportunity to buy, and resistance as an opportunity to sell.

Conclusion

Identification of key support and resistance levels is an essential ingredient to successful technical analysis. Even though it is sometimes difficult to establish exact support and resistance levels, being aware of their existence and location can greatly enhance analysis and forecasting abilities. If a security is approaching an important support level, it can serve as an alert to be extra vigilant in looking for signs of increased buying pressure and a potential reversal. If a security is approaching a resistance level, it can act as an alert to look for signs of increased selling pressure and potential reversal. If a support or resistance level is broken, it signals that the relationship between supply and demand has changed. A resistance breakout signals that demand (bulls) has gained the upper hand and a support break signals that supply (bears) has won the battle.


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What Are Charts?

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A price chart is a sequence of prices plotted over a specific time frame. In statistical terms, charts are referred to as time series plots.

International Business Machines (IBM) example chart from StockCharts.com

On the chart, the y-axis (vertical axis) represents the price scale and the x-axis (horizontal axis) represents the time scale. Prices are plotted from left to right across the x-axis with the most recent plot being the furthest right. The price plot for IBM extends from January 1, 1999 to March 13, 2000.

Technicians, technical analysts and chartists use charts to analyze a wide array of securities and forecast future price movements. The word "securities" refers to any tradable financial instrument or quantifiable index such as stocks, bonds, commodities, futures or market indices. Any security with price data over a period of time can be used to form a chart for analysis.

While technical analysts use charts almost exclusively, the use of charts is not limited to just technical analysis. Because charts provide an easy-to-read graphical representation of a security's price movement over a specific period of time, they can also be of great benefit to fundamental analysts. A graphical historical record makes it easy to spot the effect of key events on a security's price, its performance over a period of time and whether it's trading near its highs, near its lows, or in between.

How to Pick a Time Frame

The time frame used for forming a chart depends on the compression of the data: intraday, daily, weekly, monthly, quarterly or annual data. The less compressed the data is, the more detail is displayed.

International Business Machines (IBM) time frame example chart from StockCharts.com

Daily data is made up of intraday data that has been compressed to show each day as a single data point, or period. Weekly data is made up of daily data that has been compressed to show each week as a single data point. The difference in detail can be seen with the daily and weekly chart comparison above. 100 data points (or periods) on the daily chart is equal to the last 5 months of the weekly chart, which is shown by the data marked in the rectangle. The more the data is compressed, the longer the time frame possible for displaying the data. If the chart can display 100 data points, a weekly chart will hold 100 weeks (almost 2 years). A daily chart that displays 100 days would represent about 5 months. There are about 20 trading days in a month and about 252 trading days in a year. The choice of data compression and time frame depends on the data available and your trading or investing style.

  • Traders usually concentrate on charts made up of daily and intraday data to forecast short-term price movements. The shorter the time frame and the less compressed the data is, the more detail that is available. While long on detail, short-term charts can be volatile and contain a lot of noise. Large sudden price movements, wide high-low ranges and price gaps can affect volatility, which can distort the overall picture.
  • Investors usually focus on weekly and monthly charts to spot long-term trends and forecast long-term price movements. Because long-term charts (typically 1-4 years) cover a longer time frame with compressed data, price movements do not appear as extreme and there is often less noise.
  • Others might use a combination of long-term and short-term charts. Long-term charts are good for analyzing the large picture to get a broad perspective of the historical price action. Once the general picture is analyzed, a daily chart can be used to zoom in on the last few months.

How Are Charts Formed?

We will be explaining the construction of line, bar, candlestick and point & figure charts. Although there are other methods available, these are 4 of the most popular methods for displaying price data.

Line Chart

Sun Microsystems, Inc. (SUNW) line chart example chart from StockCharts.com

Some investors and traders consider the closing level to be more important than the open, high or low. By paying attention to only the close, intraday swings can be ignored. Line charts are also used when open, high and low data points are not available. Sometimes only closing data are available for certain indices, thinly traded stocks and intraday prices.

Bar Chart

Perhaps the most popular charting method is the bar chart. The high, low and close are required to form the price plot for each period of a bar chart. The high and low are represented by the top and bottom of the vertical bar and the close is the short horizontal line crossing the vertical bar. On a daily chart, each bar represents the high, low and close for a particular day. Weekly charts would have a bar for each week based on Friday's close and the high and low for that week.

Sun Microsystems, Inc. (SUNW) bar chart example chart from StockCharts.com

Bar charts can also be displayed using the open, high, low and close. The only difference is the addition of the open price, which is displayed as a short horizontal line extending to the left of the bar. Whether or not a bar chart includes the open depends on the data available.

Sun Microsystems, Inc. (SUNW) bar chart example chart from StockCharts.com

Bar charts can be effective for displaying a large amount of data. Using candlesticks, 200 data points can take up a lot of room and look cluttered. Line charts show less clutter, but do not offer as much detail (no high-low range). The individual bars that make up the bar chart are relatively skinny, which allows users the ability to fit more bars before the chart gets cluttered. If you are not interested in the opening price, bar charts are an ideal method for analyzing the close relative to the high and low. In addition, bar charts that include the open will tend to get cluttered quicker. If you are interested in the opening price, candlestick charts probably offer a better alternative.

