Fundamental Analysis

Let's say China needs a lot of steel. And they sign a new contract with a company in Australia that makes steel. Theoretically, the share price for that Australian steel company should go up. You read about that deal in the newspaper, then call your broker and buy some of that company's shares. That's a trading decision based solely on fundamental analysis.

Another example might be that the company hires a new CEO, and that CEO did very well for the last company he/she worked at. You'd expect the share price to go up.

If a company is expected to announce $5m in profit for the year, that's also a good thing. So the share price should go up. But if actually everyone was expecting $10m in profit, turns out $5m in profit is not so good, so the share price will go down. It's not that $5m in profit is actually bad - it's that it's bad compared with peoples' expectations.

This is the bit that makes fundamental analysis a little tricky - not only do you need to know about the company, you also need to know what other traders' expectations are about that company. If everybody already knew about that deal between China and the Australia steel company, it has already been factored in to that company's share price. Buying when you read about in the newspaper is probably too late.

For currencies, there are a range of things which make the price fluctuate, which normally revolve around the flow of money.

Think of a currency like any other commodity - it responds to supply and demand. Too much supply and the price goes down. Too much demand and the price goes up.

Demand increases when people want to move their money into that country.

A simple example is when you travel to a country, you exchange your money into that local currency. What you've done is sold your currency and bought the local currency. If there was a natural disaster almost wiping out the tourism industry, less people want to travel there, so less people will want to buy the local currency, so it becomes weaker.

When a country's interest rates go up, so too does the interest that banks give on deposits. With higher bank interest comes more money flowing into the country, i.e. more people want to buy the local currency. That's good for that country's currency, and so it becomes stronger.

When a country's economy is strong, and an announcement is made by a government agency that it's going to get stronger, more people will want to invest in that country. Once again, they want to buy the local currency, so it becomes stronger. The Non-farm payrolls (NFP) announcement seems to shake things up a lot - a good announcement means the economy is doing well.

However, it's one thing to know what should happen, or to know why a price is going up or down. It's another thing completely to take advantage of that knowledge.
 

Technical Analysis

Technical analysis means simply looking at a chart of prices. The prices might be of a particular company's shares, or of a currency, or of an index like the NASDAQ or FTSE.

Technical analysts believe that all the fundamental information known to-date is already in the price. Further, we don't actually need to know why the price is moving, all we need to know is that the price is moving and respond accordingly.
 

Price Bars

The price of a share or currency bounces all over the place. If the price of the most recent transaction was higher than the transaction before it, that has very little weight in our trading decisions. Maybe it means the price is going up. Maybe that was just noise. It's impossible to tell by just comparing 2 transactions.

What you want is a clearer view of what the price is doing. The simplest way to do that is to convert a bunch of transactions into a candle or price bar.

A price bar is the summary of all transactions over a particular time period - whether that be 5 minutes, or an hour, or a day, week, month or year. A bar takes potentially thousands or even millions of individual transactions as input, and gives you these 4 prices:

1. open - the price at the start of the period
2. high - the maximum price reached during the period
3. low - the minimum price reached during the period
4. close - the price at the end of the period

 

Here's an example chart:
 

 

But how are trading decisions made by looking at that? Basically, by finding patterns in the chart, and knowing from past experience how likely the price is to go up or down when a particular pattern appears.
 

Entry, Exit

At the very heart of it, trading comes down to just 2 things:

1. When to open a trade
2. When to exit the trade

Each bar is a possible entry. But that gives us an infinite number of choices. We need to filter the number of possible entry bars down to a manageable number. Moreover, the bars we enter a trade on are preferably the ones that give us the greatest profit opportunity.

So how do we filter the bars? By using indicators, overlays, candlestick patterns, and chart patterns.
 

Indicators & Overlays

Both indicators and overlays are simply extra lines on the chart; the result of a mathematical equation applied to the price bars. Price bars remove the noise of all the individual transactions. Indicators and overlays help us make sense of the price bars.

The only difference is where these are charted:

• Overlays go together with the price bars. Their interaction with the price bars give us trading signals, e.g. the bar is above the line then open a long trade; below it then open a short.
• Normally indicators oscillate between a high and low figure, e.g. between 0 and 100. As such they are charted below the price bars, with their own y-axis. Trading decisions are made on the indicator's value, e.g. it being greater than 70, below 30, above/below 50, the line forms a higher trough, lower peak, etc. Or you can calculate the average value of the indicator, and the points where the indicator crosses its average can also be used as trading signals.
   

