Fundamental analysis examines the reasons behind the price action. The analyst uses economic indicators and news flows to decide on the causes behind price movements. Since one cannot determine the cause of something which has not yet happened, the causal relationships demonstrated by fundamental analysis are always about present market behavior. Nonetheless, economic events move slower than market developments, and this is the real cause of the great predictive and interpretative power of fundamental analysis.
Technical analysis is a relatively new phenomenon. It has been developed mostly in the last century, for the most part by US-based traders, for providing some clarity to short term price actions. Fundamental analysis, on the other hand, has been with us for many centuries. The ancient speculator of the Peloponnesian War in Classical Greece used news flow (hearsay, public meetings) and economic data on supply and demand (starvation, poor harvest) for stockpiling resources and for deciding when to sell them. The ancient Chinese classic Shiji, which records the lives and exploits of important personages two millennia before our time, reports on successful traders and speculators who traded wartime shortages, or the needs of warlords for massive profits. Some of these people were middlemen who exploited the inefficiencies of ancient markets, others were producers themselves with good insight into macro-scale developments, and patience allowed them to successfully utilize their analytical capabilities. But all of them used news and analysis to profit from fundamental developments, without any tool other than common sense to help them.
During the Middle Ages there were the Fugger and the Medici families who took advantage of their good relationships with royalty and governments to stay one step ahead of the markets. The Rotschild family of the 18th-19th centuries also used fundamental imbalances created by warfare to undertake contracts with sovereigns states and for maximizing profits. The twentieth century, of course, has had more than its fair share of traders and speculators capitalizing on market distortions, imbalances and bubbles for very large profits. But at the basic level, the tools of the successful investor, trader or speculator are the same: a good understanding of fundamental data, deaf ears to hyperbole, euphoria and panic, and the strength of will to act when the time is right.
Human life and natural phenomena move on causal relationships. Causality is a major principle of scientific study. And, given how our brains function, it is not possible to make any meaningful decision, judgment or choice without backing it with sensible causes. This is also where the power of fundamental analysis originates. The charts of the technical analyst may give all kinds of profit alerts, signals and alarms, but there’s little in the charts that tell us why a group of people make the choices that create the price patterns. Ultimately, most transactions in the financial markets have reasons that are independent of technical values in the long-term. If a stock goes down in response to a temporary bout of panic among traders, the price will rebound once the dust settles; or, if a currency pair plummets in value because of a false rumor or a temporary squeeze of capital, the situation will inevitably be corrected once a stream of concrete data establishes the false nature of the fears.
Fundamental analysis allows us to decide on the value of an asset. We are unable to be certain about the future value of an asset, and past value is never a good indicator for future prices. But, by all means, we posses the faculties and resources necessary for deciding if the price of an asset is expensive or not, and that is the basis on which the fundamental analyst bases his choices. We can establish the causes behind a trend, we can establish if they are ongoing, and we can exploit that knowledge to bring us profits.
There are many traders who successfully used fundamental analysis to obtain great wealth, but the exploits of George Soros, and his Quantum Hedge Fund have made them household names in our era, particularly after the notorious Black Wednesday on which Britain was forced to drop out of the European exchange rate mechanism. In the rest of this article we will examine this interesting event to drive home the great power of fundamental analysis and how accurate and profitable its predictions can be.
Most traders today know that the British pound is not a part of the Eurosystem. It is an independent currency managed by its own central bank. While some may attribute this fact to the insular mentality of the British and their typical desire for independence from continental customs and habits, this is not the real cause of the existence of the pound today. The real reasons are to be found in the developments of September 16th 1992, and the events leading up to them.
Before it was launched, the nations which today share the Euro as their national currency had to abide by an agreement known as the European Exchange rate mechanism (ERM) which was the precursor to the eventual unification of currencies. The ERM stipulated a fixed currency exchange rate between each national currency and the ECU (the European currency unit, which would eventually be called the Euro), but bilateral currency values were allowed to float within a margin of 2.25 of the the fixed rate. The ERM was created in 1979, and Britain was one of the later members of the EU to join the mechanism in 1990.
At the time Britain joined, the government of Margaret Thatcher was lost in intrigues and disputes about the benefits and the need for ERM. With inflation at 15 percent, to restrain the expansionism of the previous era, the British government had for a while been mirroring the Bundesbank’s policy rates. The decision to join was partly taken to formalize this policy of copying the central bank rates of Western Germany, and also as a result of an argument between the chancellor of the exchequer (the equivalent of the Treasury secretary), Nigel Lawson and the prime minister’s economic advisor, which resulted in the resignation of Lawson. He was replaced by the future prime minister John Major, who in turn finalized the entry of Britain into the ERM in 1990 at a rate of 2.95DM to the pound, with commitment to intervene at 2.778.