Candlestick Chart

Originating in Japan over 300 years ago, candlestick charts have become quite popular in recent years. For a candlestick chart, the open, high, low and close are all required. A daily candlestick is based on the open price, the intraday high and low, and the close. A weekly candlestick is based on Monday's open, the weekly high-low range and Friday's close.

Sun Microsystems, Inc. (SUNW) candlestick chart example chart from StockCharts.com

Many traders and investors believe that candlestick charts are easy to read, especially the relationship between the open and the close. White (clear) candlesticks form when the close is higher than the open and black (solid) candlesticks form when the close is lower than the open. The white and black portion formed from the open and close is called the body (white body or black body). The lines above and below are called shadows and represent the high and low.

Point & Figure Chart

The charting methods shown above, all, plot one data point for each period of time. No matter how much price movement, each day or week represented is one point, bar, or candlestick along the time scale. Even if the price is unchanged from day to day or week to week, a dot, bar, or candlestick is plotted to mark the price action. Contrary to this methodology, point & figure Charts are based solely on price movement, and do not take time into consideration. There is an x-axis but it does not extend evenly across the chart.

point & figure example chart from StockCharts.com

The beauty of point & figure charts is their simplicity. Little or no price movement is deemed irrelevant and therefore not duplicated on the chart. Only price movements that exceed specified levels are recorded. This focus on price movement makes it easier to identify support and resistance levels, bullish breakouts and bearish breakdowns. This P&F article has a more detailed explanation of point & figure charts.

Price Scaling

There are two methods for displaying the price scale along the y-axis: arithmetic and logarithmic. An arithmetic scale displays 10 points (or dollars) as the same vertical distance no matter what the price level. Each unit of measure is the same throughout the entire scale. If a stock advances from 10 to 80 over a 6-month period, the move from 10 to 20 will appear to be the same distance as the move from 70 to 80. Even though this move is the same in absolute terms, it is not the same in percentage terms.

A logarithmic scale measures price movements in percentage terms. An advance from 10 to 20 would represent an increase of 100%. An advance from 20 to 40 would also be 100%, as would an advance from 40 to 80. All three of these advances would appear as the same vertical distance on a logarithmic scale. Most charting programs refer to the logarithmic scale as a semi-log scale, because the time axis is still displayed arithmetically.

Verisign, Inc. (VRSN) price scaling example chart from StockCharts.com

The chart above uses the 4th-Quarter performance of VeriSign to illustrate the difference in scaling. On the semi-log scale, the distance between 50 and 100 is the same as the distance between 100 and 200. However, on the arithmetic scale, the distance between 100 and 200 is significantly greater than the distance between 50 and 100.

Key points on the benefits of arithmetic and semi-log scales:

  • Arithmetic scales are useful when the price range is confined within a relatively tight range.
  • Arithmetic scales are useful for short-term charts and trading. Price movements (particularly for stocks) are shown in absolute dollar terms and reflect movements dollar for dollar.
  • Semi-log scales are useful when the price has moved significantly, be it over a short or extended time frame
  • Trend lines tend to match lows better on semi-log scales.
  • Semi-log scales are useful for long-term charts to gauge the percentage movements over a long period of time. Large movements are put into perspective.
  • Stocks and many other securities are judged in relative terms through the use of ratios such as PE, Price/Revenues and Price/Book. With this in mind, it also makes sense to analyze price movements in percentage terms.

Conclusions

Even though many different charting techniques are available, one method is not necessarily better than the other. The data may be the same, but each method will provide its own unique interpretation, with its own benefits and drawbacks. A breakout on the point & figure chart may not occur in unison with a breakout in a candlestick chart. Signals that are available on candlestick charts may not appear on bar charts. How the security's price is displayed, be it a bar chart or candlestick chart, with an arithmetic scale or semi-log scale, is not the most important aspect. After all, the data is the same and price action is price action. When all is said and done, it is the analysis of the price action that separates successful technicians from not-so-successful technicians. The choice of which charting method to use will depend on personal preferences and trading or investing styles. Once you have chosen a particular charting methodology, it is probably best to stick with it and learn how best to read the signals. Switching back and forth may cause confusion and undermine the focus of your analysis. Faulty analysis is rarely caused by the chart. Before blaming your charting method for missing a signal, first look at your analysis.

The keys to successful chart analysis are dedication, focus, and consistency:

  • Dedication: Learn the basics of chart analysis, apply your knowledge on a regular basis, and continue your development.
  • Focus: Limit the number of charts, indicators and methods you use. Learn how to use them, and learn how to use them well.
  • Consistency: Maintain your charts on a regular basis and study them often (daily if possible).

