Forex

Foreign exchange market

The foreign exchange market (currency, forex, or FX) trades currencies. It lets banks and other institutions easily buy and sell currencies.

The purpose of the foreign exchange market is to help international trade and investment. A foreign exchange market helps businesses convert one currency to another. For example, it permits a U.S. business to import European goods and pay Euros, even though the business's income is in U.S. dollars.

In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market started forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per theBretton Woods system.

The foreign exchange market is unique because of

• its trading volumes,
• the extreme liquidity of the market,
• its geographical dispersion,
• its long trading hours: 24 hours a day except on weekends (from 22:00 UTC on Sunday until 22:00 UTC Friday),
• the variety of factors that affect exchange rates.
• the low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes)
• the use of leverage

Main foreign exchange market turnover, 1988 - 2007, measured in billions of USD.

As such, it has been referred to as the market closest to the ideal perfect competition, notwithstanding market manipulation by central banks. According to the Bank for International Settlements, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion. Trading in the world's main financial markets accounted for $3.21 trillion of this. This approximately $3.21 trillion in main foreign exchange market turnover was broken down as follows:

• $1.005 trillion in spot transactions
• $362 billion in outright forwards
• $1.714 trillion in foreign exchange swaps
• $129 billion estimated gaps in reporting

Contents 1 Market size and liquidity 2 Market participants 2.1 Banks 2.2 Commercial companies 2.3 Central banks 2.4 Hedge funds as speculators 2.5 Investment management firms 2.6 Retail foreign exchange brokers 2.7 Non-bank Foreign Exchange Companies 2.8 Money Transfer/Remittance Companies 3 Trading characteristics 4 Determinants of FX Rates 4.1 Economic factors 4.2 Political conditions 4.3 Market psychology 5 Algorithmic trading in foreign exchange 6 Fundamental trading in foreign exchange 7 Technical Analysis in foreign exchange 8 Financial instruments 8.1 Spot 8.2 Forward 8.3 Future 8.4 Swap 8.5 Option 8.6 Exchange-Traded Fund 9 Speculation 10 See Also

World currency

The US dollar and euroare by far the most used currencies in terms ofglobal reserves.

In the foreign exchange market and international finance, a world currency,supranational currency, or global currency refers to a currency in which the vast majority of international transactions take place and which serves as the world's primary reserve currency. In March 2009, as a result of the global economic crisis, China and Russia have pressed for urgent consideration of a global currency and a UN panel has proposed greatly expanding the IMF's SDRs or Special Drawing Rights.

Currencies have many forms depending on several properties: type of issuance, type of issuer and type of backing. The particular configuration of those properties leads to different types of money. The pros and cons of a currency are strongly influenced by the type proposed. Consider, for example, the properties of a complementary currency.

The euro and the United States dollar

Worldwide use of the euro and the U.S. dollar United States External adopters of the US dollar Currencies pegged to the US dollar Currencies pegged to the US dollar w/ narrow band Eurozone External adopters of the euro Currencies pegged to the euro Currencies pegged to the euro w/ narrow bandNote that the Belarusian ruble is pegged to the Euro, Russian Ruble and U.S. Dollar in a currency basket.

Since the mid-20th century, the de facto world currency has been the United States dollar. According to Robert Gilpin in Global Political Economy: Understanding the International Economic Order (2001): "Somewhere between 40 and 60 percent of international financial transactions are denominated in dollars. For decades the dollar has also been the world's principal reserve currency; in 1996, the dollar accounted for approximately two-thirds of the world's foreign exchange reserves" (255).

Many of the world's currencies are pegged against the dollar. Some countries, such asEcuador, El Salvador, and Panama, have gone even further and eliminated their own currency (see dollarization) in favor of the United States dollar. The dollar continues to dominate global currency reserves, with 63.9% held in dollars, as compared to 26.5% held in euros (seeReserve Currency).

Since 1999, the dollar's dominance has begun to be eroded by the euro, which represents a larger size economy, and has the prospect of more countries adopting the euro as their national currency. The euro inherited the status of a major reserve currency from the German Mark (DM), and since then its contribution to official reserves has risen as banks seek to diversify their reserves and trade in theeurozone continues to expand.

As with the dollar, quite a few of the world's currencies are pegged against the euro. They are usuallyEastern European currencies like the Estonian kroon and the Bulgarian lev, plus several west Africancurrencies like the Cape Verdean escudo and the CFA franc. Other European countries, while not being EU members, have adopted the euro due to currency unions with member states, or by unilaterally superseding their own currencies: Andorra, Monaco, Montenegro, San Marino, and Vatican City.

As of December 2006, the euro surpassed the dollar in the combined value of cash in circulation. The value of euro notes in circulation has risen to more than €610 billion, equivalent to US$800 billion at the exchange rates at the time (today equivalent to circa US$968 billion).

