Learn about CFDs
- Beginner
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- Getting Started
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Getting Started
Trading stocks has gone on for hundreds of years, and yet, in the 21 st century's global economy, it is an activity that perennially increases. Recent decades have seen incredible investment and advances in stock-market technology as well as share-related instruments. As a consequence of that, never before have the benefits and excitement of the stock market been available to so many people. Certainly since the 1980s, it has not been unusual for the man and woman on the street to possess shares and, at the very least, dabble in the markets.
On a global basis, individuals trade stock shares and 'contracts for difference', or CFDs, a share-based product that adds flexibility to an individual's trading options. Whether they are trading shares and CFDs from companies with household names like Tesco or Virgin, or entire indices like the FTSE 100 Index, they put their money to work for them in a more dynamic and intriguing way than depositing it in a bank appears to do. And they do so every day.
And the fact that you're here suggests you want to join in too. This is an ideal place to learn about shares and CFDs, as well as the tools and information you will need to start trading them. So let's get started.
In this first section, we will explain the following to get you on your way to making your first trade:
Shares - Pieces of a Company
Shares are pieces of a company, with every individual share representing part-ownership. So even if you own just 1 share in a company that has issued 1,000 shares, then you still own 0.1 percent of that company. Likewise if you own just 1 share in a company that has issued 1,000,000 shares, then you own 0.0001 percent of that company.
Companies alone decide how many shares they issue. Traders and other market participants cannot create their own shares and are restricted to trading those shares that the company has issued.
Shareowners are entitled to share in their company's successes and failures, its profits and the losses. When companies make money, the value of their shares usually rises. But, of course, the converse is equally true. Like a marriage, shareholding is for better or worse. Speculation on any share price can drive it up or down in the short term, but a company's performance is really what drives its price in the long term.
Traders buy and sell shares to capitalize on a share's price movement. If a share rises in value whilst you own it, then you make money. So if you bought a Google share (GOOG:xnas) for $400 and then sold it after the price soared to $500 you would make $100 ($500 - $400 = $100).
If you sell a share short (which means you borrow the share from your dealer and sell it on the open market), and the price of that share goes down, you make money. For example, if you borrow a share of Google from your dealer and sell it on the open market for $600, buy it back for $500 and then return it to your dealer, you make $100 ($600 - $500 = $100).
It Is Not Necessarily Just About Making Money
As a shareholder, you are entitled to vote for members of the company's board of directors - and on other issues that are brought before the owners of the company. So you can take a real and proactive interest in its management.
But money is very much what stock trading is about. Companies issue shares to raise money. Very often this is not because they do not already make money but because management sees a potential to generate more product or service if the company has more money to invest. They might, for example, realise that they could easily double production of electroplaters if they had the capacity. If there are plenty of orders, if there is little competition, if the profit margin is good, if demand is anticipated to rise, if such production could easily be managed, then such an investment would probably be sound.
When companies need money, they raise it in two ways. They borrow it from lenders or receive it from investors. The latter don't just give cups of money to companies for nothing. They want something in return. They want pieces of the companies, and by selling shares, companies are able to oblige them.
Publicly-traded companies usually have thousands (and sometimes millions) of individual owners because they ordinarily issue millions of shares and every share has an owner. All of these owners must understand that they share risks as well as profits. As we all know, because the mantra of the Advertising Standards Authority repeatedly warns us of it, the value of investments can fall as well as rise.
The following table illustrates what will happen to the value of your shares based on whether you bought or sold the share to enter your trade:
Share Price Goes DOWN
Share Price Goes UP
BUY the Share
Lose Money
Make Money
SELL the Share
Make Money
Lose Money
Share prices fluctuate on a daily basis. Traders must predict the direction they believe a share price is going to move and place their trades accordingly. You will learn more about share analysis and how to anticipate price movements in later sections.
Stock Traders
Stock traders who want to buy or sell a share submit their orders to Saxo, and Saxo takes care of the rest. It really is very simple. The complete process is as follows:
- You submit an order to Saxo
- Saxo submits the order to the appropriate stock exchange
- he exchange fills the order by matching it with another order (or orders)
- The exchange confirms to Saxo that the order has been filled
- Saxo updates the order in your account
All of this takes just seconds because Saxo provides a trading platform that enables near-instantaneous order execution for individual investors like yourself.
Re-use of Collateral
Saxo allows up to 60 percent of collateral invested in certain shares and ETFs (Exchange Traded Funds) to be used for margin trading activities (Forex and CFD trading). So if you hold eligible shares worth £20,000 you can re-use up to £12,000 of this as collateral for trading Forex and CFDs.
Contracts for Difference (CFDs)
Contracts for difference (CFDs) bear comparison with the stocks and stock indices on which they are based. But they are beneficial because they give users extra leverage. Whereas stocks are certificates of company ownership, CFDs are simply contracts between two parties (you and your dealer, in most cases) that decide how much money you will make/owe depending on where the price of the underlying stock or stock index moves. So, in a sense, they're like virtual shares.
Whereas there are a limited number of stock shares available for each company, there are no such limits on CFDs. Companies don't issue CFDs or determine how many are available - traders do. Providing there are traders willing to buy or sell CFDs, and dealers or others willing to take the opposite side of the trade (which can mean believing the opposite of what you are convinced will be the case), the number of CFDs you can trade on each share or share index is effectively limitless.
Despite their differences, CFDs and stocks work in much the same way. CFDs alone cannot gain or lose. A stock, on the other hand, can gain or lose all by itself. Yet a CFD attached to a stock share loses or gains in parallel with share. As the share price rises, the CFD moves. Conversely, as the share price falls, the value of the CFD moves.
CFDs and stock shares are like people and hot-air balloons respectively. People cannot fly unaided. Yet balloons fly by themselves. But if you put people inside their baskets, they fly underneath balloons as passengers. As the balloons rise, the passengers also rise. As the balloon descends, the passengers likewise descend.
Every CFD has a specific underlying stock or stock index on which it is based. If you trade a CFD for the Nikkei 225 Index (an index of Japanese stocks that trade on the Tokyo Stock Exchange), for instance, the performance of your CFD is based on the price performance of the Nikkei 225. If you buy the Nikkei 225 CFD and the price of the Nikkei 225 rises, then the value of your CFD will also rise. Conversely, if you sell the Nikkei 225 CFD and the price of the Nikkei 225 moves lower, then the value of your CFD will also move higher.
The following table illustrates what will happen to the value of your CFDs based on whether you bought or sold the CFD to enter your trade and the price movement of the underlying asset:
Underlying Asset Price
Goes DOWNUnderlying Asset Price
Goes UPBUY a CFD
Lose Money
Make Money
SELL a CFD
Make Money
Lose Money
CFD values fluctuate daily as the price of the underlying asset climbs or falls. Stock traders must determine in which direction underlying assets should move so they can place CFD trades accordingly. You will learn more about how to analyse underlying assets, and predict where prices will go, in later sections.
As an aside, it is perhaps worth mentioning that CFD holders are not entitled to vote for members of the company's board of directors or on other issues that are brought before the owners of the company. CFDs also give you no ownership rights whatsoever in a company.
Along with being quite easy to trade, CFDs enjoy another tremendous advantage over stocks: leverage.
Leverage
CFDs bestow leverage, and leverage is the one characteristic of CFDs that intrigues individual investors the most. Levers employ a small amount of power to achieve a big effect. The physical world is full of levers. Our bones are levers through which we apply force, using muscles, to do everything from tap on a keyboard to land a knockout punch. And CFDs are the stock market's levers. They can sometimes allow traders to use smaller amounts of money to achieve disproportionate gains in the same way that a small child can lift their dad off the ground on a see-saw if both child and dad sit in the right places.
The same principle applies to CFDs. You can make money by simply investing your own money, but you can make much more money if you can use the tool of financial leverage by borrowing money from your dealer. You can also lose more money when trading with leverage.
Incidentally, be warned that, whilst some dealers allow you to use leverage to buy shares on margin, the maximum leverage you can use is limited and not all traders will qualify.
You can lever your CFD accounts, or increase their investing power, by using some of your own money to enter a trade and then borrowing the balance from your dealer. So you might buy or sell a CFD on some popular shares and indices using as little as 10 percent of your own money and borrowing the remaining 90 percent of the price from your dealer.
The leverage employed when trading CFDs is decided by the margin you post for each trade.
Margin
The CFD market proffers exciting possibilities for those traders whose dealers are willing to lend money to enable them to increase the profit-generating potential of all trades. Before your dealer loans money, you will need to show that you have sufficient to cover any and all losses you may incur. This money, set aside by your dealer for safe-keeping, is called margin.
For example, if you bought an Exxon Mobil CFD, you would perhaps be required to set aside 10 percent of the share price as margin. With a share price is $90 you must set aside $9 to prove to your dealer that you can cover losses of at least $9 (a 10 percent loss) should your trade move against you.
But the aforementioned 10 percent margin is a contrived example. Different CFDs have different margins. CFDs corresponding to shares and indices that are actively traded need smaller margins because their high levels of liquidity make it easier to enter and exit trades quickly. Dealers therefore can be confident that they can rapidly close out your positions without incurring unexpected losses if the going gets tough. CFDs covering stocks and indices that are not actively traded need bigger margins since their low levels of liquidity make it harder to enter and exit trades quickly.
Many novice CFD traders often mistakenly believe that the money they set aside as margin is a deposit on stock shares or indices. It is not. They borrow 100 percent of the price from the dealer. The margin only assures the dealer that there is money to cover any losses as they occur.
CFD Financing credit/debit rates
As it is a margined product, you finance the traded value of the CFD with an overnight credit/debit charge. In return for that charge, your dealer is flexible in its lending. When you hold a CFD overnight (e.g. you have an open CFD position at close of market i.e. 17.00 New York time) your CFD position will be subject to the following credit or debit:
- When you hold a long CFD position overnight, you pay interest, meaning that you are debited an amount calculated using the relevant Inter-Bank Offer Rate for the currency in which the underlying share is traded (e.g. LIBOR) plus a mark-up (times Actual Days/360 or Actual Days/365).
- When you hold a short CFD position overnight, you receive interest, meaning that you are credited an amount calculated using the relevant Inter-Bank Bid Rate for the currency in which the underlying share is traded (e.g. LIBID) minus a mark-down (times Actual Days/360 or Actual Days/365).
The credit/debit is calculated on the total nominal value of the underlying share(s) at the time the CFD contract is established (and irrespective of whether it is long or short).
If you open and close a CFD position within one trading day, you are not subject to these credits and/or debits.
CFD Traders
CFD traders who wish to buy or sell CFDs submit their orders to Saxo, and Saxo takes care of the rest. With CFDs, however, Saxo fulfils orders in one of two ways. It either sends the order to a centralized CFD exchange or it acts as the counterparty to the trade.
When you submit an order for a CFD that trades on a centralized exchange, Saxo will handle your order the same way it would handle a stock order viz:
- You submit an order to Saxo
- Saxo submits that order to the appropriate exchange
- The exchange fills the order, matching it with another order (or orders)
- Saxo receives a confirmation that the order has been filled
- Saxo updates the order in your account
When you submit an order for a CFD that does not trade on a centralized exchange but is to be fulfilled by Saxo instead, the order process is slightly different, viz:
- You submit an order to Saxo
- Saxo fills the order
- Saxo updates the order in your account
Regardless of the type of CFD you buy or sell, the entire process happens within a matter of seconds. It is virtually identical in that respect to trading a stock.
Short Selling CFDs
The short selling of CFDs directly on exchanges (where Saxo does not market-make) is subject to the rules of the host nation's share market. When trading Australian CFDs, for example, you might find that the volume of CFDs you can short trade in a single day is limited due to limited borrowing availability in the underlying market.
The forced closure of positions if CFDs are recalled can occur. This can easily happen if the share becomes hard to borrow due to takeovers, dividends, rights offerings (and diverse merger and acquisition activities), or due to increased hedge fund selling of the share.
⇑ Top - Determining Stock Values
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Determining Stock Values
Stock prices can be a roller-coaster ride, and it is this movement that motivates people to trade stocks and CFDs. If stock prices didn't rise and fall, then you couldn't make money trading stocks and CFDs, and you wouldn't be here. And, without traders, much of industry and commerce would be starved of the funds and liquidity they need.
The market is a dynamic environment. Within it, stock prices incessantly move up and down so that they are worth one price at any given moment and yet another price a few seconds later. It may seem random, but stocks invariably move up and down for a reason. And the reason can be anything from an earnings announcement to a whim to a full-blown economic recession. But the root of all reasons is the need to balance the forces of supply and demand. To be successful, you have to pay attention that root of all reasons, but being able to zoom in and focus in minutiae is also extremely useful.
To explain why share prices move up and down in value we will look at the following:
- The forces of supply and demand
- Who is participating in the share and CFD market
- The factors traders look at when pricing a share
Supply and Demand in the Stock and CFD Markets
The forces of supply and demand drive prices. Supply is driven by the number of stocks or CFDs available to the investing public. Demand is driven by the wish of traders to buy or sell a stock or CFD.
Here you can see a typical supply and demand chart (see Figure 1 ). Demand is represented by the line sloping downward from left to right, whilst supply is represented by the line sloping upward from right to left. The intersection of these two lines represents the price the market will accept for the stock or CFD.
Figure 1-Supply and Demand Chart
Supply and demand can both fluctuate according to sundry market conditions. We are going to examine how movements in either supply or demand can influence the value of a stock or CFD as follows:
How Increasing Demand Affects Stock and CFD Values
Increasing demand for a stock or CFD pushes up its value.
On the supply and demand chart below (see Figure 2 ) it is evident that, when demand increases, the demand curve shifts to the right. As it does so, the point at which it intersects with the supply curve moves higher. This shows that increasing demand for a stock or CFD increases its value too.
Figure 2-Supply and Demand Chart (Increased Demand)
Demand for stocks and CFDs can increase when companies announce better-than-expected earnings for a quarter or the year. When Apple Inc. (AAPL:xnas) announced an earnings boost due to frenetic buying of its iPod, traders bought Apple shares in the hope that the company would have a record year and that Apple stock values and premiums would reflect that..
Unlike Apple and the iPod, market crazes are often due to surreal increases in demand that have little if anything to do with the true value of the product or service involved. A famous example is the Dutch Tulip Mania. Traders returning from the Ottoman Empire introduced tulips to Holland in the late 16th century. By the early 17 th century, tulips, and especially rare bulbs, were trading at ludicrous prices. The most expensive recorded sale was 6,000 florins for a Semper Augustus bulb. To put this in perspective, the average annual income at the time was 150 florins. That means 40 years' work would earn you a tulip bulb at a time when the average life expectancy certainly didn't accommodate 40 years' work. Assumedly, tulip brokers didn't dream of retiring to a country pile in Surrey but fantasized instead about retiring with their little black tulip. The irony is that, as anyone who has ever worked with bulbs would tell you, it is terribly hard to determine one tulip bulb from another (or, indeed, from daffodil bulbs). So it's difficult to fathom why anyone would sacrifice all for a little black bulb that's not discernibly better than its rivals. Never underestimate the effect of increasing demand.
How Increasing Supply Affects Stock and CFD Values
Increasing supply of a share or CFD decreases its value.
On the supply and demand chart below (see Figure 3 ) you can see that as supply increases the supply curve moves to the right. As it does the intersection with the demand curve moves down. Consequently increasing supply of a stock or CFD reduces its value.
Figure 3-Supply and Demand Chart (Increased Supply)
Supply of a stock or CFD can increase when a major share-market index delists a share. For example industrial supply manufacturer Honeywell (HON:xnys) used to be a component of the Dow Jones Industrial Average. As economic conditions made Honeywell a less significant share in the broader market the Dow Jones delisted it from its premier index. As a result of this delisting many fund managers who maintain portfolios based on the Dow Jones Industrial Average were forced to sell their Honeywell shares, increasing the supply for sale in the market and thus eroding the share price.
How Decreasing Demand Affects Stock and CFD Values
Decreasing demand for a sstock or CFD decreases its value.
On the supply and demand chart below (see Figure 4 ) you can see that as demand decreases the demand curve moves left. As it does so the intersection with the supply curve moves lower, showing that increasing demand for a stock or CFD decreases its value.
Figure 4-Supply and Demand Chart (Decreased Demand)
Demand for a stock or CFD can slump if traders hear bad news or rumours about a company. For instance in 2004 the international pharmaceutical manufacturer Merck & Co. (MRK:xnys) withdraw its arthritis drug Vioxx amidst claims of increased coronary risk for users. Trader concern over loss of revenue and the likelihood of a class action dramatically undermined Merck's profitability, and their stock value plummeted.
