A candlestick with a long hollow body shows how buyers pushed the price up. On the other hand, a candlestick with a long filled in body shows that sellers brought the price down. Candlesticks with short bodies indicate that there wasn’t much trading activity so the price remained relatively stable from open to close. A candlestick with a long upper shadow shows that buyers gained control and drove up the price but sellers brought the price back down by market close. A candlestick with a long lower shadow means that sellers drove the price down but buyers pushed the price back up before market close.
One basic candlestick pattern is called a spinning top. These candlesticks have short bodies and long upper and lower shadows. This means that buyers and sellers fought but when the market closed neither party could get the upper hand. Another basic candlestick pattern is referred to as a marubozu. This candlestick has a long body with no shadows. This means the open and close price were the same as the high and low price. Lastly, there is a Doji. This candle has an extremely small body because the open and close prices are the same. If there is a series of long white bodies and dojis it can indicate that buying pressure is starting to weaken and the price might begin to fall. If there is a series of black long bodies and dojis it can mean there aren’t enough sellers to continue pushing the price down and the price might start rising.
A hammer is a single candlestick pattern with a short hollow body and a long lower shadow. It occurs at the bottom of a downward trend. A hammer can signal to investors that the price has reached its lowest point and may begin to rise. A hanging man is the same as a hammer except it has a filled in body and it occurs at the top of an upward trend. A hanging man can indicate that price has reached its maximum and may soon start to fall.
A bullish engulfing occurs during a downward trend when a filled in candle is followed by a much larger hollow candle. This shows that buyers are starting to push prices back up. A bearish engulfing is the opposite. During a period of rising prices, a hollow candle is followed by a much larger filled in candle. The sellers are beginning to move the prices back down.
When three hollow long body candlesticks follow a downward trend it is called three white soldiers. This pattern indicates that the downward trend is over. A pattern called three black crows is the opposite of three white soldiers. This occurs when three filled in long body candlesticks follow an upward trend. This pattern signals to investors that price will start to fall.
The strength of a currency depends on economic growth, capital flows, the balance of trade, and government. When consumers feel confident about the direction of the economy, they are likely to increase spending. The money spent by consumers turns into earnings for companies. When companies report strong earnings they are more likely to invest in projects. The growing companies provide a strong tax base for the government. The government spends tax revenues and puts the money back into the economy. The cycle of spending has a positive impact on economic growth.
Capital flow measures the amount of money flowing through a country as a result of capital investment, purchasing, and selling. A country with positive capital flows has a foreign direct investment that exceeds investments leaving the country. An American company building a factory in Japan results in a negative cash flow for the United States and a positive cash flow for Japan.
A country that exports more than they import has a trade surplus. A trade surplus is generally accompanied by a stronger currency. For example, if tons of Americans want to buy goods and services from Germany, they will need to sell their own currency (USD) and purchase the Euro (EUR). This creates more demand for the Euro. When demand for a currency increases, the currency strengthens. If Germany’s currency strengthens, it makes it more expensive for foreigners to purchase goods from Germany and cheaper for Germans to purchase goods abroad. The opposite of a trade surplus is a trade deficit. A country with a trade deficit imports more than they export. If Germany has a trade deficit, the value of their currency will weaken. If Germany’s currency weakens, German goods will be cheaper for foreigners to purchase and foreign goods will be more expensive for Germans to purchase.
Fundamental analysts study economic indicators such as employment rate, inflation, and interest rate to make predictions about the direction of a country’s currency. For example, if a fundamental analyst learns that a country is raising interest rates he or she might choose to purchase that currency. This is because higher interest rates often cause a currency to strengthen.
Hedging reduces risk but also limits potential gains. To create a hedge, an investor will hold two or more positions at the same time. The goal is for the losses from one position to be offset by the gains from another position. Since the investor faced losses, he didn’t earn as much as he could have, however, the hedge reduced some of his risk. One hedging strategy is to select two positively correlated currency pairs. Assets that are positively correlated have similar but preferably inverse price movements in response to market events. Next the investor would need to take opposite positions on each currency pair to create the hedge.
Central banks manipulate interest rates to control inflation. Inflation is defined as the increase in the cost of goods and services. For example, in 1950 the average price of a car was $1,510 and had increased to $33,560 in 2015. The United States tries to maintain inflation of 2%. Producers like small amounts of inflation because it incentivizes customers to buy a product now rather than later because they know it will increase in price. However, some basic goods such as corn do not see as high levels of inflation. The average price of a bushel of corn grown in Iowa was $3.01 in January 1975 and $3.34 in January 2017. If inflation becomes too high, the central bank will respond by raising interest rates.
National Interest Rates: When a central bank sets an interest rate at 3%, they are setting the cost for a bank to borrow that country’s currency. For example, if the United States Federal Reserve increased the interest rate from 2% to 4%, then it will be more expensive to add new USD into the economy. Thus, the US dollar will be more expensive compared to other currencies and so will strengthen.