As we just mentioned, at the time of Britain’s entry inflation was quite high, due to the expansionist policies of Nigel Lawson. The easy money policy had created a period of boom at the end of the 80’s, but it had also created a property bubble and high inflation which had to be restrained by higher interest rates and a period of economic downturn. Thus, when the crisis struck two years after UK’s adoption of the ERM, economic conditions were already far from being ideal. Unfortunately for the British, this was also a time when German interest rates were even higher than the British rates, as the Bundesbank tried to control the inflationary impact of reunification-related spending.
Mr. Soros, who enters the scene at about this point, had established his Quantum Fund in the early 1970s in partnership with the equally famous Jim Rogers, his initial capital being provided by a number of wealthy acquaintances including the aforementioned Rotschild family. Before his rise to notoriety through his role in the British debacle, he had already made massive profits in trading the collapse of currency pegs and economic deregulation of the 70s. He and his analysts had impressive skills in analyzing the fundamental factors that drive the international economy. Indeed, apart from being a rich financier, Mr. Soros has books published on philosophy and politics, and he is equally well-known as a philanthropist and for his contributions to liberal movements around the world.
Upon analyzing the fundamental situation of the British economy and the increasing gap between the performance of the British and German economies at the time of Britain’s adoption of the ERM, Mr. Soros was increasingly convinced that the British would drop out of the system regardless of the choices they made. The fundamental health of the UK economy was incapable of coping with the demands of matching Germany at the time. Thus, he began shorting the pound as early as spring 1992, in anticipation that high interest rates would eventually deepen the recession in the UK economy, and the resulting fall of asset prices would prove unpalatable to the government authorities. It is thought that he accumulated short positions reaching 6.5 billion pounds (about 10 billion USD), at a leverage of 1:10.
Meanwhile, the situation of Britain continued to deteriorate as the USD kept depreciating, making British exports less competitive on a global basis. The breaking point came, as it often happens, through political turmoil. When in spring 1992 the Danes refused to join the ERM, and it was decided that France would have a referendum on the issue as well, the resulting nervous atmosphere reached climax in a general distrust of the currency pegs of nations that were suffering the worst of the ERM.
On Wednesday, 16th September 1992, as speculators kept selling the pound, the British cabinet held meeting after meeting on how to defend the nation’s currency. They first raised the main rate to 10, then to 12, eventually promised to raise to 15 percent in order to convince the speculators that they were facing the full determination and might of the UK government. The government also bought billions of pounds to prop up the currency, but all that was in vain. Heedless monetary expansionism of the Lawson Boom had created massive imbalances in the British financial system, and the British economy would never be able to function under such a high interest rate burden. Speculators like George Soros had already made their calculations and had discovered the untenable nature of the British peg a long time ago through fundamental analysis, and they would not be cowed into submission by the frantic, but ultimately futile endeavors of the John Major Government.
By 19:00 it was already clear that the peg couldn’t be defended, and the Chancellor of the Exchequer had to declare that the government would leave the ERM framework, and the main interest rate would remain at 12 percent. The credibility of the British government was destroyed in a few hours, the speculators left for new hunts, and George Soros pocketed an estimated 1 billion USD in the process. As the person who took the largest bet, he was instantly notorious across the globe, and to this day he’s known as "the man who broke the Bank of England".
Later, it was also admitted that the 15 percent promise was just a ruse created to calm the markets, and as many speculators believed, the government had no intention of holding the rates at such a high level given the difficulties the British economy were going through.
It is an exciting story, but the sensational value of the events has no use for our trading practices. What are the lessons that we gain from this disaster for the UK economy?
- Fundamental analysis is always right. Imbalances will always be corrected. But it takes time and patience to exploit them successfully. Mr. Soros held his position for months before market developments confirmed his expectations.
- Neither government authorities, nor company heads are immune to the temptation of lying, or “bluffing” as it’s sometimes called. If you’re a speculator, nobody will have any sympathy for you if you lose money, and the only person you can blame is yourself. So be careful about your leverage, your risk and who you believe.
- Macroeconomic events are often triggered by political developments. Political events rarely cause major economic shocks by themselves alone, but accumulated imbalances are usually balanced as a result of political shocks.
- The payback time of expansion fueled by monetary expansionism is exceptionally destructive in any economy. If the economic leadership of a nation is constrained by political obstacles when the payback time arrives, the results are doubly disastrous.