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Saturday, July 28, 2007

How To Use Barriers To Land Profitable Trades In The Forex Markets

Saturday, July 28, 2007
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To learn the ways in which traders can determine areas where many barriers are can make a trader a good profit. Many kinds of cost barriers are in the FX market. It is ordinary for currency pairs to change direction at these barriers. When traders learn the ways they can put them together, traders may create a system of trading with higher probabilities of success. A few barriers contain resistances levels, support levels, Fibonacci levels and psychological barriers. Barriers on trend lines and at pivot points can also enhance our observation. Now we will examine the various kinds of barriers that are common in the Forex market.
Support and Resistance Levels
Support and resistance levels are huge turning points that the market has consistently respected in the past. When the market respects them more, then they become stronger Support is identified as the turning point where the buyers put themselves at the top which made the currency pair go up. Resistance is any level where the market finished rising and turned down. Support and resistance levels on larger time charts are considered more significant than those on smaller time charts
Psychological Barriers
Psychological barriers are identified as huge numbers. Any numeral ending in 50 or 00 is a significant barrier. Any number ending with 000 is more significant. You will be in wonder at how much a currency pair exhausts itself and turns within a few pips of a psychological barrier.
Fibonacci Levels
Fibonacci lines are frequently used to determine if a point has the potential to reverse. Begin with your larger time charts and make Fibonacci lines on major moves. Drill down and mark all smaller moves. See where the Fibonacci lines, psychological barriers and support and resistance lines match.
Trend Lines
Make trend lines to put a mark on all major moves and then work your way down to smaller trends. If you ever run into trend lines that go in the same direction, mark them. To do this, put lines along the lowest points of an upward trend and along the tops of a downward trend.
Pivot Points
Most charting packages have either a calculator or a tool that plots your points where it can pivot. These are areas where the currency pair is likely to turn. Most tools and calculators offer several numbers both below and above the current levels of the currencies you are following.
Drawing lines to mark the various barriers that we always encounter in the foreign currency market can aid us in identifying where a pair is likely to turn. Take note of those levels where multiple barriers correspond. This increases the chance of having success while trading.
If you have many barriers that connect at a certain point, then it is very significant To find out more information about these barriers and their application on your charts, check out our website .

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The Continued Success Of Forex Currency Trading

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Forex trading is an unpredictable market that is followed closely by economists the world over. The forex market is absolutely enormous with some reports indicating that around 2 trillion dollars worth of trading is done daily on it. While it requires some of the best financial minds to predict the movements of currencies on this exchange, a number of average investors have succeeded in making money on these movements in the past. In fact, the business of forex trading has become a rapidly growing one, with an increasing number of people looking to it for a supplementary income, or even a primary one. The exponential growth in the numbers of investors has led people to believe that the returns are slowing down.

However, it is more accurate to say that most investors are making a small stream of profits but a few are making large returns. The difference between the two types is firstly, keen understanding and interest, secondly education and experience and finally, risk appetite. The forex market is highly liquid, making the trading very stimulating, though intellectually challenging.

The concept of forex trading involves a currency being traded for another, based on an exchange rate, also called the foreign exchange rate or forex rate. As compared to learning about the various stock options in the stock market, the forex market is less complicated since most people trade only a handful of currencies on this exchange. Forex currency trading took off in a big way in the nineties and still maintains its position as a sought after way to make money. But as a forex trader, one must keep in mind that a lot of time and effort goes into making a successful trader.

The idea of interest rate also plays a large part in the movement of any given currency. If the currency's interest rates are higher, this is seen as an implication of the increased demand for the currency. As the demand for a currency rises, the value of the currency increases as well making it a desirable currency to hold, due to the potential for appreciation. Though there have been cases of a country increasing interest rates in order to artificially create demand for its currency. So a forex trader must remain aware of the state of a country's economy and recent developments in the policies or situation of the country, before taking a call on the currency. This will allow for an educated decision, backed up by appropriate research and analytics.

Due to the ease of internet access, many people are able to trade currencies online from their homes. This does not mean that the market is overcrowded or that the potential profits have reduced. The size of the forex market forbids any such changes simply due to the addition of these relatively small numbers of investors. While it is possible to enter the forex market with very little investment capital, larger payoffs will generally require larger amounts of investment. A good trader will know how much risk he or she is capable of taking on and sticks with his or her decision on this important issue.

The appeal of making a quick buck still draws in a fair share of people, but most people now realize the significance of a balanced and mature approach towards investing in forex trading. Learn all you can, keep educating yourself constantly and make informed, researched decisions based on solid data.

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Six Forex Trading Tips for Newbies

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You have decided to be a trader in the forex market, and you have no idea on how to begin. Let's first start by defining what the forex market is and what it does.

The term "forex", also known as the foreign exchange is a market for the sale and purchase of all kinds of currencies. It originated in the early 1970's when floating currencies and free exchange rates were first introduced. At this time, the forex market traders were the ones who set the value of one type of currency against another.

Nowadays, the market forces determine the value of a currency against another. One unique aspect of the Forex market is that very little trading qualifications are required of anyone intending to trade therein.

Independence from external control ensures that only the market forces influence the currency prices. As the largest financial market, with trades reaching up to 1.5 trillion U.S. dollars, or USD, the money moves so fast, it’s impossible for a single investor to substantially affect the price of any major foreign currency.

In addition, unlike any stock that is rarely traded, forex traders are able to open and close any positions within seconds, because there are always a number of willing buyers and sellers.

