chapter ii. - primecfds · chapter i. introduction ... chapter ii. what are financial ... currency...

PRIME CFD’SGUIDE TO TRADING 2

GUIDE TO TRADING TABLE OF CONTENTS

PART 1. An Introduction to Financial Markets ...................................3CHAPTER I. Introduction ...................................................................3CHAPTER II. What Are Financial Markets? .......................................4CHAPTER III. Keeping it Simple with Options ....................................8CHAPTER IV. Taking Control. Forex, CFDs & Margin Trading ..........10

PART 2. Trading in Depth ................................................................16CHAPTER V. The Platform ...............................................................16CHAPTER VI. Leveraging the Margin ................................................17

PART 3. Powering up with Knowledge. Financial Analysis ..............22CHAPTER VII. An Introduction to Financial Analysis .......................22CHAPTER VIII. Charts, Candles and How to Read the Patterns .......23CHAPTER IX. Indicators Indicating Success ....................................26CHAPTER X. Learning to Trade – Risk, Recklessness & Reason ....30


PART ONEAn Introduction to Financial Markets

CHAPTER IIntroduction

Kids see money as what they need in order to buy stuff; adults see it as something you get paid with. And more and more people are beginning to realize that money is actually an asset – just like oil or real estate – that can be used as a tool. We use our abilities and training to find a job; we can use money to generate wealth… to make more money.

Investment bankers and Wall Street brokers have known this for years. Regular working folks have only realized during the past century or so. Now, they can do themselves, without needing to rely on a bank clerk or a broker who – the past decade have shown us – may not invest our money for us in the best manner possible.

The financial crisis of 2008, and – indeed – that of the 1920s and nearly every economic meltdown in history has shown us that financial institutions do not always have the best interests of their clients at heart. Fortunately, the computer revolution has placed the information they have at our fingertips, as well; plus, anyone can nowadays access financial markets directly as easily as we shop online.

In this eBook, we will explain how to go about investing your own money so that it will generate the additional income you may need for that end-of-the-year vacation or a new car.

A word of warning: if you expect to be making easy money, quit now! You cannot expect to make inordinate profits on something you know nothing about. Investing – unlike gambling – means that you are aware of the forces that drive the markets and are prepared to read the news on a daily basis.

So let’s begin at the very beginning and find out precisely...

There is actually very little difference between a financial market and your local supermarket: you go to one to buy (or sell – if you’re a manufacturer/producer) bread, meat and vegetables; you go to the other to buy and sell financial assets – shares, commodities, currency (forex) pairs and other derivatives. In financial markets you can also buy and sell futures contracts, contracts for difference, options, swaps and intruments that follow various stock market indexes.


CHAPTER IIWhat Are Financial Markets?


In the supermarket you exchange money for produce; in financial markets money is just one of many financial assets that you can buy or sell – all in order to make a profit: here, you can be on either side of the cash register!

Let’s take them one by one:

Shares

Shares (sometimes referred to as ‘stocks’) are without doubt the first thing that comes to mind when people think about financial markets. Strangely, this is not because they are the most prevalent (the forex market outpaces the stock market by far), but quite simply because they are ‘sexier’ (what would you rather invest in – Apple shares or apple futures? Lamborghini or oil?).

When companies need to raise money (to build another factory, pay employees, develop a new product), one possibility is to sell parts of themselves in return for cash. Anyone who pays that cash becomes a part owner in the company – an investor, since he/she expects to get more back than what he/she invested.

The investor will receive a share in future profits and – in some cases – the ability to vote at board meetings (if he/she purchased ‘preferred’ shares). Historically, proof of such ownership was detailed in actual printed certificates; but in recent years, computerized ledgers have replaced these.

The first shares in a public company were sold by the Ancient Romans, who contracted public works (road building and so forth) to companies owned by the public. More recently, the first publicly traded company to issue shares was the British East India Company. The Dutch took the idea one step further by creating a stock exchange (the ‘bourse’ or ‘pocket’) where such shares could be first sold (a public ‘offering’ of shares) and later traded between investors as the value of the company rose or fell – consequently adding or subtracting value for each share.

Today, secondary markets offer ‘derivatives’ on these share, such as options or contracts to buy or sell shares at a later date. We’ll come to that later; but suffice for now to say that such derivatives were originally created for the benefit of buyers/sellers/manufacturers in




order to cushion them from the dangers of the market (to ‘hedge’ their exposure).

Commodities

Commodities are raw materials and basic products that satisfy a need – milk, fabrics, gasoline, metals and so on. Commodities trading is the oldest form of trading between humans, evolving from when the first stone-age man/woman realized he/she could exchange one product (usually something he/she had more of than he/she needed) for something he/she required.

But what makes a product a commodity is the ability to be easily traded: to be a commodity, a material must be commoditized. That means that one unit must resemble another unit to the point of being interchangeable. It would be unfair, for example, if one person gave his/her best silk and received in exchange 2 or 3 good hammers but 8 hammers that fell apart on their first nail. Defining a set of parameters for a product called ‘a hammer’ would help fairness in trading.

And so, oil being traded on a commodities market must conform to a set of requirements. One barrel of oil produced in the North Sea, for example, must be identical in nature and quality to another barrel from the North Sea; a bushel of wheat must be identical in weight and quality to another; two bars of gold must weigh the same and have the same concentration of the same material.

Today, we differentiate between ‘hard’ and ‘soft’ commodities. The hard ones are extracted from the earth – usually through mining – and the soft ones are mainly agricultural.

