Technical and Fundamental Analysis

the discrete-systematic trading method using statistical dependencies.

The majority of traders who do not use system trade can be roughly divided into two groups: the first group includes the proponents of a mainly fundamental approach to market speculations; the second group includes traders making decisions based on technical analysis. There is a third (however not large) group of traders considering both approaches, but preferably using one of them. Disputes between the proponents of various approaches are typical for the Internet forums where profession- als and amateurs meet to discuss urgent problems of the market. How- ever, these forums look like the principal dispute described in Gulliver’s Travels, where the Lilliputian governments quarreled about the right end on which to crack eggs.

I consider these disputes useless, and I am sure that the positive re- sult itself is much more important than the means that helped to attain it. Both the fundamental and technical approaches in their classical form have their own advantages and disadvantages, which are mainly avoided or offset in the offered trading method. Let us begin with the problem fac- ing the proponents of both trade conceptions. In this chapter, I describe some paradoxes that are in my opinion worth thinking about.

Despite the fact that the market moves mainly due to fundamental factors, the problem of fundamental analysis is not simple. A fundamental trader needs to work hard to earn his bread. To carry out fundamental analysis effectively, a trader needs to have a deep understanding of macroeconom- ics, international finances, and political and social processes. He needs to adequately evaluate certain events and consider their influence on a spe- cific currency rate, and he needs to forecast market trends in order to gain profit from the results of previous political or economic changes. The in- fluence of each event or news should be estimated, considering all other factors affecting the market and a specific currency rate. However, even skilled economists, financial experts, political scientists, and professional market analysts are sometimes unable to complete this task. Also, the ma- jority of small individual speculators often cannot evaluate the impor- tance of a particular fundamental factor for the market.

In reality, market reaction to an obvious news event is often contradic- tory and unexpected. Chances of a correct forecast of market trends are in- versely proportional to the number of traders sharing the same point of view. In other words, most traders are more often wrong than right in their understanding of fundamental events and phenomena, and their forecast of near-future market movements based on the fundamental data is erroneous.

These are five paradoxes that I noticed regarding the issue of predict- ing the market.

Paradox 1

The vast majority of FOREX traders are unable (because of their limited competence in macroeconomics and finances) to interpret correctly many of the various fundamental factors influencing the market, but the specu- lative trade based on fundamental analysis is widespread among individ- ual traders-investors. Paradox 2 is interconnected with paradox 1.

Paradox 2

Despite the practical impossibility of forecasting market movements us- ing fundamental analysis, there is a simple, rational, and fundamental ex- planation of previous market events and shifts after all.

It is relatively simple for the individual speculative trader who watches the main economic data and has access to sources of financial information, to predict the general trend of economic development of various countries. Hence, it is simple to compare economic growth rates of two separate

countries or regions. This allows the trader to determine the main trends in changing national currency rates with greater probability. The disadvan- tage is the approximation used for the analysis, which is useless for short- term speculative operations because of the inaccurate determination of levels of entering and exiting the market. This leads to the next paradox.

Paradox 3

The vast majority of traders use long-term global economic trends. Being deliberate or forced proponents1 of short-term speculations, they are un- able to benefit from their own long-term forecasts and analyses.

A trader wants to know exactly why the various events and market movements occur, but this knowledge cannot help him much. I think the question Why? is of less importance to a trader, and cannot be compared to the importance of other questions that traders should answer before making their decisions. Questions like Where? When? and How many? should be of more importance for a trader—especially those who trade short-term positions or are involved in daily trading. In many cases, infor- mation about various market movements is not important. If the trader was late and did not take part in the previous movement, knowledge of the exact causes of the rate fluctuations does not help. Even if the prof- itable or unprofitable position was open at the moment of the market movement, the knowledge of the exact causes cannot help to reimburse losses or threaten the profit.

Sometimes, there could be certain exceptions to this rule, and these exceptions do not upset the generally secondary importance of the ques- tion Why? Exceptions include situations in which the long-term influence of news events on the market should be evaluated. Even in these rare cases, the trade operations based on the common sense method are possi- ble and preferable.