1. The first thing you need to do is open a forex account. You will have to fill an application form which includes a margin agreement stating if the broker will be allowed to intervene with any trade when it appears too risky. Since most trades are done using the broker's money, it is only logical that he protect his interests. However, once you have established an account, you can fund it and begin trading in the forex market.

2. Adopt a trading strategy, that has proven to be successful for you. Remember that strategies will work differently for different traders, so don't try to adopt a strategy that works well for another trader. It might backfire on you. The two available approaches are either technical analysis or fundamental analysis. A combination of the two is a more preferred choice for experienced traders.

3.Understand that prices move by trends. Forex has a popular saying, “The trend is your friend.” There are certain movements that have been studied over many years in order to identify a pattern in the trend. These trends need to be understood in order to understand a good trading strategy. For small accounts that are $25,000 and under, trading with a trend may help improving your odds when compared to bi-directional trading. Most newbie’s will look to trade in any direction, when they should be trading with a trend.

4. Ensure you know which are the top five currencies pairs in the foreign exchange. These are USD/Yen, Swiss franc/USD, Euro/Yen, Euro/USD and Pound/USD.

5. For newbies, it is advisable to maintain two accounts to ensure you learn to play the trading game. Keep one real account, one that you will actually use to trade real money; and the second account should be a demo, one that you can use to test alternative moves in the trading game. You can easily use your demo account to shadow the trades in your real account so you can widen your stops to see if you are being too conservative or not.

6. Always examine the one hour, four hour and daily charts that concern your trades. Although you can trade at 15 and 30 minute time intervals, doing so requires a handful of dexterity.

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Tips For Trading Forex II

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Why do hundreds of thousands online traders and investors trade the forex market every day, and how do they make money doing it?


This two-part report clearly and simply details essential tips on how to avoid typical pitfalls and start making more money in your forex trading.


  1. Trade pairs, not currencies - Like any relationship, you have to know both sides. Success or failure in forex trading depends upon being right about both currencies and how they impact one another, not just one.




  2. Knowledge is Power - When starting out trading forex online, it is essential that you understand the basics of this market if you want to make the most of your investments.


    The main forex influencer is global news and events. For example, say an ECB statement is released on European interest rates which typically will cause a flurry of activity. Most newcomers react violently to news like this and close their positions and subsequently miss out on some of the best trading opportunities by waiting until the market calms down. The potential in the forex market is in the volatility, not in its tranquility.




  3. Unambitious trading - Many new traders will place very tight orders in order to take very small profits. This is not a sustainable approach because although you may be profitable in the short run (if you are lucky), you risk losing in the longer term as you have to recover the difference between the bid and the ask price before you can make any profit and this is much more difficult when you make small trades than when you make larger ones.




  4. Over-cautious trading - Like the trader who tries to take small incremental profits all the time, the trader who places tight stop losses with a retail forex broker is doomed. As we stated above, you have to give your position a fair chance to demonstrate its ability to produce. If you don't place reasonable stop losses that allow your trade to do so, you will always end up undercutting yourself and losing a small piece of your deposit with every trade.




  5. Independence - If you are new to forex, you will either decide to trade your own money or to have a broker trade it for you. So far, so good. But your risk of losing increases exponentially if you either of these two things:


    Interfere with what your broker is doing on your behalf (as his strategy might require a long gestation period);


    Seek advice from too many sources - multiple input will only result in multiple losses. Take a position, ride with it and then analyse the outcome - by yourself, for yourself.




  6. Tiny margins - Margin trading is one of the biggest advantages in trading forex as it allows you to trade amounts far larger than the total of your deposits. However, it can also be dangerous to novice traders as it can appeal to the greed factor that destroys many forex traders. The best guideline is to increase your leverage in line with your experience and success.




  7. No strategy - The aim of making money is not a trading strategy. A strategy is your map for how you plan to make money. Your strategy details the approach you are going to take, which currencies you are going to trade and how you will manage your risk. Without a strategy, you may become one of the 90% of new traders that lose their money.




  8. Trading Off-Peak Hours - Professional FX traders, option traders, and hedge funds posses a huge advantage over small retail traders during off-peak hours (between 2200 CET and 1000 CET) as they can hedge their positions and move them around when there is far small trade volume is going through (meaning their risk is smaller). The best advice for trading during off peak hours is simple - don't.




  9. The only way is up/down - When the market is on its way up, the market is on its way up. When the market is going down, the market is going down. That's it. There are many systems which analyse past trends, but none that can accurately predict the future. But if you acknowledge to yourself that all that is happening at any time is that the market is simply moving, you'll be amazed at how hard it is to blame anyone else.




  10. Trade on the news - Most of the really big market moves occur around news time. Trading volume is high and the moves are significant; this means there is no better time to trade than when news is released. This is when the big players adjust their positions and prices change resulting in a serious currency flow.




  11. Exiting Trades - If you place a trade and it's not working out for you, get out. Don't compound your mistake by staying in and hoping for a reversal. If you're in a winning trade, don't talk yourself out of the position because you're bored or want to relieve stress; stress is a natural part of trading; get used to it.




  12. Don't trade too short-term - If you are aiming to make less than 20 points profit, don't undertake the trade. The spread you are trading on will make the odds against you far too high.




