A little while back, I wrote a post on surface vs. deep reasoning in technical analysis. The gist of that post was that technical analysis, like any form of analysis, may be conducted simplistically by following untested, linear relationships or in a more sophisticated manner by exploring supply/demand relationships within and across markets.
While I sometimes call permabears to task for their simplistic analyses (and the untold number of Dow points they have cost their followers), I'd have to say that the retail currency markets are the bastion of simplistic technical analysis. Perhaps this is because (apart from the currency futures markets), there really isn't a consolidated market (and hence consolidated volume figures) for spot currency trading. It is difficult to investigate price-volume relationships when volume data are not available.
As a result, many retail currency traders trade some variation of the theme: past price change informs us about future price change. There is no consideration of *why* currency markets would be rising or falling; only a (simplistic) analysis of whether markets are rising, falling, overbought, oversold, etc.
Professional traders of currency markets, on the other hand, seem to have a broader grasp of intermarket relationships. They will look at various currency crosses and use these to better gauge whether, say, a rising Euro/Dollar is a function of a strong Euro, a weak Dollar, or both. They will also look keenly at economic reports and central bank decisions--not just in the U.S., but worldwide--to better understand relationships among currencies. Finally, the pros carefully watch interest rate trends--interest rates and yield curve dynamics worldwide--to gain a better sense of how money will flow to attract the best returns.
A simple test of Forex traders in the U.S. is to ask them about recent ECB and BOJ policy and recent movements in European and Asian interest rates and what those mean for the currency markets. If you get blank looks, you know that you're dealing with market participants who are a couple of toys short of a happy meal.
But that doesn't mean that all technical analysis applied to currency markets need be simplistic. Studies of interest rate movements vs. future currency behavior, for example, may be most enlightening and will be the topic of a future post.
Even within the domain of price action, relationships may be informative. Consider the volatility of currency price movement. In a volatile currency regime, there is considerable uncertainty over the proper valuation of one currency vs. another. In a stable regime, valuations are more settled. In that sense, we can view currency price volatility as a kind of sentiment gauge.
I went back to the start of 1978 (N = 7437 trading days) and examined the British Pound (GBP) vs. the Dollar on a daily basis (cash market). Specifically, I took the median size of daily price changes over a moving sixty-day period and examined the relationship to price changes in the GBP/Dollar over the following 60 days.
This is a relevant analysis, because the Pound has not only been strong vs. the dollar, but the median volatility of daily price movements over the last 60 days has been historically low-- below the median level since 1978.
Based on a simple median split of the data, when we've had a relatively volatile Pound/Dollar over a 60-day period, the next 60 days in the Pound have averaged a loss of -.31% (1760 up, 1959 down). On the other hand, when we've had a relatively calm Pound/Dollar over a 60-day period, the next 60 days in the Pound have averaged a gain of .65% (2042 up, 1676 down).
Interestingly, when the Pound has been up vs. the Dollar over the past 60 days *and* volatility of median daily price movement has been low, the Pound has averaged a gain of .94% over the next 60 days of trading (1167 up, 895 down).
What that suggests is that volatility may be an important variable in determining prospective currency market returns. A strong currency in a regime of relative daily consensus regarding valuations may be likely to continue its strength until economic fundamentals and/or central bank policies dictate a change. Such analysis takes us just a little closer to a deeper understanding of why foreign exchange markets move, enabling us to tilt probabilities a bit in our favor.
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19 comments:
Brett
By the same token if the Pound were weaker than the Dollar, and we have low volatility, will it follow that we will have an increase in volatility and a weaker Pound against the Dollar?
Thank you.
Hi Dr. Brett,
In the last week or so you have been touching upon a theme that I must humbly disagree with.
In this post, as well as the "surface technicals" post, and an earlier post called "Defining Qualities of Market Pros" you basically put forth the idea that the market pros do not use simple linear analysis, but rather think in much more complex relative terms. That notion, I definitely agree with. However, what I don't agree with is the notion that they all think in inter-market analysis terms and seek asset class mis-pricings as the basic form of their more complex analysis.