How Decreasing Supply Affects Stock and CFD Values
Decreasing supply of a share or CFD increases the value of that stock or CFD.
The supply and demand chart below (see Figure 5 ) shows that as supply decreases the supply curve moves to the left. As it does so, the intersection of the demand and supply curves moves higher. This proves that restricting the supply of a stock or CFD increases its value.
Figure 5-Supply and Demand Chart (Decreased Supply)
Stock or CFD supply slumps as companies buy back shares. Cash-rich companies that feel their stock is underpriced often buy their own stock shares to drive up the price and therefore increase inward investment.
In summary, changes in supply and demand can affect stock and CFD prices. But no doubt you are asking what causes those changes in supply and demand. We shall explain.
Stock and CFD Market Participants
Stock and CFD markets could be compared with the Tower of Babel . Traders represent every ethnicity, every culture and every language. But all of these people must recognize, if they are to survive for long, the forces of supply and demand. Yet every participant has a personal agenda and individual needs. Some look for quick profits whilst others take a long-term view. Some have zillions to invest while others barely have enough to meet account minimums. You will never understand what is going on in every trader's head. Yet broadly understanding their motivations can help you to anticipate market developments and enable you to outperform it. And that is the key. Outperform the market, and you should be in marked profit.
For the purposes of this discussion, we will divide the major market participants into two groups:
Institutional investors are substantial professionals who typically control huge sums of money and involve themselves in mutual funds, hedge funds, pension funds and so forth. Being so influential, you should focus on them when trying to decode the market.
Individual investors are people like you who either trade for a living or as a sideline to boost income and net worth. This group should play a less significant role in your analysis.
Institutional investors drive markets. Having so much money in their portfolios, they are a potent influence on the market and its prices. Their ability as traders to buy shares in huge volumes will invariably drive prices more than traders who dabble ever could.
Institutional investors largely operate under strict mandates, they observe certain trading rules and they invest in specific classes of assets. For example some institutional investors only operate funds that are known as large-cap funds. This means that they exclusively contain shares in companies with a market capitalization exceeding $5 billion. Meanwhile other institutional investors stick to technology funds so they buy shares in technology-based companies such as Microsoft (MSFT:xnas) or Google (GOOG:xnas). Others operate only with ethical or green or fair-trade funds.
As an aside, and since we mentioned market capitalization, it equates the number of shares issued multiplied by the price per share. For example, General Electric (GE:xnys) has nearly 9.99 billion shares and a share price (at the time of writing) of $32.23. This gives the company a market cap (or capitalization) of more than $321 billion (i.e. 9.99 billion × $32.23 = $321+ billion).
Divining what institutional traders are doing with their portfolios enables you to determine how the forces of supply and demand are acting - and how those dynamics are going to influence stock prices. You are never going to know exactly what these institutional traders are doing. Certainly you would have to be privy to their deals to know. Yet, if you know what they are watching when they make their decisions, you can watch the same things and intelligently deduce what they might do next.
Factors that Affect Stock Prices
Many different factors influence stock prices. A handful of key factors play important roles in determining stock values, and the following are the four factors you should observe most closely:
- Earnings and other fundamentals
- Dividends
- Economic announcements
- General shifts in market/sector strength
Earnings and Other Fundamental Numbers
It is largely company performance that drives share prices. If you buy a stock, then you buy a slice of the company, a slice of its successes and failures. A company that performs well attracts more interest in its shares. Interest translates to demand, and demand translates into higher prices. The converse is true for a company that performs disappointingly.
To determine company performance, traders and analysts examine several fundamental figures (i.e. numbers derived from a company's balance sheet and income statement). A company's earnings - the amount it makes after paying its expenses - is typically the most important of these. Yet there are other fundamental numbers such as the return on equity (ROE) and the price-to-book ratio that present traders with an indication of the overall health of a company. There will be more about company fundamentals later.
Dividends
Companies can do two things with profits: they can keep and reinvest them or they can pay shareholders a dividend. Dividends are per-share payments so if a company with 1,000,000 shares issued pays a £5,000,000 dividend, each share receives £5.
Traders value dividends highly because, assuming the shares are held for a time, they represent regular cash returns on investments. Since dividends are prized, a company can boost share value by boosting its dividend (though investors will want to see that the company can afford this generosity). Companies increasing dividends generally enjoy stock-price increases, whilst the converse is equally true. Despite this, fewer companies pay dividends nowadays and instead retain earnings to reinvest in the company. In such cases, an investor who needs regular income is forced to sell at least some shares or invest, instead, in companies that do generate dividends.
Depending on whether you are a share or CFD trader, Saxo treats company dividends differently.
Dividends on Stock Positions
Saxo credits dividend payments on share positions to your account with any applicable standard withholding taxes deducted. For obvious reasons, Saxo cannot currently support or offer preferential withholding tax rates that may be available due to residency or legal status.
Dividends on CFD Positions
When dividends are paid on underlying shares, holders of long CFD positions qualify for proportional payouts. Holders of short CFD positions have to pay an amount equal to the full (gross) dividend paid on underlying shares.
All cash dividends for CFD positions are settled on pay date. Cash dividends are booked on ex-date to reflect market price movements on the ex-date, but the actual value of the payment is settled on pay date.
Dividends on CFD positions are cash adjustments paid or debited by Saxo and not by the underlying company. Dividends paid on CFDs are not eligible for any preferential withholding tax rates sometimes associated with dividends paid on physical shares, so may differ from the dividends payable on underlying shares.
Dividends on Index Trackers
When underlying shares that are part of Index CFDs go ex-dividend, the Index CFD prices are adjusted to reflect dividends. The weighted proportion of the dividends within the Index are credited to client accounts for long positions and debited for short.
Note that the DAX30 is a Total Return Index, so the index is automatically adjusted for dividends.
Index Dividend = Share Dividend * Shares in index / Index Divisor*.
* Divisor: the amount used to stabilize the index value when its composition changes. The sum of all index members' prices is divided by the divisor to achieve the normalized index value. The divisor is adjusted when capitalization amendments are made to the index members, allowing the index value to remain comparable at all times. To prevent the value of an index from changing due to such events, all corporate actions affecting market capitalization of the index require divisor adjustment to ensure the index values remain unaffected by the event.
Economic Announcements
Economic announcements, usually released by governments and other large groups, include interest rates and gross domestic product (GDP). They often affect the economy as a whole, not just individual companies. Such news may well be important to you as a stock and CFD trader, but you should not miss it because it is scheduled months in advance. Traders know a year in advance when the U.S. Federal Open Market Committee (FOMC) will meet to discuss interest rate changes. Likewise in the UK , the government's budgets and mini-budgets are scheduled well ahead of the actual events. This gives you plenty of time to research the likely content of announcements and position your portfolio accordingly.
Fortunately for you, Saxo provides an up-to-the-minute economic calendar so you can know exactly what news is scheduled for release today, tomorrow and into the future (see Figure 1 ).
Figure 6-Economic Calendar
A cursory glance at the calendar tells you about upcoming events that have the potential to influence the movement of the stocks and CFDs you are watching. These events might include announcements involving German unemployment data, U.K. money supply and U.S. gross domestic product (GDP), as is demonstrated by the figure above.
Investment analysts, economists and other market participants constantly analyse these announcements, trying to second-guess their content. Analysts seldom agree, but the body of opinion produces what is called the "consensus estimate" and is broadly reliable.
Familiarity with the consensus estimate lets traders take advantage of price movements once the economic announcement is released because the consensus estimate will already be "priced in" to the value of the stocks and CFDs. Investors will have placed trades before the announcement to take advantage of where they believe stocks and CFDs will move. If the economic announcement matches the consensus estimate, then prices will barely move because most institutional investors have already placed their trades. It is only really when the consensus estimate has been inaccurate because the market is wrong-footed that prices have to adjust to accommodate the new economic realities. At such a time, when market participants are scrambling to factor in the new information, you will have opportunities to capitalise on price movement. Yes this is flagrant opportunism, but that should become second nature.
General Shifts in Market/Sector Strength
Companies prefer their stock price to reflect their individual corporate performance, yet other general market forces can lift or lower share values regardless of that performance.
There's an old adage that every trader ought to know: "A rising tide floats all boats." Simply put, it means that in a bullish market most stocks go up because the market and the economy in general are going up. On the other hand, it means that in a bearish market, most shares go down because the market and the economy in general are going down.
This truism may apply to the market in general but not necessarily to certain sectors of it. For instance, healthcare stocks may be booming but retail shares may be slumping. Bullish and bearish forces within individual sectors can have the same impact on the stocks within those sectors as bullish and bearish forces can have on the overall market. Nothing is set in stone.
We will tell you more about the analysis of market and sector trends in a later section. Right now simply knowing that these forces exist will put you well ahead of most retail traders.
⇑ Top - Technical Analysis: Trends, Support and Resistance
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Technical Analysis: Trends, Support and Resistance
Stocks are eternally rising and falling. Financial reports tell of stocks moving up and down. They are, of course, referring to prices. Stock prices change daily and fortunes rest on the ability to predict such changes. Your job as a stock or CFD trader is to learn to identify where the prices of actual or potential investments are going to go next.
Stock and CFD traders track historical prices using price charts. By keeping track of historical prices, traders are able to more accurately project where prices are likely to head in the future. The process of analyzing historical prices to intelligently predict future price movement is called technical analysis.
Technical analysis, or chart reading, is the natural progression after you have conducted your fundamental analysis. Fundamental analysis helps you determine whether you should buy or sell a particular stock or CFD. Technical analysis helps you determine when you should buy or sell that stock or CFD.
Despite the science and math behind it, technical analysis is considered by most traders to be almost an art form which takes time and practice to master. It may seem complex, but technical analysis is indispensable to good trading, and the fundamentals are reasonably simple:
Trading with the Trend
Identifying trends and trading intelligently with them in mind is vital to your success as a stock or CFD trader. Traders are gregarious, and when one or two identify an opportunity or a threat, the others typically follow suit to push the price in the same direction. Once a stock has achieved some momentum, it is likely to be sustained for a while. Spotting such a trend will increase your likelihood of making money (or not losing it, which is equally important). Bucking a trend generally turns out to be a loss-making proposition.
Trends indicate where prices will probably head in the future. If traders push a price higher, then you ought to buy to make money. If traders push a price lower, then you ought to sell to prevent losses. If traders disagree over a price, then you could alternate between buying and selling, or you could wait until a clear trend emerges, then ride it.
Trends are not entirely linear. Prices rarely move straight up or straight down. Movements are always a little fuzzy because of the many individuals who are trading, and because they are largely trading in idiosyncratic ways. Yet there is a herd mentality. When a majority of traders believes the stock price is going to move in one direction, they can overpower the minority of traders who disagree with them. When this occurs, the price begins to trend and will usually move in one direction for a while until the majority loses confidence – which is reflected in reduced momentum. At that point, the minority can momentarily exert its influence and push the stock price in the opposite direction. And so on. It is a little like rugby.
Like in rugby, there are turning-points is price trends. There are moments when the application of huge amounts of force may achieve nothing, and therefore the effort is wasted, just as there are moments when a smaller and well-timed effort can achieve spectacular results. Trading is very much an activity in which timing is critical. Learning to identify the critical moments as a trader, the moments when a price will soar or plummet to create an opportunity, all hinges on the recognition of upward and downward trends.
Upward trends - stocks or CFDs that are upward trending form a series of higher highs and higher lows (see Figure 1).
Figure 1–Up Trend
Down trends - stocks or CFDs that are trending downward form a series of lower highs and lower lows (see Figure 2).
Figure 2–Down Trend
Sideways trends - stocks or CFDs that are trending sideways form a series of highs that are at approximately the same price level and a series of lows that are at approximately the same price level (see Figure 3).
Figure 3–Sideways Trend
Trends–whether they are upward trends, downward trends or sideways trends–can become immediately apparent or take a while to spot. Identifying the following trends over each time-frame and being able to utilise them will be crucial to your success as a stock or CFD trader:
Long-Term Trend
Fundamental factors are the major drivers of long-term trends. If companies perform fundamentally well, their stock prices typically rise. If companies perform fundamentally poorly, their stock prices typically fall. Whilst the outlook for a company can literally change overnight, the trends established by a company's fundamental strength or weakness tend to last for a while.
Long-term trends, sometimes called major trends, are those trends that have dominated a stock or CFD for the longest period. Looking at this weekly chart of McDonalds (MCD:xnys), you will notice that the price has steadily risen in an upward trend, which runs from left to right. Notice the series of higher highs and higher lows as time progressed (see Figure 4 ).
Figure 4–Long-Term Trend
When you see a strong upward trend, like that on the McDonalds chart, you know that traders are keen to invest in its stock, and you should consider doing the same if you want to make money. If the trend on the McDonalds chart had been downward, you would then have been advised to consider selling to take advantage of the price movement.
Next, you ought to examine an intermediate trend to see if it is heading in the same direction as the long-term trend.
Intermediate Trend
Intermediate trends, sometimes called minor trends, move more quickly than long-term trends because they do not last for so long. These trends are also affected by a company's fundamental factors. As the daily McDonalds chart shows, the price has not moved straight up but has followed a long-term upward trend. At times, the intermediate trend has seen the price move sideways, and at times it has fallen, but the overriding trend is clearly upwards (see Figure 5 ).
Figure 5–Intermediate Trend
Notice that, whilst there have been periods when the intermediate trend was moving both sideways and downward, the long-term trend was still upwards. Trends tend to move in a stepped fashion. Rarely do they move straight up or straight down.
Seeing this price trend should motivate you to buy McDonalds. You would then be bullish since you would anticipate that the price would continue to rise. But you might want to wait to buy when you saw the intermediate trend move upward-and in line with the long-term trend.
Next, you should look at the short-term trend to see if it is heading in the same direction as the long-term and intermediate trends.
Short-Term Trend
Short-term trends, sometimes called micro trends, are more volatile than both long-term and intermediate trends because they cover the shortest period of time and are driven by the news of the day. Often, these short-term trends rapidly reverse. Looking at the McDonalds hourly chart you can see that the price was initially on a short-term downward trend. Notice the series of lower highs and lower lows as time progressed (see Figure 6 ).
Figure 6–Short-Term Trend
Notice that, whilst the short-term trend was downward, the intermediate and long-term trends were upward. So it is possible to have trend time-frames simultaneously moving in different directions.
Seeing this downward trend on the hourly chart would probably have prevented you from bullishly investing in McDonalds at that time, even though the intermediate and long-term trends were bullish. However, since it is the only the short-term trend that might undermine confidence, you should still be bullish about McDonalds.
In fact, if you look at the end of the hourly chart for McDonalds, you can see that the short-term trend is changing direction and that this change could soon align the short-term, intermediate and long-term trends in a way which should encourage you to buy.
Aligning Trend Time-frames
Your most profitable trading opportunities will come when the long-term, intermediate and short-term trends all line up in the same direction. Just as it is easier to swim downstream instead of upstream against the current, it is easier to trade with a trend than against it. When long-term, intermediate and short-term trends all rise in unison, it is an ideal time to buy a stock or CFD. When long-term, intermediate and short-term trends all fall in unison, it is an excellent time to sell.
The McDonalds chart shows that the trend for each time-frame has risen for the past few months, during which the price has soared. Had you invested in the company throughout this time, it would have been very profitable for you (see Figure 7 ).
Figure 7–Aligning Various Trend Timeframes
Understanding trends is critical to technical analysis. Yet, you also have to understand the concepts of support and resistance.
Paying Attention to Support and Resistance
Support and resistance levels are like the ends of an Olympic swimming pool. Just as the ends of the pool force swimmers to turn and swim in the opposite direction, support and resistance levels tell traders that the price of a stock or CFD is likely to stop moving, to turn around and to start moving in the opposite direction. Knowing when such a reversal should occur helps traders to buy and sell at the most profitable times.
Support is a price level at which a currency pair tends to stop falling, turns around and starts climbing again. Support usually occurs because of the following:
- Traders who missed an earlier buying opportunity decide it is a good time to invest
- Traders who bought the stock or CFD decide it is a good time to add to their positions
- Traders who sold the stock or CFD decide it is a good time to take profits
Resistance is a price level at which a currency pair tends to stop rising, turns around and starts falling again. Resistance usually occurs because of the following:
- Traders who missed an earlier selling opportunity decide it is a good time to trade
- Traders who sold the stock or CFD decide it is a good time to add to their positions
- Traders who bought the stock or CFD decide it is a good time to take profits
Support and resistance levels are not precise. You could compare them with soft buffers or crash barriers. They are the vague limits at which traders say 'they cannot be worth so much; I'm selling' or 'they cannot be worth so little; I'm buying.' You would only frustrate yourself trying to pinpoint a price level of 1410 on the S&P 500 as the ideal time to support. Instead you would be much better off identifying a price range of 1400 to 1420, or 1390 to 1430, as support. So support and resistance levels should be flexible.