History

Spanish dollar: 17th-19th centuries

In the 17th and 18th century, the use of silver Spanish dollars or "pieces of eight" spread from the Spanish territories in the Americas westwards to Asia and eastwards to Europe forming the first ever worldwide currency. Spain's political supremacy on the world stage, the importance of Spanish commercial routes across the Atlantic and the Pacific, and the coin's quality and purity of silver helped it become internationally accepted for over two centuries. It was legal tender in Spain's Pacific territories of the Philippines, Micronesia, Guam and the Caroline Islands and later in China and other Southeast Asian countries until the mid 19th century. In the Americas it was legal tender in all of South and Central America (except Brazil) as well as in the U.S. and Canada until the mid-19th century. In Europe the Spanish dollar was legal tender in the Iberian Peninsula, in most of Italy including: Milan, the Kingdom of Naples, Sicily and Sardinia, as well as in the Franche-Comté (France), and in the Spanish Netherlands. It was also used in other European states including the Austrian Habsburg territories.

19th - 20th centuries

Prior to and during most of the 1800s, international trade was denominated in terms of currencies that represented weights of gold. Most national currencies at the time were in essence merely different ways of measuring gold weights (much as the yard and the meter both measure length and are related by a constant conversion factor). Hence some assert that gold was the world's first global currency. The emerging collapse of the international gold standard around the time of World War I had significant implications for global trade.

In the period following the Bretton Woods Conference of 1944, exchange rates around the world werepegged against the United States dollar, which could be exchanged for a fixed amount of gold. This reinforced the dominance of the US dollar as a global currency.

Since the collapse of the fixed exchange rate regime and the gold standard and the institution of floating exchange rates following the Smithsonian Agreement in 1971, most currencies around the world have no longer been pegged against the United States dollar. However, as the United States remained the world's preeminent economic superpower, most international transactions continued to be conducted with the United States dollar, and it has remained the de facto world currency.

Only two serious challengers to the status of the United States dollar as a world currency have arisen. During the 1980s, the Japanese yen became increasingly used as an international currency, but that usage diminished with the Japanese recession in the 1990s. More recently, the euro has increasingly competed with the United States dollar in international finance.

Hypothetical single supranational currency

An alternative definition of a world or global currency refers to a hypothetical single global currency or supercurrency, as the proposed terra or the Dey (acronym for Dollar Euro Yen), produced and supported by a central bank which is used for all transactions around the world, regardless of thenationality of the entities (individuals, corporations, governments, or other organisations) involved in the transaction. No such official currency currently exists.

There are many different variations of the idea, including a possibility that it would be administered by a global central bank or that it would be on the gold standard. Supporters often point to the euro as an example of a supranational currency successfully implemented by a union of nations with disparate languages, cultures, and economies. Alternatively, digital gold currency can be viewed as an example of how global currency can be implemented without achieving national government consensus.

A limited alternative would be a world reserve currency issued by the International Monetary Fund, as an evolution of the existing Special Drawing Rights and used as reserve assets by all national and regional central banks. Indeed, on March 26, 2009, a UN panel called for a new global currency reserve scheme which with "greatly expanded SDR (Special Drawing Rights), with regular or cyclically adjusted emissions calibrated to the size of reserve accumulations, could contribute to global stability, economic strength and global equity."

Russia and China call for global reserve currency

On March 16, 2009, in connection with the April 2009 G20 summit, the Kremlin called for a supranational reserve currency as part of a reform of the global financial system. In a document containing proposals for the G20 meeting, it suggested that the "IMF (or an Ad Hoc Working Group of G20) should be instructed to carry out specific studies to review the following options:

Enlargement (diversification) of the list of currencies used as reserve ones, based on agreed measures to promote the development of major regional financial centers. In this context, we should consider possible establishment of specific regional mechanisms which would contribute to reducing volatility of exchange rates of such reserve currencies.

Introduction of a supra-national reserve currency to be issued by international financial institutions. It seems appropriate to consider the role of IMF in this process and to review the feasibility of and the need for measures to ensure the recognition of SDRs as a "supra-reserve" currency by the whole world community."

On March 24, 2009, Zhou Xiaochuan, President of the People's Bank of China, called for "creative reform of the existing international monetary system towards an international reserve currency," believing it would "significantly reduce the risks of a future crisis and enhance crisis management capability." Zhou suggested that the IMF's Special Drawing Rights, a currency basket comprising dollars, euros,yen, and sterling and could serve as a super-sovereign reserve currency, not easily influenced by the policies of individual countries. US President Obama, however, rejected the suggestion stating that "the dollar is extraordinarily strong right now." In the G8 summit the Russian president revealed the world currency.

Other proposals for a global currency

In March 30, 2009, at the Second South America-Arab League Summit in Qatar, Venezuelan PresidentHugo Chavez proposed the creation of the Petro is a supranational currency, in order to face the instability that the generation of fiat currency has caused in the world economy.^[11] The petro-currency would be backed by the huge oil reserves of the oil producing countries.

Arguments for a global currency

Advocates, notably Keynes, of a global currency often argue that such a currency would not suffer from inflation, which, in extreme cases, has had disastrous effects for economies. In addition, many argue that a global currency would make conducting international business more efficient and would encourage Foreign direct investment (FDI).