As Europe evolved from an agrarian to an urban society during the Middle Ages, the movement of goods and basic materials required the establishment of commodities markets where fewer farmers sold more goods and more building materials were offered for the construction of cities. Later, commodities markets also enabled the trading of futures contracts, as well. One example is the Dojima Rice exchange in Osaka, where Samurais (who were paid for their services in rice) could trade rice futures; another is the Amsterdam Tulip exchange.




The US Bureau of Labor Statistics is credited with producing the first commodity price index in modern times, and the Chicago Board of Trade (CBOT – established in 1848) was the first exchange to issue Call options, which enabled prices to be locked in for a premium.

Currencies

Shares and commodities may be sexy, but for sheer scale, nothing matches the 5 trillion-dollar-a-day (!) forex market. Here, we are talking about the trade in money, the exchange of currencies between countries and companies and people – covering everything from backpackers exchanging dollars for local drachmae 5 at a time, to nations purchasing squadrons of F-35s for $100 million apiece.

Since most investors are unlikely to lug around sacks of money, exchanging them for whatever currency offers the highest interest rate at any given moment, most of us invest in contracts covering the relative values of any two currencies. Each of these currency pairs is known as a ‘currency pair’, or a ‘Forex’ pair (from FOReign EXchange).

Currency pairs are designated by the 3-letter abbreviations of the two currencies traded. Thus the Euro versus US Dollar pair will be the EURUSD, the Pound Sterling versus Japanese Yen – the GBPJPY, and so on. The first 3 letters represent the ‘base’ currency, which is the currency upon which the pair’s value rests. Thus ‘1’ unit of EURUSD is the Euro. The second 3 letters represent the ‘counter’ currency, the currency for which we are going to exchange that single Euro, and that value determines the pair’s value. And so, if 1 Euro equals 1.0903 US Dollars, the EUR/USD pair is said to be worth 1.0903 – detailed to the 4th and sometimes 5th place after the decimal point.

Currency pairs are measured in Pips, each of which equals 1/10,000th of the currency pair, or 0.0001. And in forex trading, there is usually a difference between the buy and sell rates, which is called the ‘spread’ – also measured in pips. (Incidentally, in currency pairs where the Yen is the counter currency, a pip equals 1/100th of the pair’s value). More on this in the chapter of Forex trading.




Indexes

An index is basically a listing. At the end of some books, we may find an index: key words and on what page to find them. In mathematics and economics this is a statistical measurement of a group of data points. And in finances it is a measurement of market data. There are indexes that measure producer, wholesaler and consumer prices indexes (which serve to determine inflation); others measure consumption, sentiment and confidence.

There are indexes that indicate a nation’s economic health, such as purchasing managers’ indexes, housing indexes and so forth. Some of these entail actual quantitative measurements, others are based on conducted polls. Finally, and most notable, we have stock/share indexes, which measure the performance of a specific stock exchange.

Because indexes are actually measurements, we can’t really invest in them (imagine investing in a kilometer). What we can invest in are funds and contracts that follow these indexes, such as contracts for difference

(CFDs) or Exchange Traded Funds (ETFs).

The history of stock market indexes begins when Henry Varnum Poor (of the Standards & Poor’s – the S&P) who in 1860 published a listing of companies laying railroad tracks throughout the US. Soon after, Charles Dow, one of the founders of the Wall Street Journal, published the first stock market index, which was simple an average of the top 12 stocks on the New York Stock Exchange.

Today, nearly every stock market publishes an index that reflects the market’s trading based on various forms of weighted and otherwise-computed averages. These indexes then provide a benchmark against which one may compare the performance of other shares on that exchange.



CHAPTER IIIKeeping it Simple with Options

As we have seen above, some assets cannot be traded on (indexes) and some are for most of us impractical (commodities and forex – we simply don’t have the room to store that much cattle). Some assets are quite simply too expensive (shares, especially when you consider that these are heavily taxed); and often the legal paperwork entailed in drawing up the contracts would make a rich man poor – unless he/she is a lawyer.

For most of us, the only practical way of investing in financial markets is by trading on derivatives – financial assets that draw their value from an underlying asset. When we invest in our children’s education and in healthier but more expensive food, we are not investing in the child him/herself. What we are doing is imbuing that child with added value that, we hope, will express itself in that child’s future happiness and well-being.

The two most common types of derivatives are options and contracts.

What are Options

An option is a choice, and a financial option is the choice to invest (not an actual investment) in the asset. As such, it is considered a derivative that derives its value from the value of an asset that would have been traded. Consider that if you invested in an option to buy a plot of land and suddenly the price of that land increased, the person who sold you the option would still have to accept the originally agreed - upon price. You could buy the land at that previous price and sell it for the current price and make a profit. Alternatively, you could now sell the option – also for a profit, since the seller would still have to sell the land for its original price to whoever purchased that option (then he/she could sell the land for a profit).

The first recorded trade of an option was in Ancient Greece, when the scholar Thales purchased options to use the country’s oil presses upon hearing that the year’s crop would be bountiful. He then leased the oil presses to the farmers. Another well-known example of options trading occurred in 1636 in Holland. At that time, Tulips had become



CHAPTER IIIKeeping it Simple with Options

a very sought after luxury item, and futures contracts were valued at 20 times higher than the actual asset. The market collapsed when traders refused to honor their contracts.

In modern times, options received their official stamp of approval once again in Chicago. Perched on the Great Lakes crossroads of industrial, agricultural and metropolitan America, Chicago became the hub for the nation’s telegraph and railroad networks, and – consequently – the commodities these hauled. As mentioned above, the Chicago Board of Trade was established here and to deal with the complexity of ensuring and insurance, CBOT established the CBOE – the Chicago Board Options Exchange. Here, in the 1970s (long before binary code became a staple on every computer-fiend’s tongue), the Binary Option – often called ‘digital, or, fixed-return options’ (FROs) – was invented to simplify what had become a very complex art of defining and pricing various kinds of options.