There are different types of support and resistance levels, and you will need to learn to recognize the following:
Horizontal Support and Resistance
Horizontal support and resistance levels form as prices rise or fall. You can see these support and resistance levels take shape on charts which track the stocks and CFDs that you are interested in trading.
On the Caterpillar (CAT:xnys) chart, for instance, you can see that certain price levels (indicated by bold black lines) acted as strong levels of support and resistance. From June 2007 until the early part of August 2007, the $77.50 price level served as support for the stock (see Figure 8). This same price level, once the stock tumbled down through it in mid-August, served as resistance to the price rising through the rest of August and into September.
Figure 8–Horizontal Support and Resistance
If you had bought into Caterpillar in early September at $72.50 as it was bouncing off the support level, and it was now nearing $82.50, you might well think of selling. Previously, this price had marked a significant resistance level. Consequently the price might now turn around and move lower.
Once you can confidently identify horizontal levels of support and resistance, you can move on to diagonal levels of the same.
Diagonal Support and Resistance
Diagonal support and resistance levels can be invaluable to a trader. Whilst these levels can be more difficult to identify for novices, they are invaluable for analyzing a trend. Remember it is much easier to make profitable trades when a stock or CFD is in a trend.
As you look at the charts of the stocks and CFDs you will notice that they often form higher highs and higher lows (or lower highs and lower lows) as their fortunes wax and wane. The lines connecting these highs and lows are diagonal support and resistance levels.
Examine the Caterpillar (CAT:xnys) chart again. You can see that the price hit a series of lower highs and lower lows toward the end of 2007. If you connect all of the highs with one diagonal line and all of the lows with another diagonal line (indicated by bold black lines) you will be able to see the diagonal levels of support and resistance that drove Caterpillar's price (see Figure 9).
You can also see that a downward trend level between the support and resistance levels served as both support and resistance during this same time period.
Figure 9–Diagonal Support and Resistance
If you were to invest in Caterpillar, you would most likely wait until you saw the price rise to the downward trending resistance level before you would sell and take your profits.
The knack of effectively investing using support and resistance levels is to combine both horizontal and diagonal levels in your analysis. As is apparent from these illustrations of Caterpillar's price chart, such levels co-exist and interact. In conclusion, your stock and CFD charts have a wealth of information locked within them, and they are waiting for you to unlock that information with simple-but-effective technical analysis techniques.
⇑ Top - Money Management
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Money Management
Wise inve stment necessarily involves money management. Money management involves spreading your risk appropriately across your portfolio. If you capably manage your money, you can trade successfully for years, but ineptitude in the long or short term could wipe out any fortune you have.
Trading in stocks and CFDs is invariably compared with poker, and clearly some of the skills are transferable. Both require astute money management to be successful in the long term. Both are activities in which an ability to collate, retain and use information will increase the odds of a win. But, of course, poker is very much about the perceptions of opponents-while in trading, you will find yourself unable to bluff the market.
The investors who tend to enjoy the greatest sustained success are those who stick to predetermined, clearly defined rules. These rules help them to avoid major crises.
We will look at three money management rules you need to incorporate in your trading:
You will also learn about one of the stock and CFD market's most important trading tools: the so-called 'stop-loss.'
Live to Trade Another Day
Living to trade another day is perhaps the most important goal. Regardless of whether you make bad decisions during any trading period, if you live to trade another day, you will have a chance to recoup losses and ultimately achieve success. The common-sense rules we suggest that you impose on your trading will enable you to survive everything that the stock and CFD market throws at you. If you understand and observe these rules, you will already have an advantage over most investors. That advantage means you should, of course, not only survive but outperform the market.
The single factor that causes most investors to overextend themselves and suffer catastrophic losses is greed. Greedy investors take unnecessary risks. Typically they will fool themselves that a single indicator is the absolute key to success. You could draw a parallel with those who bet on horses using the formula that the next stake has to be sufficient to potentially wipe out any previous losses. Clearly such a strategy can only work if the gambler is wise enough to quit whilst he is ahead and does not run out of the necessary funds, the amount he needs to wipe out previous losses, first. Of course, such a gambler, when he is left with a reduced stake, can only recoup all of his losses by gambling at longer odds. Those longer odds reflect the likely chances of success. So the risks become increasingly acute, and the apparent necessity to gamble all that is left means ever-increasing risk. This is the kind of desperation which traders need to avoid.
Unfortunately, there is no secret to sure-fire gains in the markets-just like there is that a race-goer will beat the turf accountants. Most traders have confidence in specific indicators. Many focus on particular markets and hope that this focus, and the quantitative or qualitative data they collect, will prove to be the key to investment success. But markets are dynamic and essentially volatile. In such an environment there are no cast-iron certainties. To help you avoid a roller-coaster ride, we are going to show you how to live to trade another day so that, no matter what changes take place in the market, you can enjoy at least modest and worthwhile success.
Know What You Are Willing to Risk
Know what you are willing to risk before you ever enter a trade is the basic tenet of living to trade another day. If you do not risk too high a proportion of your funds in any one trade, or in a handful of trades, then you will be able to continue trading whatever the outcome of your trades. In other words, it is not sound investment practice to put too many eggs in one basket.
You will have to decide what percentage of your account you are willing to lose in any one trade. Once you have decided that, the rest is simple math. Most investors feel comfortable risking approximately 2 percent of their total account balance in any one trade. This is a general rule of thumb, but it is up to you to decide how aggressive or conservative you want to be. If you want to be more aggressive, you could risk a larger percentage of your account in any one trade. If you want to be more conservative, you could risk a smaller percentage of your account in any one trade. It is up to you to determine how much you are willing to risk.
Once you have decided what percentage of your account you are happy to risk, all you have to do is enter that value into the following equation:
Account balance × risk percentage = amount at risk
The math is simple. Imagine that you have an account balance of £50,000 and would like to risk 2 percent of your account in any one trade. If you drop these numbers into the equation, you will see you should not risk more than £1,000 in any one trade.
£50,000 × 0.02 = £1,000
Clearly, the same math works even if you want to invest in dollars or euros.
Remember that this is the maximum amount to risk in any single trade. You may have much more at risk if you are simultaneously involved in other investments. If you were in five trades at once, for example, you would risk only £1,000 per trade but have a total amount at risk of £5,000. Once you decide how much you are willing to risk, you are ready to determine your trade size.
What we should emphasize at this point is that you ought to consider every penny of your investment to be at risk of a total loss-unless you have a 'stop-loss' (something we are going to explain, but essentially it means a limit at which you would definitely sell an investment that was losing money and cut your losses).
Know How to Determine Trade Size
You need to know how to determine trade size to prevent unnecessary exposure to risk. Trade size is the volume of stocks or CFDs you buy or sell in any individual transaction. Once you know how much you are willing to risk, you need to know how to set up your trades so that you do not risk more than you are comfortable with. It is pointless deciding what risks you will tolerate but then, for whatever reason, entering a transaction that exposes you to too much risk.
To determine your trade size, you must first decide where you are going to set your stop-loss. Once you have decided where to place the stop-loss, you have to calculate the difference between that price point and the point where you enter the trade. Then all you have to do is enter that difference into another simple equation.
Amount at risk ÷ distance between entry price and stop-loss price = size of your trade
e.g. £1,000 ÷ (£,1000 - £700) = £300
The size of your trade is now, in effect, not the whole amount invested but the part of it which is at risk between your entry point and the stop-loss.
Knowing exactly how to size your trade will help you eliminate the nightmare scenario-one where you could lose more than you are comfortable losing, and perhaps even lose everything in that stock or CFD. Using a stop loss you will make investing much less stressful, and the presence of such boundaries will increase the likelihood of you making an overall profit on your trading rather than a loss.
Stop-Loss Orders
A stop-loss order is an order you place with your dealer to sell if the stock or CFD reaches a predetermined price point. Stop-loss orders allow you to automatically protect your trading account even in your absence-i.e. when you are not in front of your computer. This is essential since most traders cannot watch their investments 24/7.
If you buy a stock or CFD, you should always place a stop-loss order somewhere below the current price. This will protect you if the stock or CFD loses value.
If you sell a stock or CFD to enter your trade, you should always place a stop-loss order somewhere above the current price. This will protect you if the stock or CFD uexpectedly increases in value.
We will give you an example. Imagine you buy 50 shares of General Electric (GE:xnys) stock at $35. You know that there is strong support approximately $5 below this price level at $30. You therefore decide that if GE falls below this $30 level, it may continue lower. To protect your investment, you set a stop-loss order with your dealer at $30. If the price of GE drops to $30, even momentarily, at any time during the trading day, your dealer will automatically sell your stock for you.
Stop-loss orders provide safety and security when you are trading, and they ought to play a critical role in all of your money-management decisions. You should never place a trade without one.
Lastly, we ought to explain a more sophisticated type of stop-loss order. When you have a little confidence in the use of ordinary stop-loss orders, you could experiment with trailing stop-losses. These move as the price of the stock or CFD moves. You can set a trailing stop-loss to trail the price of the stock or CFD by £5, for instance.
You might buy at £35 and initially set your trailing stop-loss at £30. Then, if the price rose to £40, your trailing stop-loss would automatically rise to £35 (i.e. £5 below the highest price the stock or CFD reached). If the stock or CFD then suffered a reversal and fell back to £35, your stop-loss level of £35 would trigger the stock's sale.
⇑ Top
- Intermediate
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- Charting Basics
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Charting Basics
Charts are an invaluable tool for stock and CFD traders. Indeed, any time that you as a trader spend studying price charts will be worthwhile. Charts can be an immense and influential aid to intelligent trading. Becoming familiar with how they function, and with what they show, will enable you to fully harness the advantages that they offer.
To help you become familiar with a range of charts and their effective use, we have provided information the following topics:
These materials will also explain how state-of-the-art technical indicators can be added to your charts to improve your trading results. As you work through this information, you should fully understand each step before progressing to more advanced material.
Chart Setup
We shall begin by explaining how a simple stock price chart is created.
Stock price charts (see Figure 1) are two-dimensional and therefore revolve around only two axes. The X axis is horizontal whilst the Y axis is vertical.
Figure 1-Basic Chart Setup
The X axis runs horizontally along the bottom of the chart and shows the timeline. The most distant data appears on the left of the chart while the most recent data appears on the right.
The Y axis runs vertically up the right side of the chart-providing a price scale for the chart. Lower prices appear at the bottom of the chart while higher prices appear at the top.
Taken together, the two axes allow you to determine the price at which a stock was trading at any time falling within the parameters of the chart. It is easy to see, for example, that the S&P 500 was trading at 13,675 on 14 March 2007 (see Figure 2).
Figure 2-Identifying the Date and Price
Chart Time Frames
Charts allow you to track the price movements of stocks or CFDs in which you have an interest on a minute-by-minute or month-by-month basis. The charts are flexible so you can select whichever time-frame is best for you.
As a general rule, traders who are more interested in short-term trends and investments will tend to use shorter time-frames for their charts. Conversely, traders who are more interested in long-term trends and investments will tend to use extended time-frames for their charts. For example, traders who hope to capitalize on temporary price surges will typically use one-minute or five-minute charts, while traders who are more interested in long-term investments will typically use daily or weekly charts.
Some traders use multiple time-frames so that they can chart stock or CFD movements from different perspectives. This technique is explained later.
Changing the time-frame on your chart to suit your needs is easy. Click on the button at the top of the chart. A drop-down menu will appear. Then you select your preferences (see Figure 3).
Figure 3-Chart Time Frames
Chart Types
Saxo charts let you analyse the price movement of any stocks or CFDs in several formats. These include line, bar and candlestick charts, so they are very flexible. Traders are individuals and the system has been developed to accommodate their individual preferences.
Technical analysts typically use one of the following three chart types:
Line Charts
Line charts are the most basic chart type because they are uncluttered. With line charts, it is easy to identify support and resistance levels.
Line charts plot the closing prices for each trading period and then connect them with a single line (see Figure 4).
Figure 4-Line Chart
Bar Charts
Bar charts contain more information than line charts. Whereas line charts only show closing prices, bar charts show the opening and closing prices, as well as the high and low prices, for each period.
It is important to realise that these bar charts are a little more complex than the elementary bar charts we all used at school. Each bar is, in effect, shaped like a tree (see Figure 5).
You create the chart by plotting a series of these bars across it. Each bar represents one trading period. To create each bar, you plot the high and low prices of a trading period and connect them with a vertical line. Imagine this as a trunk on which the highest price will always be at the top and the lowest price at the bottom.
Then you plot the opening price to the left of the vertical line you have just drawn, and connect that point to the vertical line (i.e. the trunk) with a horizontal line. So you now have a branch on the left.
Finally you plot the closing price to the right side of the vertical line (the trunk), and connect that point to the vertical line with a horizontal line. So you now have a branch on the right.
Looking at the bar, you can instantly see if the stock concerned gained or lost value between opening and closing. If the 'branch' on the right is higher than its counterpart on the left, then the value climbed between the open and close. If the 'branch' on the right is lower than its counterpart on the left, then the value fell between the open and close.
Meanwhile, of course, the height of the 'trunk' tells you whether the value of the stock or CFD fluctuated a great deal during the trading for this period. A short 'trunk' (or, indeed, if it has no height at all) means that the price remained very stable.
This information can be harnessed as a predictive tool. If the stock or CFD closed on a high, for example, then the 'branch' on the right would be at the top of the 'trunk'. If you are interested in short-term gains, you might be tempted to assume that the stock would continue to rise as soon as trading recommences. This would, of course, be a gamble. Equally it would be a gamble to assume that a stock or CFD which closed on a low would continue to fall when the market re-opened. The bar chart's function is to provide you with information to make an intelligent decision.
Figure 5-Price Bar
The bar chart enables you to identify performance trends. If the price of a stock or CFD rose during the period, then investors were bullish (i.e. confident and likely to buy). If the price lost during the period, then investors were bearish (i.e. not confident and likely to sell).
See an example of a complete bar chart below (see Figure 6).
Figure 6-Bar Chart
Candlestick Charts
Candlestick charts are a Japanese invention dating back to the 18th century that were originally used to track deals on the rice market. They show the same information as bar charts, but their format is a little different. It appears to be easier for most traders to spot patterns using candlestick charts.
Essentially, the process is not so different from what you would use to create a bar chart.
To create a candlestick chart, you must plot a series of candlesticks. Each candlestick represents one trading period. To create an individual candlestick, you plot the high and low price of a trading period and connect them with a vertical line. This line is called the wick of the candlestick. Essentially this is the same as you would have done for a bar chart.
Next, you plot the opening price by drawing a horizontal line through the vertical line, or wick. This is similar to what you'd do when creating a bar chart. But this time you cross all the way through the vertical line (see Figure 7).
Then you plot the closing price by drawing another horizontal line through the vertical line. Again, this is very much like a bar chart but you cross all the way through the vertical line.
These two horizontal lines effectively mark the top and bottom of the body of the candlestick.
Finally, you can fill in the area between the opening price and the closing price (and, in effect, rub out the wick which would disappear within the candlestick). This area is the body of the candlestick.
Figure 7-Price Candlestick
Like the bar chart, the candlestick chart enables you to identify trends. If the price of a stock or CFD rose during the period, then investors were bullish. If the price lost during the period, then investors were bearish. Really the choice between bar charts and candlestick charts is a personal one. Both continue to be popular and self-evidently provide identical information. However, some feel that candlestick charts make it a little easier to determine, at a glance, whether there has been a substantial overall price shift between the open and close and whether the entire period's trading has been within narrow or broad confines.
You can see an example of a candlestick chart below (see Figure 8).
Figure 8-Candlestick Chart
⇑ Top - Company Fundamentals
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Company Fundamentals
Company fundamentals, like how much money companies earn and how efficiently they utilise their resources, drive the stock and CFD markets. Traders buy companies they believe will keep growing and sell companies they believe will stop growing. Learning a few basic fundamental concepts, as well as how to evaluate the data that professional traders act on, will help you to accurately anticipate market trends.
Company fundamentals wax and wane as the moon does, and consequently shares and CFDs ebb and flow like the tide. As a company fundamentally strengthens, the tide comes in, in effect. The company's ships come home on it, and this lifts the value of that company's share price. Yet, whenever company fundamentals weaken, it is like the tide going out. And, with that, there's a lowering of the company's share value.
