RISK ANALYSIS.TECHNICAL ANALYSIS.FUNDAMENTAL ANALYSIS

forex trading

258
cfd trading

The factors influencing the market prices are covered in the fundamental analysis section of our website.

Risk management depends very much on the types of assets the trader is interested in. In this text we would like to discuss the tools that can be used in order to minimise potential losses resulting from adverse price changes.

Study the different types of assets

Depending on the type of asset you are interested in, there may be more or less volatility related. The higher the volatility, the higher the financial risk associated with the given market.

This means that operating on a such market involves potentially higher profits and losses than in the case of markets with lower volatility. There are markets where there is not much movement, while others change very often and the price changes may be quite significant.

Plan your risk management strategy.

The strategy shall define the key aspects of the trades, including their time horizon. There are assets where it is difficult to trade in the short term, as the cost of transaction is relatively high in relation to the size of typical price movements.

However, it is still possible to consider such markets for the purposes of investment in the longer term. On the other hand, assets that change very often could provide a good possibility for transactions in the short and ultra short term.

Establish the maximum acceptable risk for an investment or trade

It may be a good idea to establish a maximum amount of money that your are willing to risk in any given transaction. Such an amount can be defined as a percentage of the available capital.

Considering an example where the trader is willing to risk no more than 3% of the portfolio, 3% of that amount would mean that the investor is willing to “risk” no more than $3 USD on any given trade, out of a 100 USD account.

The limit calculated as shown above, or using any other method, can be taken into account when considering where to set the stop loss or close the transaction by any other means. In order to do that, one should also consider a value of a pip.

Assuming that for a specific asset the pip value is equal to $1 USD, and the acceptable risk is $3 USD, then a trader may consider placing a stop-loss with a value of 3/1 = 3 pips from the level where the transaction was opened.

Make use of all the different orders available on the MetaTrader 5 platform

  • Stop-loss

Stop-loss orders are additional orders available for both pending orders and market orders. They can also be attached to already opened positions on a given market. These types of orders are the most basic orders designated for limiting the potential losses, for example when an investor is not able to follow prices all the time.

A trader establishes stop-loss levels by either specifying the level in points from the current price or by specifying an exact price level. For long positions, the stop-loss value must be lower than the current price.

For short positions, the stop-loss value must be higher than the current price.

  • Take-profit

Take profit is an additional order available for both pending orders and market orders. They can also be attached to already opened positions on a given market. The difference between this order and the stop-loss order is that in the take-profit order, a trader will fix the exact profit he wants to realise.

Sometimes, investors are not actually sure how much a price will continue its direction, so they fix a value for which a profit is guaranteed if the price reaches that level. For long positions, the take-profit level must be above the current price.

For short positions, the take-profit level must be lower than the current price.

Technical analysis is the process of studying the evolution of securities, in a quest to determine the probable future rates.

The specialists in technical analysIs start from the principle that the forces of demand and offer are reflected in the prices and volumes of traded securities.

The technical analysis does not offer certitude to what concerns futures, but it can help by predicting possible trend changes.

The information that lay at the basis of technical analysis are represented in a real-time graph, which is interpreted with the purpose of determining when to buy and when to sell securities.

At the basis of technical analysis lay 3 large principles

  • Price reflects reality

This principle refers to the fact that all fundamental aspects of securities influence their demand and offer and thus they are included in the price.

  • Price moves depending on trends

The price of securities shall keep for a certain period its increase of decrease trend.

It is highly unlikely that the investors’ trust moves quickly from trust to mistrust.

Thus, if the price of securities starts to increase, this trend shall be kept for a period of time.

The identification on time of a trend is a very important key for a successful investment.

  • History repeats itself

The technical analysis of securities reveals immediately the repetitive character of the evolution of its price. We can make an analogy with the cycles of economy.

We shall always have a succession of economic growth and negative ones as well (this is the correct term. It is used “negative economic growth” and not “economic decline”). After many years of technical analysis, the ones who dedicated to study this area have identified some patterns for the prices on the financial market.

The most known ones are implemented in our trading platform and can be easily used.

Price evolution charts

Line and bar charts are the most popular type of charts used, with line charts providing a quick overlook and bar charts – optimum amount of information.

There are different types of charts used in a technical analysis which represent price movements over a given period. Which type of chart to use is a matter of preference by the investor. The most popular are line charts – most often used in the media to represent average price movements.

Next are bar charts and Japanese candles (also known as candlestick charts) – both preferred by investors and traders around the world due to their versatility and the

  • Line charts

Line charts are the preferred charts used by the media, because of their simplicity.