CHAPTER IVTaking Control. Forex, CFDs & Margin Trading

What is Forex?

As mentioned before, Forex trading involves investing in the changing values of currency pairs – their exchange rates. It is analogous to selling one currency and buying another – your profit depends on the change in relative values before and after the exchange.

Because nearly every transaction on the global market involves the exchange of money in one form or another, the Forex market is the largest financial market in the world – accounting for trillions of dollars-worth of transactions daily! From tourists exchanging their home currency to that of the country they are visiting, through businesses trading abroad and all the way to countries dealing with one another, maintaining their fiscal policies and strengthening their economies – they’re all participants in the Forex market.

A central bank, for example, may seek to stabilize the nation’s currency and economy by determining interest rates, making the local currency more or less attractive to investors; they may directly influence a national currency’s value by simply printing or ceasing

to print money; and they can stimulate the economy by purchasing government debt or other assets – once again, influencing the demand for the nation’s currency. All these are defined as monetary policy. Governments can determine fiscal policy in much the same way – taxation, financial incentives for investment, etc. In China, central policy-makers actually determine the exchange rate between the local currency and its peers.

Basic Terminology

One of the first things people interested in financial trading realize is that financial trading has a language all of its own. However, most of the terminology is quite functional and even self-evident.

Bids, Asks and Spreads

When changing money at a money-changer or at a bank, one might be surprised to see 2 or even 3 prices for each currency rate. The middle rate is usually the rate as determined by the central bank – the interbank exchange




rate – while the other two are those at which the broker buys or sells a currency.

The sell price is always higher than the buy price, and you will always pay more for a currency than what you will get for it. In forex, we call these the ‘bid’ – that at which the broker buys a currency – and the ‘ask’ rate – that at which the broker sells it. The ‘bid’ is always higher than the ‘ask’, and the difference is the ‘spread’. The ‘spread’ covers the money-changer’s profit (unless he/she takes a commission). Thanks to the competition between more and more online brokers, however, spreads have been declining and are the basis of competition between brokers.

You may find that in certain assets one broker is more competitive whereas in another – less so.

Base and Counter Currencies

When trading Forex, we invest in the relative value of pairs of exchangeable currencies – Currency Pairs, or Forex Pairs. These pairs are designated by 6-letter names: the first 3 letters

representing one currency and the last 3 – the other. Thus, the EURUSD is the European Euro (EUR) – US Dollar (USD) currency pair; the AUDJPY is the Australian Dollar (AUD) – Japanese Yen (JPY) pair, and the value of the pair equals the exchange rate between the two.

The first currency named in the pair is the BASE currency and the second – the COUNTER currency; and the value of the pair is the amount of counter currency units equal to 1 unit of the base currency. Thus, if the value of the EURUSD is 1.13242, then 1 Euro equals 1.13242 US Dollars.

The value of the pair rises if the value of the base currency rises or else if the value of the counter currency drops (or both). Either way, you will now need more counter currency units to buy one base currency unit, and if you invested in a CALL option, the value of your pair is now higher than when you invested in it (going LONG on an asset).

The value of the pair decreases if either the value of the base currency falls or that of the counter currency grows (or both). In




both cases, the result is that one will now need less counter currency units to buy one base currency unit. Here, for a successful investment, you may invest in a PUT option (going SHORT or SHORTING an asset) – one that depends upon the value declining (it’s as though you sold the pair at a higher price BEFORE you later bought it at a LOWER price).

Pips

If currency pairs are the assets we invest in, PIPS (often referred to as Basis Points) are the standard unit by which we measure changes in a forex pair’s value. One pip equals the value of a single unit located in the fourth decimal place of the pair’s value, i.e. one ten thousandth of a unit (for pairs where the US dollar is the counter currency, for example, one pip equals 1/100th of one cent). Thus, if the value of the EURUSD pair increases from 1.1344 to 1.1347, it has risen by 3 pips.

Notice, though, that in pairs that include the Japanese Yen, the pip is located in the second decimal place (i.e. 1/100th of a unit). AN increase in the USDJPY from 12.54 to 12.57

would entail a 3-pip increase.

Lots

The volume of a forex transaction is measured in lots. Each standard lot is equal to 100,000 units of the underlying asset (or 1,000,000,000 pips). Because fluctuations in the forex market are quite small, one must open a considerably large position to realize any profit. However, you may also trade in mini-lots (10,000 units) or micro lots (1,000 units).

One lot of EURUSDs is equal to 100,000 Euros, or 100,000 times the exchange rate in US dollars. If the value of the EURUSD equals 1.13242, one lot will equal 113,242 US Dollars.

Now, because the fluctuations in forex values are measured in 100th of a cent (for dollar-pairs), one may surmise that these




fluctuations are small, and – subsequently – one would need to invest vast amounts to see any profit. In other words, you would need to be a central bank or thereabouts to have the funds to make a feasible and profitable investment. To overcome this, brokers offer Forex traders leveraged investments – investments in which the broker invests his scale of assets alongside you, leveraging your investment by providing you with a loan, of sorts.

Leverage is the level by which a broker increases a trader’s investment. It is expressed as a ratio, such as 1:50, 1:100, 1:400, etc,

in which the larger number represents the broker’s investment and the smaller one – the trader’s.

Thus, if a trader opens a position using a 1:100 ratio of leverage, for every dollar he invests, the broker invests 100, thus multiplying the profit by 100.