Traders focus much of their attention on a handful of fundamental indicators when they evaluate a company. All such information, and more, is available to you too. So you have access to the self-same information that professionals use when they make buying and selling decisions. Thus by learning about company fundamentals, you can anticipate the direction a company's share price should move and then seize trading opportunities.
We will now address the following categories of fundamental information.
Company Earnings
Stock and CFD traders initiate their fundamental evaluations by examining how much profit the company is making for its owners. Anyone who buys a stock share becomes an owner, so naturally they will be concerned about how much money the company is earning.
The fundamental data that alerts traders to how much money the company earned for each owner is called earnings-per-share, or EPS. To calculate EPS, traders take the company's overall earnings and divide them by the number of shares the company has issued. If a company earns £1 billion and has 1 billion shares issued, the company's EPS is £1.
Once traders identify a company's EPS, they then examine share costs in relation to the earnings per share. The fundamental ratio that divulges this information is the price-to-earnings ratio, or P/E ratio.
The P/E ratio gives traders an inkling of whether a stock share is relatively overpriced or underpriced, which is crucial because traders looking to buy are looking for bargains. For example, if a share has an EPS of £1 and the share is trading for £20 then it has a P/E ratio of 20. By looking at historic P/E ratios, traders can assess whether the current P/E ratio of 20 is comparatively high or low.Traders also want to know if companies are likely to increase earnings in the future. Good earnings today are helpful, but traders want to know if a company has a rosy future.
Luckily, you will not have to do the spade-work to work out if a company has good prospects. Large financial institutions employ armies of analysts to execute that kind of research, not only on the companies themselves but also on the industries in which they operate and how they should fare in future market conditions. Much of that information is available to the investing public.
When you are looking to buy, ensure the underlying businesses have real growth potential. When you are looking to sell, ensure the underlying businesses are likely to have little or no growth.
Operating Efficiency
Once traders have evaluated the profit a company earns its owners, they tend to examine how efficiently the company utilizes its resources. Shares in efficient companies usually outperform shares in inefficient companies, since efficiency generally leads to greater profit and more earnings flow into owners' pockets.
One resource that traders prefer to see used efficiently is shareholder equity. Shareholder equity is company cash, hard assets and retained earnings (i.e. those which the company keeps to invest instead of distributing them to shareholders). Traders are interested in equity because if a company can't efficiently use such assets, they would be better invested elsewhere.
To monitor the efficiency of asset utilization, shareholders make a comparison similar to that which they make with price compared to the earnings in the P/E ratio. But this comparison is called the price-to-book ratio.
Suppose you have two piggy banks and both are notionally worth £100. However, the piggy banks are not identical. In the first you would find £100. Meanwhile in the second you would find only £10. Which piggy bank would you rather buy? Obviously you would want the piggy bank with £100 in it. A company price-to-book ratio is very similar.
To find a company's price-to-book ratio, you need the book value of the company, which equates to the shareholders' equity divided by the number of shares the company has issued. If a company has £5 billion in assets and issued a total of 1 billion shares, the company book value is £5 per share. That is how much money is inside the piggy bank per share. Next divide the current share price by the book value to get the price-to-book ratio. If the share trades at £20 its price-to-book ratio is therefore 4.
Like the P/E ratio, price-to-book ratios intimate whether current share prices are cheap or not.Cash Flow
Cash is a company's life-blood. Regardless of how a company performs, if it runs out of money, it will fold up. A company must pay its employees, vendors and shareholders. Shareholders want a dividend unless the company retains cash to grow itself and increase share value.
Some believe a company's bottom line, its net income, represents the cash the company generated. But that is not the case. Net income is what is left over after expenses are subtracted from revenues.
Net income is the government valuation when deciding tax liabilities. But governments need entrepreneurial growth to boost the economy and provide jobs, so incentives like depreciation and interest deductibility are allowed and can distort net income figures.
Traders are more interested in cash creation than earnings after adjustments, so they look at a company's free-cash-flow, its 'true' cash flow, and what it has had available to invest in new initiatives or to pay investors via dividends. A company's free-cash-flow is its net income plus both depreciation and amortization expenses, but then minus the company's changes in working capital and capital expenditures. See below.
Net income
+ Amortization
+ Depreciation
? Changes in working capital
? Capital expenditures
= Free cash flowTraders also use a company's free-cash-flow data in a discounted-cash-flow analysis to see if its share price is expensive compared to the cash the company is able to generate.
⇑ Top - Technical Analysis: Technical Indicators
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Technical Analysis: Technical Indicators
Charts speak volumes. Yet sometimes charts may as well be in a foreign language. But help is at hand. Technical indicators are the interpreters of the stock and CFD markets. They examine price information and translate it into simple, easy-to-read signals that enable you to determine when to buy and when to sell.
Technical indicators are based on mathematical equations that produce values that are then plotted on charts. For example, a moving average calculates the historic average price of a stock or CFD and plots it on your chart as a line. As your stock or CFD chart moves forward, the moving average is revised accordingly. The system then plots new points. As you'll see, this moving average irons out a lot of the temporary price fluctuations (because it is based on a larger sampling of data) and provides a smooth line that indicates the direction in which direction the stock or CFD is moving (see Figure 1).
Figure 1–Technical Indicator: Moving Average
Each technical indicator provides unique information. Because traders are individuals they gravitate toward specific technical indicators, but it is important to familiarize yourself with all of the technical indicators at your disposal.
You should also be familiar with the one weakness associated with technical indicators. They are based on historical price data and therefore lag behind the current market, However, they still provide excellent information.
Technical indicators are divided into the following categories:
Trending Indicators
As the name suggests, trending indicators identify and follow the trend of a stock or CFD. Traders make most of their money when there is a trend on which they can capitalise. It is critical that you therefore know when a stock or CFD is on a trend and when it is consolidating. If you invest shortly after a trend begins, and sell shortly after the trend ends, you will be quite successful.
The following trending indicators are worth examining now:
Moving Averages
Moving averages are the most fundamental trending indicator. They indicate the direction in which a stock or CFD is going and where potential levels of support and resistance may be. Moving averages themselves can serve as both support and resistance levels because they will be watched by many traders and will be influential because of that.
Regarding moving averages we shall examine three key topics:
How a Moving Average is Constructed
Moving averages utilise the average closing prices of a stock or CFD, plotting these points on a price chart. The result is a fairly smooth line that follows price movements (see Figure 2).
You can influence the volatility of a moving average by adjusting the time-frame the indicator uses to obtain an average price. Moving averages that examine a shorter time are more volatile (and therefore jerky). Moving averages that examine a longer time-frame are less volatile (and therefore smoother).
Figure 2–Moving Average
Moving Average Trading Signal
Moving averages provide useful trading signals for stocks or CFDs that are following trends.
Entry signal - when a stock or CFD is enjoying an upward trend and bounces back up after hitting an upward-trending moving average, or when a downward-trending stock or CFD bounces back down after hitting a downward-trending moving average.
Exit signal - when you invest in an upward-trending stock or CFD you should set a stop-loss below the moving average. As the moving average rises you can move your stop-loss up along with the moving average. If the price ever sinks far enough below the moving average your stop-loss will prompt you to sell.
When you invest in a downward-trending stock or CFD, set a stop-loss above the moving average. As the moving average falls, move your stop-loss down along with the moving average. If the stock or CFD ever breaks far enough above the moving average, your stop-loss will prompt you to sell.
Strengths of a Moving Average
Moving averages enjoy the following strengths:
- They identify simple trends
- They are flexible enough to work in both short-term and long-term time frames
Weaknesses of a Moving Average
Moving averages have the following weaknesses:
- They lag behind the market. The data used to calculate a moving average is historic, which doesn't necessarily influence what will happen in the future.
- They cannot identify trends, or levels of support or resistance, during channeling markets.
Bollinger Bands
Bollinger bands are a trend indicator named after their creator, John Bollinger, and they indicate both the direction and volatility of a stock or CFD's price movement. There are just two Bollinger bands, an upper band and a lower band, which work above and below a moving average.
The following three topics are critical in respect of Bollinger bands:
How Bollinger Bands are Constructed
Bollinger bands are typically based on a 20-period moving average. A moving average is sandwiched between the two bands.
A standard deviation is a statistical term that measures how far various closing prices diverge from the average closing price. The upper band is plotted two standard deviations above the 20-period moving average. The lower band is plotted two standard deviations below the 20-period moving average (see Figure 3).
Therefore, 20-period Bollinger bands tell traders how wide, and therefore volatile, the range of closing prices has been during the past 20 periods. When the price has been volatile, the bands will be wider. When the price has been relatively stable, the bands will be narrower.
Figure 3–Bollinger Bands
Bollinger Band Trading Signal
Bollinger bands provide useful breakout signals for stocks or CFDs that have been consolidating.
Entry signal - when the bands widen and begin moving in opposite directions after a period of consolidation (see Point A on Figure 4), you can enter the trade in the direction the price was moving when the bands began to widen. Clearly you are trying to capitalize on renewed volatility.
Exit signal - at some point after the breakout occurs, the bands will begin to move back toward each other (see Point B on Figure 4). When this happens, you should set a trailing stop-loss to prompt you to sell if the trend reverses (see Point C on Figure 4 ).
Figure 4–Bollinger Bands Exit Signal
Strengths of Bollinger Bands
Bollinger bands enjoy the following strengths:
- They help you identify the trend
- They identify current market volatility
Weaknesses of Bollinger Bands
Bollinger bands have the following weaknesses:
- They lag behind the market because the data used to calculate Bollinger bands is historic and cannot predict the future.
- The bands do not, as is commonly believed, serve as support (lower band) and resistance (upper band) levels.
Oscillating Indicators
As their name suggests, oscillating indicators are indicators that move back and forth as prices rise and fall. Oscillating indicators can help you decide how strong a current trend is and warn when that trend is in danger of losing momentum and being reversed.
When an oscillating indicator moves too high, the stock or CFD is considered to be 'overbought' (too many people have bought it and there are not enough buyers left in the market to push the price higher). This indicates the upward trend is at risk of losing momentum-causing the trend to reverse or the price to stagnate.
When an oscillating indicator moves too low, the stock or CFD is considered to be 'oversold' (too many people have sold it and there are not enough sellers left in the market to depress the price). This indicates the downward trend is at risk of losing momentum-causing the trend to reverse or the price to stagnate.
The following oscillating indicators are worth examination:
Commodity Channel Index (CCI)
Developed by Donald Lambert, the commodity channel index (CCI) is an oscillating indicator that can show you how bullish or bearish traders are and how dramatic their sentiments are. You can see the volatility of a stock or CFD with the CCI, much like you can with Bollinger bands.
The CCI is usually plotted below the price movement on a chart.
We will now examine the following three aspects of the CCI:
How the Commodity Channel Index (CCI) is Constructed
The commodity channel index (CCI) is based on the average value of historic price movements and how far those price movements have deviated from the average. It tells you how volatile the price has been.
If an average price rises, the CCI will also rise. Just how quickly the CCI rises depends on how volatile the stock or CFD is. If the price is more volatile, the CCI will rise quickly. If it is less volatile, the CCI will still rise, albeit more slowly.
If an average price falls, the CCI will fall too. Just how quickly the CCI falls depends on how volatile the stock or CFD is. If it is more volatile, the CCI will fall faster. If it is less volatile, the CCI will still fall, albeit more slowly.
The CCI moves back and forth, crossing 100, zero and -100, as it cycles through its progression (see Figure 5).
Figure 5–Commodity Channel Index (CCI)
Commodity Channel Index (CCI) Trading Signal
The commodity channel index (CCI) produces trading signals as it crosses back and forth above and below both 100 and -100. These are, in effect, entry and exit signals.
Entry signal - when the CCI rises above 100 and then falls back below 100, you can sell the stock or CFD knowing that buyer momentum is exhausted and the price is likely to decline soon.
When the CCI falls below -100 and then rises back above -100, you can buy the stock or CFD knowing that seller momentum is exhausted and the price is likely to rise soon.
Exit signal - when a downtrending CCI reverses direction and rises after you have sold a stock or CFD, place your stop-loss just above the nearest level of resistance. If the stock or CFD reverses and rises above resistance, your stop-loss will prompt a sale.
When an uptrending CCI reverses direction and falls after you have bought a stock or CFD, place your stop-loss just below the nearest level of support. If the stock or CFD reverses and falls below support, your stop-loss will prompt a sale.
Strengths of the Commodity Channel Index (CCI)
The commodity channel index (CCI) enjoys the following strengths:
- It helps you identify volatility in a stock or CFD
- It helps you identify potential reversal points for a stock or CFD
- It helps you confirm the strength of current trends
Weaknesses of the Commodity Channel Index (CCI)
The commodity channel index (CCI) has the following weaknesses:
- It lags behind the market because the data used to calculate the CCI is historic and doesn't necessarily influence the future.
- It cannot invariably predict reversal points for a stock or CFD.
Moving Average Convergence/Divergence (MACD)
The moving average convergence/divergence (MACD) is an oscillating indicator developed by Gerald Appel. It can indicate when trading momentum changes from being bullish to bearish and vice versa. The MACD can also indicate when traders are becoming over-extended, which usually results in a trend reversal for the stock or CFD.
The MACD is usually plotted below the price movement on a chart.
It is worth looking at the following three aspects of the MACD:
How the Moving Average Convergence/Divergence (MACD) is Constructed
The moving average convergence/divergence compares a series of moving averages and their relationships. The standard MACD looks at the relationship between the 12-period and 26-period exponential moving averages of a stock or CFD. When the 12-period moving average is above the 26-period moving average, the MACD line will be positive. If the 12-period moving average is below the 26-period moving average, the MACD line will be negative (see Figure 6).
The MACD line is accompanied by a trigger line. This line is a 9-period exponential moving average of the MACD line.
Figure 6–Moving Average Convergence/Divergence (MACD)
You can also plot the MACD as a histogram below the chart. When the histogram is above the 9-period signal line (illustrated by a horizontal line on the histogram), it is signaling that the 12-period moving average is above the 26-period moving average (see Point A of Example 1). When the histogram is below the 9-period signal line, it is signaling that the 12-period moving average is below the 26-period moving average (see Point B of Example 1).
Example 1–Moving Average Convergence/Divergence (MACD) Histogram
Moving Average Convergence/Divergence (MACD) Trading Signal
The moving average convergence/divergence (MACD) produces trading signals as it crosses the trigger-line.
Entry signal - when the MACD rises above the trigger line, you can buy as the market shifts from being bearish to bullish.
When the MACD falls below the trigger line, you can sell as the market shifts from being bullish to bearish.
Exit signal - when the MACD falls below the trigger line after you buy, you can sell as the market shifts from being bullish to bearish.
When the MACD rises above the trigger line after you sell, you can buy as the market shifts from being bearish to bullish.
Strengths of the Moving Average Convergence/Divergence (MACD)
The moving average convergence/divergence (MACD) enjoys two key strengths:
It helps to identify when the momentum of a stock or CFD changes.
It helps to confirm the strength of current trends.
Weaknesses of the Moving Average Convergence/Divergence (MACD)
The moving average convergence/divergence (MACD) has the following weaknesses:
- It lags behind the market because the data used to calculate the MACD is historic and doesn't necessarily help to predict the future.
- It can generate misleading signals.
Slow Stochastic
The slow stochastic is an oscillating indicator. Developed by George Lane , it can alert you to a shift of investor sentiment from bullish to bearish or vice versa. The slow stochastic can also alert you to when traders are becoming over-extended, which usually results in a trend reversal.
The slow stochastic is usually plotted below the price movement on a chart.
The following three aspects of the slow stochastic are worth your attention:
- How the slow stochastic is constructed
- Slow stochastic trading signals
- Strengths of the slow stochastic
How the Slow Stochastic is Constructed
The slow stochastic consists of two lines–%K and %D–that oscillate in a range between 0 and 100.
%K reflects the most recent closing price of a stock or CFD in relation to the range of historical closing prices.
%D is a moving average of %K.
If the closing price is near to the peak of historical closing prices, then the %K line (followed by the %D line) will rise.
If the closing price is near the bottom of the range of historical closing prices, the %K line (followed by the %D line) will move lower (see Figure 7 ).
As an example, if the EUR/USD has closed between 1.4200 and 1.4300 during each of the past 14 trading periods, and it now closes at 1.4295 (near the peak of the range), %K will move toward the top of the indicator's range.
Figure 7–Slow Stochastic
Slow Stochastic Trading Signal
The slow stochastic produces trading signals as it enters its upper and lower reversal zones.
