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What is fundamental analysis?
Fundamental analysis of the Forex market
Price changes in global currencies, commodities, and metals are connected to a plethora of developments that have an influence on the situation in a particular country and on the world as a whole. These can be economic or political changes as well as natural disasters. This is exactly what people look at when they carry out fundamental analysis. If we look at history, it’s possible to correlate changes in management at major enterprises, in heads of state, or of production output, with fluctuations in currency pairs or other assets.
What fundamental analysis is based on
Traders are mostly interested in whether or not they can profit by predicting the price movements of an instrument before or after a certain event. History plays a part in this analysis as it helps you anticipate the level of volatility at the time of publication as well as determine the direction in which the trend will move if the figures come out higher or lower than predicted.
The basic tenets of fundamental market analysis:
- Prices never change on their own; there’s always a reason.
- It’s possible to predict the impact of various factors on price movements.
- An accurate assessment of the dynamics of economic/political factors provides a reliable indicator of future price changes.
- Force majeure circumstances have an impact of price fluctuations, but are difficult to predict.
Fundamental analysis of the Forex market can be done either on its own, or together with technical analysis. So, an unfavourable prediction about future price movements can lead to traders prematurely closing their open positions or cutting their losses on orders on which they had at least hoped to break even. Some people are of the opinion that the publication of news temporarily stops technical analysis from working, and so if your trading strategy is based on technical analysis, you should exit the market during such releases, and only re-enter when the resulting price fluctuations have subsided.
Types of news that affect the market
To give you a quick understanding of what fundamental analysis is, you can take a look at the Forex economic calendar, where the most important upcoming events across the world are listed. To learn how these events impact exchange rates, oil prices, metals, or other assets, you need to study them separately. No one is going to simply reveal the secret behind it. A good way to get around this is to study the economic calendar as well as other sources for previous periods and take note of the actual price changes on the chart. Fundamental analysis requires having a real grasp of the situation in countries whose national currencies the trader plans to earn from by trading.
Economic events are split into the following categories based on how much influence they have on the market:
In practice, news items vary in volatility at the time of publication as a result of impulsive movements, both planned and chaotic, which complicates the trading process. As a result, positions can be closed prematurely and with minimal profit, despite the activation of a trailing stop.
On the other hand, the potential profit from important news items is higher. For guaranteed profit, however, you need to know which way the price will move. This is impossible without fundamental analysis. You can make a profit on any news item; the most important thing is choosing the right time to open your position. This approach helps you maximise your profit; by entering the market at the peak, rather than halfway through the process, as often happens when people trade the news.
Political factors affecting price changes
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News on a country’s domestic and foreign policy will exert an impact on that country’s national currency. For example, instability will weaken the currency, decreasing its value. During presidential and parliamentary elections, prices can fluctuate solely on the basis of rumours, many of them unfounded. According to experts, these kinds of situations are created intentionally, allowing people to take advantage of and profit from temporary drops or rises in price.
Some political news has a negligible effect on the market. For example, a political leader’s position on a certain issue is generally known beforehand, so when official speeches by them are aired, this doesn’t tend to cause any serious price fluctuations. Traders are sometimes faced with unexpected circumstances. For example, someone could voice a different opinion than expected before clarifying that they were misunderstood. These types of situations generally lead to an impulsive jump or decline before prices return to their original levels.
The role of political news in trade is relatively small. Fundamental analysis of Forex usually considers this as an additional factor that has a greater impact on the long term, while short-term trading is conducted on the basis of economic performance.
The value of a national currency relative to that of other countries depends on the economic situation in the country. When working with major currency pairs, the comparison is made with the US dollar, while with cross currency pairs this is made with other currencies, although the US dollar still has a role in the calculations. On the one hand, this relationship results in the currency pair reacting to any American news, and on the other, to events in the country where the “second” currency of the pair is in circulation.
The key indicators of each country are:
- Data on the labour market, such as the level of unemployment, the amount of unemployment benefits paid, and the positive/negative dynamics of these indicators. Statistics on the industrial and agricultural sectors are analysed separately.
- Trade balance, which shows the volumes of its own production, import, and export volumes (gross indicator for all types of products).
- Gross Domestic Product (GDP), that is, the sum of all goods and services produced in the country in a given period.
- Changes in the monetary policy of individual countries and the Eurozone.
One peculiarity of the Forex market is that fundamental analysis tends to be done simultaneously in several countries. The United States is often the main reference when forecasting price changes or trends, while the countries of currencies included in a pair may only add to or mitigate the effects had on price movements.
The influence of force majeure situations on prices
Natural disasters (earthquakes, hurricanes, deaths, droughts, floods) influence the market in an unpredictable way. In part, weather forecasts can help predict them, but working with these calculations is quite risky. The same goes for technological disasters; there is no way to predict them and the trader will only see the impact on the market once they have happened.
It is easier to operate with factors of a social nature, such as coups d’état, military conflicts, revolutions, strikes, etc. Any public upheaval can cause a fall in the value of the national currency. Depending on the currency pair, this may result in a rise or fall in price. You can predict these changes in detail, but only for long-term events.
How to use the economic calendar
One of a trader’s main tools when practising fundamental analysis is the economic calendar. In it, the main events are displayed by country (including events of low impact on the market). The list also shows the estimated and past results. For the trader, they are useful only when related to a previously made prognosis; whether they will fall in line with expectations, or whether they will be higher or lower.