What I believe is the defining feature of market pros is their rich mental maps and extensive experience base. But to assume that this has to take the form of inter-market analysis, asset class mis-pricings, or the fundamental undercurrents of market movements is to imply that a certain *style* of analysis is key to being a market pro. In reality though, I have read about, heard of, and know market pros that use no such analysis. They only look at their market; they don't know what other markets or asset classes are doing (and they don't care to know); and they don't inquire about the fundamental basis for their market's movement. But does that mean they look at things in a surface manner? Absolutely not. These pros have rich mental maps and complex thinking suitable for the reality of the markets. These pure tape and chart readers think in non-linear terms, but do so *within* the market they're trading and *within* the context of pure technical analysis. So they may be watching nothing more than one market's price chart or tape, but they're looking at many complex relationships: S/R reference points, larger and smaller time frame trends, momentum, volatility, volume, price structure, value etc. and they're seeing how all of these interplay to produce a complex and unique picture of the market. Then they base their decisions off of this deep reasoning view, backed by an experience base that tells them what works in which situations, and the many different possibilities to expect and be ready to adapt to. This can hardly be called linear reasoning, even though it includes no knowledge of any other markets or fundamental relationships.
What I think you have noticed among most professionals is that they indeed use extensive inter-market analysis, and thus you have concluded that this is a key and ascertained that novices really need to start thinking in these terms. But I am of a strong conviction that no style or methodology is a key to success, and fundamental inter-market relationships represent nothing more than a methodology or style of analysis. It may have gained a lot of popularity recently with market pros due to the increasing inter-connection of the global economy, but in the end even if any given market now has many more influences on its price, if a trader is very skilled at reading that price in a non-linear way, it doesn't necessarily have to matter to him what is making the price move and why it is moving.
This is just my humble opinion, but I think it's a very important point to put out there because many traders who may read these posts may wrongly conclude that to be successful they need to start looking at inter-market relationships and get a strong grasp of macro-economics. But what if they don't enjoy this type of analysis, and it doesn't fit their strengths? That would then sabotage the true ingredient for success in trading, which is finding a style that fits your talents and interests.
Ziad
Hi Brett,
Does volume on new currency ETFs inform us in anyway?
Regards,
Jeff
Dear Dr. Brett,
I have been deeply troubled by your assertion that the pro traders approach markets in a more sophisticated manner by exploring supply/demand relationships within and across markets (to quote you).
I thought about writing you a lengthy comment to dispute your claim of how pro traders read markets. Luckily Ziad above saved me all the work and effort. And he did in a much more humble and professional manner that I ever could.
I have been trading futures full time since 1998. I trade the German Bund futures and DJ Euro Stoxx 50 futures. I believe I meet your compentency criteria of being able to make net profits after all transaction and slippage costs. Trading is my only source of income and I don't do anything else.
While I trade the Bund, I know ABSOLUTELY NOTHING about ECB interest rate policy, I know NOTHING about the economic fundamentals of Europe. You will definitely get a blank stare from me if you ask me about these subjects.
When I trade the Bund or Stoxx 50 I look ONLY at the price action of the Bund (or Stoxx) SEPARATELY AND INDIVIDUALLY. In fact I make it my rule NOT to look at any other market for inter-market influence and relationships because every time I do that, it creates mental bias that negatively affect my trading.
I don't even look at volume. All I look at is price action by reading the tape with reference points such as pivots, intra day highs and lows, and trends within different time frames, i.e. from intra day to daily to weekly to monthly.
Ziad has basically nailed my trading style and process to the dot but of course in a far more humble way and with much better clarity than I could ever put down on paper myself.
When I read your ES market commentaries, i.e. how you look at volume, TICK, Market Profile equilibrium, value areas, and then coupled these with intermarket relationships with Treasurys and Dollar Yen, I find myself shaking my head and thinking no wonder the majority of traders lose money.
If I have a son and he wants to learn trading, I would NEVER start him off in that direction of complexity.
A very successful floor trader I know told me to trade KISS - KEEP IT SIMPLE STUPID.
Thank you again Ziad for your insightful and invaluable clarification that not all pros trade with mind boggling complexity.