  13. Don't be smart - The most successful traders I know keep their trading simple. They don't analyse all day or research historical trends and track web logs and their results are excellent.




  14. Tops and Bottoms - There are no real "bargains" in trading foreign exchange. Trade in the direction the price is going in and you're results will be almost guaranteed to improve.




  15. Ignoring the technicals- Understanding whether the market is over-extended long or short is a key indicator of price action. Spikes occur in the market when it is moving all one way.




  16. Emotional Trading - Without that all-important strategy, you're trades essentially are thoughts only and thoughts are emotions and a very poor foundation for trading. When most of us are upset and emotional, we don't tend to make the wisest decisions. Don't let your emotions sway you.




  17. Confidence - Confidence comes from successful trading. If you lose money early in your trading career it's very difficult to regain it; the trick is not to go off half-cocked; learn the business before you trade. Remember, knowledge is power.


The second and final part of this report clearly and simply details more essential tips on how to avoid the pitfalls and start making more money in your forex trading.




  1. Take it like a man - If you decide to ride a loss, you are simply displaying stupidity and cowardice. It takes guts to accept your loss and wait for tomorrow to try again. Sticking to a bad position ruins lots of traders - permanently. Try to remember that the market often behaves illogically, so don't get commit to any one trade; it's just a trade. One good trade will not make you a trading success; it's ongoing regular performance over months and years that makes a good trader.




  2. Focus - Fantasising about possible profits and then "spending" them before you have realised them is no good. Focus on your current position(s) and place reasonable stop losses at the time you do the trade. Then sit back and enjoy the ride - you have no real control from now on, the market will do what it wants to do.




  3. Don't trust demos - Demo trading often causes new traders to learn bad habits. These bad habits, which can be very dangerous in the long run, come about because you are playing with virtual money. Once you know how your broker's system works, start trading small amounts and only take the risk you can afford to win or lose.




  4. Stick to the strategy - When you make money on a well thought-out strategic trade, don't go and lose half of it next time on a fancy; stick to your strategy and invest profits on the next trade that matches your long-term goals.




  5. Trade today - Most successful day traders are highly focused on what's happening in the short-term, not what may happen over the next month. If you're trading with 40 to 60-point stops focus on what's happening today as the market will probably move too quickly to consider the long-term future. However, the long-term trends are not unimportant; they will not always help you though if you're trading intraday.




  6. The clues are in the details - The bottom line on your account balance doesn't tell the whole story. Consider individual trade details; analyse your losses and the telling losing streaks. Generally, traders that make money without suffering significant daily losses have the best chance of sustaining positive performance in the long term.




  7. Simulated Results - Be very careful and wary about infamous "black box" systems. These so-called trading signal systems do not often explain exactly how the trade signals they generate are produced. Typically, these systems only show their track record of extraordinary results - historical results. Successfully predicting future trade scenarios is altogether more complex. The high-speed algorithmic capabilities of these systems provide significant retrospective trading systems, not ones which will help you trade effectively in the future.




  8. Get to know one cross at a time - Each currency pair is unique, and has a unique way of moving in the marketplace. The forces which cause the pair to move up and down are individual to each cross, so study them and learn from your experience and apply your learning to one cross at a time.


  9. Risk Reward - If you put a 20 point stop and a 50 point profit your chances of winning are probably about 1-3 against you. In fact, given the spread you're trading on, it's more likely to be 1-4. Play the odds the market gives you.




  10. Trading for Wrong Reasons - Don't trade if you are bored, unsure or reacting on a whim. The reason that you are bored in the first place is probably because there is no trade to make in the first place. If you are unsure, it's probably because you can't see the trade to make, so don't make one.




  11. Zen Trading- Even when you have taken a position in the markets, you should try and think as you would if you hadn't taken one. This level of detachment is essential if you want to retain your clarity of mind and avoid succumbing to emotional impulses and therefore increasing the likelihood of incurring losses. To achieve this, you need to cultivate a calm and relaxed outlook. Trade in brief periods of no more than a few hours at a time and accept that once the trade has been made, it's out of your hands.




  12. Determination - Once you have decided to place a trade, stick to it and let it run its course. This means that if your stop loss is close to being triggered, let it trigger. If you move your stop midway through a trade's life, you are more than likely to suffer worse moves against you. Your determination must be show itself when you acknowledge that you got it wrong, so get out.




  13. Short-term Moving Average Crossovers - This is one of the most dangerous trade scenarios for non professional traders. When the short-term moving average crosses the longer-term moving average it only means that the average price in the short run is equal to the average price in the longer run. This is neither a bullish nor bearish indication, so don't fall into the trap of believing it is one.




  14. Stochastic - Another dangerous scenario. When it first signals an exhausted condition that's when the big spike in the "exhausted" currency cross tends to occur. My advice is to buy on the first sign of an overbought cross and then sell on the first sign of an oversold one. This approach means that you'll be with the trend and have successfully identified a positive move that still has some way to go. So if percentage K and percentage D are both crossing 80, then buy! (This is the same on sell side, where you sell at 20).