The economic calendar indicates the most important events, that is, the data that we must analyse first.
When trading based on the economic calendar, the key points are:
- The more important the news, the greater volatility one can expect from the currency pair. In this case, placing orders with market execution is more difficult because of a high load on the broker’s server. As such, it is recommended to enter the market early, with the help of pending orders.
- In long-term trading, central bank publications are important. By analysing their monetary policies, you can make a prediction of the financial situation in a specific country, a set of countries, and even the world as a whole.
- You have to pay attention to the forecasts. If the recently published data outperformed your expectations, the currency’s value is likely to increase. If there are no significant changes in the data, even if the news is strong, there will be no significant price jumps.
The economic calendar shows all events. If a trader usually deals with a specific currency pair or a group of currencies, it is recommended that you create a filter to view only the countries that relate to these currencies. For example, when trading the USDJPY pair, you can hide the news from European countries, as the events influencing the pair are in the US and Asia.
The influence of fundamental analysis on technical analysis
Discussions about the best type of analysis; fundamental or technical, usually lead to the conclusion that it is best to employ both. Monitoring support and resistance levels helps predict trend changes when the price breaks an important level during certain news releases. Combining fundamental and technical analysis (FA and TA, respectively) leads to a more effective outcome.
The fundamental analysis of the currency market influences technical analysis as follows:
- The impact of news often disrupts previously formed patterns, abruptly changing market trends. In times like these, TA traders prefer to just watch the market swings.
- A lot of trading strategies are based on correctional phases, which are very common after strong news. The principles of TA begin to apply again during these correctional phases.
- Fundamental factors take precedence over technical ones. If the news points to a likely rise in the price of a certain asset, the technical picture may prove to be incorrect (in the long run).
Operations performed at intervals of H4 or more should definitely include fundamental analysis. It is very difficult to get high profits without taking political and economic factors into account. Looking at the price history of any asset, you can see many cases of the price returning to its point of origin within a short time (in a matter of days or even weeks).
Trading strategies based on news
Trading on the Forex market based on economic news and policies is done both manually and automatically (via “consulting” robots). The latter, depending on the type of trading strategy, is configured to close or open positions ahead of news releases. Preparation for the opening of the orders may include technical analysis, but the trader can opt to reject this in favour of economic forecasts.
Distinguishing features of news-based trading:
- The manual opening of market orders with a high chance of profit is usually available only on one currency pair. Changing between graphs and successfully entering the market from anywhere can be achieved only with the help of advisors/scripts.
- The use of pending orders is very common. But you have to take into account that when opening at the best available price, the stronger the news, the greater the likelihood of slips, which is a normal occurrence.
It’s recommended for traders who practice fundamental analysis to subscribe to newsletters published by experienced Forex analysts. By studying independent forecasts it will eventually become easier to navigate the current trends. After all, you don’t always have the time and desire to figure everything out on your own. This type of approach is more efficient, since market signals are analysed based on the knowledge of competent experts.
Fundamental Analysis & Trading the News
Watch any financial network or read a business magazine and you’ll find a mix of opinion and fact. Both can offer insight, but it’s important for traders to consume them intelligently. Sometimes the opinion of a famous financier or economist can help you see what a market is doing. His or her opinion might confirm your own or get you to rethink some of your assumptions.
However, even experts can be wrong sometimes. Rather than be swayed by a name or job title, look at the numbers and the logical argument that expert offers to support her opinion. Does she have the same trading style? Does she back up her assertions with evidence? Did she offer the opinion casually or as a recommendation to investors? And finally, do the numbers add up?
Sometimes experts make good arguments, but are referring to a longer timeframe than you plan to trade. If the head of a large hedge fund says he expects the Nasdaq to go up, for example, he may mean over the next six months, not in the next few days. If you bought without being clear about the timeframe, you might easily be buying into a short-term dip.
Opinion is not news—except when it is
Economists, analysts, and even politicians like to say they focus on the numbers. But financial opinions are not just about numbers, but about the story you tell yourself about those numbers. The same goes for trading decisions. One person may see a series of higher highs and higher lows and decide it’s a buy signal. Another trader may see the same upward-sloping line and decide that the rally is exhausted and ready to come back down. Same data, different stories.
One day’s news might include excellent unemployment numbers, positive earnings from major corporations, and great news on housing or manufacturing—all things that should cause the stock market to rally. And yet, the market could very well go down, or not do much of anything.
That is one of the risks of trading the news: if you assume you know how the market will react, you are probably assuming too much. What the market should do is really an opinion. In the end, you can only trade what the market actually does.
Balance fundamentals with technical factors
In the end, no matter what experts or logic or historical patterns say a market should do next, markets only move when buyers and sellers adjust the price levels at which they agree to make deals. If there is a large volume of sellers and not many motivated buyers, prices are going to come down regardless of what the jobless claims number was. And if people get eager to buy, sellers are going to charge higher prices and move the market up, even if all the headlines are pessimistic.
Often what happens is that larger players, institutions and funds, get bullish based on good economic news, but still want to get bargain prices. They may try to push prices down during low-volume periods, so they can buy in larger quantities once prices are low enough. The big, smart money routinely “runs the stops” and takes out smaller, retail traders in order to gain advantage in this way.
So it’s wise to look at the numbers in the news as well as on the chart. For example, if an Energy Department report shows that crude oil is oversupplied, it’s reasonable to expect a drop in prices. At the same time, you want to get the best possible risk to reward ratio in your trade. That means trading with an effective entry and exit strategy.