Paradox 4

Many traders, whom I know personally, usually spend much time discov- ering and discussing the causes of previous fluctuations in the money

1I call forced proponents of daily and short-term speculation those traders who simply cannot afford long-term trade, despite their inclination to the positional trade. Their investment capital is not large enough to open and keep strategic po- sitions. In the positional trade, stop orders should be fixed at a considerable dis- tance from the initially opened position, and a single loss can completely ruin the trading account if it’s a small one. Such traders often dream of multiplying the size of their trading account, so that they can switch into longer-term trading.

market. This knowledge has no practical value because by that time the train has gone and the market has already reacted to certain fundamental stimuli and the exchange rate is adjusted accordingly.

The proponents of technical analysis and technical trading methods are numerous—even though this science is relatively new. Their numbers grow every day, along with implantation of these revolutionary ideas into the arsenal of the vast majority of currency speculators. The founders of tech- nical analysis (such as John Murphy) stated that technical analysis could become the only tool to forecast market movements and completely re- place fundamental analysis. The number of publications on this subject has evolved, and now, even beginners can freely discuss head-and-shoulders formation. Technical analysis enjoys wide popularity among traders. Any computer software dealing with financial markets includes lots of indica- tors and other tools for technical analysis.

Technical indicators are used as the basis for the development of the majority of trade strategies and systems. Many traders skilled in mathemat- ics try to optimize existing indicators and oscillators, as well as to develop new ones. The so-called black and gray boxes, which are, in essence, soft- ware with input trade algorithms, are based on these technical elements. However, not everything is so clear and unclouded in technical analysis. The main difficulty of technical analysis is an uncertainty that allows inter- pretation of almost each specific market situation in several different ways.

Besides, the basic elements of technical analysis widely used in every- day work do not behave the same way as they were described in textbooks and publications. See Figure 6.1. This way, the market prevents every trader (who has read the textbook and learned the scientific fundamentals) from profitable trading on the financial markets. Difficulties arise when technical analysis is used in daily short-term trading because of minor mar- ket fluctuations that, in essence, are just the market noise. This noise can be compared with radio interference hindering clear reception. Unfortu- nately, the amplitude of this interference is too high to be ignored in short- term trading, and it disturbs the market harmony. See Figure 6.2.

Paradox 5

The forecast on markets with a minimum number of technical traders among other participants is much easier. For example, daily plots of the DJIA, NASDAQ, and S&P indices often provide a technical picture that is

FIGURE 6.1 According to technical analysis textbooks, a triangle should be a reversal formation. As you can see on this picture, it’s not always like that. So, to avoid being caught with the wrong opinion, the trade should rather be based on actual market behavior than on views, opinions, and projections.

FIGURE 6.2 10-min USD/CHF chart shows how fast and volatile the market can be, sometimes making crazy swings in both directions. Despite all this craziness, the picture still makes perfect technical sense. Take a look at the formation. It is a broadening triangle we can clearly see on the chart.

close to ideal and easy to understand. However, stock-market traders tra- ditionally prefer fundamental analysis, and the percentage of technical traders is still not sufficient. The FOREX market, filled with technically skilled speculators using the classic technical analysis tools, becomes more and more difficult to forecast.

Let us now look at the advantages and disadvantages of the main ele- ments of classical technical analysis and select the most important ele- ments, considering specific trade signals they send to traders.

According to my observations, the probability of functioning of the most obvious formations like head and shoulders, double top, triangle, and such, has decreased greatly during the last three to five years. Today, the more obvious the formation is on the plot, the higher is the probability that the next neckline test will be false, and the main market shift will be in the direction opposite to the one indicated. See Figure 6.3.

FIGURE 6.3 Slightly ascending but almost perfect double bottom formation on USD/JPY Daily chart. The measured objective target has not been reached, despite the fact that all the other attributes of a classic formation description are present. Even an unsuccessful attempt to come back and break the neckline from above is seen on the picture, but the run for the target has still failed.

