TECHNICAL ANALYSIS

Should I buy today? What will prices be tomorrow, next week, or next year? Wouldn't investing be easy if we knew the answers to these seemingly simple questions? Alas, if you are reading this book in the hope that technical analysis has the answers to these questions, I'm afraid I have to disappoint you early--it doesn't. However, if you are reading this book with the hope that technical analysis will improve your investing, I have good news--it will!

Some History

The term "technical analysis" is a complicated sounding name for a very basic approach to investing. Simply put, technical analysis is the study of prices, with charts being the primary tool.
The roots of modern-day technical analysis stem from the Dow Theory, developed around 1900 by Charles Dow. Stemming either directly or indirectly from the Dow Theory, these roots include such principles as the trending nature of prices, prices discounting all known information, confirmation and divergence, volume mirroring changes in price, and support/resistance. And of course, the widely followed Dow Jones Industrial Average is a direct offspring of the Dow Theory.


Charles Dow's contribution to modern-day technical analysis cannot be understated. His focus on the basics of security price movement gave rise to a completely new method of analyzing the markets.



The human element

The price of a security represents a consensus. It is the price at which one person agrees to buy and another agrees to sell. The price at which an investor is willing to buy or sell depends primarily on his expectations. If he expects the security's price to rise, he will buy it; if the investor expects the price to fall, he will sell it. These simple statements are the cause of a major challenge in forecasting security prices, because they refer to human expectations. As we all know firsthand, humans are not easily quantifiable nor predictable. This fact alone will keep any mechanical trading system from working consistently.



Because humans are involved, I am sure that much of the world's investment decisions are based on irrelevant criteria. Our relationships with our family, our neighbors, our employer, the traffic, our income, and our previous success and failures, all influence our confidence, expectations, and decisions.

Security prices are determined by money managers and home managers, students and strikers, doctors and dog catchers, lawyers and landscapers, and the wealthy and the wanting. This breadth of market participants guarantees an element of unpredictability and excitement.

Trading Timing

At the time a trade is made through a broker, the trader does not know the name of the counter party. Subsequently, credit limits are checked, and it may turn out that one dealer bank must refuse a counter party name because of credit limitations. In that event, the broker will seek to arrange a name-switch i.e., look for a mutually acceptable bank to act as intermediary between the two original counter parties.

The broker should not act as principal.

Beginning in 1992, electronic brokerage systems (or automated order-matching systems) have been introduced into the OTC spot market and have gained a large share of some parts of that market.

In these systems, trading is carried out through a network of linked computer terminals among the participating users.To use the system,a trader will key an order into his terminal, indicating the amount of a currency,the price,and an instruction to buy or sell. If the order can be filled from other orders outstanding, and it is the best price available in the system from counter parties acceptable to that trader’s institution, the deal will be made.

A large order may be matched with several small orders.

If a new order cannot be matched with outstanding orders, the new order will be entered into the system, and participants in the system from other banks will have access to it. Another player may accept the order by pressing a “buy”or “sell” button and a transmit button. There are other buttons to press for withdrawing orders and other actions.

Electronic brokering systems now handle a substantial share of trading activity. These systems are especially widely used for small transactions (less than $10 million) in the spot market for the most widely traded currency pairs—but they are used increasingly for larger transactions and in markets other than spot. The introduction of these systems has resulted in greater price transparency and increased efficiency for an important segment of the market.

Quotes on these smaller transactions are fed continuously through the electronic brokering systems and are available to all participating institutions, large and small, which tends to keep broadcast spreads of major market makers very tight. At the same time electronic brokering can reduce incentives for dealers to provide two way liquidity for other market participants. With traders using quotes from electronic brokers as the basis for prices to customers and other dealers, there may be less propensity to act as market maker. Large market makers report
that they have reduced levels of first-line liquidity.

If they need to execute a trade in a single sizable amount, there may be fewer reciprocal counterparties to call on. Thus, market liquidity may be affected in various ways by electronic broking.

Proponents of electronic broking also claim there are benefits from the certainty and clarity of trade execution.For one thing there are clear audit trails, providing back offices with information enabling them to act quickly to reconcile trades or settle differences. Secondly, the electronic systems will match orders only between counter parties that have available credit lines with each other.