If you intend to use fundamental analysis in the way George Soros used it, you will need a good understanding of both politics and economics. Achieving such a skill is not that hard, provided you have the commitment and the patience to complete your task.
Technical strategies aim to predict future prices on the basis of past developments. All that the technical analyst is interested in is the price, and news, or data have no bearing on his decisions. In this article we will examine some of the basic concepts behind technical strategies, and will attempt to summarize the main tools used by technical traders in braking down price patterns.
As we noted technical analysis chooses to ignore everything except the price in its decisions. A technical strategy will usually involve several phases, each clarifying some aspect of the price action, until a credible entry or exit point is determined. The phases for this are.
1. Identify the type of the market and the type of the trade..
Needless to say, the first step in technical analysis must be the identification of the market with which the trader is interacting. After that he must determine the time period of the trade he will enter. What kind of charts will the trader use for his trade? Will it be a monthly trade, or an hourly one? If it’s a monthly trade, there’s no need to worry about the hourly changes in the price, provided that the strategy regards the present value as an acceptable monthly entry or exit point. Conversely, if the trade is for the short term, the trader may desire to examine charts of longer periods to gain an understanding of the bigger picture which may guide him with respect to his stop loss or take profit orders.
The trader will use trend lines, oscillators, and visual identification to determine the type of market that the price action is presenting. Strategies in a flat, ranging, or trending market are bound to contrast strongly with each other, and it is not possible to identify a useful strategy without first filtering the tools on the basis of the market’s character. Once this is done, and the time frame of the trade is determined, the second stage is -
2. Picking the technical tools
On the basis of the criteria discussed in the previous item, we must pick the appropriate technical tools for the chart we examine. If the market is trending, there’s little point to using the RSI. If it’s ranging, the moving averages are unlikely to be of much use. If the underlying currency pair is strongly cyclical (for example, if the currency is issued by a commodity exporting nation) the commodity channel index could be a good choice. If it is highly volatile, smoothing out the fluctuations with moving average crossovers could be very beneficial for identifying the trend.
Of course the list can be extended. The trader must refine his approach to trade over time by deciding on the kind of indicators which he understands best, and then combining them later to form a simple and concise method.
3. Refine the periods, and other inputs
Upon deciding on the technical tools, the analyst must decide on the periods, and ranges for which values must be supplied to the software. Today’s traders have many advantages over those in the past, but diligence and patience may not be one of those. As we’re so used to having everything automated and performed by the computer with no questions asked, many don’t even bother to tinker with the minutiae that can in fact be all the difference between success and failure for the trader’s analysis.
Thus, before going any further, the trader must check which periods, which values provide the pattern that is most fitting for the price action on the chart. For example, for the RSI, will we pick a period of 14, 10, or 7 for the chart we examine? Or what will be the periods of the moving averages that constitute the MACD indicator? These can only be answered through trial and error, and for each price pattern, a different value may be necessary.
4. Seek the signals
Once the technical tools are setup, we must now seek the signals that will show us the trade opportunities created by investor sentiment and temporary imbalances in the supply and demand for a currency pair. The signals that we seek are the ones created by the interaction between a number of indicators, such as that between moving averages, various oscillators, or between the price and the indicator. Our purpose is to confirm our ideas with various aspects of technical analysis. If there’s an oversold or overbough level, we will confirm it with a divergence/convergence. If there’s a breakout, we will seek to ascertain it with studies of crossovers.
We will examine the signals in greater detail a bit later, but in summary they are channels, crossovers, divergence or convergences, breakouts, consolidation patterns, the various price patterns like triangles, flags, and head and shoulders. We will keep our indicators simple, but we will make sure that the signals generated by them are examined and exploited to the full, allowing us to draw a complete picture of the price action.
5. Perform the analysis
After deciding on the signals and their meaning, we will perform our analysis by identifying actionable signals, and deciding on capital allocation in light of proper money management techniques. When analyzing the data we must make our utmost exertion to ensure that we focus on signals relevant to our selected period and trading plan. This stage of analysis will involve the separation of wheat from chaff, and data from noise.
6. Compare the results, execute the trade
After examining the various scenarios presented by the charts, and determining on which of them are actionable, the trader will compare them in terms of credibility and profit potential (for example, how extreme are the indicator values, how much profit or loss will be generated in case a take- profit or stop-loss order is realized?) Once that is done, he will pick the trade that offers the highest returns with the lowest risk on the basis of the technical scenario that is the most contrarian.