I agree with Ziad,
It's hard to watch ES, NQ, ER2, and ZN, and ESTX50, DAX, EURO, Gold, and crude oil to get a sense of the intermarket relationship for day trading, all the while you are gauging volume and S/R zones on these charts. It may just be easier to look for one chart setup to get one good scalp in based on a pattern you regularly observe. However, for swing trading, looking at interest rates, and the bond futures, there may be a little less to worry about to make a more educated trade based on technicals and fundamentals.
Look forward to your next post Dr. B
I'm trading short a few happy meals too!!
To Jeff,
I don't think anyone in the right mind would trade currency ETF's when there are better forms of leverage and commission costs available, also you have to consider that most of the news events that effect currencies are done premarket of NYSE open, so you would incur large gap openings on a regular basis by trading these products and open yourself to greater risk from not being able to manage your position when the currency markets are open.
Ziad raises many good points about market analysis.
Inter-market analysis always raises that nagging question: What is moving that other market, which, supposedly, is moving the market that I am trading? What is the "root cause" for any market to move?
It does not matter which form of market analysis that you use such as technical, fundamental or inter-market analysis, it is all based on past history, which may or may not have anything to do with the future.
What may be moving the markets is a consensus oppinion about the perception of future prospects and opportunities in various economies. The trick to trading is to understand what the majority expect to happen in the future.
Charles
Regarding the absence of real volume data in the distributed FOREX marketplace...
Seems to me that an important question is the degree to which the volume for Futures on Currency Pairs, (the most prominent examples being the Pairs traded at the CME), constitutes a meaningful surrogate for the absent FOREX volume.
My belief is that the futures volume is a pretty darn good surrogate.
Thoughts?
Dear Readers,
Thanks for your insightful comments on the post. Special thanks to Ziad for his excellent distinction between "rich mental maps" and intermarket analysis. I agree with the rich mental maps idea wholeheartedly.
Here's my dilemma, folks. I have worked with traders at a number of proprietary trading firms, investment banks, and hedge funds over the last few years. I've easily met with over 100 professional traders in that time. So it's not a huge sample, but it is a pretty good cross-section.
The sample includes quite a few Forex traders. But I can't find one trader in the whole lot who uses simple price action tools in currency markets to make money.
Of the successful Forex traders, even the shorter-term guys are cognizant of what's happening in different crosses and larger picture concerns re: ECB/BOJ/Fed policy, rates, etc.
In fact, the algorithms that are trading currency markets with high frequency generally take their cue from mispricings across market groups (futures vs spot) and crosses.
I completely agree with the sentiment that complexity for its own sake is no good. But there comes a point where simplicity becomes willful ignorance. That's what I'm seeing in the retail Forex market, where traders *do* keep it simple and lose money in shocking proportion.
I would be only too happy to report that traders in the currency markets were making oodles of money by looking at chart patterns, indicator readings, and S/R levels. But that has not been my experience. Just the opposite: the retail traders who use those tools lose, and the professional traders who are consistently profitable are looking beyond those tools.
Perhaps my sample is biased in some way, and I'm sure there are exceptions to every generalization. Still, I feel an obligation to report my observations unvarnished, especially when so many advertisements for Forex brokers tout what great trending markets and easy profits are available via the currencies.
Brett
Dear Readers,
Thanks for your insightful comments on the post. Special thanks to Ziad for his excellent distinction between "rich mental maps" and intermarket analysis. I agree with the rich mental maps idea wholeheartedly.
Here's my dilemma, folks. I have worked with traders at a number of proprietary trading firms, investment banks, and hedge funds over the last few years. I've easily met with over 100 professional traders in that time. So it's not a huge sample, but it is a pretty good cross-section.
The sample includes quite a few Forex traders. But I can't find one trader in the whole lot who uses simple price action tools in currency markets to make money.
Of the successful Forex traders, even the shorter-term guys are cognizant of what's happening in different crosses and larger picture concerns re: ECB/BOJ/Fed policy, rates, etc.
In fact, the algorithms that are trading currency markets with high frequency generally take their cue from mispricings across market groups (futures vs spot) and crosses.
I completely agree with the sentiment that complexity for its own sake is no good. But there comes a point where simplicity becomes willful ignorance. That's what I'm seeing in the retail Forex market, where traders *do* keep it simple and lose money in shocking proportion.