An often over-looked alternative to an establishment-created global reserve currency is for anyone to adopt already existing mechanisms that traditionally has worked very well in conducting international business. There are, for example, no obstacles for legal or physical persons to start drawing contracts and invoicing in XAU - Gold - as opposed to the defunct USD, the EUR, the YAN, or any "basket" of national/regional currencies.

Arguments against a single global currency

Some economists argue that a single global currency is unworkable given the vastly different national political and economic systems in existence.

Loss of national monetary policy

One currency can only be provided by two institution printing and setting the interest rate on money deposited or lent to banks. However the central bank is a lender of last resort, and is not, contrary to popular belief, involved in most transactions involving money. The interest rate set by the central bank only indirectly determines the interest rate customers has to pay on their bankloans. Given that private firms or persons see different risks with different lendings the interest rate can be very different from one investment to the next, from one person to the next, or one country to the next. In general lending to poor involves more risk, and you need higher interest to compensate for that risk. Still only one set of politics for interest can be made at any time by one central bank. In general a bigger currency area will in general have less chance of using interest rate to stabilize the economy, because different areas may be in different stages in the boom-bust cycle, and the interest rate setting must be a compromise between the interests of the different part of the currency area.

Political difficulties

In the present world, nations are not able to work together closely enough to be able to produce and support a common currency. There has to be a high level of trust between different countries before a true world currency could be created. A world currency might even undermine national sovereignty of smaller states.

Most modern currencies have an interest rate, while one of the largest religions in the world, Islam, is against the idea of paying interest for loans. This might prove to be an unsolvable problem for a world currency, if religious views concerning interest do not moderate. This is not necessarily a fatal flaw, however, as a large number of religious adherents who oppose the paying of interest are still currently able to take advantage of banking facilities in their countries which are able to cater to this. An example of this might be Islamic banking, which operates well enough in nations where the central bank sets interest rates for most other transactions. However, banking systems in the Middle East region is less developed then in the west, and investments like for instance housebuilding have to rely more on equity or private lendings from family or close friends.

Economic difficulties

Some economists argue that a single world currency is unnecessary, because the U.S. dollar already provides many of the benefits of a world currency while avoiding some of the costs.

If the world does not form an optimum currency area, then it would be economically inefficient for the world to share one currency.

A further argument is most easily conveyed by an analogy. Water carried in a biscuit baking pan will rapidly flow from high points to the lowest point, causing a sudden uncontrollable imbalance that forces the high points higher and the low point lower. The same quantity of water in cups on the biscuit pan will have no such inherent instability. Hegemonic currencies, free of regional limitations, flow rapidly away from high risk areas exacerbating their problems disproportionately to original causes^{[citation needed]}. Such events are very damaging to the prosperity of the affected area. See for example the events leading up to, and subsequence consequences of, the Corralito in Argentina. For those with the power to do so, predicting, or even causing, such capital flights can lead to immensely profitable speculations; so profitable indeed that their likelihood of occurrence increases in proportion with the scale of the currency involved.

Tobin tax

A Tobin tax is the suggested tax on all trade of currency across borders. Named after the economistJames Tobin, the tax is intended to put a penalty on short-term speculation in currencies. The original tax rate he proposed was 1%, which was subsequently lowered to between 0.1% and 0.25%.

On August 15, 1971, Richard Nixon announced that the US dollar would no longer convert to gold, effectively ending the Bretton Woods system. Tobin suggested a new system for international currency stability, and proposed that such a system include an international charge on foreign-exchange transactions.

The idea lay dormant for more than 20 years and was revived by the advent of the South East Asiaeconomic crisis in the late 1990s. In 1997 Ignacio Ramonet, editor of Le Monde Diplomatique, renewed the debate around the Tobin tax with an editorial titled "Disarming the markets". Ramonet proposed to create an association for the introduction of this tax, which was named ATTAC (Association for the Taxation of financial Transactions for the Aid of Citizens). The tax then became an issue of the global justice movement or alter-globalization movement and a matter of discussion not only in academic institutions but even in streets and in parliaments in the UK, France, and around the world.

Tobin tax projects around the world

It was originally assumed that the Tobin tax would require multilateral implementation, since one country acting alone would find it very difficult to implement this tax. Many people have therefore argued that it would be best implemented by an international institution. It has been proposed that having the United Nations manage a Tobin tax would solve this problem and would give the U.N. a large source of funding independent from donations by participating states. However, there have also been initiatives of national dimension about the tax.

Europe

In Europe the Tobin tax idea was the subject of much discussion in the summer of 2001. On June 15,2004, the Commission of Finance and Budget in the Belgian Federal Parliament approved a bill implementing the Spahn tax (a version of the Tobin tax proposed by Paul Bernd Spahn). According to the legislation, Belgium will introduce the Tobin tax once all countries of the eurozone introduce a similar law. In July 2005 former Austrian chancellor Wolfgang Schüssel called for a European Union Tobin tax to base the communities' financial structure on more stable and independent grounds. However, the proposal was rejected by the European Commission.

Canada

In Canada, it was revived largely through the efforts of Canadian activists in the 1990s, and in March 1999 the Canadian House of Commons passed a resolution directing the government to "enact a tax on financial transactions in concert with the international community."