What the above implies is that, when a trend follower trades, he will wait for the corrections, acting on a contrarian basis to the short term movement, while conforming to the main trend. When he desires to bet against the trend, he will await the most extreme valuations generated by the trend, and when the momentum is highest, he will make a contrarian bet at the first credible reversal.
/////////////////////////
A forex trading strategy is created by using many different types of price phenomena that are manifested on many different kinds of indicators. We will examine strategies later, but at this stage let us examine the signal types that are used to create them.
1. Channels
Channels are two parallel trend lines that constrain the price action in opposite directions. The upper line prevents bullish breakouts, while the lower line checks the bearish ones. A channel is a very regular formation, and offers great potential for realizing a profitable trade, but it’s also relatively rare.
Channels are used to generate signals that help us identify breakout points. If the indicator used to analyze the channel stayed above or below a certain level for a long period of time, a breakout can be confirmed by excessive values. But given how regular and controlled the price movement must be while inside a channel, the trader can devise many other ways of trading it, and some of his methods can be based on fundamental analysis too.
The existence of a channel will allow the trader to use other tools, such as overbought, oversold indicators, to generate additional signals. A channel also signals that market participants are expecting a major development to decide the direction of the trend, and that the trader must be alert about potential 
2. Crossovers
Crossovers occur when one indicator’s value suddenly rises or falls below that of another one which is used as a signal line. Crossovers signal momentum change in the market, and are often used to generate trade signals that are more reliable than those indicated by single indicators.
In the hourly chart of AUD/USD we see the 14-day moving average shown by the yellow line falling below the 100- day moving average shown by red, and we notice that the price later made a major move in the same direction. Crossovers are not limited to one type of indicator, and of course, the trader can use them in many different situations for analyzing price patterns.
The disadvantage with crossovers is born of the fact that they’re fairly common, and thus prone to generate conflicting and false signals. Unless confirmed by other, more reliable phenomena like divergence/convergence, the trader should be cautious about regarding the crossover as an actionable signal. 
3. Breakthroughs, breakouts
This signal is generated when a range or a consolidation pattern breaks down, allowing the price to move violently and rapidly in the direction of the breakout. Potential breakouts are identified first by direct visual examination (for instance, an uptrend is fluctuating around a price level for a prolonged period ), and then confirmed by the behavior of indicators (a very calm MACD registering strong values, or an moving average crossover).
A consolidation occurs when a trend fluctuates around a value for a relatively long period without jeopardizing its strength. A breakout is when a range pattern breaks down, and the price action is no longer constrained. A breakthrough is the situation where a previously strong resistance level is breached by an ongoing trend.
Consolidation, breakout and breakthrough may all occur on the price chart, or on the indicators themselves. The interpretation will differ depending on the significance of the levels breached (for example, the price breaking through a multi-year resistance line is more important than the RSI reaching a previously unbreached level.)
False breakouts are relatively common in the markets, and many traders try to avoid them by getting into the trade when the breakout is going through its correction phase. Deciding on the nature of a breakout will of course depend on probability analysis. Experience, and proper money management methods are our best friends.
4. Divergence/convergence
The tendency of all indicators to create false signals is well-known among technical traders, and to overcome this problem, traders have been looking at divergences between indicators, or between an indicator and the price for quite some time. Convergence occurs when successive values of two indicators are closer to each other with the passage of time. Divergence occurs when the values are farther apart as time passes. In both cases, the principle behind convergence/divergence dictates that the indicators make movements in opposing directions, and the phenomenon is used to signal that the ongoing trend is getting weaker.
In the above example of AUD/USD, we see that the MACD is making lower values even as the price keeps getting higher. In other words, the price action is not only comfirmed, but contradicted by the indicator. Traders seek these signals to decide on opportunities that offer a greater risk-reward potential. 
5. Price patterns
Price patterns, such as triangles, head and shoulders, pennants, flags can all be used to identify a potential trade, or at least be used to signify an emerging opportunity. These patterns all have different ways of being interpreted, but the seasoned analyst is unlikely to move on any of them without receiving a confirmation from a secondary source, such as an indicator. We will examine the patterns in detail later.
Conclusion
Technical strategies are created by the combination of the above signals and patterns. It is a good idea to combine signals of indicators with price patterns to receive more reliable indications on a potential trade. For example, an MACD crossover after a major counter-trend move can be much more reliable as a trade signal than any value of the MACD, however extreme it may be. In a major triangle movement, a divergence or convergence between the RSI and the price can be far more reliable than the extremes registered on the indicator.
In short, instead of absolute values, the technical analyst will choose to focus on the rarer phenomena which we just discussed. In following chapters of this section, we will discuss technical strategies in greater detail.