The majority of traders I have met in my career do not have adequate knowledge of the technical analysis basics, and are unable to identify cor- rectly certain classical formations or interpret widely known and practi- cally used technical signals. However, the transaction level according to common practice should be expressed by the specific currency exchange rates, so we should pay adequate attention to them.

Most indicators describe the market mainly in an ideal form, but reason- able thinking indicates it could not be otherwise, because such indicators are based on previous and current market information. The mathematical formulas, which determine the indicator lines and histograms, include the data for the previous period. Using them, a trader tries to make a forecast based on extrapolation. See Figure 6.4.

Unfortunately, in reality, the indicators that are good for the correct de- scription of the past cannot provide a true picture of the future. I think the main drawback of these indicators lies in their plotting principle. This prin- ciple distorts the current market situation due to the artificial smoothing of

FIGURE 6.4 Cable on Weekly charts. Technical traders must love this picture. The indicator was able to provide the ideal description of the past. Unfortunately, it’s too late now to benefit from it.

the real market signals by the mathematical manipulations on which an in- dicator formula is based. The momentum indicator signals are often too late, and the indicators intended to signal market overbought or oversold conditions are simply ridiculous. The market can move thousands of pips, even after the indicator gave the overbought or oversold signals on the daily or weekly graphs. See Figure 6.5.

It is not reasonable to keep floating losses of thousands of pips, ex- pecting the market to return to your position levels, because it might never happen. The retracement could be shorter than the market’s initial movement against the open position. In this case, the indicator can over- pass the overbought or oversold zone before the market reaches the level of the initial position’s opening price. Then the market renews its move- ment against an open position. Traders face this situation almost daily, but (having no better tools) they may consider this approach satisfactory for the development of various trading systems. See Figure 6.6.

Many traders simultaneously use several indicators in their trading systems. However, sometimes different indicators send contradicting sig- nals. (See Figure 6.7.) Therefore, traders should select some of the indica- tors for certain situations and disregard the others. The selection of

FIGURE 6.5 Technical traders should hate this picture, especially those who rely on such indicators in their trading. After entering an extremely overbought area, crossing toward the downside and sending a false sell signal, the indicator became practically useless. It took more than three years for the market to get back to the short position initial open price after going against it for 3.600 pips.

FIGURE 6.6 This shows a very nice trip for the indicator from the overbought area to the oversold zone. The market did not share its pessimistic view, though, and it refuses to follow the indicator down all the way.

FIGURE 6.7 Two different and the most popular indicators on USD/CHF weekly chart are sending controversial signals to traders. The picture needs some addi- tional study and research for traders to make a decision. What if other indicators give the same controversial signals?

indicators requires strong skills and experience, but often the selection does not work in spite of those skills. Some traders often use different fil- ters to exclude false signals, which complicates the system and make it even less effective. These trading systems (though not dependable enough) require more time for analysis and decision making. Many such trading systems often generate false signals, so the statistical ratio is in fa- vor of the failed trades. It is clear that such a system can be profitable only if the average profit per one trade surpasses the average loss. Then, traders can be successful, not because of the dependable and effective system generating true trading signals, but mainly because of their money management skills and technique.

Technical analysis theories named after their authors (for example Fi- bonacci and Dow retracement theories, the Elliott Wave Theory, and the Gunn analytical method) are not useful for the trader. The Elliott Wave Theory sometimes describes market past events accurately, but gives only an approximate forecast of the future. I think the theory can be used only for mental exercises, but not as a real tool to earn money. It assumes a lot of options for a single case, and it relies on a trader’s extensive experience

FIGURE 6.8 The trend was obvious, and so were the retracement and its target. For some reason still unknown to me, USD/JPY follows the Fibonacci ratios the most accurately, if you look back in history and compare other currency pairs.

in trading. However, this theory remains a puzzle toy for intellectual traders, rather than a practical tool for the majority of traders. Don’t for- get that Elliott himself was unable to use his theory in practice to make any money on the real market. (See Figure 6.8.) By contrast, the retrace- ment theory can easily and naturally be used in my method because, in real cases, it provides precise numerical rate value levels. Traders can consider these values when they choose strategy and tactics, and they can plan their transactions for each trading period.