Economic event binaries
Nadex does offer a way to trade the fundamental economic number itself, without speculation about the market’s possible reaction. Take positions on the weekly jobless claims, monthly nonfarm payroll, or Fed Funds interest rate number with a binary option. This way, your trade is based solely on the number itself, not on what the market might do in reaction to it.
Of course, you’ll still have plenty of opinions coming at you in the days and weeks before those numbers are announced, but it removes one variable from your decision-making.
Anton Kreil. Hedge strategies based on fundamental analysis
Anton Kreil is famous for his TV show on BBC “Million Dollar Trader”, earlier he worked as trader at Goldman Sachs, now he is partner at Institute of Trading and Portfolio Management.
1. Description of course and trade approach
The course of trading held by Anton Kreil, is based on macroeconomic, fundamental, technical analysis and risk management. His approach to trading copies hedge fund strategies. Moreover, not only the trading strategy is copied, but also the strategy of the traders’ behavior. The strategy of the hedge fund traders’ behavior is that they get their monthly income at the expense of wages, and not from trading. Salary is in the form of a percentage of the management of the attracted capital. They reinvest half of the incentive bonus from the profits again to the fund. In this way, hedge fund traders increase their capital, and at the expense of interest capitalization they will eventually earn much more after the sale of the fund than if they simply withdrew their earnings each month. To make a fortune, you need to imitate the hedge fund managers, and not listen to advertising, in which you will be told that you will earn a certain amount every day from trading. When you withdraw money, you will not increase your capital. Course begins from this.
The trading strategy taught in this course also repeats hedge fund strategies. The goal is a stable profit and moderate volatility of the account when you earn both in a good and a bad market. In the course of trading, you are taught to create diversified portfolios of long and short transactions with the time of holding spread positions during 1-3 months. The focus on medium-term trade is made for the reason that over the past decades the volatility of markets has steadily declined. The statistics on the indices, shares, including into the index, currencies, shows that 80% of the time the market is asleep.
The increase in the number of players, the development of algorithmic trade, strengthening of the role of central banks led to the fact that the opportunities for earning, especially within the day, are becoming less. Volatility is now too small to earn money regularly by day trading. However, day trading is not rejected, in the course you are taught to move from portfolio trading to day trading and back, depending on the volatility of the market. But in total, 80% of the time will be occupied by portfolio trading, and 20% – this is a deal inside the day.
The downside of this style of trading is the increased requirements for the availability of capital, as for the trade it is necessary to form 8-14 pairs so that the risk is distributed and not concentrated in several positions, as most retail traders do in day trading. In addition, money is needed to carry positions for the next day, the leverage in this case is much smaller than it is given by a broker for trading within a day.
The course begins with an analysis of the historical volatility of the instrument at opening and closing prices for the day. It is necessary to understand whether it is possible to earn money in an instrument or not. If it sleeps or not. The distribution of daily profit is made on the basis of data that can be collected in the public domain (the course is entirely based on the analysis of data from open sources). From statistics it is clear how many percent can be made (and with what probability) when buying an asset at the opening and selling at the close.
Also, it is important to calculate the potential profit considering the commission. It may be, for example, that if the ratio of profitable and unprofitable trades is 1:3, you will need to make 50% of profitable trades to be only in the black. 50% of profitable trades is an indicator of very good traders.
On the basis of historical data, it is important to consider the chances of this or that size of movement in the instrument. In the course with the help of statistics analysis of volatility index S&P500 is shown that in 80% of days to earn intraday trading is very difficult. Also, you still have big risks in the distribution tails areas. There are days that can cause noticeable damage to the account. Approximately 1 day out of 100, the S&P500 has movements of more than 3%.
Shares in the S&P500, repeat the situation with the index S&P500. It is similar situation with currencies. For example, analyzing the GBP/USD pair, in the course is shown that in half of the day prices fluctuate from -0.25 to + 0.25% of revenue per day. If you consider the commission, then it is problematic to earn within a day, buying at the opening and selling at the closing. On a usual day, opportunities for day trading are very small. That is why you need to expand the time interval of trade and shift the probability of earning in your favor.
Also, in the course is given example of the calculation of the ATR tool based on historical data from open sources. You need to know what intraday movements you can count on, what risks can be in the tool.
The volatility considered is the historical volatility of the instrument. Further in the course, is shown future volatility. For the S&P 500, this is the VIX expected volatility index, which is calculated at option prices that reflect market expectations for future volatility.
The VIX should be considered as traffic lights. It says, when you need to engage in day trading, and when to trade a portfolio. You have a portfolio formed with a certain volatility. You need to monitor how volatility changes over time. For example, if VIX increases by 25%, then you can get rid of half the positions in the portfolio. An important thought that the author of the course wants to convey to us is that when the volatility increases, the risk of the portfolio also increases linearly. If you have a position of 1 million and VIX doubles, then your million turns into 2 million, as fluctuations in profits and losses of portfolio have doubled. If volatility rises, and you do not close part of the positions, then your risk grows uncontrollably.
If volatility increases (plus 25% of the average annual VIX value), then short-term opportunities at the market grow, and you begin to free up capital for day trading. Day trading in the course means the retention of positions during 1-5 days. If VIX falls (minus 25% of the average annual VIX value), you need to collect a portfolio of positions.