More on leverage in our chapter on Margin Trading.




Contracts for Difference – The New Wave of Financial Trading

Like FROs and Forex trading, CFDs are financial derivatives. Traders can invest in the rising and falling values of shares, commodities and indexes. The profit or loss on a position is determined by the difference between an asset’s price when the contract is opened and that when it is closed. And as in Forex trading, these investments are usually leveraged by the broker.

Profiting on Loss

Many novice investors find themselves constantly fretting over the concept of investing in a falling market (a ‘bearish’ trend). In fact, the explanation is quite simple.

As in Forex, when a client goes Long, he/she is investing in an asset’s appreciating in value (a ‘bullish’ trend), promising to accept a profit that is calculated on the difference between the contract’s opening and closing price. When he/she goes Short, he/she is investing in the asset’s value depreciating, once again – the

profit computed as the difference in price.

CFDs are – in fact – a form of Futures contract, which derive their history from the traditions of commodities trading. They were created to ensure profits, on one hand, and to insure against losses, on the other.

Thus, for example, if a milk distributer fears a future shortage of milk, he may sign a contract with a dairy farmer to purchase milk at a bit higher than current prices but still lower than the inflated future price expected, were demand much higher than supply (a CALL option, or going LONG on milk). If, on the other hand, a dairy farmer wants to ensure profits in spite of a feared glut in milk, he/she will sign a futures contract with a distributer who promises to pay him a certain amount that may be somewhat lower than current prices, but higher than that in an oversupplied market (a PUT option, or going SHORT on – shorting – milk).

Bullish trendMarket rising - Go LONG

Bearish trendMarket falling - Go SHORT




Hedging Through History

And so, we come to CFDs, which are – in fact – a comparatively new wave of trading, rooted in the roaring ‘90s of London City brokers. Brian Keelan and Jon Woods were the two traders who invented this instrument – in fact no more than an equity swap (a swap of cash flows) between two traders and leveraged by the broker. Soon CFDs were being used to hedge exposure to shares. An additional advantage was that, because no actual assets changed hands, the deals could not be taxed.

By the end of the decade retail traders were also using CFDs, by which time online trading provided access and leverage to all. Today, CFDs are available on shares in nearly every market, including US stock exchanges (even though CFDs in the US are still forbidden). CFDs are also traded on indexes, bonds and commodities.

Advantages of CFDs

Like Forex trading, CFD contracts have no specific expiry date. Positions are closed

either manually or by limit orders placed through the platform. They reflect the value of their underlying assets almost 1-to-1, barring the broker’s spread. Contract sizes are affordably small, providing a much lower entry threshold, compared to direct investment in shares; and CFDs are leveraged by the broker, enabling one to earn high profits on low investments, but also to lose more than they bargained for.


PART TWOTrading in Depth

CHAPTER VThe Platform

There are 2 types of trading platforms for financial trading: the more complex, like MT4®, MT5®, NetStation®, etc., which can be downloaded for free, and the web-based solutions, which are proprietary to most online brokers and in their desk/laptop configuration do not require any downloads (the mobile versions require you download a free app.

This being an introduction, we will dedicate ourselves to online platforms, specifically, Prime CFDs proprietary platform, which is powered by Tradersoft.

Before we begin to actually describe the mechanics of trading CFDs and forex, some more definitions are in order.

Trades & Orders

Unlike Fixed Return Options where one actually invests one’s own money in an option, with Forex and CFD trading one ‘opens a position’; you have not actually invested in anything but rather initiated a contract to buy or sell an asset in the future. When that position or

contract is closed, you either receive or pay the difference between the opening and closing values of the asset. When investing in an option, it is yours to pass on until that option expires. A contract or position is maintained between you and your counterparty (in most online trading – the broker).

Finding your way around the assets and placing an order is relatively simple; what adds the edge is the extra control you have over your investments.

Most Forex brokers will provide a demo account for beginners: USE IT!!

Learn to place your pending and limit orders as you read about them, and let the platform take care of you and your money (though please keep an eye on your balance – it will be in a state of constant change so long as you have open positions).

MT4® & MT5® are registered trademarks of MetaTrader 4/5 – products manufactured by MetaQuotes Software Corp.NetStation® is a registered trademark of NetDania Creations ApS.



CHAPTER VILeveraging the Margin

Margin and Leverage

Due to the interchangeability of the oft-bespoken terms, margin and leverages, the two are sometimes confused. They are, indeed, two sides of the same coin; and how you deal with one certainly dictates how the other deals with you!

Leverage

Leverage is the ratio by which a broker increases a trader’s investment: 50:1, 100:1, 400:1, etc. Using a 100:1 leverage ratio, for every dollar you invest, the broker invests 100, thus multiplying your profit (or losses) by 100. A leveraged investment, therefore, is one that has been enlarged by volume of scale.

Margin

In finance, the term margin is simply another word for collateral, and trading on margin means that an investor borrows money to trade on an asset. Margin is the money the investor himself may have to provide to cover

potential losses.

‘Required Margin’ is the amount you need to have in your account to open a position. For a $10,000 investment using a leverage ratio of 100:1, the margin requirement would be 10,000/100 = $100.

Required margin = the bid or ask price of an asset (depending on your option type) multiplied by your lot size multiplied by your leverage ratio.

Notice, though, that margin requirements differ for different assets or asset classes.

Leveraging Margin into Equity

Clearly, margin and leverage are conversely related. Using 200:1 leverage would require a margin of 1/200= 5%.