I would be only too happy to report that traders in the currency markets were making oodles of money by looking at chart patterns, indicator readings, and S/R levels. But that has not been my experience. Just the opposite: the retail traders who use those tools lose, and the professional traders who are consistently profitable are looking beyond those tools.
Perhaps my sample is biased in some way, and I'm sure there are exceptions to every generalization. Still, I feel an obligation to report my observations unvarnished, especially when so many advertisements for Forex brokers tout what great trending markets and easy profits are available via the currencies.
Brett
To Ziad and PWH,
I wouldn't pretend to tell you how to trade, or to tell you about your markets. You obviously know them very well. I also think you make a valid point that deeper analysis doesn't necessarily entail intermarket analysis.
However, when it comes to the currency markets, I will say this...a good trader really really should have an understanding of intermarket relationships between the various currencies. This is ESPECIALLY important to people trading on a shorter time-frame. I don't like to be dogmatic, but in this instance I will be. The reason is that arbitrage relationships exists between all of the various crosses, and these certainly have an effect. This is not a matter of 'x might move y,' but a matter of 'x MUST move y.' This is just as important as knowing when and for which currencies economic announcements occur. Again, in trading currencies this is something every trader should be aware of, regardless of timeframe.
Even if a currency were successful without being aware of these things, which I hardly think possible, he would be much more successful knowing about them. That's not to say that a complex sort of analysis is needed, but mainly a good grasp of the dynamics involved.
Again, I don't pretend to tell you about your markets, but in this area I will staunchly stand beside my assertions.
BW
Thanks for the comments everyone... this has turned out to be a very thought-provoking debate. But although it seems like there is an irreconcilable dichotomy on the issue, I think things are more simple than they may seem.
My solution to the seeming dilemma is this. It is indeed true as Dr. Brett mentioned that the vast majority of amateurs (who also happen to be losing in the markets) are looking at chart patterns, indicator readings, and S/R levels. It is also probably true that the majority of professionals are looking at inter-market and other fundamental relationships. This makes it seem that the latter's style is the reason for their success. But the real probing question to ask is: why are the pros using this analysis and why are the amateurs looking at charts and indicators in the first place? And the answer to that is that charts and indicators seem to lend themselves to linear thinking, while inter-market analysis does not. And linear thinking is what the vast majority of traders want. They don't understand how difficult this business is, and they don't have it in them to put in the months and years of effort to develop expertise. They want a simple short-cut to riches.
But the subtle key to the whole matter is that while charts and indicators may lend themselves to linear thinking because of their apparent simplicity (with the popular media endorsing that image enthusiastically), their correct and successful use (i.e. one that produces an edge) does not lie in linear thinking. So in a sense the amateurs are fooled; they flock to charts and indicators for trading success, but find none there. But does that mean the weakness lies in the exclusive analysis of charts and indicators? I beg to differ. The weakness is not in this deceivingly simple form of analysis, but rather in its linear application.
But this deceptive simplicity does more than to fool the traders who think it will be easy to make money using it; it also creates a subtle illusion. The illusion it creates is that on its own, it is an inferior method. And it's not hard to see how it does this. The traders who are "destined to lose" flock to it and stay away from the seemingly more complex and effortful inter-market analysis, while the ones with a greater commitment to success and all the hard work it entails do not shy away from inter-market analysis. **This creates a biased pool of traders that are more likely to succeed (by default) in the inter-market analysis camp.** And the result of this of course is the illusion that the successful traders are so because they use inter-market analysis and the losing traders are so because they use "simple" technical analysis. But in reality there are many (although granted a relative minority) of pros that have the commitment for success and pursue that through the use of 'simple' charts- although their thinking and mental maps are far from simple, which is the real key to their success. (A glaring example of this is Mark Weinstein from Jack Schwager's Market Wizards, who used a myriad of technical indicators and chart patterns exclusively, but developed incredible mental maps and immense expertise in applying his art).