I think this theory is one of the best for the development of my trading method, because it is more precise than the retracement theory. Each buy or sell level at the moment of opening or liquidating positions is expressed in this theory by a certain value rate. This theory greatly simplifies calcula- tions and provides an almost ideal profit/loss forecast. Furthermore, this theory is free from the disadvantages of practical trade methods and sys- tems, which are based on a set of various indicators. There is no fluctua- tion smoothing effect, and there are no late trade signals. However, sometimes, as in the case of trading based on market formations, false sig- nals are possible. See Figure 6.9.

FIGURE 6.9 The trend lines on the USD/DEM daily chart. Several triangle-like patterns are unmarked but are also clearly seen here.

CHARTS: POINT AND FIGURE, JAPANESE CANDLESTICKS

Both of these charts are designed, not for the real graphic reflection of the market, but for the analysis and forecast of future trends. There is no place for these charts in my common sense trading technique, not only be- cause my technique needs no forecasting, but also because it was undesir- able to complicate trading tactics that were effective enough without these extras. Also, I was too lazy to learn and memorize a lot of Japanese terms and designations, because the value of the method itself seemed doubtful to me. However, I recommend that my students get familiar with both types of basic charts and methods of using them, for the purpose of general knowledge and the ability to understand some professional dis- cussions. See Figures 6.10 and 6.11.

As a result of an investigation, search, and analysis of the tools, trade methods and theories available to the trader, I came to the following con- clusion: Some of these resources (especially if they do not require fore- casting and provide exact market description) could be included in the method I was developing, but they could not solve the whole problem. In any case, I could not find a dependable combination of tools and theories

FIGURE 6.10 Point and figure chart sample. It seems pretty obvious when de- scribing the past, but not so sure about the future. It has not been used in my trad- ing method, but is is recommended for general education purposes only.

FIGURE 6.11 Japanese candlesticks chart sample. This is the oldest known study technique for market analysis, and it has also been popular in modern times. It is a perfect fortuneteller’s tool, requiring a rich imagination and some knowledge of the Japanese language. There is no need for practical usage if you follow the common sense trading technique. The Japanese candlesticks chart sample is rec- ommended for the purpose of general education, as well.

to develop the method that would satisfy my requirements. In the process of my practical work on the market, I noticed some repeated regularity in market trends that were not mentioned in the literature or used by the traders I knew. All these regularities were caused by similar extensions, and they clearly expressed statistical regularities in a certain sequence of market oscillations. I liked the idea of describing and formulating these regularities to use them in the method I was developing. This would take me close to the ideal successful trading method.

PAR T III

The Igrok Method

should master a trading technique based on natural and statistically justi- fied patterns of market behavior, to be able to effectively follow the mar- ket fluctuations without the necessity to foresee or forecast. The optimal solution could be a trading system based on natural market features and regularities.

Thus, I state that successful and consistent trading results can be achieved by investigating natural market features, and by using purely sta- tistical estimation methods of market movement probability in any direc- tion at a given moment. This probability estimation is based on the standard set of templates projected on the current currency chart. If a tem- plate coincides with the current market situation, I make the decision to enter the market. In every case, each trading position on the market is cho- sen in the most probable direction of the movement, which provides a pos- itive statistical balance in favor of profitable trades. In this chapter, we discuss which features and regularities can be considered as natural mar- ket activities.

CHAPTER 7

Philosophy of the

Igrok Method

1.The market considers everything.

2.The market moves in accordance with trends.

3.History repeats itself.

Although I accept and share these statements, I offer my own philo- sophical conception on the basis of which I developed my trading method based on common sense. In general, it does not contradict technical analysis principles, rather it supplements them.

The following three main postulates are the philosophical basis of the new method and supplement the philosophical principles of technical analysis:

1.There are only two possible directions of a market movement.

2.The market moves permanently.

3.The market forms its trading range daily.