Trend following is perhaps the most popular long-term strategy in all financial markets. It is exceedingly effective and profitable when the conditions are favorable, is quite straightforward in its methodology, and there are many individuals, past and present, famous or obscure, who have used this strategy to success and riches. We should note that the technical aspect of trend following is in fact quite simple, but also that it requires, before everything else, discipline, sound money management, and patience from the trader. Trend following is not a short-term method, and patience and determination are as important as correct analysis as a result.
Trends are created by powerful underlying economic factors which may not be all that clear to those who are not very familiar with fundamental analysis. But the simple patterns created by the price action in response to the economic events can often be identified through methods that are easy to learn and apply. Thus, the retail trader has as much potential of success as the most experienced analyst if he can control his emotions and behave logically.
To apply this strategy we must first be aware of the existence of a trend. Without identifying a trend we would be gambling, and that’s not the purpose of trading forex. Both fundamental and technical analysis can be employed for identifying a trend, and both of them have their advantages and drawbacks. It is in general a good idea to use a combination of them for deciding on the trend’s character, and deciding on our entry and exit points.
From here, let us use the dialogue between the successful trader and the beginner in order to explain the principles in an easier way.
B: I want to use the trend following method. How do I do it?
ST: You must first choose whether you want to employ technical or fundamental analysis for your method, or a combination of both.
B: Is there a difference between these methods?
ST: Yes. Fundamental analysis can provide you with information which can predict the strength and length of a trend., while technical analysis can show you how it develops. It is possible to base your strategy on one of these to the exclusion of the other, and it is still possible to turn a profit if you are lucky enough, but our principle has always been to reduce the role of luck to as little as possible. Fundamental analysis is more reliable than technical analysis in defining a trend that has long term potential, but without technical analysis it would be extremely difficult to decide when or how to trade. Technical analysis can suggest the beginning of a trend, but it’s unlikely to tell much about the length or strength of the same. Thus, I suggest that you use both technical and fundamental methods for your trend following strategy, with fundamental factors eliminating the false signals of technical analysis, and technical tools providing you with a time-price frame for deciding on entry points.
B: How do I decide on the existence of a trend?
ST: There are many technical tools that can signal the phenomenon, but there are an equal number of false signals generated by them. Remember that there are only three kinds of trends that can exist at any time: flat, up or down, and it is possible to speak of trends between any two points on a price chart. Simply take two random points on a chart, draw a moving average on it, and the pattern that arises can be analyzed as a trend. Thus it is always necessary to have at least a basic of understanding of the economic factors that can create trends, before deciding on the validity of a chart pattern.
B: And how do I do that?
ST: Familiarize yourself with the big picture; understand what drives market participants; recognize the stage of the business cycle.
B: What kind of price pattern will create a trend?
ST: The trend that we seek to trade is different from random fluctuations, range patterns and similar price movements in that the price itself, in the absence of any technical indicator, can still be recognized as showing a trend. In other words, there is some driving conviction behind the price action which allows the trader to easily identify it visually. Depending on the type of the trend (that is, an up- or downtrend), successive highs and lows should constitute a rising or falling pattern, with relatively few irregularities. But such a case is often a rarity, and the trader will have to back his technical patterns with conviction that can perhaps only be gained through fundamental analysis.
B: If the trend can be identified visually, why use technical tools?
ST: Even though we can notice the existence of a trend, we still need technical tools to trade it, and time it.
B: So will you try time the market? I’m told that never works.
ST: Market timing never works when one is trying to predict reversal points on a technical basis. However market timing in the context of a trend, with the purpose of picking the counter-trend extremes, and using them to enter a trade, is necessary and profitable. And there lies the main principle of a trend following strategy: recognize the trend, identify counter-trend moves, and use them to enter a trade in the direction of the trend.
B: In a sense, then, you’re behaving as a contrarian of short scale moves, and the follower of the long-term trend
ST: Yes. Indeed, there lies the soul and spirit of all trading. To utilize short-term irrational behaviors of the market in order to enter into long-term positions in positive alignment with fundamentals (or, sometimes just the trend), is the core of all successful trading.
B: How long should the trend follower maintain his position?
ST: Forever, or to be exact, for as long as the fundamental reasons that back the trend are dominant. If the trader cannot identify those reasons, if he’s unwilling to do so, or if he doesn’t believe, for some unfathomable reason, that they are useful, he can use technical patterns to time his exit point. Even if the trader is aware of the fundamental factors, and is able to evaluate them correctly, technical analysis can still provide him with a very useful early warning system. If the price action is suggesting strongly that there’s some error in the trader’s fundamental outlook, he can use the technical signals as an occasion to reevaluate and reexamine his fundamental picture.