Latin America

In Latin America, the Tobin tax has been supported by the president of Brazil, Luiz Inácio Lula da Silva, and the president of Venezuela, Hugo Chávez; President Chávez announcing his own interest in a Tobin tax in January 2003.^[2] Recently, a regional Tobin tax was adopted by the Bank of the South, after an initiative of Presidents Chavez and Néstor Kirchner from Argentina.

United Kingdom

In the UK, the proposed Tobin tax was initially spearheaded by development charity War on Want who campaigned for its introduction from 1998 and who set up the Tobin Tax Network in 2002. At that time, global trade on the foreign exchange markets was running at $1,500bn every day. From the development lobby's point of view, the Tobin tax had the advantage of combining regulation of the international financial system with a means of raising money for development to counteract the falling aid budgets of most rich countries.

Whilst finding some support in countries such as France and Latin America, the Tobin tax proposal came under much criticism from economists and governments, especially those with a large international banking sector, who said it would be impossible to implement and would destabilise foreign exchange markets.

In 2005 the Tobin tax was developed into a modern proposal by the UK NGO Stamp Out Poverty. It simplified the two-tier tax in favour of a mechanism designed solely as a means for raising development revenue. The currency market by this time had grown to $2,000 billion a day. The possibility of a currency transaction tax for the UK was investigated by City of London firm Intelligence Capital, who found that a tax on sterling wherever it was traded in the world, as opposed to a tax on all currencies traded in the UK, was indeed feasible and could be unilaterally implemented by the UK government.

The Sterling Stamp Duty, as it became known would be set at a rate 200 times lower than Tobin had envisaged, so that it would not adversely affect currency markets and could still raise huge sums of money. The global currency market has since grown again to $3,200 billion a day in 2007, or £400,000 billion per annum with the trade in sterling, the fourth most traded currency in the world, worth £34,000 billion a year. A sterling stamp duty set at 0.005% would therefore raise in the region of £2 billion a year. The All Party Parliamentary Group for Debt, Aid and Trade published a report in November 2007 into financing for development in which it recommended that the UK government undertake rigorous research into the implementation of a 0.005% stamp duty on all sterling foreign exchange transactions, to provide additional revenue to help bridge the funding gap required to pay for the Millennium Development Goals.

Original idea and global justice movement

In an interview given to Der Spiegel on 2001, James Tobin distanced himself from the global justice movement and continued to state the validity of his proposal,

"I have absolutely nothing in common with those anti-globalisation rebels. Of course I am pleased; but the loudest applause is coming from the wrong side. Look, I am an economist and, like most economists, I support free trade. Furthermore, I am in favour of the International Monetary Fund, theWorld Bank, the World Trade Organisation. They've hijacked my name ... The tax on foreign exchange transactions was devised to cushion exchange rate fluctuations. The idea is very simple: at each exchange of a currency into another a small tax would be levied - let's say, 0.1% of the volume of the transaction. This dissuades speculators as many investors invest their money in foreign exchange on a very short-term basis. If this money is suddenly withdrawn, countries have to drastically increase interest rates for their currency to still be attractive. But high interest is often disastrous for a national economy, as the nineties' crises in Mexico, South East Asia and Russia have proven. My tax would return some margin of manoeuvre to issuing banks in small countries and would be a measure of opposition to the dictate of the financial markets."

Tobin observed that, while his original proposal had only the goal of put a brake on the foreign exchange trafficking, the antiglobalization movement had stressed the income from the taxes with which they want to finance their projects to improve the world. He declared himself not contrary to this use of the tax's income, but stressed that it was not the important aspect of the tax.

ATTAC and other organizations have recognized that while they still consider Tobin's original aim as paramount, they think the tax could produce funds for development needs in the South, and allow governments, and therefore citizens, to reclaim part of the democratic space conceded to the financial markets.

Debate on the tax and critics

Opinions are divided those who applaud that the Tobin tax could protect countries from spillovers of financial crises, and those who claim that the tax would also constrain globalization and dry up worldliquidity.

Unexpected, though qualified, support for the Tobin tax has come from the multi-billionaire speculatorGeorge Soros, who stated that, while the tax goes against his personal interests, he thinks that its introduction could have positive effects on the world economy. However, he advocates a variation to the Tobin tax: Special Drawing Rights or SDRs that the rich countries would pledge for the purpose of providing international assistance.

The "City Notebook" column in the British broadsheet The Guardian, August 30, 2001, put the case against such a tax in straightforward terms. It said that currency speculators are "an exceptionally useful lot, working day-in, day-out, risking their own wealth to supply a thing called liquidity. Without liquidity, markets dry up, prices become volatile and goods become difficult to shift." If a Tobin tax were in place, the editorial continued, that useful work would not be as well accomplished. "The net result is that everyone involved — producer, trader, buyer — becomes poorer, not richer", wrote The Guardian.