  15. One cross is all that counts - EURUSD seems to be trading higher, so you buy GBPUSD because it appears not to have moved yet. This is dangerous. Focus on one cross at a time - if EURUSD looks good to you, then just buy EURUSD.




  16. Wrong Broker - A lot of FOREX brokers are in business only to make money from yours. Read forums, blogs and chats around the net to get an unbiased opinion before you choose your broker.




  17. Too bullish - Trading statistics show that 90% of most traders will fail at some point. Being too bullish about your trading aptitude can be fatal to your long-term success. You can always learn more about trading the markets, even if you are currently successful in your trades. Stay modest, and keep your eyes open for new ideas and bad habits you might be falling in to.




  18. Interpret forex news yourself - Learn to read the source documents of forex news and events - don't rely on the interpretations of news media or others.

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Tips For Trading Forex

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Tip 1. Gamblers go to casino. All unproved, spontaneous actions in Forex trading — are a part of pure gambling.

Any attempt to trade without analysis and studying the market is equal to a game. Game is fun except when you are losing real money...

Tip 2. Never invest money into a real Forex account until you practice on a Forex Demo account!

Allow at least 2 month for demo trading. Consider this: 90% of beginners fail to succeed in the real money market only because of lack of knowledge, practice and discipline. Those remaining 10% of successful traders had been sharpening and shaping their skills on demo accounts for years before entering the real market.

Tip 3. Go with the trend!
Trend is your friend. Trade with the trend to maximize your chances to succeed. Trading against the trend won't "kill" a trader, but will definitely require more attention, nerves and sharp skills to rich trading goals.

Tip 4. Always take a look at the time frame bigger than the one you've chosen to trade in.
It gives the bigger picture of market price movements and so helps to clearly define the trend. For example, when trading in 15 minute time frame, take a look at 1 hour chart; trading hourly would require obtaining a picture of daily, weekly price movements.
If a trend is hard to spot — choose a bigger time frame. Up and down market patterns are always present. Always make sure you know the dominant trend, unless you are a scalper. Scalpers have no need to spend their time studying big trends, what's happening in the market here and now (during 5-10 minute time frame) should be of only importance to a Forex scalper.

Tip 5. Never risk more than 2-3% of the total trading account.
One important difference between a successful and an unsuccessful trader is that the first is able to survive under unfavorable conditions on the market, while an unsuccessful trader will blow up his account after 5-10 unprofitable trades in the row.
Even with the same trading system 2 traders can get opposite results in the long run. The difference will be again in money management approach. To introduce you to money management, let's get one fact: losing 50% of total account requires making 100% return from the rest of money just to restore the original balance.

Tip 6. Put emotions down. Trade calm.
Don't try to revenge after losing the trade. Don't be greedy by adding lots of positions when winning.Overreaction blocks clear thinking and as a result will cost you money. Overtrading can shake your money management and dramatically increase trading risks.

Tip 7. Choose the time frame that is right for you.
Choosing wise means that you are comfortable and have time enough to analyze the market, place and close orders etc. Some people can't wait for hours for the price to make a move, they like action and therefore prefer smaller time frames. On the contrary, for others 10-15 minutes is a hustle to be able to make the right decision.

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Thursday, July 26, 2007

Trade Balance

Thursday, July 26, 2007
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Definition:
Trade balance measures the ratio of exports to imports for a given country's economy. If exports are higher than imports (a trade surplus), the trade balance will be positive. If imports are higher than exports (a trade deficit), the trade balance will be negative.

Importance

Knowing the exchange rate is obviously critical for any foreign exchange trader, but information on the net exports in a country can help to predict future trends in inflation and foreign investment, and thus can give clues to the future behavior of any given currency market.

Background

Trade balance is derived primarily from three factors:

  1. The price of goods in a country
  2. Tax and tariff levies on imported or exported goods
  3. The exchange rate between two currencies.

This last factor is fundamental to foreign exchange trading. Since the trade balance depends so heavily on the current state of exchange rates between two countries, trade balance is a key coincident indicator for the state of a foreign exchange asset market.

There are a number of measures for trade balance, but one of the chief sources of information on the state of trade in the US is the International Trade report released monthly by the Census Bureau and the Bureau of Economic Analysis. This report is released around the third week of every month and details the performance of several exported goods and services in various sectors of the economy.


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Forex Money Management, Part 1

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Best system will fail in long-term if it is without proper . On the contrary, bad system can turn profitable if used with a good money management. Currency trading always go through the cyclical ups and downs, where winning and losing are just part of the game. However, with the right money management, you will ride on satisfying streak of winners and make good profits, while skipping most losses during bad times.

Have you ever wondered why you made so much profit so easily only to lose all of it plus your principal in a flash? Then you're trading without a proper money management. You've got to be disciplined, or your winnings are guaranteed to lose sooner or later. But it's no big deal now! Learn these money managements today, you'll keep the winnings forever.

Alexander Elder's 2% and 6% Rules

First and foremost, note down your account equity at beginning of the month. Then compute 2% and 6% of the account equity. For example, if your account equity at the beginning of the month was $100,000 then 2% of $100,000 was $2,000, and 6% of it was $6,000. But what are these numbers used for?