B: How do I time my trade with technical analysis?
ST: The best tools for trend following are supplied by moving averages and simple price charts. Bar charts, candlesticks and many others can be equally useful if employed with moving averages. For example, between October 2007 and April-May 2008, the price action of USD/SGD always remained below the 100-day moving average. When the pattern broke down, in June of the same year, the trend had also broken down, and the price went on to break the 200-day average, and a medium-term upward trend was established. It is also possible to use moving average crossovers, and myriad other methods, but whichever you choose to use, you should ensure that you do not complicate the main aspect of your strategy, which is trend following.
B: Which time frame do you recommend for the moving average?
ST: If you want to trade on a weekly or daily basis, the 100-day MA will probably be able to capture most of the important trends for you. Anything with a longer period is likely to be meaningless because of too much data discarded , and any time frame that is too much below the 100-day period may be too sensitive to price action. But as usual, one can use other timeframes below 100, provided that he doesn’t clutter his screen with lots of indicators, charts, tools.
B: When trend following, where should I place my stop-losses and take profit orders?
ST: This partly depends on the term and nature of your trend following method. A stop-loss order can be placed a short distance above or below the trend line, whether it is provided by the moving average, or a simple line drawn on the chart. In our opinion, the trend follower should not realize his profits until he has a good reason to do so. The purpose of this strategy is to focus on underlying price dynamics by stripping out volatility and short term movements, and there is little logic to realizing profits in response to fluctuations which are irrelevant to the main action of the trend.
B: But I still have to take profit at some point. Where should I do that?
ST: Go as far as the trend goes, then stop. There you can take profits.
B: How do I know how far it goes?
ST: As we just explained, you can use the MAs to decide on that, but it’s far better to identify the fundamental causes behind a trend, and then to exit the trade once those causes are eliminated.
To sum it up, we can repeat that trend following is the easiest and most straightforward way of making money in the forex market. But successful trading requires the foresight provided by analysis and the patience that only comes with confidence. Those of us who prefer quick profits and instant ratification will find the method uninspiring, but it is reliable and will work wonders if you give it the chance.
That high leverage is dangerous is well-known to most people, but it is not unusual to make spectacular profits with a highly leveraged account, just as it is not unusual to throw three heads in a row during a coin-tossing competition. The sad fact is that even those spectacular profits are highly likely to be wiped out if the trader continues to make bets utilizing high leverage, as we examined in the previous articles on gambling strategies in forex. The inability of the trader to get rid of high leverage after a bout of successful trades is related to a concept called the “gambler’s conceit”. The gambler’s conceit is not caused by high leverage only, but we will limit our discussion of this subject to high leverage since it’s so common among traders.
Many of us have that genie beside our ears who whispers to us all the time that risking too much is not a problem because we are wise enough to exit a risky bet while still running profits. High leverage may be wrong, undercapitalization may be dangerous, but our trades have so far been profitable, and as soon as the profits diminish or losses are being registered, we will close our positions, and exit the game, be it gambling with cards or gambling with forex.
It's very convincing. After all, why would one want to risk losing the profits of such a risky practice as high leverage? What is the point of continuing to practice a losing strategy even after your profits have been halved by a string of losses?
Many beginning traders who make a lot of money randomly in the forex market in a short period of time are convinced that it is their method, style, attitude that makes those large profits possible. On the other hand, the experience and knowledge possessed by a trader at the start of his career is insufficient for practicing self-control or employing money management methods successfully. Thus, in many cases (but not always), the doubling, or tripling of the account of a new trader is just a chance event, regardless of the rationalizations which the trader uses to explain his situation. What is more, even in the case of a highly successful, highly disciplined trader, the occasional very large profits are not at all a sign of increased efficiency or better understanding: There’s nothing extraordinary about the occasional extremes in a trader’s career. Instead of emphasizing them too much, and thinking about what he did right or wrong to deserve such large profits or losses, the seasoned trader will evaluate them for what they are: statistical anomalies on which neither a career, nor a trading strategy can be based.
The Gambler’s conceit prevents such a rational explanation. Instead of understanding the gains after highly-leveraged bets as random developments, the trader ties these results to his own exceptional luck, skill, or insight in evaluating the market action, or to his superior trading strategy, and convinces himself that he will be able to terminate his trading activity due to his controlling power over his trading results. With such false confidence, when the inevitable large losses occur he will ponder on what went wrong with his trade, which indicator, which scheme he needs to revise and refine, instead of accepting and understanding that gains on highly leveraged bets are illusory, and unlikely to remain with him permanently. When a peer confronts him about the unusually high leverage of his trades, and his irrational expectation that he can keep profiting with such high risks, he will protest by mentioning his past successes.