In practice, opening a mini-lot on the EURUSD when the value of the pair equals 1.17542 requires an investment of $11,754 (10,000 units at 1.17542 per unit). If our account has been set to a 1:200 ratio leverage, our




investment would equal $58. The remaining $11,698 would be provided by the broker.

Now, let’s say we had a $100 balance in our account before opening the position. That number would immediately begin to change based on the position’s current condition. Our balance is no longer $100 but rather our original balance MINUS our potential losses PLUS our potential gains.

This new balance is called our ‘equity’ – what we are worth at any given moment. So long as we are in the money (value rising if our position was a call or dropping for a put) our equity will rise; if the position begins to lose, our equity will begin to drop.

Margin Level

Margin level (available margin) is that part of you CHANGING equity that is dedicated to covering the potential losses of all your open positions at any given moment.

As soon as your margin level equals your equity, you will no longer have any left over

as required(maintenance) margin (required to open new positions). Moreover, as soon as your margin level attempts to go BEYOND your equity, a position will be automatically close to provide that extra margin. Different brokers have different policies regarding the order in which positions are automatically closed; some will automatically close all open orders. Either way, positions closed may be the ones that are just about to turn a profit. So always make sure that your equity is way above your margin level… just in case.

(Think of a page you are trimming. You need to have a margin around the text so as not to cut into the text. No margin and there goes the text!)

This is the SIZE of the position, not how much you have invested in it.




Most platforms will provide a margin call – an alert that is sent to warn traders of an impending stop-out once your margin level hits a certain percentage of one’s equity. For some accounts, your margin call will be set at 100%, meaning that you will receive an alert the moment your free equity is less than the required margin for your open trades; for some, the alert will be executed at 30% free equity to required margin – a safety margin around your margin, if you like...

And so we begin…

At the very top of the Prime CFDs platform, you will find two tabs. One tab is dedicated to CFDs, and the other to Forex.

Beneath these, we have our 3 main windows:

• an assets window, which provides a list of assets and their current value,

• a charts window, which can show one or several line, bar or candlestick charts, and

• a trades window, which details open positions and their current status.

Trading Orders

When opening a position on an asset, you may simply select an asset and investment volume, and then click on the buy or sell buttons (as you would in FROs), remembering to close them when a certain profit or loss is achieved. Just make sure first, that the “one click trading” chackbox is marked (and remember to uncheck it afterwards). Or you may want to automate the procedure based on expectations and risk factors. For these purpose, we have ORDERS – opening orders and closing orders.

Opening orders

• Market Orders

A market order is executed the moment you click on buy or sell. Your entry price is the buy or sell rate shown on the platform, determined by the original market price and plus/minus the broker’s spread.




• Pending Orders

A pending (entry) order will wait for the asset to reach a level you determine ahead of time; otherwise the position will not open. A pending order will allow you to determine the maximum or minimum price at which a position will be opened. There are 4 types of pending orders:

- Buy Limit order: you determine a value below which you are prepared to open a buy position;

- Sell Limit order: you determine the value above which you are prepared to open a sell position;

- Buy Stop order: you determine the value above which you are prepared to open a buy position;

- Sell Stop order: you determine the value below which you are prepared to open a sell position.

Closing orders

• Take-Profit (Limit) Order

The take-profit order (TP) determines the level at which you would like to close the position for maximum profit. That is the level at which you believe a favorable trend may reverse.

• Stop-Loss (Limit) Orders

The stop-loss order (SL) determines the maximum loss you are willing to take on a losing position. When does a fluctuation become a trend? How much are you willing to lose before realizing that you’re not going to recoup your losses?

Whereas using a take-profit order is wise, opening a position with a stop-loss is a matter of fiscal responsibility. Never open a position without one.




Withdrawing Funds

Finally, the moment has come. You’ve invested money in your account, traded and discovered that you’ve made enough to be able to withdraw your winnings. One word of warning, though: never withdraw all available funds! The conditions surrounding your open trades may shift – always retain a safety margin to prevent margin calls.

Your “equity at hand” is your account balance (free equity) minus your required margin plus cumulative profits on open trades, minus cumulative losses on open trades.

Subtract another 25% as safety margin and withdraw the rest.


PART THREEPowering Up with Knowledge.

Financial Analysis

CHAPTER VIIAn Introduction to Financial Analysis

As online investing matures, more responsibile investors are finding that they have more responsibility to carry upon their shoulders – they must relinquish the wild gambles in favor of the educated investment.

The difference is simply in the word ‘educated’. Without understanding how financial markets work, investing remains a mere horse race; and even when betting on horses, it pays to know who’s riding which horse, are they both being properly fed, and is the track dry or muddy...

Technical Fundamentalism & Fundamental Technophobia

In financial analysis we examine the viability of an investment. Several schools of analysis exist, but for now let’s look at the two main ones – technical and fundamental analysis. Both compare market conditions, past performance and potential future trends (the third based on the first two).

Fundamental analysis examines the intrinsic value of an asset. For shares, this means

learning about the market sector within which the company issuing those shares operates, its managers, and so on. Financial news, corporate announcements and quarterly earnings reports are the main tools. For currency pairs and commodities, the daily news and economic announcements found in economic calendars are the principal sources.

Technical analysis relies on financial charts, trading volumes and COT (Commitments of Traders) reports. This approach states that external factors are reflected by the market reaction, since the market is made up of people whose basic reactions to events is universal and cyclical. Thus, given similar stimulants, the market – or the people who make up the market – will react in a predictable manner.

Technical indicators, based on mathematical formulas and statistical rules, are then applied, and all that’s left to do is follow the lines (or candles).