They display the price (usually average or closing price) of assets (e.g. Commodities or currencies) during a predefined period, e.g. 3 months.

They are helpful for a quick overlook of the medium/long-term trend of an asset.

  • Bar charts

Bar charts, or sometimes called OHLC, are graphical representations of price levels during a certain time.

They are portrayed by one vertical bar and two horizontal notches on each side of the bar, where the vertical bar represents a price movement in a time unit (e.g. 1, 5, 10 minutes).

When the time unit starts, the “Open” level/price is established and a horizontal notch is displayed on the left side of the vertical bar. The “Closing” level/price is set up the same way (but on the right hand side of the bar) and can be higher or lower than the “Open” price.

During the mentioned period both “High” and “Low” prices are displayed and they account for the length of the vertical bar, where the “Low” is the lowest part of the bar (lowest price level in that time unit) and the “High” is the highest level of the bar (Highest price level in that time unit).

  • Candlestick charts

Candlestick charts are popular amongst traders, as they deliver a quick insight into the situation on a market – maximum amount of information in a clear way.

Candlestick charts began their history in Japan, and are probably one of the oldest types of charts, but at the same time one of the most popular. They are somewhat similar to bar charts, however colours differentiate a price increase from a price decrease.

As with a bar chart, candles have one major vertical bar, representing a time unit (e.g. 1, 5, 10 minutes), but instead of having notches on the right and left hand sides, there is a body for which the inside colour depends on a price change. Its increase usually is represented by the colour white or blue, when its decrease is represented by the colours black or red.

Candlestick shadows or wicks represent the lower and maximum price level for a specified time unit, and are thinner than the body. Therefore, candles stress out how a close price relates to an open price.

Trends

Trends can be analyzed from the point of view of period they refer to.

We can analyze:

  • Short-term trends
  • Medium-term trends
  • Long-term trends

It is very important when analyzing a trend, to take into consideration a relevant period of time for the investments that we are used to do or we set to do.

If you are accustomed with closing positions in the same day after you open them, it is unlikely to study a security trend for a period of 6 months.

It is very possible for the same security to be different on the short, medium and long term.

  • Trend line

Trend line is probably the most basic technical indicator. It is a line which shows for a certain time if the trend is up or down-moving.

For an uptrend, the line should unite opening lows with closing lows.

For a downtrend, the trend line shall unite opening highs with closing highs.

  • Trend channel

The trend channel is represented by a trend line and one line parallel with the trend one in the trend’s direction.

For an uptrend, the parallel line shall be above the trend line.

For a downtrend, the parallel line shall be below the trend line.

  • Support and resistance

Support and resistance are price levels below or above which a security tends to stay.

A support level represents the level under which the security shall not drop.

Once reached the support level, the security price tends to drop.

After being reached and exceeded many times, the support levels tend to become resistance levels and the other way round.

Gann analysis

The Gann analysis is based on Natural Law, geometrical proportions, and the Gann’s law of vibration, where every asset has its own vibration according to its individual energy

William Delbert Gann, was the creator of the very popular Gann analysis, which includes such tools as the Gann Fan, Gann Trend and Gann Grid. Gann used Natural Law (the usage of reason to analyse human nature and its moral acts) and geometric proportions based on the circle, square and triangle, to forecast prices and to provide a base for his theories. His analyses were based only on the relationship between time and price.

Another theory which the general Gann analysis is based on is the Law of Vibration. The principles of Gann’s Law of Vibration, applied to the capital markets, were first presented to the public in his interview in 1909 to the “Ticker and investment digest”, and may be summarised as follows:

Each stock has its own distinctive path and range of activities based on trade volume, direction and others. All of them move according to their individual patterns or as defined by Gann “Vibrations”. Gann also compared the stocks to atoms by stating that the first are also a kind of centre of energy which may also be defined mathematically. Another interesting statement from Gann is the opinion that stocks possess powers just as magnets do – they can attract and repel – meaning that sometimes they may be leaders in a market for a moment, and in the next, just stagnate.

Together with the above theories, Gann concepts were mostly based on mathematics, and its numbers retrieved from ancient history, like egyptology or even the bible. Some numbers had special meaning in his concepts of price forecasting, the most significant being 16, 25, 36, 49, 64, 121 and 144. According to Gann, these numbers together with geometry and natural law have provided the proposed tools with a very significant forecasting ability.

Fibonacci analysis

The Fibonacci analysis is based on the “golden ratio” – properties of an infinite number discovered by Fibonacci.