Also, in the course is given an example of calculating the index of future volatility for any instruments in your portfolio, for which there are options. When we have historical and future volatility, then we can see the whole picture, we begin to understand what the instrument is.
Common mistake traders make is that they tell the market that they will trade in a certain way, despite the fact that the market is changing. You need to change the style of trading depending on the volatility. However, there are no clear rules of how to do this. It all depends on whether you are better at: trading a portfolio or short-term positions. Proceeding from this, you choose proportions in long-term and short-term trade. It is not necessary to go from one extreme to the other.
The course shows that trade ideas should be formed on the basis from the general to the special. The analysis begins with the analysis of the market as a whole, with a macro level, and, further, passes to industries and shares. At the same time, everything revolves around analysis of volatility. That’s why we gave her so much time above. The general scheme of the approach to trading is as follows:
The course involves the organization of systematic, repeatable processes in your work on market analysis, the search for trading ideas. If you want to develop in the field of trading and in the future, for example, to attract investors’ money, then investors will be interested in how your strategy works. Systematic processes are needed in order to protect the money of investors. Investors are interested in protecting the value of their money, protecting against inflation, hedging in different markets. They are interested in stable profit making with low volatility. No one is interested in investing in trade, which brings in one month + 10%, and in the next month gives -10%. Investors who understand finance and markets will not give money, for example, for day trading currencies. This course assumes a diversified approach to the formation of a portfolio with moderate volatility and an upward trend in profitability in any situation.
2. General market analysis
The portfolio is formed for the market, which we predict. To begin with, you need to understand where the market came from, where it is and where it is heading. We form a portfolio for a bullish or bear market. Very often traders misunderstand what a bearish and what a bull market is. The bear market starts when the price goes down by 20% from the high of the previous business cycle. The bull market is the return of the index to the bear market point, set by the past business cycle and overcoming this point. Below is example on the chart of the S&P 500 index:
According to the S&P 500, high was at 1576 point in July 2007. Minus 20% of this high was 1260 point in June 2008. After that, the market is considered bearish. The market began to be considered bullish again when it overcame the 1260 point in January 2020.
It is interesting to compare the S&P 500 with the behavior of the British FTSE 100 index at the same time. The FTSE 100 had a high of 6754 in July 2007. Minus 20% of this high was 5407 in January 2008. The market began to be considered bullish again when it overcame the 5407point in January 2020, i.е., a year earlier than the S&P 500:
This is an important point. FTSE 100 includes companies that are sensitive to business cycles. The idea is to form a portfolio of instruments that are sensitive to business cycles and are not sensitive, depending on the bull market or the bear market. You need to focus on sectors that are more sensitive to business cycles and which will give more revenue than just investing in the market index. If we are positive about GDP and think that it will go up, then we buy cyclical sectors (sensitive to business cycles) and sell defensive (not sensitive to business cycles), and if we assume a reduction in GDP, then we buy defensive sectors and we sell cyclic. We will come back to this topic below.
Now we will consider the question of what drives the markets and whether these movements can be predicted. Markets are driven by GDP dynamics of countries. First of all, this is the GDP of the USA, China and Europe. If we can predict the GDP of these regions, then we will have a very clear picture of the world economy. Statistics correlation of GDP and S&P500 for the past 60 years is as follows: S&P500 in 59.59% of cases (quarters) is growing along with GDP. In 7.76% of cases, they fall together. 67% of the time they move together. GDP explains the movement of S&P500 in 67% on a quarterly basis. This means that the chances are on our side if we can correctly predict GDP. If we predict correctly in 3 out of 4 quarters, then we will be right in 75% of cases.
The problem is that in reality the S&P500 index is ahead of GDP statistics for 3-6 months. When statistics on GDP is published, it is already very outdated information, on the basis of which it is impossible to trade, and you cannot trade on news in the media. But there is statistics that is really useful and predicts GDP for 12 months, and the S&P500, respectively, for 6 months. This is the statistics, which is made by The Institute for Supply Management.
PMI and the indicators included in the ISM are leading indicators in relation to the S&P500. They reflect business cycles. When the ISM goes down, in 12 months the GDP is reduced. Although PMI reflects a small part of the economy (20%, manufacturing companies), it is interesting because it has statistical data since 1948 which can help to trace the patterns of influence of this indicator on GDP and index. According to data from 1948 ISM correlates with GDP in 85% of cases with a lag of 12 months.
If the ISM is above 50% and is growing, then it says that the US economy will grow in 12 months, and we are leaning towards long positions. If it is more than 50%, but slows down, we can have a flat portfolio, or we can close positions. When it falls below 50% and declines, the US economy will decline, and we tend to short positions. If the ISM is below 50% and grows, then we tend less to shorts, we are in a flat or close positions.
In addition, in the ISM reports we receive a qualitative assessment of experts from the companies surveyed. This is a good material where you can take ideas for trade. From comments of experts it is possible to understand, what sectors will grow, and what will fall. Expert estimates predict the profits of companies.
The most sensitive indicator of the ISM report is the statistics for new orders. New orders are the leading indicator for ISM. But the problem with ISM is that ISM predicts too early. We can go into too early, when the market has not spread yet, and we can lose money during a couple of months. ISM gives the original idea (not a trade) of what will happen to the US GDP in 12 months. To determine the exact time of entry, you need additional indicators. It is necessary to agree the time of the transaction. This is done using technical analysis, which we will discuss below.