The upper reversal zone is the area of the indicator that is above 80. When %K exceeds 80, the stock or CFD may be overbought and could suffer a reversal soon.
The lower reversal zone is the area of the indicator that is below 20. When %K is below 20, the stock or CFD may be oversold and could suffer a reversal soon.
Entry signal - when %K dips below 80, you can sell knowing that investor sentiment is shifting from being bullish to bearish.
When %K rises above 20, you can buy knowing that investor sentiment is shifting from being bearish to bullish.
Exit signal - when %K reverses direction after having risen above 20 or fallen below 80, and crosses over %D, you can sell knowing that investor sentiment is changing direction again.
Strengths of the Slow Stochastic
The slow stochastic is strong because:
- It helps you spot when investor sentiment changes
- It helps you confirm the strength of current trends
Weaknesses of the Slow Stochastic
The slow stochastic has the following weaknesses:
- It lags behind the market because the data used to calculate the slow stochastic is historic and doesn't necessarily have any bearing on the future.
- It can provide false signals.
Volume Indicators
Volume indicators provide a very different kind of indicator because, instead of relying solely on the price, they take volume into account.
Prices tell you in which direction an investment is moving, but volume can tell you what kind of support is influencing the price. For instance, if you see a price rise accompanied by high volume, then you know that there are a lot of traders who have confidence in this investment. Seeing this support should give you confidence too. On the other hand, if you see the price of a stock of CFD rise on low volume, you know that there are only a few investors pushing the price. This should discourage you from buying yourself.
There are two volume indicators that you ought to know about:
On-balance-volume
Developed by Joe Granville, on balance volume is a volume indicator that demonstrates positive and negative volume flow. It can also show you when price movement is not reflected in increasing volume, which usually results in a trend reversal.
On-balance-volume is usually plotted below the price movement on a chart.
There are four aspects of on balance volume which you ought to know about:
- How on balance volume is constructed
- On balance volume confirmations
- Strengths of on balance volume
- Weaknesses of on balance volume
How On balance volume is Constructed
On balance volume involves a calculation that utilizes today's volume and the previous trading day's on-balance-volume level.
If today's closing price is higher than yesterday's, you add today's volume to yesterday's on balance volume level. You then record the resultant value below the price chart.
Alternatively, if today's closing price is lower than yesterday's, you subtract today's volume from yesterday's on balance volume level. You then record the resultant value below the price chart.
Connecting each on balance volume value gives you a smooth line that illustrates how volume has, or has not, supported the price movement of the stock (see Figure 8 ).
Figure 8–On-balance-volume
On balance volume Confirmations
Traders need to know whether a trend will sustain its momentum. On balance volume can help you decide if there is enough momentum behind a price to sustain it or continue pushing it higher.
Positive confirmation- on balance volume can provide positive confirmations of both upward and downward trends. If the on balance volume line is in an upward trend while the price is likewise rising, you know there is strong buying support. If the on balance volume line is in a downward trend whilst the price is also falling, you know there is strong selling support.
Negative confirmation- on balance volume can provide negative confirmations of both upward and downward trends. If the on balance volume line is in a downward trend while the price is in an upward trend, you know there is only weak buying support underpinning the upward trend. If the on balance volume line is in an upward trend whilst the price is in a downward trend, you know there is weak selling support underpinning the downward trend.
Strengths of On balance volume
On balance volume enjoys the following strengths:
- It does not rely on price alone in its calculation
- It helps you to confirm the strength of current trends
Weaknesses of On balance volume
On balance volume suffers from the following weaknesses:
- It lags behind the market since the data used to calculate on balance volume is historic and will not necessarily reflect what will happen in the future.
- It can give misleading indications of trends.
Accumulation/Distribution
Marc Chaikin's accumulation/distribution line is a volume indicator that reveals the cumulative flow of money into and out of a stock or CFD. The accumulation/distribution line can also indicate when price rises are not mirrored by increasing volume, which usually results in a trend reversal.
The accumulation/distribution line is usually plotted below the price movement on a chart.
There are four aspects of the accumulation/distribution line which need to be examined:
- How the accumulation/distribution line is constructed
- Accumulation/Distribution line confirmations
- Strengths of the accumulation/distribution line
- Weaknesses of the accumulation/distribution line
How the Accumulation/Distribution Line is Constructed
The accumulation/distribution line is similar to the on balance volume line, but the calculation has one distinct difference. It does not compare the current trading period's price movement in relation to the previous period's price movement. Whereas the on balance volume line is calculated based on the closing price in the current period compared to that in the previous period, the accumulation/distribution line shows where the price closed in relation to the mid-point of that period's price movement.
If the stock price closes above the mid-point, you must add a value between 0 and 1 to the cumulative value of the accumulation/distribution line. If the stock price closes below the midpoint, you subtract a value between 0 and -1 from the cumulative value of the accumulation/distribution line.
Therefore, if the stock price closed at the high for that trading period, you would add 1 to the cumulative value of the accumulation/distribution line. Conversely, if the stock price closed at the low for that trading period, you would subtract 1 from the cumulative value of the accumulation/distribution line.
Connecting each accumulation/distribution data point gives you a smooth line that illustrates how volume has, or has not, supported the price movement (see Figure 9).
Figure 9–Accumulation/Distribution
Accumulation/Distribution Line Confirmations
Traders are always eager to know whether a trend can sustain its momentum. The accumulation/distribution line can help you decide if the momentum behind a price rise is sufficient to continue pushing the price up.
Positive confirmation - the accumulation/distribution line generates 'positive' confirmations of both upward and downward trends. If the accumulation/distribution line is soaring whilst the stock price is doing likewise, you know there is strong buying support. If the accumulation/distribution line is on a downward trend whilst the price is doing likewise, you know there is strong selling support.
Negative confirmation - the accumulation/distribution line generates 'negative' confirmations of both upward and downward trends. If the accumulation/distribution line is diving whilst the stock price is rising, you know there is only weak buying support. If the accumulation/distribution line is on an upward trend whilst the price is on a downward trend, you know there is weak selling support.
Strengths of the Accumulation/Distribution Line
The accumulation/distribution line has the following advantages:
- The calculations do not rely on price alone
- It helps confirm the strength of current trends
Weaknesses of the Accumulation/Distribution Line
The accumulation/distribution line has these weaknesses:
- It lags behind the market because the data used to calculate the accumulation/distribution line is historic and may have no relevance to the future.
- It can give false indications of some trends.
- Trading Using Multiple Time-frames
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Trading Using Multiple Time-frames
Stock markets worldwide function because, at any given time, some traders want to buy whilst others want to sell. Traders' desires to buy or sell depends on their strategy, their objectives and their chart time-frames. Short-term traders and long-term traders see dramatically different perspectives on their charts. Short-term traders usually watch 1-minute to 15-minute charts, whilst long-term traders usually watch daily, weekly or monthly charts.
Trends, support and resistance lines, and technical indicators look different on a 1-minute chart than they do on a daily chart. For example, you may look at a 1-minute chart for Barclays (BARC:xlon) and see that the stock price appears to be in a downward trend. But, if you switch to a daily chart, you would probably see that the price has been in an upward trend for years. So a momentary reversal is unlikely to be of consequence.
It is important to realise that, in this example, both charts are right-depending on your perspective and your trading time-frame. If you are a short-term trader, you should be focusing on short-term charts and trends. If you are a long-term trader, you should be focusing on long-term charts and trends. However, when the short-term and long-term trends are in agreement, you are probably right to be confident in an investment.
To get a comprehensive idea of the trends and support and resistance levels that influence the stocks and CFDs in which you have an interest, you should analyse the following three charts:
- Trend chart (Longer-term chart)
- Signal chart (Chart you typically use)
- Timing chart (Shorter-term chart)
Once you have analyzed each time-frame on an individual basis you can combine them to confirm if, taken together, they indicate a high probability of this being a good time to invest.
Trend Chart
As its name suggests, the trend chart helps users to identify the predominant trend. If the price on the trend chart is in an upward trend, you should consider buying the stock or CFD. If the price on the trend chart is in a downward trend, you should consider selling.
The optimum time-frame for your trend chart is determined by the time frame you typically use for your trading (signal) charts.
The list below identifies the most common signal-chart time frames and identifies the most appropriate time frame to use for your trend chart:
- 1-minute signal chart 15- to 30-minute trend chart
- 5-minute signal chart 1-hour trend chart
- 15- to 30-minute signal chart 4-hour trend chart
- 1-hour signal chart 1-day trend chart
- 1-day signal chart 1-week trend chart
- 1-week signal chart 1-month trend chart
As you can see from the pairings above, if you typically trade stocks and CFDs looking at a 1-hour chart, then you should use a 1-day chart for your trend chart. It is fairly straight forward.
Once you have identified the ideal time frame for your trend chart, you can spot the prevailing trend using diagonal support and resistance levels or moving averages.
You can see on the weekly chart for Exxon Mobil (XOM:xnys ) that both the diagonal support level and the moving average show that its price is in an upward trend (see Figure 1 ).
Figure 1-Trend Chart
If there is an upward trend on your trend chart, then you should be looking for buy signals on your signal chart. If there is a downward trend on your trend chart, then you should be looking for sell signals on your signal chart.
Once you have identified the trend, you should begin to look for potential trading signals.
Signal Chart
The signal chart is your most important chart. It provides the trading signals that tell you when to look for buying and selling opportunities. For instance, if you typically use the commodity channel index (CCI) to help you identify trading signals, then you will use it here on the signal chart (see Figure 2 ).
Figure 2-Signal Chart
Using a signal chart in conjunction with a trend chart enables you to more accurately identify potentially profitable trade signals. For example if your trend chart shows the stock price is on an upward trend, you should only be looking for buy signals on your signal chart. The best way to capitalise on a long-term upward trend is to buy the stock or CFD. If your trend chart shows the stock price is on a downward trend, you should only be looking for sell signals on your signal chart. The best way to take advantage of a longer-term downward trend is to sell the stock or CFD.
In effect, the trend charts allow you to ignore the less-profitable half of the trading signals you see on your signal chart. Since these trading signals are going against the long-term trend, they have a higher likelihood of performing poorly.
Having identified your trading signals you need to decide when to enter and exit your trades using your timing chart.
Timing Chart
Timing charts, as their name implies, help time entries and exits. Timing can be critical to profitability when you are a trader because even small swings in the price of individual stocks or CFDs could be very significant if you own or manage lots of them.
The list of common signal-chart time-frames below identifies the ideal time-frame for your timing chart:
- 1-minute signal chart Tick timing chart
- 5-minute signal chart 1-minute timing chart
- 15- to 30-minute signal chart 5-minute timing chart
- 1-hour signal chart 15-minute timing chart
- 1-day signal chart 1-hour timing chart
- 1-week signal chart 1-day timing chart
- 1-month signal chart 1-week timing chart
You can use one of the following methods when pinpointing entry and exit signals on your timing charts:
- You can identify the trend as well as its support and resistance levels
- You can use the same technical indicator you use to generate your trading signals
Identify trend as well as its support and resistance -if you see a buy signal on your signal chart, then you should be looking for an upward trend on the timing chart. Hopefully, the price is closer to support than it is to resistance. This tells you the stock or CFD has the potential to move higher before hitting resistance. Of course, if it has just broken up through resistance, it may continue to move higher.
Using a technical indicator -if you use a technical indicator, such as the commodity channel index (CCI), on your signal chart to generate buy and sell signals, you can likewise use that same indicator on your timing chart to help confirm those signals.
For example, if you use the CCI on your signal chart and it creates a buy signal, then you could add the CCI to your timing chart and watch for it to generate a buy signal there too. If the CCI is not giving a buy signal on the timing chart, you should wait for that to happen before acting (see Figure 3 ).
Figure 3-Timing Chart
High-Probability Trade Setup
Let's examine a high-probability trade setup using the multiple time-frame strategy. We will look at the Altria Group (MO:xnys) using a weekly chart as the trend chart, a daily chart as the signal chart and a 1-hour chart as the timing chart.
First, look at your trend chart to see the currency's trend. On the Altria weekly chart, the stock price has been in an upward trend for some time (see Figure 4 ). It would be unwise to ignore such a trend and prematurely sell the stock or CFD.
Figure 4-Trend Chart (High-Probability Trade Setup)
Next, look at the signal chart to spot a buy signal for the Altria Group. This time we are using the commodity channel index (CCI) to generate the trading signal. On the daily Altria Group chart, the CCI gave a buy signal on 13 February as it crossed up from below the -100 threshold. The stock price also bounced up off support at that same time (see Figure 5 ).
Figure 5-Signal Chart (High-Probability Trade Setup)
Lastly, look at the timing chart to see an appropriate time to invest in the Altria Group. On the 1-hour chart, the stock price has found support at approximately $72 and appears to be moving slightly higher (see Figure 6 ).
Figure 6-Timing Chart (High-Probability Trade Setup)
Seeing the trading signal on the signal chart correspond so well with the trend on the trend chart and the currency movement on the timing chart should increase your confidence in the probability of an investment making money.
Using multiple time-frames provides you with a variety of accurate and useful pieces of trading information. Using this strategy wisely can help lead to better trades. Better trades lead to more profits.
⇑ Top
- Advanced
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- Hedging with CFDs
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Hedging with CFDs
Successful traders realise that protecting the money they have is just as important, if not more so, than earning more money from trading. They know that it takes money to make money, and they do whatever it takes to protect their investment capital.
Hedging lets you protect the trades you are in against sudden and unexpected losses, providing the means to remain in investments when you may otherwise have been forced to exit at a loss. Perhaps its greatest benefit is you do not have to hedge every trade, yet you could apply a hedge to almost any trade at any time.
CFDs can be used as part of a hedging strategy to help protect existing positions and your total portfolio. Since a CFD is a margined product its leverage protects the total value of a stock position without you having to pay much up front for it.
In this section we will explain three strategies for hedging individual positions and your entire account:
Hedge - Single Share
One popular strategy, and a useful one in turbulent times, uses a hedge to protect a single stock position with a CFD.
Imagine you currently hold 10,000 Ruritanian Rock Bank shares. It is November 2007 and the bank has problems due to the credit squeeze stemming from difficulties in the U.S. housing market - creating what you believe it is only a short-term weakness, whilst the bank is probably a sound long-term investment.
Initially you bought those 10,000 shares at £5.82 back in November 2005 for a total of £58,200. Currently, Ruritanian Rock is trading between £7.20 and £7.40. But, with the credit crisis looming, you anticipate significant short-term losses, perhaps wiping out all the gains on it to date. However, you expect to see the share price find support and climb again.
Because you don't know if the market will rise or fall, you decide to hedge your position rather than selling out. So you sell an equal number of CFDs at the current market price to offset your stock investment and create the hedge. That will be 10,000 Ruritanian Rock CFDs at £7.40 to cover the 10,000 shares of Ruritanian Rock Bank share you own. Thanks to the leverage you enjoy with CFDs, you must only put up 10 percent of the value of Ruritanian Rock Bank shares - at a cost of £7,400 (10,000 shares × £7.40 per share × 10% = £7,400).
At this point one of the following three things can happen:
Share price rises - if the share price rises, you gain on your share trade but offset that against the loss on your CFD trade. If the share price climbed from £7.40 to £8.40, for example, you would make £10,000 on your share trade but lose £10,000 on your CFD trade. If you believed the share price is going to rise again you could unwind the hedge by buying back the CFDs you sold.
Share price falls - if the share price falls, you gain on your CFD trade but offset that against the loss on your share trade. If the share price dropped from £7.40 to £6.40, for example, you would make £10,000 on your CFD trade but lose £10,000 on your share trade. If you believed the share price is ready to resume its previous trend, you could unwind the hedge by buying back the CFDs you sold.
Share price stalls - if the share price stalls, you will make neither a gain nor loss on either your share or CFD. For example if the share stalled at £7.40 you would make £0 on your share trade but lose £0 on your CFD trade. At this point, if you felt the share price was ready to resume its previous trend, you could unwind the hedge and buy back the CFDs.
Regardless of the share price, the hedge lets you retain any profit from the point at which you employ it.
Pair Trading
Another popular hedging strategy involves buying one company's CFD and simultaneously selling a rival company's CFD. This is called pair trading because you trade a pair of CFDs. The shares of companies in the same industry tend to move in the same direction so, if the industry performs well, most of the shares of the companies within that industry tend to do well too. Of course, the converse is equally true.