This avoids the problem sometimes faced by voice brokers when a dealer cannot accept a counter party he has been matched with, in which case the voice broker will need to arrange a “credit switch,” and wash the credit risk by finding an acceptable institution to act as intermediary.

Mechanics of Trading Through Brokers

Voice Brokers and Electronic Brokering System The traditional role of a broker is to act as a go between in foreign exchange deals, both within countries and across borders.Until the 1990s, all brokering in the OTC foreign exchange market was handled by what are now called live or voice brokers.

Communications with voice brokers are almost entirely via dedicated telephone lines between brokers and client banks. The broker’s activity in a particular currency is usually broadcast over open speakers in the client banks, so that everyone can hear the rates being quoted and the prices being agreed to, although not specific amounts or the names of the parties involved.

A live broker will maintain close contact with many banks, and keep well informed about the prices individual institutions will quote, as well as the depth of the market, the latest rates where business was done, and other matters. When a customer calls, the broker will give the best price available (highest bid if the customer wants to sell and lowest offer if he wants to buy) among the quotes on both sides that he or she has been given by a broad selection of other client banks.

In direct dealing, when a trader calls a market maker, the market maker quotes a twoway price and the trader accepts the bid or accepts the offer or passes. In the voice brokers market, the dealers have additional alternatives.

Thus,with a broker, a market maker can make a quote for only one side of the market rather than for both sides.Also, a trader who is asking to see a quote may have the choice, not only to hit the bid or to take (or lift) the offer, but also to join either the bid or the offer in the brokers market, or to improve either the bid or the offer then being quoted in the brokers market.

It can all happen very quickly. Several conversations can be handled simultaneously on the dealing systems, and it is possible to complete a number of deals within a few minutes. When he hears the quotes, Mike will either buy, sell, or pass—there is no negotiation of the rate between the two traders.


If Mike wants to buy $10 million at the rate of CHF 1.4590 per dollar (i.e., accept Hans’ offer price), Mike will say “Mine” or “I buy” or some similar phrase. Hans will respond by saying something like “Done I sell you ten dollars at 1.4590.” Mike might finish up with “Agreed—so long.” Each trader then completes a “ticket”with the name and amount of the base currency, whether bought or sold, the name and city of the counter party, the term currency name and amount, and other relevant information.
The two tickets, formerly written on paper but now usually produced electronically, are promptly transmitted to the two “back offices” for confirmation and payment.For the two traders, it is one more deal completed, one of 200-300 each might complete that day.But each completed deal will affect the dealer’s own limits, his bank’s currency exposure, and perhaps his approach and quotes on the next deal.


The spread between the bid and offer price in this example is 5 basis points in CHF per dollar, or about three one-hundredths of one percent of the dollar value. The size of the spread will, other things being equal, tend to be comparable among currencies on a percentage basis, but larger in absolute numbers the lower the value of the currency unit—i.e., the spread in the dollar-lira rate will tend to be wider in absolute number (of lire) than the spread in dollar-swissie, since the dollar sells for a larger absolute number of lire than of Swiss francs.

The width of the spread can also be affected by a large number of other factors the amount of liquidity in the market, the size of the transaction,the number of players,the time of day, the volatility of market conditions,the trader’s own position in that currency, and so forth. In the United States, spreads tend to be narrowest in the New York morning-Europe afternoon period, when the biggest markets are open and activity is heaviest, and widest in the late New York afternoon, when European and most large Asian markets are closed.

Market Maker

A trader can contact a market maker to ask for a two-way quote for a particular currency. Until the mid-1980s, the contact was almost always by telephone over dedicated lines connecting the major institutions with each other or by telex.
But electronic dealing systems are now commonly used computers through which traders can communicate with each other, on a bilateral, or one-to-one basis, on screens, and make and record any deals that may be agreed upon.
These electronic dealing systems now account for a very large portion of the direct dealing among dealers.