Also worth mentioning such advanced indicator as the NMI indicator for the service sector. The service sector is 80% of the US economy. The meaning of the indicator is the same as for ISM indicator. We watch: it is higher or lower than 50%, what is its dynamics. It is useful to observe how the NMI and ISM indexes relate to each other. Indicators, which we examined above, belong to the sphere of production. For completeness, we still need to consider indicators related to consumption.
The leading indicator related to consumption is the Consumer Sentiment Index of the University of Michigan (UMSCI). The indicator has 80-85% correlation with the business cycle, with a time lag of 12 months. The average value of the UMSCI index is 85. If the indicator is between 60-70, then the mood of consumers is negative, if the indicator is between 70-80, then the situation is neutral, and if the indicator is above 80, then the indicator is optimistic and the long-term growth of the US economy is expected. Level 85 coincides with the long-term economic growth of 3%. If the indicator is below 85, then you can expect growth of less than 3%. Using ISM, NMI and UMSCI, you can get a clear picture of the well-being of the US economy and get the right direction.
Another leading indicator, which should be mentioned, is the statistics on the number of applications for new construction in the US. The number of applications for new construction is a very important predictor. It reflects the well-being of the mortgage market, the commitment of banks to issue loans. This indicator is also associated with sectors of timber, builders, steel producers, paints, furniture manufacturers, banks. The lagging indicators in this sector are Pending Home Sales, New Home Sales, Existing Home Sales, The Case Schiller Index, The Housing Market Index. They will confirm or deny your ideas.
As for the leading indicators, I would like to say one more important thing regarding day trading. Trading within a day is also necessary on leading indicators, and only when volatility allows it. Most retail traders trade everything, any statistics, both leading and confirming, and lagging, without making a difference between them. If you are trying to trade within a day at the time of the release of lagging statistics, then you simply provide liquidity to those who close positions that were opened several months ago in accordance with leading indicators.
We verify the correctness of the implementation of ideas using coincident indicators. Coincident indicators do not predict the future, but tell us what is happening with the economy now. For example, a coincident indicator is the unemployment report. For the growth of the US economy by 3%, is needed an increase of minimum 250-300 thousands new jobs. At the peak of business cycle, when the economy is growing, fewer positions are added.
The next confirmatory indicator is durable goods and a report on their deliveries. The indicator for durable goods should be cleared of the influence of the defense sector and the transport sector,as one large order can greatly affect the performance. This report will confirm or disprove what you saw 12 months ago in the ISM production report. These reports confirm or disprove data on PMI and GDP.
Another confirmatory indicator is the Industrial Production Index. INDPRO will help to understand what is happening in different industries. It also confirms or disproves data on PMI and GDP. The indicator of industrial production is a continuation of what we believe based on the PMI data, which we analyzed 6-12 months earlier.
Coincident indicators exist not for making decisions on the opening of positions. Positions are opened long before the entry of these indicators. They only confirm or disprove the correctness of previously made decisions. In most cases, these data are already taken into account by the market.
USA Leading indicators:
– ISM Manufacturing Index, ISM Non-Manufacturing Index, University of Michigan Consumer Sentiment Index, Authorized Building Permits, Money Supply (M2), Yield Curve (Interest Rate Expectations).
USA Coincident indicators:
– Producer Price Index (PPI), Consumer Price Index (CPI), The Employment Situation Report (Non-Farm Payrolls), Jobless Claims, Industrial Production, Durable Goods Orders, FOMS Meetings, Personal Income, Factory Orders.
USA Lagging indicators:
– Gross Domestic Product (GDP), The Unemployment Rate (NFP Report), Federal Reserve Beige Book, Retail Sales.
We examined indicators for the US economy. Now let’s move on to European indicators. The most important European leading indicator is Economic sentiment indicator (ESI). It is a survey of economic sentiment. ESI predicts future European GDP for 6-18 months. An average of 12 months.
ESI includes several indicators. If we take the ESI for 100%, then the indicators included in it are distributed by weight as follows:
– INDU – ISM analogue in the USA – 40%,
– SERV – analogue of non-productive index NMI – 30%,
– CONS – consumer confidence index similar to the consumer sentiment indicator of the University of Michigan – 20%,
– RETA – indicator of confidence in retail trade – 5%,
– BUIL – an indicator of confidence of real estate developers, similar to building permits in the US, but at the same time includes industrial and commercial construction – 5%.
There are ESI reports separately for European Union countries, from which one can understand condition of economies of these countries. It is possible to distribute countries from the best, with a growing economy, to less successful ones. Accordingly, appear ideas to take shares from a country with a growing economy in long, and with a falling economy in short. For 4-12 weeks. For example, to form a portfolio of 10 shares in long and 10 in short.
Take the statistics from ec.europa.eu and sort the countries whose index has grown the most and least. Sorting is made by sectors of the economy. This information is the basis for trading ideas. For example, we look at the country and sectors where the index is highest and, accordingly, the shares of companies from this country and from this sector will be interesting for opening long positions. We also look at the country whose index is the worst, and we also select sectors and shares from these sectors to open short positions. We look at the dynamics of indicators, if they slow down or accelerate. For you it will be a repetitive, monthly process, because statistics is published monthly.
European leading indicators:
Composite European Economic Sentiment Index includes:
– Industrial Confidence Indicator – 40%,
– Services Confidence Indicator – 30%,
– Consumer Sentiment Indicator – 20%,
– Retail Trade Confidence Indicator – 5%,
– Construction Confidence Indicator – 5%.