In fact, gains on a highly leveraged account have the potential to be even more destructive than losses. Losses will teach the trader to be humble, and will lead him to revise his methods. Gains, on the other hand, will addict him to his errors. Sadly, such an addiction can only be broken by the pain of a totally wiped-out account sometimes. Fortunately for you, we’re here to warn you about the dangers associated with this risky practice.
The best remedy of the gambler’s conceit is avoidance of the addiction entirely. Instead of consoling yourself that you will give up the practice once the profits are gone, convince yourself to never begin the unhealthy game. Do not aim at exceptional results; aim at consistency. But if you find that you’re already deep into the game of high leverage and risky practices, our advise to you is to cut it off right now, without waiting for the losses to show up. Just close the chapter, quit trading for a while, and a few weeks later, or maybe a month, restart your career by practicing sane and sensible strategies this time. Not only will you find intellectual satisfaction at having overcome a dangerous addiction, you will also have a profitable path before yourself as you improve your skills, recognize your errors.
To repeat, brief periods of enormous profits is never the purpose of a successful trader. Such periods are always temporary, and the false confidence that becomes instilled your psyche is often destructive to your career as a trader: aim at consistent profits, do not aim at high very high profits.
I
f money management is one half-of trading, determination of entry/exit points constitutes the other half. No amount of successful analysis will be useful if we can't determine good trigger points for our trades. Even if we know that the value of a currency pair will appreciate in the future, unless we have a clear conception of when that appreciation will occur, and where it will end, our knowledge is unlikely to bring us great profits. Similarly, even in the unfortunate situation where the analysis that justified the opening of a position is false, mastery of trade timing might allow us to register positive returns due to the high volatility in the forex market. Clearly, we need powerful strategies to help us calculate the best trigger values for a trade justified by careful and patient analysis.
We have discussed the various ways of creating stop-loss orders on this website, and in this article we'll continue on that theme by handling this subject in a more general way by identifying some principles for the management of our positions. The opening and closing of a position are the most frequent activities of any trader; it is obvious that this should also be the subject to which we devote the greatest attention. However, as in the case of a doctor or an engineer, the final task that is performed routinely and most frequently depends on certain skills, education and study which for the most part lack any obvious relationship to it. Thus, it is important to note that the study of trade timing is one of the final lessons for which the trader must prepare himself. The other courses that would lead us to this subject, such as technical and fundamental analysis, may not always have clearly definable benefits at first sight, but they pave the way to our ultimate goal of timing our trades successfully and profiting from them.
Before going into the technical aspects that complicate our trading decisions, we must say a few words on the necessity of emotional control in ensuring a successful and meaningful trading process. Let's repeat again, as we've done many times on this site, that without proper control over our feelings not a single word in this text would help us to trade profitably. The psychological endurance necessary for achieving a successful trading career is an important precursor to both money management and trade timing. Consequently, even before beginning the study of trade timing, we must concentrate our energies toward the goal of understanding and restraining our emotions, and gaining control over the psychological aspects of decision-making in a trading career. The Main Principle of Trade Timing
The first principle of trade timing is that it’s impossible to be certain about both the price and the technical pattern at the same time. The trader can base his timing on the actualization of a technical formation, or he can base it on a price level, and he can ensure that his trade is only executed when either of these events occur, but he cannot formulate a strategy where his trade will be executed when both of these occur at the same time. Of course it is possible that by chance a predefined price level is reached precisely at the time that the desired technical pattern occurs, but this is rare, and unpredictable.
Supposing that the trader is desiring to buy one lot of the EURUSD pair, he has the option of basing his entry point on the realization of a technical pattern, or the reaching of a price. For example, he may decide that he’ll buy the pair when the RSI indicator is at an oversold level. Or he may decide, for money management purposes, that he’ll buy it at 1.35, to reduce his risk. Similarly, he may choose to place his stop-loss order at the price point where the RSI reaches 50, or he may choose to enter an absolute stop-loss order at 1.345, to cut losses short. But due to the unpredictability of the price action it is not possible to define an RSI level, and a price level at the same time for the same trade.
We may examine this further on a chart.