The Fibonacci analysis techniques are based on the characteristics of a number discovered by Leonardo Fibonacci in the 13th century.

Fibonacci analysed a sequence of numbers, where starting figures are 0 and 1, and each number in the sequence is calculated by adding together the two previous numbers. He discovered that this sequence is characterised by an interesting feature.

As the numbers in the sequence are rising, the proportion between the consecutive numbers is getting closer to the infinite number 1.6182[…]. It was discovered that the number 1.6182[…]called “phi” (Φor φ) is a very important number in different areas of science like biology, architecture and others. It is also called golden number or golden ratio due to its specifications.

The golden number is also used in financial markets for forecasting and decision making methods. Another key number is 0.382, which results from the division of one number by the following number of the Fibonacci sequence, or by subtracting from 1 the golden number.

Some of the tools based on the theories behind the Fibonacci numbers are: Fibonacci Fans, Arcs, Time zones, retracement, channel and expansion, Fibonacci retracement being the most popular.

Oscillators

Oscillators are very useful instruments showing the dynamics of price action.

Oscillators are popular amongst traders following technical analysis, as they reflect how fast prices change, as well as the direction in which they are heading. Tools such as price formations are aimed at analysis of trend and its possible reversals, and oscillators try to explain the price dynamics by referring to “overbought” and “oversold” market conditions.

Typically, oscillators reflect the market price changes in relative terms – in respect to some values adopted as boundaries, between which the oscillation takes place, depending on the construction of a given instrument. As the price moves close to the extreme values of such a range, the market is considered to be “overbought” – typically in the case of upper parts of the range, or “oversold” – in the case of lower boundaries.

The most basic method of interpretation of oscillators refers to the oversold/overbought levels – a market that is oversold is expected to regain at least a part of the losses, whereas the market that is overbought is considered to retrace back in a short time.

Signals can be provided also through so called divergencies – situations when the movement of an oscillator does not confirm the movement on the corresponding market. It is assumed that in such a case the market may retrace in the direction indicated by an oscillator.

Some of the oscillators can also be analysed in the same way as a price chart. In this respect trends, trendlines and technical formations can be identified, such as channels or triangles. Results from such an analysis may indicate the possible movement of the given oscillator, and consequently the underlying market.

Oscillators combined together with other tools, such as trend indicators or price formations, may provide a detailed insight into the situation on a given market. It is considered that oscillators perform better when horizontal trends are observed, while providing less reliable signals in the case of fast moving trends.

Trend and its indicators

Trend is the crucial concept in technical analysis of financial markets, as many traders claim – “trend is your friend”.

The concept of trend is fundamental for the appropriate interpretation and use of technical analysis. Basically, the purpose of use of most instruments in the vast array of technical analysis tools, has something in common with the current market trend – sometimes their purpose is to identify its direction or potential moments of its reversal.

Other tools concentrate on measuring the dynamics and strength of the dominating market tendency. However, trend always remains in the centre of technical analysis interest.

Trend in respect to financial markets is understood as the direction where the market prices in general are heading. As such, market trends may be horizontal, upward or downward. As the markets typically do not move in a straight line, (they seem to “jump” instead), the general direction of price waves are the subject of a trend analysis.

Several technical analysis indicators have been created in order to identify the market trend direction, from the most basic heuristic assessment to the most sophisticated statistical tools. The most popular trend indicators are most often based on the average or other statistical instruments, like standard deviation. It may be combined with short or long-term averages to provide buying or selling signals, as for example in the case of Moving Averages. Other more complicated trend indicators use short, medium and long-term averages to provide signals and show trend directions and/or changes.

Elliot waves

Elliot waves combined with Fibonacci ratios may be used to forecast potential price targets.

After observing the stock markets, Ralph Elliott (the author of the so-called Elliott theory), concluded that prices tend to move in waves. The Elliott wave theory has been successfully used by traders to predict price movements and/or patterns.

Waves according to Elliott may be divided into two types. The first ones are called “impulse waves”, and are regarded as the main waves moving according to price trend. The second are called “corrective waves” which are considered to be medium/short-term waves moving against a trend. Elliott got even further by stating that impulse waves are divided into five smaller waves (of which two are corrective waves), while corrective waves are divided into three smaller waves.

Elliott waves together with Fibonacci ratios may present very interesting results regarding potential price targets. The most important Fibonacci ratios are 38.2% and 61.8%, beside the 0% and the 100% levels. After defining the beginning of a wave (i), 0% level is defined. The end of wave (i) is defined as 38.2%. Together with an impulse wave, using the Fibonacci ratios, it is possible to potentially define the target level of a wave.