Technical analysis

Technical analysis is a security analysis discipline for forecasting the future direction of prices through the study of past market data, primarily price and volume. In its purest form, technical analysis considers only the actual price and volume behavior of the market or instrument. Technical analysts may employ models and trading rules based on price and volume transformations, such as the relative strength index, moving averages, regressions, inter-market and intra-market price correlations, cycles or, classically, through recognition of chart patterns.

Technical analysis stands in distinction to fundamental analysis. Technical analysis "ignores" the actual nature of the company, market, currency or commodity and is based solely on "the charts," that is to say price and volume information, whereas fundamental analysis does look at the actual facts of the company, market, currency or commodity. For example, any large brokerage, trading group, or financial institution will typically have both a technical analysis and fundamental analysis team.

Technical analysis is widely used among traders and financial professionals, and is very often used by active day traders, market makers, and pit traders. In the 1960s and 1970s it was widely dismissed by academics. In a recent review, Irwin and Park reported that 56 of 95 modern studies found it produces positive results, but noted that many of the positive results were rendered dubious by issues such as data snooping so that the evidence in support of technical analysis was inconclusive; it is still considered by many academics to be pseudoscience. Academics such as Eugene Famasay the evidence for technical analysis is sparse and is inconsistent with the weak form of the efficient market hypothesis. Users hold that even if technical analysis cannot predict the future, it helps to identify trading opportunities.

In the foreign exchange markets, its use may be more widespread thanfundamental analysis. While some isolated studies have indicated that technical trading rules might lead to consistent returns in the period prior to 1987, most academic work has focused on the nature of the anomalous position of the foreign exchange market. It is speculated that this anomaly is due to central bank intervention.^[14] Recent research suggests that combining various trading signals into a Combined Signal Approach may be able to increase profitability and reduce dependence on any single rule.

Titles: Chartists and Technical Analysts

Users of technical analysis are most often called technicians or market technicians. Some prefer the term technical market analyst or simply market analyst. An older term, chartist, is sometimes used, but as the discipline has expanded and modernized the use the term chartist has become rare.

General description

Technical analysts seek to identify price patterns and trends in financial markets and attempt to exploit those patterns.^[16] While technicians use various methods and tools, the study of price charts is primary.

Technicians especially search for archetypal patterns, such as the well-known head and shoulders ordouble top reversal patterns, study indicators such as moving averages, and look for forms such as lines of support, resistance, channels, and more obscure formations such as flags, pennants or balance days.

Technical analysts also extensively use indicators, which are typically mathematical transformations of price or volume. These indicators are used to help determine whether an asset is trending, and if it is, its price direction. Technicians also look for relationships between price, volume and, in the case of futures,open interest. Examples include the relative strength index, and MACD. Other avenues of study include correlations between changes in options (implied volatility) and put/call ratios with price. Other technicians include sentiment indicators, such as Put/Call ratios and Implied Volatility in their analysis.

Technicians seek to forecast price movements such that large gains from successful trades exceed more numerous but smaller losing trades, producing positive returns in the long run through proper riskcontrol and money management.

There are several schools of technical analysis. Adherents of different schools (for example, candlestick charting, Dow Theory, and Elliott wave theory) may ignore the other approaches, yet many traders combine elements from more than one school. Technical analysts use judgment gained from experience to decide which pattern a particular instrument reflects at a given time, and what the interpretation of that pattern should be.

Technical analysis is frequently contrasted with fundamental analysis, the study of economic factors that influence prices in financial markets. Technical analysis holds that prices already reflect all such influences before investors are aware of them, hence the study of price action alone. Some traders use technical or fundamental analysis exclusively, while others use both types to make trading decisions.

History

The principles of technical analysis derive from the observation of financial markets over hundreds of years. The oldest known example of technical analysis was a method developed byHomma Munehisa during early 18th century which evolved into the use of candlestick techniques, and is today a main charting tool.

Dow Theory is based on the collected writings of Dow Jones co-founder and editor Charles Dow, and inspired the use and development of modern technical analysis from the end of the 19th century. Other pioneers of analysis techniques include Ralph Nelson Elliott and William Delbert Gann who developed their respective techniques in the early 20th century.

Many more technical tools and theories have been developed and enhanced in recent decades, with an increasing emphasis on computer-assisted techniques.

Principles

Stock chart showing levels of support and resistance ; levels of resistance tend to become levels of support and vice versa.

Technicians say that a market's price reflects all relevant information, so their analysis looks more at "internals" than at "externals" such as news events. Price action also tends to repeat itself because investors collectively tend toward patterned behavior – hence technicians' focus on identifiable trends and conditions.

Market action discounts everything

Based on the premise that all relevant information is already reflected by prices, pure technical analysts believe it is redundant to do fundamental analysis – they say news and news events do not significantly influence price, and cite supporting research such as the study by Cutler, Poterba, and Summers titled "What Moves Stock Prices?"

On most of the sizable return days [large market moves]...the information that the press cites as the cause of the market move is not particularly important. Press reports on adjacent days also fail to reveal any convincing accounts of why future profits or discount rates might have changed. Our inability to identify the fundamental shocks that accounted for these significant market moves is difficult to reconcile with the view that such shocks account for most of the variation in stock returns.