Financial Analysis

CHAPTER VIIICharts, Candles and How to Read the Patterns

Charts display lines and – in finances – candles. They describe the evolution of an asset’s value.

Candles

Usually, traders will require more than simply a linear description of prices. To provide that, charts employ an 18th Century Japanese invention called the Doji Candle – a double wicked candle. Its width describes a specified time period (anywhere from minutes to years); its top and bottom describe the opening and closing prices for that period; and its wicks (shadows) indicate maximum and minimum prices achieved during the candle’s enclosed period. The color of the candle determines the candle’s direction of movement – green or white for rising (bullish) and red or black for falling (bearish).

Dojis can be simple, long legged (long wicks indicating volatility), dragonfly (a long lower wick – bullish forces, regardless of the color), Hanging Man (long upper wick – bearish forces), and so forth.

When several candles together form a pattern, they are defined as ‘complex’. For example, 3 consecutive rising candles – 2 White Candles – confirm an uptrend; a rising candle followed by a falling one whose close is below the first candle’s middle or the exact reverse are called Piercing Dojis, and indicate a trend reversal. If the closing points of the second candle extend beyond the previous candle’s opening, we have an Engulfing Doji. Five candles going in one direction followed by a 6th in the other is usually indicative of a Breakaway Doji. Other dojis include Morningstar, Shooting Star, Morning and Evening dojis and so on.

Let’s begin with line charts: here you will be able to discern patterns, such as flags and triangles (triangular formations formed by support and resistance converging or spreading). The most prevalent is the Head & Shoulders, where a small price rise is followed by a small drop, a sharp rise and return, and finally another small rise and drop. The Cup & Saucer is merely the reverse of that. A Double Top shows an M formation and a double

High Upper shadow

Upper shadow

RealBody

RealBody

Lower shadow

Lower shadow

High

Open

Open

Close

Close

Low

Low



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bottom – a W. Between one day’s (week’s) close and the next open, we will often see a gap, which is either filled thereafter or the herald of a sharp breakout in prices.

What is a trend?

A trend is a movement in a general direction. It may rise, even in a zigzag shape; it may fall; or it may be flat – a sideways trend. It may fluctuate along a regular amplitude; it may converge as fluctuations get smaller; or it may widen.

A rising trend describes prices rising and a falling trend describes them falling. Likewise, a fluctuating line will be rising if successive highs and lows are rising, and falling if successive highs and lows are falling. In a rising trend, the (usually shorter) falling actions are called ‘retracements’ and vice versa for a falling trend.

In a fluctuating trend connected highs and lows will usually form a channel within which the price action is contained.

And finally, remember that it’s all relative – an hour-long rising trend may be part of a longer-term falling trend and vice versa.

Going Up? Going Down? Follow the Trend

The first thing to remember in technical analysis is that it bears little resemblance to high school geometry… even though they both use charts. The second thing to remember is that these charts, by describing price action, are in fact describing supply and demand for an asset: prices go up when demand (buyers) exceeds supply (sellers): the asset becomes more sought after and sellers demand a higher prices for their asset. Contrariwise, prices fall when supply exceeds demand, since now the ball is in the buyers’ court: they can bargain for a lower price between sellers.

Charles Dow, the 19th Century journalist who created the Wall Street Journal and published the Dow Jones Industrial Average index, defined the 6 rules of classical technical analysis:

AB

C

A Left shoulderB HeadC Right shoulder



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1. The market has 3 movements – a major trend, a reaction and a minor movement.

2. Market trends have 3 phases – accumulative, motivated by the movers & shakers, rapid price change, motivated by the reacting masses, and distribution, when the movers & shakers react to the demands of the masses.

3. The market discounts the news; since it reacts to it, the news is factored into the resulting price movement.

4. Averages confirm each other.

5. Volume confirms trends; i.e. movements accompanied by high volumes are more trustworthy than those accompanied by low volumes, since they are more difficult to subvert; and

6. Trends exist until proven otherwise. Market noise, i.e. small random movements, should not be considered trends until confirmed as such.

Support and Resistance

Trends are usually cyclical; thus, if we zoom out far enough, we will see that they are usually constrained within two horizontal lines. The same is true within a trend, if we zoom in on a small portion of it.

The lower constraining line is called ‘support’. This is the price below which prices will not fall, for then, the asset has been oversold; its price is well below its fair value, and we can expect it to begin rising again. The reason is that anyone selling at this point will be selling for a loss. No sellers, more demand, the price begins to rise again!

The upper line is defined as ‘resistance’. Here, an asset is considered to be over-bought. The number of buyers begins to decline, since there is no way they will be able to later sell at a profit. Now, sellers are left with excess inventory and to sell it they must lower their price.

The drop is a retracement

Support

Support

Resistance

Resistance



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CHAPTER IXIndicators Indicating Success

As mentioned before, over the years mathematicians and analysts have created constructs that can be applied to charts. These are ‘technical’ indicators and once superimposed onto an asset’s chart, leave very little room for interpretation.

‘Fundamental’ indicators are the lists of data published by firms, governments and polling institutes. They require a firmer understanding of how the market operates and cannot be automatically applied.

Before setting out to use any kind of indicator – fundamental or technical – please pay close attention to the name: INDICATOR! These are NOT road maps but signs along the way. If you don’t set out with a clear route and destination, indicators are no more than meaningless signposts on a dark night.

Indicators are to be used within a context that is defined by your knowledge of an asset and what makes it tick. At that point, the indicators will rarely surprise you but rather confirm your thoughts and help fine-tune your strategy.