In the end I strongly believe trading success has nothing to do with your form of analysis. PWH is right that many traders lose when they try to trade complex inter-market relationships. But the complexity is not the reason they lose, it's the wrongful application of linear thinking to the 'complex' analysis. And Dr. Brett is right that many traders lose when they try to trade using simple chart analysis. But the simplicity of the charts is not the reason they lose, it's the wrongful application of linear thinking to the 'simple' analysis. The common thread then is linear thinking. That's what amateurs do, and that's what pros don't do. That's the key, no matter the analysis type. And if we realize that, then we can see that there is in fact no dilemma at all.
And just as a final note to Dr. Brett, an added reason why you may see such a high concentration of successful traders using inter-market analysis (and thus have the dilemma you have) could be due to the "herd" effect. This is not to imply it in a negative connotation, but if the many successful traders you've worked with work at hedge funds and prop firms, then naturally these traders will pick up on the same styles that they see their colleagues using. After all if they see a great trader using inter-market analysis, they would very likely feel that it's the reason for his success (as we see is quite easy to believe) and they would feel that they are missing something if they don't use that style, which only adds to perpetuate the style.
So anyways, that's my 2 cents worth. It really only goes to confirm Dr. Brett's views that expertise is a product of talent and an immersion in one's work that changes perceptions and builds rich internal maps. Now whether one does so through inter-market analysis or pure technical analysis is a matter of style and does not inhibit immersion or the creation of expertise in my opinion.
Ziad
Brandon,
I understand your point of view and can see why you would strongly believe in it. But try to look at it from a different perspective. Everyone who uses a certain style naturally comes to believe that the style is the right way to trade the markets and that if someone doesn't use it they are missing out on some very important stuff. This makes sense in the person's mind because they view the world from this particular lens, and they know THEIR trading would greatly suffer if they didn't have that info. But because they view their reality as THE reality (after all they see certain relationships and KNOW they exist) they assume it must apply to everyone.
But think of it from this perspective. You may be absolutely right that arbitrage relationships have an effect on your market and thus conclude that it is imperative to know them. But do you realize that there could be hundreds of things that regularly affect your market which you are completely unaware of? Actually I would venture to say that it's not a mere possibility but a certainty. The markets are far more complex than we could ever think. But does that mean then that you have to be aware of everything that affects your market (even regularly) to be a successful trader? I really don't think so. In fact right now there are traders using certain forms of analysis that will tell you you're crazy if you're not aware of them, and that they are crucial for success. But you'll KNOW that's not true because you're successful while being completely ignorant of them.
Well it's the same way with inter-market analysis. Yes other markets and arbitrage affect your market, but no you don't have analyze and be aware of all of these effects to trade successfully. And you can tell other traders that they're crazy not to, but they'll KNOW that's not true because they are successful using them. And there are many successful currency traders who trade on pure technicals.
You can have an edge without knowing these vitally important things. And indeed while your edge may be larger if you did know them, that's not necessarily the case. Knowing them may create decision inefficiencies that slow you down because they cause too many contradictory signals. Even in this issue, the best form of thinking is non-linear thinking, because things aren't as simple as they seem.
I've seen so many styles of trading now that I have come to the firm conclusion that there is no reality in markets or trading. No matter how convinced you are of the importance of a form of analysis or style (and no matter how right you are) other traders can be totally successful without having an ounce of awareness of these 'crucial' things.
Again, that's just the logical conclusion I've come to after seeing traders being successful using completely different (and sometime opposing) methods.
Ziad
Ziad,
Very well put. I would only add that it is not necessarily true that intermarket analysis precludes charts. Charts are helpful in a lot of ways, particularly for someone as visually oriented as I am. In fact, I am so visually oriented that most of the time I use an analogy or diagram to understand abstract relationships. I have also been working to develop some proprietary indicators to bring intermarket analysis to the chart itself. The idea is that one person cannot fully bring their analytical capabilities to bear in real-time and for me that they help my brain to analyze the information (note: I personally do not really trade off of charts, I'm an algorithmic trader). This is especially true with this intermarket sort of trading. As a solution I've developed various tools that encapsulate part of my thinking and digest the information for me.