 

It is the mathematical formulae that make overlays and indicators statistically relevant. That is not to say they are fool-proof. Before too long you will hear of the "holy grail" indicator, which is a mythical creature that works 100% of the time and in all trading conditions.

More realistically, each overlay and indicator (henceforth "indicator" will refer to both) will work in certain conditions; be that when the price is trending strongly or when the price is ranging, but not in both.
 

 

The names of the indicators in the chart above are not important at this stage. You should simply come away knowing that indicators are just lines on the chart; you can make trading decisions from them; and none of them work perfectly in all conditions. But they can tilt the balance of probabilities in your favour.

So let's make a quick trading rule based on the lines above. I'll just refer to them as the blue and pink line.

Trading rule attempt #1. Open a long trade when:

1. the close of the bar is above the blue line

Following that rule you would have one great trade starting about the middle of the chart. But look to the left in that ranging section and the same rule gives you a lot of dud trades. So this rule did filter out a lot of the bars, but not enough.

The solution then, is to find a combination of indicators that work together. Most likely one main indicator for your trading decisions, and another (or others) which lets you know when it's okay to rely on that main indicator.

Trading rule attempt #2. Open a long trade when:

1. the close of the bar is above the blue line; and
2. the pink line forms a higher trough (than the one before it)

There are only 3 places where the pink line forms a higher trough:
 

 

In the first instance, the close of the bar is not above the blue line, so we don't open a trade. Good thing too. In the second instance, that is exactly where we want to open a trade. And in the third instance, again, it's all good. The second indicator has done a very good job of filtering the trading signals of the first.

And what we have demonstrated above is, very simply, how to make a trading system:

1. Look at the chart of price bars.
2. Mark on the chart where you would ideally like to enter and exit.
3. Add indicators to the chart.
4. Try and find patterns in the indicators that match your desired entry and exit points.
5. Remove indicators that don't seem to help, keep the others.
6. Once you're happy, backtest the system to confirm your theory over the longer term.
    

Candlestick Patterns

A guy called Steve Nison made popular in the West trading techniques that had been in use in Japan for centuries. These are candlestick patterns, and that's why a lot of them still have Japanese names.

Candlestick patterns are completely similar to indicators in that the interpretation is the same - find a pattern and decide where the price is most likely to go based on past experience. There are patterns which most likely indicate a reversal of the price, and patterns which most likely indicate a continuation of the current trend.

Candlestick patterns are completely different to indicators in that there is no maths involved. It's simply finding patterns amongst the bars themselves.
 

 

The theory is that the bars tell a collective story of traders' moods. Imagine a long white candlestick, where the open equals or is near the low, and the high equals or is near the close.
 

 

We can deduce that during the period of that bar, buyers kept pushing the price higher and higher. In such a buoyant atmosphere, you would expect the price to continue rising.

Now imagine a long candlestick where the open equals the close, somewhere in the middle between the high and low.
 

 

In this bar there are 2 possibilities. Either (a) buyers pushed the price as high as they could, only to be overcome by sellers who pushed it as low as they could, only for buyers to come back and eventually they finished back where they started; or (b) sellers went first, were overcome by buyers, but then came back and eventually they finished back where they started.

Both scenarios highlight 2 things:

1. Major indecision. There is no consensus on what the price should be. Neither buyers nor sellers could gain dominance. It's a very different story to the one told to us by the long white candle example above.
2. Price bars help us by taking the noise of individual transactions away. Conversely, price bars don't help us when we need to know the detail. Did the price go up-down-up, or down-up-down? There is no way to know by looking at the price bar alone. It's an important thing to know when backtesting using price bars.

There are about 100 candlestick patterns available for use in our automated trading software. A good explanation of some of them can be found at Incredible Charts.
 

Chart Patterns

Follow these links for explanations of the head and shoulders pattern, triangles and wedges, triple tops. There's a bunch more.

These are similar to candlestick patterns, although chart patterns normally involve a whole lot more price bars, and a whole lot more discretion. That is to say, these kinds of patterns are better spotted by humans than computers. They are not used in our automated trading software.
 

Creating A Trading System

What we have shown above is just a small part of what is needed to make a complete trading system. In essence, we only showed you how to decide on entry rules. Entry rules are important no doubt, but they are only one part of the whole.

Once you have decided when to enter, you then need to know where to enter. You also need to know where you want to put your initial stop loss. And so on. After you have finished reading this "trading basics" series, please head over to this FAQ on how to set up trading systems.