Fundamental (Economic) Indicators

When researching an asset, we usually speak of measurable and non-measurable indicators. For shares, the non-measurable indicators include the personnel that make up a company’s decision making ranks; for currencies and commodities – the political news. Since these are difficult to quantify, their influence is a matter of subjective analysis.

Luckily, there are also measurable quantities. Again, for a company, these will include earnings, cash-flow, capitalization, growth rate, dividend payouts and yield, return on equity, and other data that can be quantified.

For currencies, commodities and stock indexes, we have a wide array of economic indicators that describe an economy. These are published by governments, polling institutes, and so forth. Calendars will include past results, expected results and actual results. When a result exceeds expectations, the related asset will usually rise in value and vice versa.

Fundamental indicators may lead or lag.



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Leading indicators are those that the economy reacts to. The best example here is stock indexes that, when they rise, the economy is expected to rise as a result. If it doesn’t, a bubble is in the making. Manufacturing activity, inventory levels and retail sales provide a more precise measure of a national economy. Building permits and other housing indicators also reflect the state of personal wealth.

Lagging indicators are a reflection of the economy. GDP – Gross Domestic Product and economic growth (the change in real GDP), income and wages, and the consumer and producer price indexes tend to reflect wealth and, more importantly, inflation. Interest rates, determined by a country’s central bank, directly impact a currency’s viability.

Unemployment, average hours worked, the cost of labor, and other indicators describe the labor market. Thus, for example, unemployment may be low, but the economy will stall if workers are making less than they used to, are employed part-time, etc.

Household consumption, personal savings,

government spending, retail and wholesale sales are another set of indicators; and purchasing managers’ indexes report how much inventory was acquired by company purchasing managers, i.e. how active the companies were. In addition, there are indicators that measure sentiment and confidence that are also numerically quantified.

The biggest problem with fundamental indicators, though, is that, although they are easier to identify with – perhaps because they describe real-world data – they are often difficult to translate into actual market data. For between these measurements and the reaction of the asset lies the human trader whose reactions cannot be quantified.

Technical Indicators

Technical indicators may seem daunting, at first, especially considering their names, which are often based on the economist who formulated them, other times seemingly named by people whose explicit intention was to make them seem unfathomable (the



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Moving Average Convergence Divergence indicator is my personal favorite). However, these indicators are extremely simple to apply (push the button) and read (if the result is x, do y). Indicators most often found on trading platforms and which are truly push-button affairs include:

Moving Average: Because charts reflect noise, i.e. momentary fluctuations, a moving average will display a flattened out image of the price line, superimposing it over the original line, thus displaying trends more clearly. The moving average simply computes each point along its line by averaging out a preceding number of points along the asset’s price line. A moving average may be simple (Data point N = the average of n points before it. Data point N+1 = the average of the same number of points before it, i.e. starting 1 point later and ending 1 point later …), or weighted (each point computed for the average is strengthened by a factor that increases the closer it is to the N point,

e.g. N= (1*n1+2*n2+3*n3…)/(1+2+3…).

RSI (Relative Strength Index): The RSI appears as an oscillator – a line underneath the price line that fluctuates between 0 and 100. By measuring previous opening and closing prices, the RSI determines if an asset is oversold (under 30) or overbought (above 70). In either case, one may expect a trend reversal as a result.

Stochastics is another oscillator that resembles the RSI, also purporting to identify overbought and oversold assets.

Bollinger Bands: Named after the American author and financial analyst John Bollinger, this indicator superimposes two moving averages upon the price line – one moving average is computed upon support levels and the other upon resistance levels. Thus, Bollinger gauges the volatility of a price movement. If the price level crosses above or below one of these lines, it’s beyond where it should be and a return to within the bands is a fair prospect.

Fibonacci Retracements: This indicator superimposes a set of horizontal lines upon the chart that indicate where retracements

RSI (Relative Strength Index)

Bollinger Bands

Fibonacci Retracements



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should take place. The lines are located along a desired range at the bottom (0%) and top (100%) and in between at 23%, 38% and 62%. These levels correspond to the Fibonacci Sequence, in which each value is the sum of the 2 values preceding it (1, 2, 3, 5, 8, 13 …) – a sequence formulated by the 13th Century Italian Mathematician, Leonardo Bonacci. Strangely the sequence appears in nature, Sanskrit and other esoteric settings. The indicator has been branded black magic, a self-perpetuating, self-fulfilling prophesy, proof that financial markets are in harmony with cosmic imperatives, and more. But it seems to work…

Elliot Waves: Also named for the person who created it, Ralph Nelson Elliot was an author and accountant, active in the first half of the 20th Century. Suggesting that markets, which are based on human emotions, move in waves that are motivated by optimism and pessimism, impulses and corrections. When confirming to Elliot waves, an asset’s price movement will display 3 major impulses and 2 corrective corrections. These may be found over varying time frames – from the century-

long Grand Supercycle to the minute-long Sub Minuet.

Pivot Points: Pivot points are accessible from most advanced charting platforms; however, to prevent confusion, they may also be found in updating, real-time tables on the web. Quite simply, the central pivot line at any time period is calculated on the previous period’s support and resistance level. Above and below this are located pivot points numbered from 1 to 3 (2 for each), which represent where one should open and close a positions. At last count, there were about 150 technical indicators (not counting expert advisers and other programmable algorithms), including the Welles Wilder Smoothing Average, the Triple Exponential Moving Average Oscillator, the Chande Momentum Oscillator and so on. A good number of these can be easily implemented on your platform. Given such a wide choice, though, it is best to adopt a handful, learn them well and use that limited number on a consistent basis, so that eventually they will become tools to use and not crutches to be abused

SupportPivotResistance



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CHAPTER XLearning to Trade – Risk, Recklessness & Reason

The long and the short of it

Previously we mentioned Warren Buffet’s maxim, ‘Know Your Asset’. However, not less important is to know the most important asset you have when trading financial markets: Yourself!