This is an hourly chart of the GBPUSD pair between 5 December 2008 and 5 January 2009. We’re supposing that we opened a long position at around 1.5, where the RSI registered an extreme value at 24. In this case we expect to close our position when the value of the indicator rises above 50, to acquire healthy profits while not risking too much by staying in the market for long. We could have alternatively placed a real stop-loss order at 1.48, for example, but we decide not to do so because of the high volatility in the market. However we do expect that if the RSI rises, we will not need a stop-loss order, because the price would have been at a higher level indicating a profit, since it’s supposed to rise with a rising price.
But such is not the case, as we can see in the picture above. When the RSI had risen to 49.35 on the chart, which is a close enough point for our goal on the indicator, our position is, surprisingly, in the red. Not only do we fail to match our stop-loss to a lower price, but we actually match a lower price with our take profit point, which was 50 as mentioned. To put it shortly, the indicator converged on the price action, contrary to our expectation that it would move in parallel.
How to time our trades: Layered trade orders
What are the lessons derived from this example? First, the correspondence between technical values and actual prices is weak. And as we stated in the beginning, it’s not possible to base our trade timing on a price and an indicator at the same time. Second, technical indicators have a tendency to surprise, and how much a trader relies on them will depend on both his risk tolerance and trading preferences. Lastly, technical divergences, while useful as indicators, can also be dangerous when they occur at the time when we are willing to realize a profit.
So what is the use of technical analysis in timing our trades? Most importantly, how are we going to ensure that we don’t suffer great losses when divergences on the indicators appear and invalidate our strategy, and blur our power of foresight?
The potential of the divergence/convergence phenomenon for creating entry points has been examined extensively by the trader community, but its tendency to complicate the exit point has not received much attention. But it is just one of the many aspects of trade timing that is complicated by the unexpected inconsistencies which appear between price and everything else. So if we had the choice, we would prefer to exclude price from all the calculations made in order to reduce the degree of uncertainty and chaos from our trades. Unfortunately that is not possible, as price is the only determinant of profit and loss in our trades.
In trade timing, the trader has to take some risk. The best way of taking the risk and avoiding excessive losses is using a layered defense line, so to speak, against market fluctuations and adverse movements and we discussed how to do this in our article on stop loss orders. The best way of taking the risk and maximizing our profits is the subject of entry timing, and the best way of doing so is using an attack line that is also layered. What do we mean by that?
In ancient warfare, it was well-understood that the commander must keep some of his forces fresh and uncommitted to exploit the opportunities and crises that arise during the course of a battle. For instance, if the commander had run out of cavalry reserves when the enemy launched a major charge against one of his flanks, he might have found himself in an extremely unpleasant situation. Similarly, if he had no rested and ready troops to mount a charge at the time his opponent demonstrated signs of exhaustion, a major opportunity would have been lost.
The layered attack technique of the trader aims to utilize the same principle with the purpose of not running out of capital at the crucial moment. In essence we want to make sure that we commit our assets (that is our capital) in a layered, gradual manner for the dual purpose of eliminating the problems caused by faulty timing, and also outlasting the periods associated with greatest volatility. By opening a position with only a small portion of our capital, we ensure that the initial risk taken is small. By adding to it gradually, we make sure that our rising profits are riding a trend that has the potential to last long. Finally, by committing our capital when the trend shows signs of weakness, we build up our own confidence, while controlling our risk properly by placing our stop-loss orders on a price level that may bring profits instead of losses.
To sum it up, the golden rule of trade timing is to keep it small, and to avoid timing by entering a position gradually. Since it is not possible to know anything about the markets with certainty, we will seek to have our scenario confirmed by market action through gradual, small positions that are built up in time. This scheme will eliminate the complicated issues associated with trade timing, while allowing us great comfort while entering and exiting trades.
Of course, there are cases where the risk/reward ratio is so positive that there is no great necessity for gradual entries. In such cases, the exact price where the position is opened is not very important. So we will not be discussing such situations in this article.
Conclusion
In surveys on what traders find most difficult about trading, timing often comes up as the top issue. Since timing is the only variable that directly influences the profit or loss of a position, the emotional intensity of the decision is great. While it is expected that every successful trader will achieve a degree of emotional control and confidence, the pressures of trade timing are often so severe for many beginners that the process that leads to a calm and patient attitude to trading never has a chance to develop.
To avoid this problem, the role of trade timing must be minimized, at least at the beginning of a trader’s career. And this can only be achieved if the size of the position is built up along with the trader’s confidence in it, and stop-loss orders are created where the closing of the position may result in gains, albeit small. All these factors lead us to consider the gradual method to the best one for trade timing, while minimizing our risk.