Prices move in trends

See also: Market trends

Technical analysts believe that prices trend. Technicians say that markets trend up, down, or sideways (flat). This basic definition of price trends is the one put forward by Dow Theory.

An example of a security that had an apparent trend is AOL from November 2001 through August 2002. A technical analyst or trend follower recognizing this trend would look for opportunities to sell this security. AOL consistently moves downward in price. Each time the stock rose, sellers would enter the market and sell the stock; hence the "zig-zag" movement in the price. The series of "lower highs" and "lower lows" is a tell tale sign of a stock in a down trend. In other words, each time the stock edged lower, it fell below its previous relative low price. Each time the stock moved higher, it could not reach the level of its previous relative high price.

Note that the sequence of lower lows and lower highs did not begin until August. Then AOL makes a low price that doesn't pierce the relative low set earlier in the month. Later in the same month, the stock makes a relative high equal to the most recent relative high. In this a technician sees strong indications that the down trend is at least pausing and possibly ending, and would likely stop actively selling the stock at that point.

History tends to repeat itself

Technical analysts believe that investors collectively repeat the behavior of the investors that preceded them. "Everyone wants in on the next Microsoft," "If this stock ever gets to $50 again, I will buy it," "This company's technology will revolutionize its industry, therefore this stock will skyrocket" – these are all examples of investor sentiment repeating itself. To a technician, the emotions in the market may be irrational, but they exist. Because investor behavior repeats itself so often, technicians believe that recognizable (and predictable) price patterns will develop on a chart.

Technical analysis is not limited to charting, but it always considers price trends. For example, many technicians monitor surveys of investor sentiment. These surveys gauge the attitude of market participants, specifically whether they are bearish or bullish. Technicians use these surveys to help determine whether a trend will continue or if a reversal could develop; they are most likely to anticipate a change when the surveys report extreme investor sentiment. Surveys that show overwhelming bullishness, for example, are evidence that an uptrend may reverse – the premise being that if most investors are bullish they have already bought the market (anticipating higher prices). And because most investors are bullish and invested, one assumes that few buyers remain. This leaves more potential sellers than buyers, despite the bullish sentiment. This suggests that prices will trend down, and is an example of contrarian trading.

Industry

Globally, the industry is represented by the International Federation of Technical Analysts (IFTA). In the United States, there are two national organizations: the Market Technicians Association (MTA), and theAmerican Association of Professional Technical Analysts (AAPTA). The United States is also represented by the Technical Security Analysts Association of San Francisco (TSAASF). In the United Kingdom, the industry is represented by the Society of Technical Analysts (STA). In Canada the industry is represented by the Canadian Society of Technical Analysts. Additional major professional technical analysis organizations are noted in the External Links section below.

Professional technical analysis societies have worked on creating a Body of Knowledge that describes the field of Technical Analysis. A Body of Knowledge is central to the field as a way of defining how and why technical analysis may work. It can then be used by academia, as well as regulatory bodies, in developing proper research and standards for the field. The Market Technicians Association (MTA) has published a Body of Knowledge and the International Federation of Technical Analysts and the Nippon Technical Analysis Association are reported to be working on knowledge base projects.

Use

Many traders say that trading in the direction of the trend is the most effective means to be profitable infinancial or commodities markets. John W. Henry, Larry Hite, Ed Seykota, Richard Dennis, William Eckhardt, Victor Sperandeo, Michael Marcus and Paul Tudor Jones (some of the so-called Market Wizards in the popular book of the same name by Jack D. Schwager) have each amassed massive fortunes via the use of technical analysis and its concepts. George Lane, a technical analyst, coined one of the most popular phrases on Wall Street, "The trend is your friend!"

Many non-arbitrage algorithmic trading systems rely on the idea of trend-following, as do many hedge funds. A relatively recent trend, both in research and industrial practice, has been the development of increasingly sophisticated automated trading strategies. These often rely on underlying technical analysis principles (see algorithmic trading article for an overview).

Systematic trading

Neural networks

Since the early 1990s when the first practically usable types emerged, artificial neural networks (ANNs) have rapidly grown in popularity. They are artificial intelligence adaptive software systems that have been inspired by how biological neural networks work. They are used because they can learn to detect complex patterns in data. In mathematical terms, they are universal function approximators, meaning that given the right data and configured correctly, they can capture and model any input-output relationships. This not only removes the need for human interpretation of charts or the series of rules for generating entry/exit signals, but also provides a bridge to fundamental analysis, as the variables used in fundamental analysis can be used as input.

As ANNs are essentially non-linear statistical models, their accuracy and prediction capabilities can be both mathematically and empirically tested. In various studies, authors have claimed that neural networks used for generating trading signals given various technical and fundamental inputs have significantly outperformed buy-hold strategies as well as traditional linear technical analysis methods when combined with rule-based expert systems.

While the advanced mathematical nature of such adaptive systems has kept neural networks for financial analysis mostly within academic research circles, in recent years more user friendly neural network software has made the technology more accessible to traders. However, large-scale application is problematic because of the problem of matching the correct neural topology to the market being studied.