European coincident indicators:
– Industrial Production, Monthly Inflation Numbers, ECB Meetings, BOE Meetings.
European lagging indicators:
– GDP, Unemployment, Retail Sales.
Now let’s look at statistics of China’s GDP. The USA, Europe, China are 50% of the world economy. In China, we have official statistics and private statistics. There are two indicators that predict China’s GDP. Official PMI and HSBC China PMI. HSBC China PMI is the PMI of the private sector. Professional traders align more with HSBC PMI, as there is not enough trust to the official PMI. In addition, the official PMI is too slow. It includes top 300 Chinese companies, while HSBC PMI includes medium and small companies that are more sensitive to changes in the economy.
You also need to know the specifics of China’s economy and stock markets. In China, the structure of the market differs from the US and Europe. There is no developed pension system in China and pension funds are not invested massively in the stock market, i.e. there is no constant inflow of funds from buyers. People invest in tangible assets. Therefore, China’s stock indices cannot be traded on the basis of PMI data. Chinese indices do not predict GDP.
Do not trade Chinese companies and indexes directly. It is better to trade companies that are traded on Western exchanges, but whose profit depends on China’s economy. Or, for example, if you take a country whose economy is largely based on Chinese demand (for example, Australia). If the growth of the Chinese economy slows down, then this country’s export falls and, accordingly, the exchange rate falls.
We need China’s PMI statistics for forecasting China’s GDP. We also need to compare Chinese PMI with the fundamental indicators of the US and Europe, because export composes 30% of China’s GDP, while export to the US and Europe composes more than 30% of China’s total export. If there is decline in US and Europe, then it will be difficult for China to grow.
There are many companies whose profit depends on Chinese demand. For example, mining companies. You can form ideas for exchange products, companies, countries that are connected with the market of China.
Chinese leading indicators:
China HSBC Purchasing Managers Index (PMI), Official PBOC Purchasing Managers Index (PMI), Export Orders, Conference Board Leading Economic Index (LEI) which includes:
– Consumer Expectations Index – 9,35%,
– PMI Export Orders – 7,22%,
– PMI Supplier Deliveries Inverted – 22,31%,
– Total Loans issued by Financial Institutions – 14,86%,
– Raw Materials Supply Index – 44,48%,
– Total Floor Space Started – 1,8%.
Chinese coincident indicators:
– Industrial Production, Monthly Inflation Numbers.
Chinese lagging indicators:
– GDP, Unemployment, Retail Sales.
The news flow is equally used for both portfolio trading and for day trading. Never open positions for matching and lagging indicators. This is all the old news, which trade most retail traders. You need to understand how the outgoing statistics affects stocks, commodities, bonds, and currencies. For example, the growth of Manufacturing ISM will lead to an increase in stocks, commodities, while bonds and the dollar will go down. This is how trading ideas are formed.
3. Analysis of market sectors
Above we reviewed statistics, which helps to understand the situation in the market as a whole. We are still at a macroeconomic level. According to the scheme, which was higher, after we agreed the direction of the market, we move to the level of industries. We will be interested in sectors that will surpass the market. We do not need sectors that are worse or the same as the market. We want to exceed the market’s profitability. As I wrote earlier, you need to concentrate on sectors that are more sensitive to business cycles and which will yield more revenue than simply investing in the market’s index.
If you are confident in GDP growth, then you can buy assets that are sensitive to business cycles. You will have a portfolio of cyclical sectors with positions in long and defensive sectors with short positions. If you assume a reduction in GDP, then you buy defensive sectors and sell cyclical ones.
Cyclical sectors in the USA:
– Consumer Discretionary,
– Information Technology.
Cyclical sectors in Europe:
– Automobiles and Parts,
– Oil and Gas Producers,
– Oil and Gas Equipment and Services,
– Industrial Metals,
– Constructions and Materials,
– General Financials,
– General Industrials,
– Industrial and commercial services,
– Personal Goods,
– Real Estate,
– General Retailers,
– Technology Hardware,
– Technology Software,
– Travel and Leisure.
Defensive sectors in the USA:
– Consumer Staples,
– Telecommunication Services,
Defensive sectors in Europe:
– Food Producers,
– Pharma and Biotech,
– Telecommunications (Fixed),
– Telecommunications (Wireless),
– Utilities (Electricity),
– Utilities (Gas, Water, Multi).
If you have a long of one company and short of the other in the same sector, then you have hedged the market and sector risks. There can be different combinations: shares from different sectors, from one sector. Accordingly, the risk size varies. If shares are from different sectors, then we do not have a market risk, but there is a sector risk. It is necessary to study in detail each sector, its specifics, relationships between companies, value chains.
4. Analysis of shares
From the sector level, we go down to the stock level. To assess the quality of shares in the course, it is suggested to use the P/E (price-to-earnings ratio) and PEG (price/earnings to growth ratio). The price/earnings ratio reflects the quality of the company’s profit. We look at the P/E of sector as a whole and the P/E of specific stock. We are interested in whether the stock is traded at a discount to the sector, or vice versa, its P/E is above the average for the sector. You also need to watch how share’s P/E changes over time.
All the data on the share has already been taken into account in its price and in P/E ratio, so there is no need to argue with the market. Even if you think otherwise, the market may remain irrational much longer than you can be solvent. Nothing is either cheap or expensive. P/E reports all the information that is needed. If P/E is low, then there is a reason for this.