As a pair trader, you buy a CFD on the share of the strongest company within the industry and sell a CFD on the share of the weakest company within the industry. Once you have entered your pair trade, you anticipate that one of two things will happen:
- The shares of both companies will rise but the share underlying the CFD you bought will gain more than the share underlying the CFD you sold
- The shares of both companies will lose ground, but the share underlying the CFD you sold will plummet more than the share underlying the CFD you bought.
In both scenarios, you count on losing money on one of your CFDs but expect to make enough on the other CFD to offset your losses and leave a net gain. It is like making a prediction that, if a new Porsche raced a 1961 Volkswagen Beetle, the new Porsche would win. Of course the new Porsche might get a flat tyre or hit a wall before it passed the chequered flag, allowing the humble Beetle to win, but the chances of that happening (unless the Beetle is Herbie) are slim.
Of course both trades could conceivably move in your favor - allowing you to profit from both the CFD you bought as its underlying security moves higher and from the CFD you sold as its underlying security moves lower.
Conversely it is also possible that both trades could end in disaster. You could lose on the CFD you bought as its underlying security moves lower, and likewise lose on the CFD you sold as its underlying security moves higher.
Imagine you wish to pair trade on shares in the oil industry, and you think British Petroleum (BP:xlon) and Royal Dutch Shell (RDSb:xlon) would make great candidates for a pair trade. British Petroleum trades at £5.72 whilst Royal Dutch Shell trades at £20.36.
It is crucial you balance your trade, otherwise it may not perform the way you expect it to. So ensure you control the same amount of value in the assets on which the CFDs are based. In this case you want to control approximately £100,000 worth - or 17,482 shares at £5.72 per share (17,482 × £5.72 = £99,997.04) - of British Petroleum shares and approximately £100,000 worth - or 4,911 shares at £20.36 (4,911 × £20.36 = £99,987.96) - of Royal Dutch Shell shares.
Once you know how many of the underlying shares you want to control, and the current price of those shares, you can enter your trade. Because you are trading CFDs, which employ leverage, you can control £100,000 of the underlying share without using £100,000 of your own money. This time you only have to cover 5 percent of the value of British Petroleum's share price, or £4,999 (£99,997.04× 5% = £5,000) and 10 percent of Royal Dutch Shell's share price, or £9,999 (£99,987.96× 10% = £10,000). This means that in total you provide approximately £15,000 in margin to enter this trade with CFDs, not the full £200,000 if you were to use the shares themselves.
Remember that you pay, or receive, interest each day when you trade CFDs on margin. This time you pay interest of £22.80 per day on the British Petroleum CFDs you have bought, yet simultaneously receive interest of £22.80 per day on the Royal Dutch Shell CFDs you have sold. These payments and credits will offset each other in this pair trade.
Now imagine that the price of British Petroleum rises slightly to £5.735 and the price of Royal Dutch Shell falls to £19.52 over the next fortnight, and you exit your trade. Your profit on the British Petroleum position is £0.015 per CFD, or £262.23 (17,482 × £0.015 = £262.23). Your profit on the Royal Dutch Shell position is £0.84 per CFD, or £4,125.24 (4,911 × £0.84 = £4,125.24). Your total profit on this pair trade is therefore £4,387.47 (£262.23 + £4,125.24= £4,387.47).
Hedge - Index Diversification
Hedging does not necessarily need you to be in two offset positions simultaneously as you do when you hedge a single stock position by offsetting it with a CFD. You can also hedge your overall account risk by diversifying your investments. Whether you expect stocks to rise or fall, you can insure against the unexpected by buying or selling a broad range of CFDs.
The easiest way to hedge by diversifying is to buy an index-tracking CFD, a contract that derives its value from a large stock index like the S&P 500 or the FTSE 100 rather than from a single stock.
You may suspect that stocks in general will rise but be unsure which ones to buy. So you buy a few index-tracking CFDs - the FTSE 100, NASDAQ, S&P 500, Dow Jones and DAX index tracking CFDs . Now if stocks in general increase in value you will make money on your trades. Whilst a few stocks in each index might decrease in value, the average performance of the entire index will counterbalance the poor investments.
This concept also works when you predict that stocks in general will fall. You then sell index-tracking CFDs and benefit from the fall you expected in the overall market.
⇑ Top - Stock and Market Risks
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Stock and Market Risks
Stock and CFD trading are inherently risky. Trading is a hazardous occupation and participants must gamble a part of their capital if they are to receive any return on their investment. Some gamblers win, but some lose too. It is important that you understand the chief risks that will confront you as a trader so that you can take steps to contain them as much as possible.
We will address the chief risks, yet traders confront many manifestations of risk in their everyday operations. Nobody can prepare you for all of them.
A trader with shares in Wal-Mart (WMT:xnys) has to know more than simply how Wal-Mart is performing on fundamentals. The general condition of economies around the world becomes crucial because Wal-Mart is multinational. The aforementioned trader needs to know how well the U.S. stock market is performing overall, since Wal-Mart's fortunes cannot be isolated from it, and whether the U.S. dollar is strong or weak, rising or falling. But that is only part of what this trader needs to know.
As you have already learned, understanding key risks enables you to counteract forces that are unhelpful to the prices of your shares and CFDs and minimise the impact of those forces on your investments' profitability.
Yet it is important to recognise that competent CFD traders welcome these risks because they constitute opportunities to make money though boom or bust. When risks are low and companies do well, CFD traders can profit as share prices soar. Conversely when risks are high and companies struggle, CFD traders can profit as share prices dive.
We will now address several types of risk and how you can contain them:
- Systematic, or market, risk
- Unsystematic risk
- Credit/Default risk
- Exchange-rate risk
- Interest-rate risk
- Political risk
Systematic Risk
Systematic risk is, as the name implies, the inevitable consequence of operating within any system. In this case, the systems are stock and CFD markets. Traders may be able to hedge against certain risks, but they cannot hedge against systematic risk. (Compare it with playing soccer; avoiding being kicked is impossible.) Consequently, participation in the markets involves tacit acceptance of its systemic risks.
Systematic risk can, in extremes, involve stock market crises with far-reaching consequences. A few of the most sobering examples are the Wall Street Crash in 1929, Black Monday in 1987, and the Asian Financial Crisis in 1997. During such crises, all prices are likely to suffer.
Traders often refer to the benefits of the system with the oft-repeated adage "A rising tide floats all boats." Incoming tides certainly lift the entire stock market. Yet the self-same tide can also retreat and can leave the entire stock market marooned. It is when the latter happens that the ability to hedge is a useful riposte to the risk.
Unsystematic Risk
Unsystematic risk, in contrast with the wholesale and unavoidable risks of a system, is the intrinsic hazard associated with a particular stock or CFD.
Shares and CFDs inevitably align those who invest in them with the fate of the companies to which they correspond for better or for worse. Many factors influence company performance. Some present opportunities but others constitute risks. And, because these risks are tied to the performance of individual companies rather than all companies, they are termed unsystematic.
Below is just a representative (and certainly not exhaustive) list of unsystematic risks:
- Unexpectedly low earnings
- Lawsuits
- Scandals
- Technology obsolescence
- Employee strikes
Any one of these risks could cause a company's shares to plummet. Yet, as you must realise, the list of unsystematic risks to which an investment might be subjected is almost infinite and constantly lengthening. In the 21 st century UK , you might add, for example, the risks posed by terrorists, by Internet whispering campaigns, by bird flu, by power grid failure and by ethical protesters. This susceptibility to unsystematic risks is inevitable despite many larger companies employing dedicated staff to predict and address them.
Unlike systematic risks, you can counteract unsystematic risk by diversifying your investments across a swathe of companies, sectors and markets. It is also advisable to hedge your positions and thereby protect yourself, to some extent, against cumulative loss.
Credit/Default Risk
Credit/Default risk is the hazard that a company either actually defaults on its debts or is, for whatever reason, perceived to be a credit risk and therefore likely to default. Although it doesn't frequently happen, companies can become insolvent and unable to repay debts to banks or to the holders of company bonds.
Insolvency may result from credit crunches, as a consequence of corporate fraud, or due to anything from a fundamentally poor company performance to bad bookkeeping. Yet, regardless of the cause, when companies have cash-flow problems, they lose the ability to function effectively. Cash is, after all, a company's life-blood.
Whilst share and CFD holders are not directly hit by loan repayment issues, they are indirectly affected because other traders know a company is fundamentally in trouble when it is technically insolvent and this undermines the share price.
Exchange-Rate Risk
Exchange-rate risk is the hazard facing investors whenever they buy and hold investments in currencies other than their native currency. Like shares, currency prices fluctuate. So, ignoring an investment's performance, if it is held in a currency other than the investor's native currency, and that foreign currency outperforms the native currency, then the investment will profit from the favourable exchange rate. However, if the foreign currency in which that same investment is held loses ground against the investor's native currency, then the investment will suffer from the unfavourable exchange rate.
Exchange-rate risk can even offset any gains the investment may have made on its own. Here is a salutary example. Imagine a British investor buys a U.S. share for $30 when the exchange rate between the pound sterling and the U.S. dollar is 1.5000. So every £1 is worth $1.50. He would therefore pay £20 for the $30 share ($30 ÷ 1.5 = £20). Subsequently the share appreciates by 20 percent, rising from $30 to $36. Yet whilst this is happening, the British pound strengthens against the U.S. dollar so the £1 now buys not just $1.50 but $2.00. So the good news is that his share made $6. The bad news is that the $36 it is now worth will correspond to just £18 ($36 ÷ 2 = £18) if he now swaps those dollars back for pounds. In this case, the share gained 20 percent but the investor would (unless he waits or reinvests or whatever) have a net loss of £2 due to the 25 percent slippage caused by the exchange-rate risk.
Interest-Rate Risk
Interest-rate decisions by central banks such as the Bank of England, the U.S. Federal Reserve and the European Central Bank have immense influence on global and local economies.
Rate increases generally make it more difficult for companies to borrow in order to expand. This makes their outlook bleaker and tends to undermine share values.
Conversely, when central banks cut interest rates it becomes easier for companies to borrow to expand. This positively influences outlook and tends to inflate share prices.
Political Risk
Political risk is the hazard you face that the political environment in the country (or countries) where a company operates may become less conducive to business growth.
At worst, political risk can involve a company being nationalized, losing shareholders most or all of their investments.
Yet political risk takes other forms. It might involve increasing corporate taxation. Or it might involve tariffs that erode a company's profit margins. Both of these would be detrimental to the best interests of shareholders as they would undermine prices.
⇑ Top - Technical Analysis: Price Patterns
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Technical Analysis: Price Patterns
Traders vote with their chequebooks. If they believe a stock or CFD is going to move higher, they will buy it. If they believe a stock or CFD is going to move lower, they will sell it. When their money is at stake, they will do whatever it takes to be profitable. Often, their actions form quite distinctive price patterns on the charts, and it is well worth your while to learn to recognize these.
Price patterns provide an insight into what stock and CFD traders are thinking and feeling. Learning to recognize various price patterns will give you an advantage over traders who only use fundamentals or technical indicators.
Imagine having the ability to precisely identify the optimum moment to buy as a stock or CFD surges as well as the ability to accurately project how far a stock or CFD is going to rise. Price patterns can give you this ability.
Price patterns are divided into the following two categories:
Continuation Patterns
Stock and CFD traders continually ask themselves whether a trend can continue. Deciding whether to invest in the middle of a trend or whether to take your profits is difficult. You can never know if a currency pair is going to turn around and start moving in the opposite direction. You can never know. But you can make an educated guess.
Continuation patterns give you advanced warning of when a stock or CFD is likely to resume its trend after a short consolidation period, and they can also tell you how far the stock or CFD is likely to move in that direction. Of course, continuation patterns are not infallible, but they do put the odds of success in your favor.
Take some time to become acquainted with the following price continuation patterns:
Pennants
Pennants are continuation patterns that form as the price of a stock or CFD moves into a tighter and tighter consolidation range. Pennants can be either bullish or bearish, depending on what the trend was before the pennant began to form. If a stock or CFD was on an upward trend before the pennant began to form, then it is a bullish continuation pattern. Alternatively, if a stock or CFD was on a downward trend before the pennant began to form, then it is a bearish continuation pattern.
Pennants usually form over short periods of time. All have the following five characteristics (see Figure 1 ):
- A: Resistance level - there is downward trend in the level of resistance as it converges with the support level.
- B: Support level - there is an upward trend in the level of support as it converges with the resistance level.
- C: Flagpole - this identifies the trend preceding the formation of the pennant. The flagpole spans the distance from the beginning of the trend to the highest point of the pennant (for a bullish pennant). Or, the flagpole spans the distance from the beginning of the trend to the lowest point of the pennant (for a bearish pennant).
- D: Breakout point - this the point at which the stock or CFD breaks up above the downward-trending level of resistance (for a bullish pennant), or the point at which the stock or CFD breaks down below the upward-trending level of support (for a bearish pennant).
- E: Price projection - this is the price to which the stock or CFD will most likely fall after it has broken out of the pennant formation (in a bearish pennant), or the price to which the stock or CFD will most likely rise after it has broken out of the pennant formation (in a bullish pennant). The distance the stock or CFD is projected to move is equal to the height of the flagpole.
Figure 1-Pennant
Flags
Flags are continuation patterns that form as the price of a stock or CFD pulls back from the predominant trend in a parallel channel. Flags can be either bullish or bearish, depending on what the trend was before the flag began to form. If a stock or CFD was on an upward trend before the flag began to form, it is a bullish continuation pattern. If a stock or CFD was on a downward trend before the flag began to form, it is a bearish continuation pattern. Flags usually form over short periods of time.
Flags all have the following five characteristics (see Figure 2 ):
- A: Resistance level is the downward-trending level of resistance that is parallel with the support level (for a bullish flag), or an upward-trending level of resistance that is parallel with the support level (for a bearish flag).
- B: Support level is a downward-trending level of support that is parallel with the resistance level (for a bullish flag), or an upward-trending level of support that is parallel with the resistance level (for a bearish flag).
- C: Flagpole is the trend preceding the formation of the flag. The flagpole spans the distance from the beginning of the trend to the highest point of the flag (in a bullish flag), or the flagpole spans the distance from the beginning of the trend to the lowest point of the flag (in a bearish flag).
- D: Breakout point is the point at which the stock or CFD breaks up above the downward-trending level of resistance (in a bullish flag), or the point at which the stock or CFD breaks down below the upward-trending level of support (in a bearish flag).
- E: Price projection is the price to which the stock or CFD will most likely fall after it has broken out of the flag formation (in a bearish flag), or the price to which the stock or CFD will most likely rise after it has broken out of the flag formation (in a bullish flag). The distance the stock or CFD is projected to move is equal to the height of the flagpole.
Figure 2-Flag
Wedges
Wedges are continuation patterns that form as the price of a stock or CFD pulls back from the predominant trend and moves into a tighter and tighter consolidation range. Wedges can be either bullish or bearish, depending on what the trend was before the wedge began to form. If a stock or CFD was on an upward trend before the wedge began to form, it is a bullish continuation pattern. If a stock or CFD was on a downward trend before the wedge began to form, it is a bearish continuation pattern. Wedges usually form over short periods of time.
Wedges all have the following five characteristics (see Figure 3 ):
- A: Resistance level is a downward -trending level of resistance that converges with the support level (in a bullish wedge), or an upward-trending level of resistance that converges with the support level (in a bearish wedge).
- B: Support level is a downward -trending level of support that converges with the resistance level (in a bullish wedge), or an upward-trending level of support that converges with the resistance level (in a bearish wedge).
- C: Flagpole is the trend preceding the formation of the wedge. The flagpole spans the distance from the beginning of the trend to the highest point of the wedge (in a bullish wedge), or the flagpole spans the distance from the beginning of the trend to the lowest point of the wedge (in a bearish wedge).
- D: Breakout point is the point at which the stock or CFD breaks up above the downward-trending level of resistance (in a bullish wedge), or the point at which the stock or CFD breaks down below the upward-trending level of support (in a bearish wedge).
- E: Price projection is the price to which the stock or CFD will most likely fall after it has broken out of the wedge formation (in a bearish wedge), or the price to which the stock or CFD will most likely rise after it has broken out of the wedge formation (in a bullish wedge). The distance the stock or CFD is projected to move is equal to the height of the flagpole.
Figure 3-Wedge
Triangles
Triangles are continuation patterns that form as the price of a stock or CFD hits a flat level of support or resistance and begins moving into a tighter and tighter consolidation range. Triangles can be either bullish or bearish, depending on what the trend was before the wedge began to form. If a stock or CFD was on an upward trend before the triangle began to form, it is a bullish continuation pattern. If a stock or CFD was on a downward trend before the triangle began to form, it is a bearish continuation pattern. Triangles usually form over long periods of time.