Managing Your Risk
When trading, periods of loss are inevitable. Experiencing a reduction in capital due to a series of losing trades is called a drawdown. A general rule is that traders should limit their risk to 2% of their capital per trade, this way during drawdowns he or she will not suffer significant losses. A trader can also manage risk by using the 3:1 ratio. This means that a trader should have the ability to earn 3 times what he risks on the trade. Using this strategy can be difficult when making a small trade because one must take into account the spread paid to the broker. This strategy is more practical for larger trades.
It is important to take volatility into account when placing trades because higher volatility indicates that the asset has a higher risk. Volatility measures the price fluctuations of an asset. If a price remains steady then the asset is less volatile whereas if a price experiences high degrees of variation then the asset is considered more volatile. To measure volatility, an investor can use Bollinger bands. Bollinger bands consist of points plotted two standard deviations above and below an asset’s moving average. When the bands widen, it indicates greater volatility. The average trading range (ATR) is another method to measure volatility. ATR simply calculates the trading range for a selected period of time. The higher the ATR, the higher the volatility.
Regression analysis looks at the relationship between a dependent variable and one or more independent variables. A simple regression model has one independent variable and one dependent variable. To run this regression, an analyst will select an independent variable that he or she believes impacts the behavior of the dependent variable. In order to perform a regression analysis, the variables must have a linear relationship. To test this, one simply has to plot all of the data points on a scatter plot. If the data points are approximately linear, one can use the ordinary least of squares method. This method produces formulae for the slope and y-intercept that best represents the relationship between the independent and dependent variables. To determine how strong the relationship is between the two variables one can look at the coefficient of variation. The coefficient of variation will be a number from 0-1. The closer the number is to one the stronger the relationship is. If there is a very weak correlation then it is likely that there are additional independent variables that impact the dependent variable.
A multiple regression equation tests the relationship between one dependent variable and two or more independent variables. In order to determine which independent variables are impacting the dependent variable’s behavior, one must use a hypothesis test to determine which coefficients are statistically significant. The null hypothesis states that the coefficient being tested is equal to zero. This means that there is no relationship between this independent variable and the dependent variable. If the null hypothesis is correct then the coefficient is deemed not statistically significant.
Sentimental analysis focuses on the emotions of market participants. Sentimental analysts attempt to quantify the number of bullish and bearish investors and use this information to forecast price directions. For example, if a large bank in Australia files for bankruptcy, people may feel very bearish about the Australian dollar, weakening AUD. If the analyst believes that this bearish sentiment is only temporary he or she might buy AUD while the price is low.
Stop-orders allow investors to limit their risk of downside. A stop loss order is only executed if the market price falls below the predetermined stop-loss price. If stops are placed too tight then one could get stopped out of the market before the price has a chance to bounce back. On the other hand, if stops are placed too wide then the stop is essentially useless.
Support and Resistance
It is important to pay attention to support and resistance levels because they can indicate a potential change in price direction. The highest point the market reaches before falling back down is called a resistance. The lowest point the market reaches before coming back up is called a support. The more often the market hits a support or resistance level without breaking it, the stronger the support or resistance zone becomes. An investor can study support and resistance zones to determine when to enter and exit the market. One method is to wait for the price to bounce off a support level or resistance level. For example, once the price bounces off a support level there is evidence that the price is going up and it may be a good time to enter the market. The price can also break through support or resistance levels. When this occurs resistance levels can become support levels and support levels can become resistance levels.
Technical analysis is rooted in the idea that history will predict the future. Technical analysts study patterns to determine indicators of price movement. When a certain pattern or indicator appears, they will use past data to predict where price will go next. One form of technical analysis is to analyze a currency’s price movement to determine if the currency is overbought or oversold. If the currency is oversold, a technical analyst would purchase the currency while if the currency is overbought, the analyst would sell it.
Types of Charts
A line chart connects the closing price from one day to the closing price of the next day. The lines indicate overall market trends.
Another type of chart is a bar chart. Each bar on a bar chart consists of three parts: a vertical bar where the top of the bar shows the highest price and the bottom of the bar shows the lowest price, a horizontal bar that indicates opening price, and a horizontal bar that indicates closing price.
The last chart is a candlestick chart. A Japanese candlestick consists of a body and two shadows. The upper shadow depicts the highest price and the lower shadow indicates the lowest price within a given period. The body shows the opening and closing price. If the closing price is above the opening price then the body will be hollow. If the closing price is below the opening price then the body will be filled in.
Weighted Moving Average
A simple weighted moving average (SMA) plots the changes in price over a period of time. When the averages are taken over a longer period of time the line will appear more smoothed out. If the averages are taken over a shorter period of time, the line will more closely reflect actual price. Exponential moving averages (EMAs) also plot price averages over periods of time. The main difference is that exponential moving averages place more weight on current price movements. By giving more weight to current price movements the line appears less smoothed out. This allows EMAs to respond to price movements more quickly than SMAs.