Most traders do not fully realize this obvious statement. Somehow, it even contradicts the opinion widely held by traders that the side trend of mar-

ket movement is a kind of third direction. However, on close examination, this side trend only occurs when there are alternating oscillations: up or down. The paradox is that the majority of traders cannot use that simple phenomenon to benefit from it. However, if you think about it, an accept- able trade strategy can be developed on the basis of this statement alone.

Some inferences from the first postulate turn out to be very important in benefiting from market rate fluctuations. Let us use common sense and elementary logic to formulate and then analyze some of these inferences according to their primary practical importance.

I consider the fact that there are only two possible directions of mar- ket movement very important because this limits the market options of reducing a trader’s money. At any given moment, the trader has a mini- mum 50 percent statistical probability opening a new position in the right direction.

Here, I have to make a brief detour and somehow explain my position about a skeptic’s opposite point of view about the same fact. Why should we consider the 50 percent probability of market movement in either di- rection as a negative factor, whereas the same probability about the trader is taken as positive? The reason for this seemingly contradiction is very simple. We consider the market behavior as primary and the trader reac- tion as secondary because, in making decisions and taking positions, the trader only responds to market changes.

So denying the assumption that trader activity causes market rate fluctuations, I suggest considering the market as spontaneously changing under the influence of factors unknown and unrecognized by us. Then, it can be concluded that a trader could survive in this environment only if he adjusts to these conditions. He should not try to dictate his will to the market, but only explore the ability to benefit from some of the market’s features. One of these features is the market’s ability to move in either of just two possible directions.

If this statement is taken as a starting point, one thing is clear. For a speculative trade on the FOREX or on any other market, it is necessary to know that the statistical probability of all trade results should exceed 50 percent to the trader’s benefit in order for the final result to be positive. (This assumes the condition that the average profit per any successful trade exceeds the average loss per any unsuccessful trade). In fact, it would be reasonable to conclude that, to get generally positive statistical results, the initial probability of achieving success from any new position opened by the trader should exceed 50 percent. Positive statistical results need an effective evaluation method for this objective probability calcula- tion at any given moment. For the development of such a probability eval- uation system, the following statements (which are the basis of this method) are of primary importance.

This statement means that if a market is not moving in one direction, then it is moving in the opposite direction. In other words, a market’s motion- less state is practically impossible. Any position opened in any direction cannot keep the trader uninformed about the result for a long time; in a few minutes or hours it will generate either an essential profit or an essen- tial loss.

An essential profit now and later means a profit equal to or exceeding

25 percent of each trade’s trading capital (or initial margin). For the major currency rates at an initial margin of 2 percent, it equals $500 for any min- imal standard contract of $100,000.

Because of specifics of money market trends, substantial fluctuation amplitude of each trend is a rule, whereas a narrow and more or less con- tinuous side trend is rather rare. Any taken position may generate profit or loss in a few days, which will be several times more than the initial margin size. This particular feature of the money market allows everybody to con- duct a very interesting experiment/investigation. First, you should picture two parallel lines at a distance of 50 to 70 or even 100 pips from each other, drawn on a randomly chosen area of a chart showing the prehistory of any of the major currency rates (distinguished by their almost ideal liq- uidity and highest activity). Then, imagine that every time the market crosses this line in the upward direction, we open a long position. Then, imagine that every time the market crosses this line in its downward di- rection, we open our short position. In other words, the open short posi- tion is always below the lower line, and the open long position is always above the upper line. See what happens next. This simple experiment helps to explain that, regardless of the initially opened position, this ac- tion will immediately bring a substantial, progressing profit. In another scenario, closed with a loss and being reversed in the opposite direction, the new position would sooner or later generate the same profit; or, as a minimum, would cover the initial losses by the subsequent profit. In this case, the multiple market movements up and down crossing the drawn horizontal lines on the charts will cover the initial loss or any possible se- ries of consecutive losses. This is true even if the zone we use is optional and we choose it in the very middle of any real horizontal trend seen in the past—even the most prolonged in the trading history of any major cur- rency pair. See Figure 7.1.