Triangles all have the following five characteristics (see Figure 4 ):
- A: Resistance level is the horizontal level of resistance (in a bullish, or ascending triangle), or a downward-trending level of resistance that converges with the support level (in a bearish, or descending triangle).
- B: Support level is the upward-trending level of support that converges with the resistance level (in a bullish or ascending triangle), or a horizontal level of support (in a bearish or descending triangle).
- C: Flagpole is the trend preceding the formation of the triangle. The flagpole spans the distance from the beginning of the trend to the highest point of the triangle (in a bullish or ascending triangle), or the flagpole spans the distance from the beginning of the trend to the lowest point of the triangle (in a bearish or descending triangle).
- D: Breakout point is the point at which the stock or CFD breaks up above the horizontal level of resistance (in a bullish or ascending triangle), or the point at which the stock or CFD breaks down below the horizontal level of support (in a bearish or descending triangle).
- E: Price projection is the price to which the stock or CFD will most likely fall after it has broken out of the triangle formation (in a bearish or descending triangle), or the price to which the stock or CFD will most likely rise after it has broken out of the triangle formation (in a bullish or ascending triangle). The distance the stock or CFD is projected to move is equal to the height of the flagpole.
Figure 4-Triangle
Reversal Patterns
Stock and CFD traders continually ask themselves the question whether a trend can continue. Deciding whether a trend is over is difficult. You can never know for sure if a stock or CFD is going to turn around and start moving in the opposite direction. You can, however, make an educated guess, and recognizing reversal patterns will enable you to do that.
Reversal patterns give you advanced warning when a stock or CFD is likely to turn around and begin a new trend. They also indicate how far the stock or CFD is likely to move in the opposite direction. Of course, reversal patterns are not infallible, but they do increase the likelihood of you correctly anticipating the market.
Take some time to become familiar with the following price reversal patterns:
Double-Tops/Bottoms
Double-tops and double-bottoms are reversal patterns that form as the price of a stock or CFD hits a support or resistance level two times before the stock or CFD turns around and moves in the opposite direction. Double-tops are bearish reversal patterns and double-bottoms are bullish reversal patterns. If a stock or CFD is on an upward trend, it will form a double-top. If a stock or CFD is on a downward trend, it will form a double-bottom. Double-tops and double-bottoms both usually form over long periods.
Double-tops and bottoms all have the following four characteristics (see Figure 5 ):
- A: Resistance level is the horizontal , or slightly angled, level of resistance.
- B: Support level is the horizontal, or slightly angled, level of support.
- C: Breakout point is the point at which the stock or CFD breaks up above the horizontal level of resistance (in a double-bottom), or the point at which the stock or CFD breaks down below the horizontal level of support (in a double-top).
- D: Price projection is the price to which the stock or CFD will most likely fall after it has broken out of the double-top formation, or the price to which the stock or CFD will most likely rise after it has broken out of the double-bottom formation. The distance the stock or CFD is projected to move is equal to the distance between the support and resistance levels.
Figure 5-Double-top
Triple-Tops/Bottoms
Triple-tops/bottoms are reversal patterns that form as the price of a stock or CFD hits a support or resistance level three times before the stock or CFD turns around and moves in the opposite direction. Triple-tops are bearish reversal patterns and triple-bottoms are bullish reversal patterns. If a stock or CFD is on an upward trend, it will form a triple-top. If a stock or CFD is on a downward trend, it will form a triple-bottom. Triple-tops and triple-bottoms usually form over long periods.
Triple-tops and bottoms all have the following four characteristics (see Figure 6 ):
- A: Resistance level is the horizontal , or slightly angled, level of resistance.
- B: Support level is the horizontal, or slightly angled, level of support.
- C: Breakout point is the point at which the stock or CFD breaks up above the horizontal level of resistance (in a triple-bottom), or the point at which the stock or CFD breaks down below the horizontal level of support (in a triple-top).
- D: Price projection is the price to which the stock or CFD will most likely fall after it has broken out of the triple-top formation, or the price to which the stock or CFD will most likely rise after it has broken out of the triple-bottom formation. The distance the stock or CFD is projected to move is equal to the distance between the support and resistance levels.
Figure 6-Triple-top
Head-and-Shoulders Tops/Bottoms
Head-and-shoulders tops are reversal patterns that form as the price of a stock or CFD hits a resistance level (forming the first shoulder), then breaks through the first resistance level and hits a higher resistance level (forming the head) and then hits the first resistance level again (forming the second shoulder).
Head-and-shoulders bottoms are reversal patterns that form as the price of a stock or CFD hits a support level (forming the first shoulder), then breaks through the first support level and hits a lower support level (forming the head) and then hits the first support level again (forming the second shoulder).
Head-and-shoulders tops are bearish reversal patterns and head-and-shoulders bottoms are bullish reversal patterns. If a stock or CFD is on an upward trend, it will form a head-and-shoulders top. If a stock or CFD is on a downward trend, it will form a head-and-shoulders bottom. Head-and-shoulders tops/bottoms usually form over long periods.
Head-and-shoulders tops/bottoms all have the following five characteristics (see Figure 7 ):
- A: Left shoulder is the horizontal , or slightly angled, level of resistance (head-and-shoulders top), or a horizontal, or slightly angled, level of support (head-and-shoulders bottom).
- B: Head is the higher horizontal, or slightly angled, level of resistance (head-and-shoulders top), or a lower horizontal, or slightly angled, level of support (head-and-shoulders bottom).
- C Right shoulder is the h orizontal, or slightly angled, level of resistance that is in line with the left shoulder (head-and-shoulders top), or a horizontal, or slightly angled, level of support that is in line with the left shoulder (head-and-shoulders bottom).
- D: Neckline is the horizontal, or slightly angled, level of support (head-and-shoulders top), or a horizontal, or slightly angled, level of resistance (head-and-shoulders bottom).
- E: Breakout point is the point at which the stock or CFD breaks up above the neckline (head-and-shoulders bottom), or the point at which the stock or CFD breaks down below the neckline (head-and-shoulders top).
- F: Price projection is the price to which the stock or CFD will most likely fall after it has broken out of the head-and-shoulders-top formation, or the price to which the stock or CFD will most likely rise after it has broken out of the head-and-shoulders-bottom formation. The distance the stock or CFD is projected to move is equal to the distance between the head and the neckline.
Figure 7-Head-and-Shoulders Top
⇑ Top - Trading Psychology
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Trading Psychology
Stock and CFD traders are not just competing with each other in the stock and CFD markets. They are competing with themselves. Traders can be emotional and irrational, and that can make them their own worst enemies.
Such emotions and instincts can provide trading successes, but they are more likely to provide trading losses unless we learn to control them. This is why understanding trading psychology is important.
Many stock and CFD traders would like to divorce themselves from their emotions. Unfortunately, that is impossible, and some emotions may even contribute to trading success. Therefore, it is more useful to learn to understand yourself as a trader, identifying your own strengths and weakness, so that you can opt for a trading style that suits you.
In this section, you will learn about four psychological biases that may adversely influence your trading results, and you will learn what you can do to overcome them:
Overconfidence Bias
Overconfidence bias is an inflated belief in your skills as a trader. Any traders who finds themselves thinking that they know the business inside-out, that they have nothing more to learn and that fortunes are theirs for the taking, may well suffer from an overconfidence bias.
Dangers of Overconfidence
Overconfident traders tend to get themselves into trouble by trading too frequently or by placing extremely large trades with the intention of making a killing. It's not inevitable, but an overconfident trader invites disaster.
Are You Overconfident?
If you want to know if you have a tendency to be overconfident, ask yourself, “Have I ever delayed or reversed a decision because I couldn't believe I was wrong?” Likewise, you could ask yourself, “Have I ever put more on a trade than I know is really prudent?”
Overcoming Overconfidence
One way to overcome an overconfidence bias is to stick to a strict set of risk-management rules. These rules should limit the number of markets you invest in, the number of stocks or CFDs you trade at one time, how much you are willing to risk on any one trade and how much of your account are you willing to lose before you take a break from trading and re-evaluate your trading strategy.
Anchoring Bias
Anchoring bias is a belief that the future is going to look extremely similar to the present. When you anchor yourself too closely to the present, you may fail to notice dramatic changes in the offing.
Dangers of Anchoring
Anchored traders tend to get themselves into trouble because they wrongly believe that current trends will never end or that companies they've always favoured will never let them down. Because they are emotionally attached to a stock or CFD, they continue to invest in a way which is not optimal in changed circumstances. With each trade, they lose more money because they are bucking the trend.
Are You Anchoring?
If you want to know if you have any anchoring tendencies then ask yourself, “Have I ever lost money because I couldn't accept that a trend had ended?” If you have done this, you need to be aware of that tendency.
Overcoming Anchoring
One way to overcome anchoring is to seek a new perspective. Look at different time-frames on your charts. If you usually rely on hourly charts for data, look instead at the daily and weekly charts to examine long-term trends as well as levels of support and resistance. You could also examine shorter-term charts to see if trends are reversing.
Broadening your perspective in this way will help you to avoid anchoring yourself to any one point.
Confirmation Bias
Confirmation bias is the habit of only looking for information that supports your beliefs. If you anticipate the price of Google (GOOG:xnas) is going to rise, for example, you will only really take in news and data that reinforce your belief.
Dangers of Seeking Confirmation
Traders who pursue confirmation of their beliefs tend to miss warning signs that would otherwise protect them from unnecessary losses. Ultimately, this can only lead to losing money because decisions to buy or sell, or even to do nothing, are being made on false premises.
Do You Seek Confirmation?
To know if you have any confirmation bias tendencies, ask yourself, “How often do I look for signs that I may be wrong in my analysis?” If your answer is rarely or never, you may be a confirmation seeker and you need to actively work to ensure that such a bias never interferes with your better judgment.
Overcoming Confirmation Bias
One way to overcome confirmation bias is to find an individual or group with whom you can discuss your trading. You don't need somebody who will simply flatter you or perpetually agree with you. Traders with different perspectives and ideas will help you to be more circumspect. Sometimes your convictions will only be reinforced by talking with other traders, but at other times, they may force a total and timely rethink.
Loss Aversion Bias
Loss aversion bias is based on the theory that losing £1,000 will have a bigger impact on you emotionally than gaining £1,000 will. In other words, fear is a more powerful motivator than greed.
Dangers of Loss Aversion
Ironically traders who fear losses are much more likely to hold onto losing positions than traders who are able to accept short-term losses and exit their trades. A reluctance to give up a losing position will not only cause you to incur bigger losses but also preclude you from finding better investments.
Do You Fear Losses?
If you want to know if you have any loss aversion tendencies, ask yourself, “Have I ever held onto a losing position, beyond the point where I knew I should have quit, because I hoped the trend would reverse and wipe out my losses?” If you have, then you need to be aware of that tendency.
Overcoming Loss Aversion
One way to overcome a loss aversion bias is to trade with physically-set (i.e. automatic) stop-loss orders. Many traders trade with just a mental stop-loss that, when it comes to the crunch, they fail to honour. They let their emotions interfere with their better judgment as they try to justify irrational decisions that prevent them from quitting and cutting their losses.
In conclusion, as soon as you invest in anything you should set your stop-loss order. It should be physically set, operate automatically, and you should respect it.
⇑ Top
- Expert
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- Exchange-Traded Funds
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Exchange-Traded Funds
Exchange-traded funds (ETFs) are investment funds traded on stock-markets. They are not mutual funds yet they offer all of the benefits of diversification that you would expect from a mutual fund. ETFs also enjoy all of the benefits of liquidity that you have from trading individual shares.
ETFs offer instant diversification because when you purchase one, you invest in a fund that buys and holds multiple assets. ETFs are like baskets into which fund managers place various assets such as stocks, bonds and commodities. When you buy an ETF, you buy ownership of a basket and its contents, not piecemeal ownership of the individual contents.
ETFs are potentially lucrative because as the value of the assets within the basket increases so too does the overall value of the basket. Yet, obviously, quite the opposite can still occur. If a sufficient number, or all, of the assets lose value, then this will pull down the overall worth of the basket.
Trading ETFs offers many benefits and in this section we will look at:
Instant Diversification
ETFs give you the ability to simultaneously invest in multiple assets without having to purchase each individually. That saves substantially on trading costs as well as on the capital you would need to buy each individual stock within an ETF that corresponded to an index, like the S&P 500.
Diversification also helps to protect against unsystematic risk. If you own just one of the stocks in the FTSE 100 and that stock loses ground, then you will lose money. Yet if you own the entire FTSE 100 via an ETF, and that same stock loses ground, the other 99 stocks are likely to ensure that the cumulative value of the entire index-linked ETF either remains stable or climbs higher.
Many popular ETFs track broad market indices, and these are just a few examples:
- S&P 500
- Dow Jones Industrial Average
- FTSE 100
- DAX Index
- Nikkei 225
- FTSE/Xinhua China 25 Index
- NASDAQ 100
- CAC 40 Index
Many ETFs also track various market sectors such as the following:
- Information technology
- Energy
- Materials
- Industrials
- Telecommunication
- Utilities
- Health care
- Financials
Free Trading
ETFs are freely traded on stock exchanges just like regular shares. As long as exchanges trading ETFs are open, you can trade in them, which is a distinct advantage over mutual funds. Mutual funds are not freely traded.
If you see ETF values rise or fall during the trading day, you can buy or sell them to take advantage of the price movement. In contrast, mutual funds are only traded at the end of the market day once all of the component assets can be valued. At that point, the mutual funds are assigned a closing value for the day and they may then be traded at this closing value. Unfortunately, this means that, during the trading day, you must hold onto mutual funds regardless of how they are performing. Whilst the sheer breadth of the shares included in a mutual fund may make sudden and significant losses unlikely, the fact that mutual funds cannot be traded freely could, in certain circumstances, be a disadvantage.
Stop-Loss Orders
You can protect ETF trades with stop-loss orders that will exit trades during the trading day when pre-determined prices are realised. Mutual funds, in contrast, would not give you this option because they are only bought and sold at the end of the trading day after the markets have closed.
So it is important to remember that stop-loss orders are an appropriate risk management measure on ETFs. Combined with intelligent diversification they will simultaneously protect your capital.
Lower Fees
We usually have to pay managers a fee to handle our investments, and that fee will largely depend on how active a role the manager plays.
ETFs usually involve lower fees because they are passively managed. This is because most ETFs track specific indices or market sectors, the composition of which rarely alters.
Yet many funds, such as mutual funds, are actively managed and thus attract larger management fees. Mutual fund managers often make daily decisions regarding portfolio content. This hands-on management, together with the trading fees generated by the execution of each trading decision they make, boosts the fees that they will earn - and charge.
⇑ Top - Market Rotations
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Market Rotations
Stock markets wax and wane as investors move their money into and out of not only the markets themselves but also the sectors within those markets. Investors forever seek the most profitable investments and, when they identify an opportunity to make a better return than they could have from whatever is currently tying up their capital, they are understandably fickle.
The law of supply and demand operates as opportunists drift from one investment to another. As demand for an attractive investment increases, more funds are pulled towards it so that its value increases but its supply, its availability, decreases. In extremis would-be investors who are slow to identify the opportunity might find it next-to-impossible to participate in the boom for love or money.
Meanwhile this is often balanced by the decline in interest in other investments. There you can observe a loss of value that pushes participants out of the investment. Demand declines so supply of the unattractive commodity increases. In extremis it may be almost impossible to give away such an investment opportunity.
It is these fluctuations in supply and demand, the interminable push and pull, which cause the ebb and flow of prices in the stock market.
The dynamic influences of supply and demand are clearly demonstrated by two types of investment rotation:
Market Rotation
There is no reason why investors should limit themselves to stocks when they can invest in bonds, commodities, property and more. Participation in two or more such markets is known as diversification. To make a decision on where to put their money, investors will assess potential returns alongside the risks of participation. The former must outweigh the latter for investors to make prudent investments. But, in essence, diversification is in itself prudent.
Investors tend to freely move their money back and forth between the stock and bond markets and, indeed, most investors diversify by having money in both of these markets at the same time. This is because bonds and stocks compliment each other within a portfolio with bonds offering security, stability, regular interest payments and guaranteed returns whilst shares offer less security but potentially greater returns.
These diversified investors have two main concerns:
- What proportion of their funds to keep in each market
- When to readjust their allocations.
When markets perform well, when economies grow and investors are optimistic, the stock markets are buoyant and therefore investors tend to rely less on bonds and more on stocks. This influx of cash raises demand for stocks that boosts their value. However, when financial markets under-perform, when economies stagnate and shrink so that investors are pessimistic, there is a flight from stocks and into bonds to protect investment capital. This influx of cash raises demand for bonds that, in turn, enhances their value.