The seminar shows in detail the algorithm for analyzing public data to find high-quality shares in the right sector with high growth rates of profit, P/E and PEG ratios. If we are looking for position on long, then we are looking for P/E with a premium to the sector, and if short positions, we are looking for tools with a discount to the sector. High P/E means that the market is ready to pay for high-quality profits, and low P/E means that the market punishes the company’s shares with low price for profit with low quality. There is no need to go against the trend and against the valuation of the share by the market.
Similarly, we act with PEG, selecting for long papers with a coefficient greater than one and for shorts with a coefficient of less than one and low growth rates. Do not follow the idea of buying “undervalued” companies, in which PEG is less than one. They are “undervalued” for some reason. The market will reward companies with larger rate of earnings per share growth than the industry average and punish companies with lower growth rates.
Further, the selected shares are combined into spreads, a spread schedule is constructed, to which the technical analysis tools are applied. To enter the position, you need to focus on the spread indicator, and not on the charts of individual shares.
5. Technical analysis
The next topic of the seminar is technical analysis. Technical analysis helps to understand whether the idea of time is correct. Technical analysis doesn’t form ideas. It is used as a filter at the stage of selecting ideas for implementation. At the seminar are considered simple models of trend, flag, triangle, “head-shoulders” model. Moving averages are considered. It is recommended to use the following moving averages:
– 20 – number of trading days per month;
– 60 – number of trading days per quarter. Companies report every quarter;
– 250 – number of trading days per year.
We watch how fast lines cross the slow, where the moment is directed.
In the technical analysis, is also used RSI. Subject of technical analysis is the shortest in the course.
The course gives a good idea of what the trader’s job is. Very often you can find seminars, books, in which the emphasis is on technical analysis, indicators. This seems simple and understandable to the masses, because these are not complex calculations in Excel. But as you have already seen, technical analysis is a small part of the trader’s work, and ideas for trading are not taken from it. This is just an auxiliary tool for finding the right time to enter, to select the best ideas from watchlist on the basis of analysis of the spread schedule.
The last topic of the course is the topic of risk management. There are many calculations in Excel on this topic in the course. If I describe everything, then the article will turn into a book. The course covers in details the procedure for calculating and monitoring the risk of the portfolio, how to form watchlist and select deals from it. Your watchlist should have 3 times more ideas than your portfolio. Weekly, you track your ideas and update information on prices, spreads, wait for the transaction to begin to match technical indicators (technical analysis, I repeat, applies to spreadsheets), and select deals that begin to work.
Next, we consider how to calculate the stop in spread transactions, taking into account ATR tools. The task is calculation of such a stop, which, on the one hand, allowed to hold the position for a long time, and at the same time would not be too large. Stop is calculated on the spread. It is recommended to put a stop-loss of 7-12% on the spread.
You cannot put stops on individual stocks. You cannot close a position on one of the spread shares. It is necessary to cover the whole pair. If you close half of the spread, then the second half has market and sector risks immediately. The basic approach to stops is a hard stop-loss and trading stop on winning trades. In winning trades, you use a trading stop and hold the position until you are knocked out by the stop. In other words, you severely cut the losing trades and squeeze the most out of the profitable. If possible, then add volume to the winning trades.
The hedging of the beta spread is also considered at the seminar. It is necessary to take into account at what speed the stock moves relative to the market. If this is not taken into account, then the pair will be unbalanced and the transaction will have market risk. If the beta pair is more than two, then this idea will require more capital. You need to look for more effective hedges with smaller beta, which will not freeze capital.
The course provides an example of a complex hedge model of two pairs of shares. The calculation of the distribution of capital by shares is carried out, depending on the beta of each share. Also, is considered an example of independent calculation of beta shares, an example of hedging currency risk in transaction, details of money management issue are discussed in detail.
Separately, is considered indicator of the trader’s work as Kelly criterion. The meaning of this criterion is that when we win, we take more risk, and when we lose, the risk is reduced. It is considered how to calculate Kelly criterion for each transaction, for portfolio trading and separately for day trading.
The issues of risk management and money-management are given quite a lot of time in the course. All these topics cannot be put in one article. They need to be studied in detail and examples of calculations in Excel should be mentioned. If you are interested in this style of trading, then I would recommend watching a video of the course. There are also many templates and examples of calculations included to the course.
Even if you do not use hedge fund strategies, this course will be useful for you because it gives an idea of the essence of the trader’s profession in such firms. Maybe one day, when you get tired of viewing graphics and wasting your time and money on experiments with various indicators of technical analysis, you will tackle the more complex and forward-looking strategies described in this article.
Trading Forex news
The news represents great profit opportunities for Forex traders. By news, we mean various economic data releases. Every major economy regularly publishes statistics like GDP, inflation, unemployment rate, etc. If you trade Forex during the times of these releases, you have a chance to make a lot of money.
However, we have to warn you that potentially big profits always come hand in hand with bigger risks. Volatility spikes during these periods and prices may move in a disorderly fashion. If you don’t have a solid trading plan for a particular event, it’s better not to engage in any trades at all.
In this tutorial, we will get to the bottom of trading on news and economic releases. There are several strategies you may use.