Rule-based trading

Rule-based trading is an approach intended to create trading plans using strict and clear-cut rules. Unlike some other technical methods and the approach of fundamental analysis, it defines a set of rules that determine all trades, leaving minimal discretion. The theory behind this approach is that by following a distinct set of trading rules you will reduce the number of poor decisions, which are often emotion based.

For instance, a trader might make a set of rules stating that he will take a long position whenever the price of a particular instrument closes above its 50-day moving average, and shorting it whenever it drops below.

Combination with other market forecast methods

John Murphy says that the principal sources of information available to technicians are price, volume andopen interest.^[26] Other data, such as indicators and sentiment analysis, are considered secondary.

However, many technical analysts reach outside pure technical analysis, combining other market forecast methods with their technical work. One advocate for this approach is John Bollinger, who coined the term rational analysis in the middle 1980s for the intersection of technical analysis and fundamental analysis. Another such approach, fusion analysis, [3] overlays fundamental analysis with technical, in an attempt to improve portfolio manager performance.

Technical analysis is also often combined with quantitative analysis and economics. For example, neural networks may be used to help identify intermarket relationships. A few market forecasters combinefinancial astrology with technical analysis. Chris Carolan's article "Autumn Panics and Calendar Phenomenon", which won the Market Technicians Association Dow Award for best technical analysis paper in 1998, demonstrates how technical analysis and lunar cycles can be combined. It is worth noting, however, that some of the calendar related phenomena, such as the January effect in the stock market, have been associated with tax and accounting related reasons.

Investor and newsletter polls, and magazine cover sentiment indicators, are also used by technical analysts.

Charting terms and indicators

Types of Charts

• OHLC - Open High Low Close charts plot the high and low of the price movement vertically and the open and close horizontally. Used to graph range and outliers.
• Candlestick chart - Similar to OHLC, but open and close are filled. Often Black or Red candles represent a close lower than the open. While White, Green or Blue candles represent a close higher than the open.
• Line chart - Connects each closing interval together on a line

Concepts

• Average true range - averaged daily trading range, adjusted for price gaps
• Chart pattern
• Coppock curve - Edwin Coppock developed the Coppock Indicator to identify the commencement ofbull markets
• Dead cat bounce - the phenomenon whereby a spectacular decline in the price of a stock is immediately followed by a moderate and temporary rise before resuming its downward movement
• Elliott wave principle and the golden ratio to calculate successive price movements and retracements
• Hikkake Pattern - pattern for identifying reversals and continuations
• Momentum - the rate of price change
• Point and figure charts - charts based on price without time

Overlays

Overlays are generally superimposed over the main price chart.

• Resistance - an area that brings on increased selling
• Support - an area that brings on increased buying
• Breakout - when a price passes through and stays above an area of support or resistance
• Trend line - a sloping line of support or resistance
• Channel - a pair of parallel trend lines
• Moving average - lags behind the price action but filters out short term movements
• Bollinger bands - a range of price volatility
• Pivot point - derived by calculating the numerical average of a particular currency's or stock's high, low and closing prices

Price-based indicators

These indicators are generally shown below or above the main price chart.

• Accumulation/distribution index—based on the close within the day's range
• Advance decline line — a popular indicator of market breadth
• Average Directional Index — a widely used indicator of trend strength
• Commodity Channel Index - identifies cyclical trends
• MACD - moving average convergence/divergence
• Parabolic SAR - Wilder's trailing stop based on prices tending to stay within a parabolic curve during a strong trend
• Relative Strength Index (RSI) - oscillator showing price strength
• Rahul Mohindar Oscillator - a trend indentifying indicator
• Stochastic oscillator, close position within recent trading range
• Trix - an oscillator showing the slope of a triple-smoothed exponential moving average, developed in the 1980s by Jack Hutson

Volume based indicators

• Money Flow - the amount of stock traded on days the price went up
• On-balance volume - the momentum of buying and selling stocks
• PAC charts - two-dimensional method for charting volume by price level

Empirical evidence

Whether technical analysis actually works is a matter of controversy. Methods vary greatly, and different technical analysts can sometimes make contradictory predictions from the same data. Many investors claim that they experience positive returns, but academic appraisals often find that it has little predictive power. Modern studies may be more positive, however –- of 95 modern studies, 56 concluded that technical analysis had positive results, although data snooping and other problems make the analysis difficult. Nonlinear prediction using neural networks occasionally produces statistically significantprediction results. A Federal Reserve working paper^[10] regarding support and resistance levels in short-term foreign exchange rates "offers strong evidence that the levels help to predict intraday trend interruptions," although the "predictive power" of those levels was "found to vary across the exchange rates and firms examined."

Technical trading strategies were found to be effective in the Chinese marketplace by a recent study that states, "Finally, we find significant positive returns on buy trades generated by the contrarian version of the moving average crossover rule, the channel breakout rule, and the Bollinger band trading rule, after accounting for transaction costs of 0.50 percent." Nauzer J. Balsara, Gary Chen and Lin Zheng The Chinese Stock Market: An Examination of the Random Walk Model and Technical Trading Rules

Critics of technical analysis include well-known fundamental analysts. For example, Peter Lynch once commented, "Charts are great for predicting the past." Warren Buffett has said, "I realized technical analysis didn't work when I turned the charts upside down and didn't get a different answer" and "If past history was all there was to the game, the richest people would be librarians."