Your point about non-linear thinking is very well put. Not that this is a contradiction, but I would still stand by my assertion that currency traders really ought to have a grasp of the relationships between the various pairs. It's hard for me to explain why this is so vital without going into the details and there aren't as many analogues in the futures or stock arena. The closes thing I could think of would be comparing the relationship between the front-month contract and the next month out...There's a certain relationship that must exist between these two, although there's certainly some give. Where the similarities break down is that in currencies the relationships are much more governed and also that we're not talking about contracts spaced out across time, but existing simultaneously. Kind of like a multiple-timeframe analysis you might do: T1 affects T2 affects T3. Only here we also have Cross1 affects Cross2 affects Cross3. These relationships are inescapable in the currencies, whether you choose to acknowledge them or not, and those who ignore them do so at their own peril. In fact the certainty of them goes well beyond the benefit of any kind of multiple timeframe analysis...it's an apodictic certainty.
Having just read your response, I'll just add this. Yes, it's possible that one could be successful without an awareness of these things, but they are crippling themselves. You could be right about decision inefficiencies, but there are ways around this. Undoubtedly there are market forces at work of which I am unaware. This is different however, because it's not speculation, it doesn't involve privileged knowledge, it's not even a statistical study, it's fact in the same way that 2 + 2 = 4.
I think the argument of 'different strokes for different folks' holds water to some degree, but not to the extent you are using it here. 2 + 2 will never equal 5. Someone could tell me it does, and they could believe it does but frankly they would be wrong (try that argument with your broker). The mere existence of perceptual lenses does not negate the idea that there really is a reality there. So, could a trader be successful without knowing that 2 + 2 = 4? Perhaps they could, but why would they want to? In fact I would argue that they are aware of these things on some level. Could they be successful thinking that 2 + 2 = 5? Absolutely not. At any rate, certainty is such a rare commodity in this business. It should be bought whenever it can.
Please understand, the type of thing I'm talking about here really isn't just some person's theory about how things work and to be honest the math is not that difficult at all. I'm talking about an integral reality of the market, in the same manner that a corn futures contract is for delivery of x bushels of corn. This isn't a matter of perception.
BW
Ziad,
P.S. I enjoy the debate. I would like to see you make the argument that traders can remain blissfully unaware of economic or other announcements that could move their markets violently, or that they can go along without knowing what their contract is worth...and that this wouldn't statistically be financial suicide...some things are essential.
BW
Brandon,
Very well argued. I too enjoy the debate, but I think we aren't really debating the same thing. What I mean by this is that we can argue all day long, but neither party is going to convince the other because we differ on the most fundamental point, which is that you believe that the inter-market relationships are not some external influence on price, but rather an intrinsic part of that price; a part of its identity that needs to be known. On the other hand I believe that while it is an absolute certainty that these inter-market influences exist and that they're not merely perceptual beliefs, all of their influence will be contained in the price and volume behavior of the given market. And actually that's the most basic precept of technical analysis. And it leads to the corollary that you don't have to be aware of what it is that is moving your price, but rather you can study the price itself as it will tell the story of supply/demand imbalances- which is all we really ultimately care about.
An example of this would be for instance, if I see my currency pair probe down below an area of support and quickly reject it bouncing away with good momentum, while seeing that the larger time frame is in an up trend. For me that could be a great long trade. Did I need to know that the reason it is rejecting lower prices is because another inversely related pair is breaking to the downside because of some fundamental factors in that market? Not really. The price of my market contained that information in the way it acted.
When I said that there is no reality in trading, that was not to say that there aren't certain things that have absolute and quantifiable influences on price. What I meant is that there's no reality to how you can define an edge. And regarding your statement whether "traders can remain blissfully unaware of economic or other announcements that could move their markets violently", of course I don't think that- but this is not a contradiction. One should be aware of all major announcements that may jolt his market suddenly, even if those announcements are from other markets. But all that means is "refrain from trading during those times to avoid unnecessary and unpredictable volatility." It doesn't have to mean "understand the fundamental basis of how it will affect your market." What's the difference? Can't another market suddenly affect mine even without any announcement? Yes it can. But even if I understood all of the fundamentals and economics of that relationship, will it help me consistently predict moves in that market so as to avoid sudden surprise moves in mine? No, because if I could predict moves in that market so well I'd be making millions trading it. Instead I will have to react quickly, and I can do so because the effect it will have on my price will tell me something about the supply/demand relationship in my market that I can use to make an informed decision- without knowing why that other market moved. In the end the difference between normal fundamental relationships playing out and planned news announcements, is that the latter will have wild volatility associated with temporary indecision regarding the news, which you are best to avoid because they are no real indication of value acceptance or rejection. But with the former, distinct dynamics are constantly playing out, and it's not necessarily a correct conclusion that being aware of them is a must you because you can distill this knowledge through your own price and what it is showing you in terms of supply/demand.