Firstly, you should never risk more than the 2% per trade. This will protect you from blowing up your account from just a few bad trades. In this example, the maximum loss of any single trade allowed is $2,000 (the 2% of $100,000). Make sure that you don't expose more than that in any trade. To enforce this rule, you have to set stop loss to limit the loss at $2,000 or less. That is usually a stop loss of at most 200 pips for a 1-lot contract or at most 50 pips for 4-lot contract. Remember that you can always set stop loss less than the 2% or execute multiple trades. Just make sure it is not larger than that.

In addition to the 2% rule, you are allowed to risk a maximum of 6% of equity in one month. In this example, allow yourself to lose not more than $6,000 (the 6% of $100,000). You may open multiple trades running concurrently, but make sure that in total you are not exposing more than $6,000. Any time you see drawdown of current month exceeds $6,000, stop trading until next month. Then in the new month, you'll have another 6% to risk. Always check that if all the open trades are lost, they won't take more than the %6.

Assuming at the start of 'new' month, your account equity is now down to $94,000. The 2% of $94,000 is $1,880 and the 6% is $5,640. In this 'new' month, you may risk a max of $1,880 per trade and a max of $5,640 per month. You have to set stop loss to all trades to make sure that these rules are always enforced. Recalculate the 2% and 6% at the beginning of every month and trade accordingly.

These two rules will save you and your precious money during bad times, and will maximum your profits during good times. The 2% and 6% rule will cut the losses short while letting the profits run as far as possible. You will ride on a long streak of winning trades but skip most losing trades.

Apply this money management to your trading today, get disciplined and become professional trader.


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Monday, July 23, 2007

How do you make money trading money?

Monday, July 23, 2007
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Investors can trade almost any currency in the world. Investors, as individuals, countries, and corporations, may trade in the forex if they have enough financial capital to get started and are astute enough to make money at it. How someone makes money in the forex is a speculative process: you are betting that the value of one currency will increase relative to another.

Currencies are traded, and priced, in pairs within the forex. For example, you may have seen a currency quote for a EUR/USD pair of 1.2131. In this example, the base currency is the euro and the U.S. dollar is the quote currency. In all currency quote cases, the base currency is worth one unit, and the quoted currency is the amount of currency that one unit of the base currency can buy. So, in this example, one euro can buy 1.2131 U.S. dollars. How an investor makes money in forex is by either an appreciation in the value of the quoted currency, or by a decrease in value of the base currency. (For an overview of foreign exchange, read A Primer On The Forex Market.)

Another way to look at currency trading is to think about the position an investor is taking on each currency in the pair. The base currency can be thought of as a short position because you are "selling" the base currency to purchase the quoted currency, which can be seen as the long position on the currency pair. In our example above, we see that one euro can purchase $1.2131 and vice versa. To purchase the euros, the investor must first go short on the U.S. dollar in order to go long on the euro. To make money on this investment, the investor will have to sell back the euros when their value appreciates relative to the U.S. dollar. For example, assume the value of the euro appreciates to $1.2141 - on a lot of $100,000 the investor would gain US$100 ($121,410 - $121,310) if he or she sold the euros at this exchange rate. Conversely, if the EUR/USD exchange rate fell by 10 pips to $1.2121, then the investor would lose US$100 ($121,210 - $121,310).

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Trading Is Timing

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Trading always comes down to timing. To truly appreciate this, we simply need to note that one of the biggest gains in stock market history occurred on October 19, 1987, during the day of its greatest crash. On that day, stocks had declined a mind-harrowing 23% by the end of the day, but at around 1:30pm, they staged a massive rally that saw the Dow Jones and S&P indexes verticalize off the bottom, rising more than 10% before running out of steam and turning down to end the day on the lows. While most traders that day lost money, those who bought that bottom at 1:30pm and sold their positions an hour later were rewarded with some of the best short-term gains in stock market history. Conversely, traders unfortunate enough to have shorted at 1:30pm only to cover in panic an hour later held the dubious distinction of losing money on their shorts during the day of stock market's greatest decline. If nothing else, the stock market crash of 1987 proved that trading is all about timing. Timing is hard to master, but you can still capture significant gains on an ill-timed trade if you follow a few simple rules.

The Advantage of Avoiding Margin
What happens to traders who are terrible timers? Can traders who are poor timers ever succeed - especially in the currency market where ultra-high leverage and stop driven price action often forces margin calls? The answer is yes. Some of the world's best traders, including market wizard Jim Rogers, are still able to succeed. Rogers - and his famous short trade in gold - is well worth examining in more detail. In 1980, when gold spiked to record highs on the back of double-digit inflation and geopolitical unrest, Rogers became convinced that market for the yellow metal was becoming manic. He knew that like all parabolic markets, the rise in gold could not continue indefinitely. Unfortunately, as is so often the case with Rogers, he was early to the trade. He shorted gold at around $675 an ounce while the precious metal continued to rise all the way to $800. Most traders would not have been able to withstand such adverse price movement in their position, but Rogers - an astute student of the markets - knew that history was on his side and managed not only to hold on, but also to profit, eventually covering the short near $400 an ounce.