How to read economic calendar
The markets tend to price in the economic outlook future periods of time. As rule of thumb, economic growth means future prosperity which then equals to a strengthening of the country’s currency. Traders look for these upticks in economic growth (positive economic releases) as they usually offer opportunities to jump on an uptrend. In contrast, economic reports showing a slack in economic growth result in the weakening of the country’s currency. So, the future value of a currency is defined based on whether the actual data hits, misses or exceeds the forecast level.
An economic calendar is a key tool that helps traders not to miss important events. Its structure is simple. Economic indicators are listed in a table for a chosen period of time. Next to a particular indicator you see three data columns: previous reading, forecast, and actual reading. Before the release, the calendar contains only the previous reading and the forecast. The actual reading appears at the time of the release.
The forecast is a so-called “consensus” forecast or, in other words, the median of estimates from a number of experts, market analysts who have been polled prior to the publication of a particular release. If the actual data is better than the forecast, the currency appreciates. If the actual figures are worse than expected, the currency tends to depreciate. In most cases, “better” means higher than forecast and “worse” means lower than forecast. However, there are several exceptions to this rule, such as unemployment claims and unemployment rate: the lower these indicators are, the better for a currency in question. We should also note that a number that is close to the forecast level has usually negligible effect. The bigger the divergence between the actual and the forecast number, the bigger is the impact on the market.
Previous readings are not as important as forecast ones. Yet, sometimes previous readings get revised. These revisions tend to take place at the time when the actual reading is released. If the revision is significant, it will contribute to the effect the news has on the market.
- Focus on the most important news that could produce the greatest effect on the market.
- Wait for the publication of the chosen release, and then dive into trade according to the plan.
- Remember that the market’s reaction to a news release usually lasts from 30 min up to 2 hours.
- If your fundamental reasoning and technical analysis fail and the market’s reaction to the news doesn’t match your expectations, do not go against the market. Follow the market’s trend (probably you missed some important details in your analysis, or misinterpreted the effect of a given release upon its publication).
- Don’t rush into a trade. Wait for really strong signals and their confirmation.
And now let’s study three strategies that can be used for trading the news.
1. Slingshot strategy
If you’re trading in a highly volatile market, your stops can be triggered before prices begin trending. This could be disastrous for your bet.
Before opening a position, identify support and resistance. These are your “cut points”: you can close the position at these levels if prices go against you. Authors of the strategy advice to define stop loss distance before the publication of the news report. In order to reduce the risks during the highly volatile period of news releases you can do the following thing: once you notice on an H1 chart that the price is 10 pips below the key support, put a BUY STOP entry order 10 pips above that key level. This way you will be able to benefit on the market’s reversal after some initial swing.
Same is with a short position: once you notice on an H1 chart that the price is 10 pips above the key resistance, put a SELL STOP entry order 10 pips below that key level.
The slingshot strategy seeks to scale out of winning positions as the trade moves in trader’s favor. If prices go in your favor, but you’re not sure how long such move will last, you may scale out your position (partially close it). If the prices keep going in the same direction, you can repeat the same procedure at further levels.
2. Trading on expectations: buy the rumor, sell the fact
The idea is very straightforward: you should understand the market’s sentiment in relation to a particular currency and open position according to the direction of this sentiment. There are short-term and long-term market sentiments. Many traders prefer trading during short periods of time, as they don’t have sufficient amount of money to maintain open positions in the periods of high volatility.
Short-term sentiment is defined by economic news. If market participants expect the data to exceed the consensus forecast, they will take this into consideration. For example, if market participants wait for the Reserve Bank of Australia to raise its interest rate, the exchange rate of the AUD will be rising before the bank’s meeting (the probable rate hikes will be well priced in by the time the actual RBA meeting takes place). Once the RBA raised its interest rate, those market participants who had been ready for such turn of affairs would probably start selling AUD/USD and the pair would actually decline and not increase after the rate hike.
In order to be better off in such situation, you need to:
- Be up-to-date on the forthcoming events and economic releases.
- Keep track of the recent economic releases and watch for the market’s reaction.
- Know the correlation between various news releases (for example, how retail sales may influence GDP, PPI, CPI, ext.; if retail sales go ahead of market’s expectation, we may wait for a strong GDP release).
3. Trading spikes
This strategy can be applied when you trade on the very important news or economic releases such as Non-Farm Employment Change (Non-Farm Payrolls – NFP). It’s one of the most influential statistic indicators published by the Bureau of Labor Statistics. It measures the number of jobs created in the nonfarm sector in the US in a month. NFP is usually released on the first Friday every month.
Nonfarm payrolls may send lots of shockwaves to the technical charts. That’s why many traders prefer to wait for the dust to settle (they don’t rush into the trade right after the announcement) and trade when they grasp a better idea of the effect the release has produced.
Your actions before the release: look at the range in which the pair is trading at the present moment, then in 5 minutes before the release place two pending orders (BUY STOP – 20 pips above the current price and SELL STOP – 20 pips below the current price).
Place |Take Profit orders 40 pips above and below the current price. You can place your Stop Loss at the current price in 5 minutes before the release or choose not to place it at all. In case of a favorable outcome, you can close the deal with profit (don’t forget to close another order). If you are lucky you can make money from both your bets (if prices change their direction and go higher/lower before falling/rising).
If the outcome is negative, the prices will move in the one of the direction, open the first order, but fail to reach your take profit. Then, prices will move in the opposite direction, open another order, but won’t reach the take profit level as well. If you have a stop, your losses will be limited. If you didn’t place any stops upon your entry, you can try to compensate your losses by opening new orders, although the risks in such case will increase.
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