An influential 1992 study by Brock et al. which appeared to find support for technical trading rules was tested for data snooping and other problems in 1999; the sample covered by Brock et al. was robust to data snooping.

Subsequently, a comprehensive study of the question by Amsterdam economist Gerwin Griffioen concludes that: "for the U.S., Japanese and most Western European stock market indices the recursive out-of-sample forecasting procedure does not show to be profitable, after implementing little transaction costs. Moreover, for sufficiently high transaction costs it is found, by estimating CAPMs, that technical trading shows no statistically significant risk-corrected out-of-sample forecasting power for almost all of the stock market indices." Transaction costs are particularly applicable to "momentum strategies"; a comprehensive 1996 review of the data and studies concluded that even small transaction costs would lead to an inability to capture any excess from such strategies.

In a paper published in the Journal of Finance Dr. Andrew W. Lo, director MIT Laboratory for Financial Engineering, working with Harry Mamaysky and Jiang Wang found that "Technical analysis, also known as "charting," has been a part of financial practice for many decades, but this discipline has not received the same level of academic scrutiny and acceptance as more traditional approaches such as fundamental analysis. One of the main obstacles is the highly subjective nature of technical analysis---the presence of geometric shapes in historical price charts is often in the eyes of the beholder. In this paper, we propose a systematic and automatic approach to technical pattern recognition using nonparametric kernel regression, and apply this method to a large number of U.S. stocks from 1962 to 1996 to evaluate the effectiveness of technical analysis. By comparing the unconditional empirical distribution of daily stock returns to the conditional distribution---conditioned on specific technical indicators such as head-and-shoulders or double-bottoms---we find that over the 31-year sample period, several technical indicators do provide incremental information and may have some practical value." In that same paper Dr. Lo wrote that "several academic studies suggest that...technical analysis may well be an effective means for extracting useful information from market prices."

Efficient market hypothesis

The efficient market hypothesis (EMH) contradicts the basic tenets of technical analysis by stating that past prices cannot be used to profitably predict future prices. Thus it holds that technical analysis cannot be effective. Economist Eugene Fama published the seminal paper on the EMH in the Journal of Finance in 1970, and said "In short, the evidence in support of the efficient markets model is extensive, and (somewhat uniquely in economics) contradictory evidence is sparse." EMH advocates say that if prices quickly reflect all relevant information, no method (including technical analysis) can "beat the market." Developments which influence prices occur randomly and are unknowable in advance. The vast majority of academic papers find that technical trading rules, after consideration for trading costs, are not profitable.

Technicians say that EMH ignores the way markets work, in that many investors base their expectations on past earnings or track record, for example. Because future stock prices can be strongly influenced by investor expectations, technicians claim it only follows that past prices influence future prices. They also point to research in the field of behavioral finance, specifically that people are not the rational participants EMH makes them out to be. Technicians have long said that irrational human behavior influences stock prices, and that this behavior leads to predictable outcomes. Author David Aronson says that the theory of behavioral finance blends with the practice of technical analysis:

By considering the impact of emotions, cognitive errors, irrational preferences, and the dynamics of group behavior, behavioral finance offers succinct explanations of excess market volatility as well as the excess returns earned by stale information strategies.... cognitive errors may also explain the existence of market inefficiencies that spawn the systematic price movements that allow objective TA [technical analysis] methods to work.

EMH advocates reply that while individual market participants do not always act rationally (or have complete information), their aggregate decisions balance each other, resulting in a rational outcome (optimists who buy stock and bid the price higher are countered by pessimists who sell their stock, which keeps the price in equilibrium). Likewise, complete information is reflected in the price because all market participants bring their own individual, but incomplete, knowledge together in the market.

Random walk hypothesis

The random walk hypothesis may be derived from the weak-form efficient markets hypothesis, which is based on the assumption that market participants take full account of any information contained in past price movements (but not necessarily other public information). In his book A Random Walk Down Wall Street, Princeton economist Burton Malkiel said that technical forecasting tools such as pattern analysis must ultimately be self-defeating: "The problem is that once such a regularity is known to market participants, people will act in such a way that prevents it from happening in the future." In a 1999 response to Malkiel, Andrew Lo and Craig McKinlay collected empirical papers that questioned the hypothesis' applicability that suggested a non-random and possibly predictive component to stock price movement, though they were careful to point out that rejecting random walk does not necessarily invalidate EMH.

Technicians say the EMH and random walk theories both ignore the realities of markets, in that participants are not completely rational and that current price moves are not independent of previous moves. Critics reply that one can find virtually any chart pattern after the fact, but that this does not prove that such patterns are predictable. Technicians maintain that both theories would also invalidate numerous other trading strategies such as index arbitrage, statistical arbitrage and many other trading systems.