Aside from his keen analytics and a steely resolve, what was the key to Rogers' success? He used no leverage in his trade. By not employing margin, Rogers never put himself at the mercy of the market and could therefore liquidate his position when he chose to do so rather than when a margin call forced him out of the trade. By not employing leverage on his position, Rogers was not only able to stay in the trade but he was also able to add to it at higher levels, creating a better overall blended price.

Slow and Low is the Way to Go
For currency traders, the Rogers trade in gold holds many lessons. Experienced traders are familiar with being stopped out or margin called from a position that was going their way. What makes trading such a difficult vocation is that timing is very hard to master. By using little or no leverage, Rogers provided himself with a much larger margin for error and, therefore, did not need to be correct to the penny in order to capture massive gains. Currency traders who are unable to accurately time the market would be well advised to follow his strategy and deleverage themselves. Just like the common cooking saying, success in FX trading is based on the idea that 'slow and low is the way to go'. Namely, traders should enter into their positions slowly, with very small chunks of capital and use only the smallest leverage to initiate a trade.

To better illustrate this point, let's look at two traders. Both traders start with $10,000 of speculative capital and both feel that the EUR/USD is overvalued and decide to short it at 1.3000. Trader A employs 50:1 leverage, selling $500,000 worth of EUR/USD pair short against the $10,000 of equity in his speculative account. On a standard 1% margin account, Trader A allows himself only 100 points of leeway before he is margin called and forced out of the market. If EUR/USD rallies to 1.3100 Trader A is out with a massive loss. Trader B, on the other hand, uses much more conservative leverage of 5:1 only selling $50,000 EUR/USD short at the 1.3000 level. When the pair rallies to 1.3100 Trader B comes out relatively unscathed, suffering only a minor floating loss of $500. Furthermore, as the pair rallies to 1.3300 he is able to add to his short position and achieve a better blended price of 1.3100. If the pair then finally turns down and simply trades back down to his original entry level, trader B already becomes profitable. Both traders made the same trade. Both were completely wrong on timing, yet the results could not have been more different.

No Stops? Big Problem!
Jim Rogers' slow and low approach to trading, while clearly successful, suffers from one glaring flaw: it does not use stops. While Rogers' method of buying value and selling hysteria has worked well over the years, it can very be vulnerable to a catastrophic event that can take prices to unimagined extremes and wipe out even the most conservative trading strategy. That is why currency traders may want to examine the methods of another market wizard, Gary Bielfeldt. This plain-spoken Midwesterner made a fortune trading Treasury bonds in the 1980s when interest rates rose to record yields of 14%. Gary Bielfeldt went long Treasury bond futures once rates hit those levels, believing that such high rates of interest were economically unsustainable and would not persist. However, much like Jimmy Rogers, Gary Bielfeldt was not a great timer. He initiated his trade with bonds trading at the 63 level but they kept falling, eventually trading all the way down to 56. However, Bielfeldt did not allow his losses to get out of control. He simply took stops every time the position moved a half or one point against him. He was stopped out several times as bonds slowly and painfully carved out a bottom. However, he never wavered in his analysis and continued to execute the same trade despite losing money repeatedly. When bonds prices finally turned, his approach paid off as his longs soared in value and he was able to collect profits far in excess of his accumulated losses.

Gary Bielfeldt's method of trading holds many lessons for currency traders. Much like Jim Rogers, Bielfeldt is a successful trader who had difficulty timing the market. Instead of nursing losses, however, he would methodically stop himself out. What made him unique was his unwavering confidence in his analysis, which allowed him to enter the same trade over and over again, while many lesser traders quit and walked away from the profit opportunity. Bielfeldt's probative approach served him well by allowing him to participate in the trade while limiting his losses. This strong combination of discipline and persistence is a great example to currency traders who wish to succeed in trading but are unable to properly time their trades.

A Little Technical Help
While both Rogers and Bielfeldt used fundamental analysis as the basis behind their trades, there are also technical indicators that currency traders can use to help them trade more effectively. One such tool is the relative strength index (RSI). The RSI compares the magnitude of the currency pair's recent gains to the magnitude of its recent losses and turns that information into a number that ranges from 0 to 100. A value of 70 or more is considered to be overbought and a value of 30 or less is seen as oversold. A trader who has a strong opinion on the direction of a particular currency pair would do well to wait until his thesis was confirmed by RSI readings. For example, in the following chart, a trader who wanted to short the EUR/USD on the premise that the pair was overvalued would have been much more accurate if he or she waited until the RSI readings dropped below 70, indicating that most of the buying momentum was gone from the pair.


Figure 1

Conclusion
Timing is a vital ingredient to successful trading, but traders can still achieve profitability even if they are poor timers. In the currency market, the key to success lies with taking small positions using low leverage so that ill-timed trades can have plenty of room to absorb any adverse price action. However, trading without stops is never a wise strategy. That is why even poor timers should adopt a probative approach that methodically keeps trading losses to a minimum while allowing the trader to continuously re-establish the position. Finally, using even a simple technical indicator such as RSI can make fundamental strategies much more efficient by improving trade entries. Some of the greatest traders in the world have proven that one does not need to be a great timer to make money in the markets, but by using the techniques discussed above, the chances of success improve dramatically.

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