Accurately identifying the market cycles when stock demand increases, and likewise spotting those cycles when bond demand increases, makes for profitable trading. Indeed, when demand shifts from bonds to stocks, and stocks subsequently put on value, you can profit from either:
- Buying indexed ETFs that should appreciate as stocks gain ground
- Selling bond ETFs that should depreciate as bonds lose ground
Alternatively when demand shifts from stocks to bonds, and bonds subsequently put on value, you can profit from either:
- Buying bond ETFs that should appreciate as bonds gain ground
- Selling indexed ETFs that should depreciate as stocks lose ground
You should remember that in some conditions bonds and stocks can simultaneously increase or decrease in parallel. However, historically they tend to move in opposite directions.
Sector Rotation
Stocks with similar characteristics are grouped together into market sectors, so companies operating within the healthcare sector are not on the same playing-field as those that manufacture microprocessors and which are therefore in the technology sector. Sector groupings are helpful because companies operating in similar industries tend to be driven by the self-same market and economic forces - forces that tend to mean that the companies' shares move in unison.
Knowing that a market sector's stocks should move together can inspire investment decisions because once one stock within a sector moves there is a likelihood that other stocks within that sector will likewise move as a consequence of the same forces. This field-dependence gives you opportunities to identify suitable investments within the same categories and capitalize on them.
Invariably some sectors will outperform others, and will therefore become a temporary focus of attention, but it is rare for every sector to simultaneously move either up or down.
The self-same forces of supply and demand, those which drive price movement within market sectors, also drive investors to shuttle their money between stocks and bonds. When a sector overcomes its inertia investors will turn to it. Increasing popularity, burgeoning demand and an influx of cash usually then inject momentum into the share price.
On the flip-side the same investors who are fuelling one share or sector's boom are decamping from less-popular avenues of opportunity where, as shares are dumped because demand decreases, the increased supply is detrimental to their value.
Accurately anticipating increased or decreased demand for shares in the sectors they occupy can clearly contribute to the likelihood of your making profitable trades.
When demand shifts sector, when stocks in popular sectors gain value whilst stocks in their unpopular counterparts lose value, profitability lies in any of the following:
- Buying ETFs that represent sectors experiencing an upsurge in popularity
- Buying individual stocks within sectors experiencing an upsurge in popularity
- Selling ETFs that represent sectors experiencing a downswing in popularity
- Selling individual stocks within sectors experiencing a downswing in popularity
- Technical Analysis: Fibonacci
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Technical Analysis: Fibonacci
Leonardo Pisano, aka Fibonacci, is credited with devising the Fibonacci sequence that bears his name. Fibonacci analysis, which we will explain after an introduction to the Fibonacci sequence itself, is an application of Fibonacci's 11th century discovery to 21st century price trends. The resultant tool enables traders to identify the levels at which price levels support and resistance are likely to form-in effect, they provide guidance on when to buy and when to sell.
The Fibonacci sequence commences with the numbers 0, 1, 1, 2, 3, 5, 8, 13, 21, 34 and 55. Each number in the sequence is the sum of the two preceding numbers. So the number that follows 55 is the sum of 55 + 34 (34 being the number preceding 55). Thus 89 follows 55. And then 89 is followed by 144, 203, 347 and 550. Clearly the sequence is infinite.
What intrigued Fibonacci about this sequence was not the numbers themselves but rather that the ratios have proved to have applications in fields as diverse as botany, psychology and astronomy. For example these ratios correspond even more exactly to the distances between the planets in our solar system and the sun than the ratio using Bode's Law (aka Titius-Bode Law, the flawed sequence which was used by astronomers almost 600 years after Fibonacci's birth to predict a planet between Mars and Jupiter that appears to have been reduced to asteroids, and a sequence which anyway breaks down for Neptune and Pluto). So Fibonacci was ahead of his time, and he could never have dreamed of the applications to which his sequence would be put.
What is perhaps more relevant than whether the Fibonacci sequence predicted the whereabouts of Neptune and Pluto is that it is widely used as a predictor of the values of stocks and CFDs. It seems curious, but historically using Fibonacci analysis has proven to be effective. And that is why you need to know about it.
This section explains how you can apply Fibonacci ratios to stocks and CFDs, predicting continued growth or even the consequences of downturns, using the following tools:
Fibonacci Retracements
When a stock or CFD price reverses a trend, traders naturally want to know how far the stock price is likely to move in its new direction. A system employing what is known as 'Fibonacci retracement' can help.
Technical analysts use the Fibonacci sequence to create two sets of three critical ratios. We are going to explain how the ratios are created. Do not worry about remembering the explanations of the calculations because they are not so important. But the handful of percentages shown in bold are essential and ought to be committed to memory.
The first set of three ratios used for retracement analysis is 61.8 percent, 38.2 percent and 23.6 percent. And this is how we arrive at those figures:
- 61.8 percent is arrived at after dividing 55 by 89. These numbers are immediately adjacent to each other.
- 38.2 percent is arrived at after dividing 34 by 89. These numbers are not immediately adjacent since one number, 55, is missing.
- 23.6 percent is arrived at after dividing 21 by 89. These numbers are not immediately adjacent since two numbers, 34 and 55, are missing.
The second set of three ratios used for retracement analysis is 50 percent, 76.4 percent and 100 percent. The second set of three ratios contains derivations from the first set. And this is how we arrive at those figures:
- 50 percent is arrived at by identifying the midpoint between 61.8 percent and 38.2 percent ((61.8% + 38.2%) ÷ 2 = 50%).
- 76.4 percent is arrived at by identifying the distance between 38.2 percent and 23.6 percent (38.2% - 23.6% = 14.6%). And that 14.6 percent is then added to 61.8 percent.
- 100 percent is arrived at by identifying where the previous trend began.
Taken together, these six Fibonacci retracement percentages form support and resistance benchmarks that can help you determine which trading tactics you are going to use at each price level..
You can see these Fibonacci levels in action very clearly on the daily Boeing (BA:xnys) chart below (see Figure 1 ). Each of the illustrated levels is based on the trend highlighted by the red arrow. If you were trading here, you could have used each level to help you determine whether to buy or sell as the stock price fluctuated.
Figure 1-Fibonacci Retracement Levels
In particular you should take note of how the stock price moved up and down, bouncing off both the 23.6 percent and 38.2 percent retracement levels.
Fibonacci Projections
Trends are usually not straight-line affairs. They are prone to temporary reversals, which could be compared with the natural ebb and flow of a tide.
When a stock price resumes its previous trend, stock and CFD traders want to predict how far the stock price is likely to continue moving. Fibonacci projection levels can help.
The sharp-eyed reader will notice that these calculations are actually the reverse of those used to create the first set of three ratios for the Fibonacci retracements we dealt with earlier. But as before, the method of calculation is not so important. Remembering the key ratios, marked in bold, is all that you ought to do.
The projection levels that you need to know are as follows:
- 161.8 percent is arrived at after dividing 89 by 55. These numbers are immediately adjacent to each other.
- 261.8 percent is arrived at after dividing 89 by 34. These numbers are not immediately adjacent since one number, 55, is missing.
- 423.8 percent is arrived at after dividing 89 by 21. These numbers are not immediately adjacent since two numbers, 34 and 55, are missing.
Knowing all three Fibonacci projection levels, and setting them as benchmarks, is a great way to predict support and resistance levels for stock and CFD trading.
You can see these Fibonacci levels in operation on the daily Coca Cola (KO:xnys) chart below (see Figure 2 ). The upward trend is highlighted by the red arrow. It has already bounced off the 161.8 percent level. If Coca Cola resumes the anticipated upward trend, you can assume that the stock will now continue to rise through and beyond the 161.8 percent level, until it bounces back down, with an adjustment, from the 261.8 percent level. Knowing the theory of this should help you to determine where to set your profit targets and, potentially, your exit levels-the levels at which Coca Cola may turn around and cause you to sell and take your profits.
Figure 2-Fibonacci Projection Levels
Notice that the stock price, based on the previous trend, is likely to move up to the 161.8 percent projection level in the near future. If it reaches this level then the 261.8 percent projection level becomes the next profit target level.
Fibonacci Fans
Fibonacci levels provide both horizontal and diagonal levels of support and resistance. So far we have looked at horizontal levels with retracements and projections.
The diagonal levels of support and resistance are called Fibonacci fans.
Fibonacci fans are based on three Fibonacci retracement levels, at 61.8 percent, 50 percent and 38.2 percent All three of these, as you've hopefully remembered, were among the six percentages used for retracements.
To construct a Fibonacci fan, you need to do the following, all of which is clearly explained by Figure 3 .
- Identify a recent trend, pinpointing where it started and ended.
- Draw two horizontal lines across the chart that go through the start-point and the end-point of that trend. These two horizontal lines equate to the highest and lowest prices that occurred during the trend.
- Draw a vertical line at the point where the trend ended. This will, in effect, run perpendicular between the horizontal lines that you've just drawn.
- Identify three horizontal Fibonacci levels (61.8 percent, 50 percent and 38.2 percent) as they relate to that trend.
- Finally, draw three diagonal lines. All three must begin in the same place, the point where the trend began. But the three all follow separate paths to where the vertical line intersects one of the three horizontal Fibonacci levels.
This may seem complicated at first, but it is essentially simple. Once you can create a Fibonacci fan, you will be able to use it to anticipate critical support and resistance levels.
We have drawn a Fibonacci fan on the daily Coca Cola (KO:xnys) chart below (see Figure 3 ). Each of the illustrated levels was calculated based on the trend highlighted by the red arrow. Had you been the owner of Coca cola stock, this fan could have helped you determine the optimum moments to buy and sell.
Figure 3-Fibonacci Fan
You should notice how the stock price bounced off the middle ray of the Fibonacci fan in early January and is currently at the resistance level formed by the bottom ray of the fan. At this point, that bottom ray of the fan has a good chance of acting as resistance and sending the price of Coca Cola lower.
⇑ Top - Speculating with CFDs
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Speculating with CFDs
Traders often follow their gut instincts about trades. Though they may not be able to explain precisely why a share or index is going to move in one direction or another, they just know what is going to happen. Anxious not to miss the profits that would emanate from the movements they've prophesied, they then place speculative trades.
Typically short-term, speculative trades are generally coupled to major market events such as central bank interest-rate decisions and company results. Traders want to capitalize quickly through a timely entry into trades that will see prices take off on the news, and then a timely exit with their profits intact.
CFDs are the speculator's investment tool of choice largely because they have the advantage of leverage that allows traders to maximise exposure whilst minimizing investment. Yet, because in speculative trades leverage can enhance not only gains but losses too, you should never place trades without utilizing trailing stops and other risk-management techniques.
In this section we will describe some typically speculative opportunities and explain how to grasp them:
Speculative Trading Opportunities
Speculative trading opportunities tend to have one unifying feature: their link to news announcements. Such announcements may contain the government's latest employment figures or they may be a company's quarterly earnings. Either way, they frequently have the potential to cause dramatic shifts in the market.
Examples of news announcements that could precipitate speculative opportunities are:
- Breaking news
- Company reports
- Economic data
- Index additions/deletions
Breaking news announcements are unscheduled events that can wrong-foot traders and are therefore not so easy to capitalise on. Breaking news like a merger announcement should be beneficial to share and CFD prices, though occasionally the wisdom of a merger is not apparent and the price adjustment will reflect that. Yet other breaking news announcements like fraud charges against a company's CEO are usually harmful to share and CFD prices.
As you might expect, negative news depresses CFD prices lower whilst positive news lifts them.
Company reports provide information regarding recent company performance and plans for the future. Scheduled well in advance, they give traders every chance to prepare themselves and take full commercial advantage of their contents.
Company reports are not only publications of results for the last quarter, half or year. They should also anticipate trading during the next six months and this will impact on prices shares and CFDs. Traders need to digest this information and form opinions on it.
When a company's report shows it performs well and will continue to do so, its prices tend to move higher. Of course, the converse is equally true. Poor and pessimistic reports depress share prices.
Economic data emerges in news releases commonly scheduled months in advance, offering traders the opportunity to consider the evidence, second-guess the announcement and capitalise on the market movements that they feel will inevitably follow.
Economic data includes inflation, gross domestic product (GDP) information, interest rate announcements and unemployment figures, all of which tend to influence broad markets rather than individual companies. It therefore makes sense to utilise index-based CFDs when speculating on these announcements.
When economic data indicates that the economy is buoyant, share and CFD prices tend to move higher. If that data is poor, however, prices will usually fall.
Index additions/deletions occur when major market-tracking companies such as Standard & Poor's adjust the composition of their indices. This might happen, for example, if a company can no longer meet market-capitalization requirements and is therefore de-listed from the S&P 500 index .
Index additions and deletions usually occur at prearranged times though the identity of the individual shares involved is not divulged until the announcement is made. Traders may well realise which shares are likely to be affected, but they cannot confirm that before the announcement.
Being added to an index typically raises a share's demand and its price. It will of course then be required as a component of index-tracking funds. Conversely when shares are de-listed the index-tracking funds sell the share, and its price typically falls.
The Expected is Already Priced In
One important thing for speculative traders to remember about opportunities precipitated around news announcements is that expected movements are already priced into CFDs.
Investment analysts, economists and other market participants fervently analyze anticipated news announcements, trying to second-guess the consequences of the news on pricing. Whilst they are unlikely to entirely agree on anything, they do generate a consensus that is useful. This consensus, containing the average estimate, allows traders to capitalize on price movements once the news announcement is released. This is because the average estimate will already be "priced into" the value of the CFD. We will explain how this occurs.
After their analysis, traders take advantage of anticipated CFD movements. They don't wait for announcements. They need to pre-empt the market. So, by the time an announcement is released, most major players have already placed their trades.
When news announcements accord with average estimates, CFDs barely move. This is because most big traders have already placed their trades. Yet, when news announcements differ from the average estimate, CFD prices must adjust - either up or down - to accommodate the economic reality. This adjustment creates opportunities for the quick-witted to speculate.
Implementing Speculative Trades
Identifying news announcement or other stimuli that should cause prices to move will then provide opportunities to capitalise on price movements in three ways:
- You can enter your trade immediately after the announcement
- You can let the market digest the announcement, then act on it and establish a trend, before you enter your trade
- You can set two entry orders, one above the CFD's current price and one below it, just before the announcement
Entering Immediately Following a News Announcement
Entering trades immediately after an announcement is fraught with difficulties. This is because prices tend to adjust sharply when investors have incorrectly guessed the news. So to do this you must get the news quickly, evaluate it quickly and then enter your trade order quickly. Moreover, you need to do this before the price has already taken off. And it will do that quickly too.
Traders jumping into trades after the announcement usually must pay more for CFDs or sell them for less. Price movements that occur between the time when you enter trades and when those trades are filled are called "slippage." It can obviously be frustrating so, if you would be uncomfortable with slippage, then you should choose one of the other two methods for reacting to, or 'trading on,' the news.
Entering Once a New Trend is Established
Most CFD traders who trade on news choose to wait until new trends are established. This is typically the easiest way to capitalise on it, because initially the CFD price will fluctuate as investors speculate on how the underlying asset will trend. Once this fluctuation has abated, it is a good time to participate, but traders who work this way need to learn to ignore the superfluous 'noise' before a clear and enduring trend settles. Doing so gives them an advantage over other traders, those who enter too quickly and are caught out by early reversals and prices that trigger their stop-losses.
The direction in which a CFD is going to move is usually clear within 2 to 5 minutes of the news announcement that sparks its movement. Those few minutes will be ample time to shake out any investors trying to buck the trend so it makes sense to use short-term charts - ideally 1 or 2-minute charts - to monitor price movements after announcements.
Using Entry Orders Before the News Announcement
Placing entry orders prior to announcements is the most profitable way to trade the news - assuming that you are correct and that the CFD moves in the preferred direction. By placing orders before the CFD moves in any direction at all you have the advantage of entering the trade at the price you want and don't have to worry about slippage. When the CFD reaches your pre-determined entry price you will be placed into your trade.
Yet this is risky because the market fluctuates wildly immediately in the aftermath of announcements and will take a little time to settle down. Ultimately the majority of participants perceive the news to be bullish or bearish then act accordingly. In the meantime, you could be knocked into the trade once your entry order is hit, then knocked right back out of it once the CFD turns around and hits your second entry order.
To prevent that you can delete your second entry order once the first entry order is hit, yet you should still place a stop-loss after you hit your first entry order.
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