There is a logical conclusion based on this simple experiment/investi- gation: Any random position opened at any randomly chosen price will al- low the trader either to get a substantial profit immediately or to be in a break-even situation after a relatively short series of simple, automatically performed transactions.

FIGURE 7.1 Two randomly chosen 70-pip ranges on EUR/USD chart. As you can see here, any long position taken at the upper lines of each range or short position open at the lower line of both ranges sooner or later becomes profitable. This is true even if the choice to open a position was made based on a coin toss. After several possible losses and reversals, at least a break even is practically guaran- teed. Try this for your own home research on any charts of major currency pairs.

In the foregoing discussion, I somehow simplified the situation by not considering the probability of draining the trading account because of so many turnovers. I have no intention of suggesting this probability as an option to the readers, but only to use it as a theoretical illustration of the statement of a market’s permanent movement. Opportunities to use the statement in practice will be described in the following chapters of the book.

Now it is time to discuss the third and final basic philosophical postu- late of my method.

The third postulate is as logical and natural for the market as both previ- ous postulates, and it is very important to a trader. It states that, during one trading day (i.e., 24 hours), the market should start and finish a cer-

tain trading range. This range can be simply calculated based on an analy- sis of each currency rate’s behavior on the preceding day even for a rela- tively short period. In other words, for any currency rate, there is the so-called daily operational task to fluctuate with amplitude of a certain value. This minimum to average fluctuation amplitude is not the same for different currency pairs. Also, from time to time, it deviates for the same currency pair, depending upon market activity due to cyclic oscillations. Nevertheless, the intraday fluctuations mean amplitude is more or less stable for each cycle. The duration of each cycle is measured in months, optimally providing the base for the approximate calculations of the mini- mum to average fluctuation amplitude. This calculation allows a trader to conduct an approximate advance forecast for the current day.

The practical use of the three basic postulates of the method will be discussed in subsequent parts and chapters of this book.

After creation of a philosophical basis of the method, formulating the basics strategy and tactics of a speculative trade was an easy job for me. It involves six steps:

1.The fundamental nature of the exchange rates’ fluctuations is not de- nied by the method, but in practice it is not taken into consideration because it does not directly affect the trader’s one and only goal, which is to gain speculative profit on the basis of these fluctuations.

2.The basis of the method is the trader’s reaction to trading signals gen- erated by the market itself. The application of substitute and artificial derivatives such as indicators, oscillators, and other man-made instru- ments is essentially limited in this method. (In reality, for the market analysis, I use only two or three indicators, which have no indepen- dent significance and serve only to confirm basic signals in accor- dance with the principles of my trade methods.)

3.The signal’s identification on a buy and sell is based on a set of market behavioral models. The trade takes place when one of the trading templates corresponds with a current market situation.

4.The templates represent a set of standard variants of a trader’s ac- tions executed in a certain sequence.

5.The basis of all templates used in the method is the estimation of a mar- ket movement probability in one or the other direction. The estimation of probability is made with the use of some rules of technical analysis combined with money management elements in each of the templates.

6.Sometimes there is a possibility of using several different templates in the same specific market situation. In this case, a final choice depends on the trader’s will, his individual desire to undertake an increased risk in exchange for an opportunity to gain an essential profit.

It is clear that the trader’s basic task is to be on the right side of the mar- ket at the right moment. Basically, it is supposed to be his only concern.

My trade method is based on probability evaluation of the market fu- ture behavior, which, as stated earlier, represents a set of templates that are formulated in advance and then tested. The trade does not occur until one of the templates corresponds with a current market situation. If and when a template corresponds with the real market situation, the decision to open or to liquidate a position will be taken by trader almost automati- cally. In addition to some elements taken from technical analysis, I also apply some issues concerning money management. They are an impor- tant part of a trade strategy and serve as the additional insurance in the event that the signal subsequently appears false and the market changes its direction.

Therefore, it is possible to tell that different templates represent combinations of trade signals received on the basis of the technical analysis, estimation of probability of common statistical laws, and money management.

CHAPTER 8

Date: 2015-12-17; view: 1065