As an example of direct dealing, if trader Mike were asking market maker Hans to give quotes for buying and selling $10 million for Swiss francs, Mike could contact Hans by electronic dealing system or by telephone and ask rates on “spot dollar-swissie on ten dollars.” Hans might respond that “dollar-swissie is 1.4585-90;”or maybe “85-90 on 5,”but more likely, just “85-90,” if it can be assumed that the “big figure” (that is, 1.45) is understood and taken for granted. In any case, it means that Hans is willing to buy $10 million at the rate of CHF 1.4585 per dollar, and sell $10 million at the rate of CHF 1.4590 per dollar.
Hans will provide his quotes within a few seconds and Mike will respond within a few seconds. In a fast-moving market, unless he responds promptly in a matter of seconds the market maker cannot be held to the quote he has presented.
Also, the market maker can change or withdraw his quote at any time, provided he says “change” or “off ” before his quote has been accepted by the counterparty.

TRADING AMONG MAJOR DEALERS—DEALING DIRECTLY AND THROUGH BROKERS

Dealer institutions trade with each other in two basic ways direct dealing and through the brokers market. The mechanics of the two approaches are quite different, and both have been changed by technological advances in recent years.

Mechanics of Direct Dealing

Each of the major market makers shows a running list of its main bid and offer rates—that is, the prices at which it will buy and sell the major currencies, spot and forward and those rates are displayed to all market participants on their computer screens.

The dealer shows his prices for the base currency expressed in amounts of the terms currency.
Both dollar rates and cross-rates are shown. Although the screens are updated regularly throughout the day, the rates are only indicative to get a firm price, a trader or customer must contact the bank directly. In very active markets, quotes displayed on the screen can fail to keep up with actual market quotes.
Also, the rates on the screen are typically those available to the largest customers and major players in the interbank market for the substantial amounts that the interbank market normally trades, while other customers may be given less advantageous rates.

Trader Vs Dealing Room

A proprietary trader, on the other hand, is looking for a larger profit margin—in percentage points rather than basis points— based on a directional view about a currency, volatility, an interest rate that is about to change, a trend, or a major policy move in fact, any strategic view about an opportunity, a vulnerability, or a mispricing in a market rate.

Some dealers institutions banks and otherwise—put sizeable amounts of their own capital at risk for extended periods in
proprietary trading, and devote considerable resources to acquiring the risk analysis systems and other equipment and personnel to assist in developing and implementing such strategies.

Others are much more limited in their proprietary trading.

Forex Positions Taking

Much of the activity in trading rooms is focused on marketing services and maintaining customer relationships. Customers may include treasurers of corporations and financial institutions; managers of investment funds, pension funds, and hedge funds, and high net worth individuals. A major activity of dealer institutions is managing customer business, including giving advice, suggesting strategies and ideas, and helping to carry out transactions and approaches that a particular customer may wish to undertake.


Dealers also trade foreign exchange as part of the bank’s proprietary trading activities, where the firm’s own capital is put at risk on various strategies. Whereas market making is usually reacting or responding to other people’s requests for quotes, proprietary trading is proactive and involves taking an initiative.


Market making tends to be short-term and high volume, with traders focusing on earning a small spread from each transaction (or at least from most transactions)—with position taking limited mainly to the management of working balances and reflecting views on very short-term forces and rate movements.

THE DIFFERENT KINDS OF TRADING FUNCTIONS OF A DEALER INSTITUTION

A dealer bank or other institution is likely to be undertaking various kinds of foreign exchange trading—making markets, servicing customers, arranging proprietary transactions—and the emphasis on each will vary among institutions.

Market making is basic to foreign exchange trading in the OTC market.

The willingness of market makers to quote both bids and offers for particular currencies, to take the opposite side to either buyers or sellers of the currency, facilitates trading and contributes to liquidity and price stability, and is considered important to the smooth and effective functioning of the market. An institution may choose to serve as a market maker purely because of the profits it believes it can earn on the spreads between buying and selling prices.

But it may also see advantages in that the market-making function can broaden in an important way the range of banking services that the institution can offer to clients. In addition, it can give the market-making institution access to both market information and market liquidity that are valuable in its other activities.

Forex Equipment

The equipment and the technology are critical and expensive. For a bank with substantial trading activity, which can mean hundreds of individual traders and work stations to equip, a full renovation can cost many, many millions of dollars.

And that equipment may not last long with technology advancing rapidly, the state of the art gallops ahead, and technology becomes obsolete in a very few years.

But in a business so dependent on timing, there is a willingness to pay for something new that promises information that is distributed faster or presented more effectively, as well as for better communications, improved analytical capability, and more reliable systems with better back-up. These costs can represent a significant share of trading revenue.