Although investing money is no place for self-help and other new-age self-improvement workshops, unless you have a good grip on who you are, you will never be able to understand, utilize and reign in those basic instincts that cause mistakes. After all, what is a 1929-style ‘run on the bank’ if not fear at play? How can we hope to understand the 2008 financial crisis until we learn to recognize greed? And most important of all, how can we expect to monetize the human urges in others before we study them using the best known model we have: Ourselves?

Let’s begin with the terms ‘going long’ and ‘going short’ – respective synonyms for Calls and Puts. When we go long on an asset, we are investing in its rising value, and that is usually a long-term endeavor: it takes time and effort to increase value. If this happens

overnight, you can be sure the asset is subject to those same elements that will instantaneously pull it down again. On the other hand, going short means losing value, and history shows us that destruction is a very swift venture to execute (think Lego).

Fear Freezes, Greed Gropes

Where money is concerned, fear and greed are the two most prominent gremlins to battle. We fear losing money – especially if domestic harmony is at risk. Even without that, nobody wants to fail. So can we really dispel fear? Or should fear simply prompt us to be more cautious? Clearly, the more we know about what we’re doing, the more cautious we are being.

But beyond that, we can easily dispel fear of failure by simply redefining our terms. Instead of considering an unsuccessful trade a failure, we should remember that behind it are factors we could not have foreseen and/or controlled. Clearly, the more experience we gain, the more we will be able to foresee and thus control. Thus, quite simply, an excellent



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habit to adopt is the post-mortem – that stage at the conclusion of every trade – successful or not – where we compare our expectations and strategy to the actual events that took place. Where did the market act unexpectedly and why? Was this a mistake in our strategy or a case of unexpected market behavior due to unforeseeable events? How can we hedge ourselves against the same factors? Thus, every lost position becomes, not a failure, but a learning experience that will contribute to future success.

Meanwhile, you should probably learn to identify the outward manifestations in yourself – sweaty palms, tunnel vision, thirst, a loss of sense of time… Place yourself in some non-life threatening situations that you know will generate fear, then take a step back. Try to remember the feeling for future reference. And when you identify one of those fear-related manifestations while trading, simply stop. Get up, make some tea, take a walk. Clear your head. Even if the trade you’ve been staring at is about to dramatically appear or end, remember – markets are cyclical and it will return. Remember, fear causes panic and panic leads to mistakes.

Greed is the other side of the coin: it causes us to accept something we think we want for more than it is. Think of nearly every scam that has ever existed: it works because it appeals to our sense of greed, of wanting something for nothing. This is an illusion and serves the salesman as instant motivation to be tapped.

Lose it!

Launch your trading career with much smaller investments than what you can afford. That way, payouts will not be something you dream of buying a boat with but the equivalent of a silver star in your first grade handwriting exercise book. Something to show your mom (incidentally, small investments also diminish the fear level: never invest more than you can afford to lose, or in our case, afford to lose with no more than an amused grunt).

Again, you should learn to conquer fear and greed not only as an exercise in personal cosmic harmony but because it’s a great way of learning about market behavior. Once you recognize your own personal manifestations of these, you will be able to recognize them



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in market behavior, as well. The next step is learning how to identify and monetize the curves and trends of market greed and panic.

Passive-Aggressive?

A huge difference between market psychology and the $500-an-hour type is that, when investing we have neither the time nor the inclination to connect the two. You’re either a passive investor or an aggressive one. Learn which and you will find your trading niche easily.

A passive investor taken to the extreme will simply let his broker do all the work, but we know where that leads (see lesson 1). For our purpose, let’s simply say that a lower level of activity would entail longer term positions – usually on shares, which fluctuate upon corporate reports and announcements. These are much less frequent that the daily news, which impacts forex and commodities. The ensuing drama will usually be fodder for the more aggressive amongst us. Passive investors will check up on their portfolios every week or so; aggressive investors –

regularly on their mobile devices.

Don’t invest in assets for which you are not emotionally suited. This will simply create an uncomfortable environment and impinge upon your objectivity.

Protecting Money

Another excellent tool to protect yourself from greed and fear is by creating a safety net. Start small, perhaps no more than you would spend on cigarettes in a single day. And manage your risk. Here, we have two rules: the 2/10 rule and the 5/20 rule.

The 2/10 rule is for the more passive investors, and it entails, a. never investing more than 2% of your entire equity in a single option, and, b. never having more than 10% of your portfolio invested at any time.

Thus, with a $250 account you should limit yourself to $5 investments and never have more than 5 open at any one time.



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For more aggressive investors, the 5/20 rule should guide: 5% in one asset and 20% invested in total. That would mean, for a $250 account, $12.50 per option and 4 options open.

Roast with Risk, Flavor with Fear

When my son was small, we were walking home from preschool one day. He wanted to walk along a stone fence, but he was scared. I told him that being scared shouldn’t prevent him from ‘adventurizing’; but because he was scared, he should find something to abate that fear with: being careful, for example.

And so we walked home – me on the pavement, he along the fence, holding hands.

Remember that fear and risk cannot be subdued; but, taken in proper amounts they add excitement to one of the most fascinating realms of human endeavor – financial markets and the entire world, which takes its cues

from them. Don’t let fear freeze you out. Instead, use it as a tool for caution and intense observation. Besides extra capital, it will open new vistas to your life’s experience.

Bon Voyage!

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