FUNDAMENTAL ANALYSIS

As with every market, investors put their money at risk in the capital and money markets on the basis of assessment of the relations between potential future profits and risks. On the other side of these markets are government, corporations and other institutions, raising funds for their activities.

The market participants are constantly evaluating both the potential profits that may be generated by those investments, as well as the risk that has to be taken for such a promise. The result of such an assessment is influenced by the new information coming to the market all the time. The changes of the assessment of the profit/risk balance results in changes of the assets traded on the markets. What information is to follow?

Some chosen types/categories of information to follow

Monetary policy

Monetary policy maintained by central banks directly influences capital and money markets, as it regulates the supply of money, thus directly influencing its cost.

Economic relations

Economic relations have a major impact on how investors perceive local markets. If a country has developed strong trade relations, investors may see this country economically stable and with opportunities to increase profits.

Situation on the other markets

The situation on the other markets is crucial when considering an investment decision related to where and when capital should be transferred between countries. When the capital markets in one country start to turn red, i.e. investors start to make loses, capital will move out from the country which may also cause the local currency to depreciate.

Companies situation/reports

One of the important factors influencing the capital markets are the current economical conditions of individual companies. A good economic situation of a company may cause the investors to invest their capital in the shares of such a company. A bad economic situation will in turn cause investors to move their assets to other companies and/or eventually withdraw capital from that country.

Legal acts and taxes

Legal acts, either local or international, may have rather medium to long-term effects on the capital markets. Legal acts may constitute barriers, or the opposite – act as an impulse for foreign economic investments.

Weather conditions

Weather affects directly the prices of commodities which in turn affects companies using those commodities as raw materials. An increase in the prices of commodities also makes product prices increase. This in turn, depending on the business type and company, will cause demand to lower, affecting the companies statements, i.e. earnings. The worsening economic condition will make the price of shares drop, which in turn makes investors withdraw capital from that company;

Political situation

Political situations or conditions have important impacts on the capital markets. When a country has a stable political situation (either internal or external – foreign policy) investors feel comfortable in investing in that country, so there should be an observable capital inflow to that country. On the other hand, in a situation of political turmoil traders may react by withdrawing the funds from the given market or region.

Economic recession

Economic recessions may have different sources. These may be financial (e.g. Banking crisis), related with commodities (e.g. Oil crisis), political or other. The common thing about recession is that in general people tend to withdraw their capital from the market in order to “save for worse moments”. Therefore the most affected segments are banking and finance, travel, automotive and others.

Economic growth

The situation of economic growth in a given country or region is strongly favourable for companies that are selling their products to the customers in that area. Economic growth typically means that customers are more optimistic and have a better economic situation, thus may afford more and are also more willing to make the actual purchase. Expected increase of the profits of the companies selling more and more of their products may attract both local and foreign investors, who generate demand and consequently increase the price of the shares of the company.

Confidence

Confidence indicators reflect the broad picture on how residents of a country perceive the prospects for the future. It is also one of the factors taken into the consideration by central banks, when shaping their monetary policy. In general, a higher confidence from customers may suggest that they are more optimistic and willing to spend more on consumption, and as a result, the companies will be able to sell more and achieve higher profits. Consequently, the attractive prospects of the companies may attract investors, believing that the value of shares will be higher in the future.

Events

One time events may have a significant impact on capital markets. A good example may be the organisation of the Olympic games in a given area, which requires extensive investments in infrastructure and attracts tourists to the region, and which has a positive stimulus for the companies involved. On the other side of the scale are more severe events, such as acts of terrorism. These are of course rare situations, but soon after the “9/11” attacks in the US – major stock markets were closed due to the severe implications to the capital markets. Occurrences in one company usually do not affect the general markets, although there are exceptions.

An example of such an exception could be the ENRON case, where over 20,000 employees were fired due to financial fraud accusations, after which ENRON turned out to be bankrupt.

The importance was not necessary because of the number of people that got sacked, but the size of the company which was one of the major energy companies.

Events must be followed very closely by investors due to the fact that the implications on the capital markets are not always clear.

Experts opinions

Expert opinions may confirm or contradict what investors were, until that time, expecting. Typically it does not have a direct influence on the capital markets, however the market sentiment may be affected when “experts” represent national authorities – either political or monetary. When monetary authorities make comments about the general economy, they may be giving signals on future interventions, or hint at the future monetary policy. This in turn will have consequences on the supply of money and interest rates, the latter being the most interesting factor for foreign investors.