Ultimately, I don't think the currency markets differ from any other market regarding the principles of price action. Every market has many certainties in what affects it- that's not the argument. The argument is whether one needs to be aware of them or if the analysis of their effect on price is all that's needed. I thin k the proof of that rests not in debate and arguments, but facts. And the facts are that there are many pro traders in all markets including currencies that focus only on the technical aspects of price and volume in their market, and are very successful doing so. That in the end, should be the final judge in this argument in my opinion.
Good debating with you!!! :)
Ziad
"This debate reminds me of a dialogue between different Kung Fu masters, who are arguing which style of martial arts is superior, Karate, Boxing, Shaolin, Tae Kwan Do, etc. etc. Then Bruce Lee, the god of martial arts says "Depends on who is using it. "
Credit - this quote was sent to me by a friend of mine upon reading the comments on Dr. Brett's post.
It's a lengthy debate already and I don't know, if joining will add something to it. But my impression was, that the discussion about intermarket relationships was very abstract, one side unable to convince the other.
Maybe an example will help.
I think we all can agree, that no market moves on it's own. Movements happen in all markets and similiar moves are often seen in related markets. In indices you see them, because the Buy/Sell-programms affect not one but multiple markets.
In the currency markets it's happening, because we don't trade currencies per se, we always trade the relationship of 2 currencies. The exchange rate tells you the worth of one currency expressed in another currency.
Now let's look at the 2 major pairs. Euro/USD and USD/Yen. If the Euro/USD moves it shouldn't affect the USD/Yen and vice versa, because we have two seperate markets.
But there is alse the Euro/Yen market.
This market must move if the Euro/USD exchange rate changes and the USD/Yen market stays fixed. Why?
Because you can either trade the Euro/USD directly or you trade Euro/Yen and USD/Yen. Meaning, you can go long Euro, by going straight long Euro/USD, or You go long Euro/Yen and you go short USD/Yen.
EG:
E/U = 1.4031
E/Y = 164.47
U/Y = 117.22
If no arbitrage exists
1.4031 should be 164.47 / 117.22
164.47 / 117.22 is 1.403088 so when trading sufficcent quantities there is currently a slight arbitrage available, but the Bid/Ask spread will take care, that it is nil, the moment you try to exploit it during normal market operations.
Now say the E/U rate goes down from 1.4031 to 1.4000.
If U/Y stays fixed at 117.22 as the european and the japanese markets are not correlated and the E/Y rate stays fixed a huge arbitrage possibility would be available to any trader fast enough to grab it. Be sure there are programs out in the market trying to do just that and they act with lightning speed. They will grab any arbitrage chance opening up. So it is 100% sure that E/Y will move if the E/U moves and U/Y stays fixed.
But why would you go long Euro/USD by trading E/Y and U/Y. Normally you won't. Unless you have already a position in one of these markets, there is no compelling reason.
But if you want to go long E/Y and you know this market can not provide the volume you need for your operation, you might as well execute the trade in the major pairs E/U and U/Y. To be long E/Y you go long E/U and you go long U/Y.
(It's long U/Y because that pair is traded inverse to E/U in the Forex market. Be aware that in the currency futures market all currency futures are traded against the USD. So there it's E/U and Y/U or Long 6E Z7 and Short 6J Z7)
Now you might notice, that E/Y or to an even greater extend the British Pound against the Yen (G/Y) can move very fast and a considerable number of pips.
So you might decide to trade that market. But trading that market without looking at the E/U and U/Y markets would be like driving in a car without right or left side-window. You need to see the cars approaching from the right or left to act accordingly. They affect the way the currency you trade directly.
Different indices affect each other, but just to an extend. If the EuroStoxx moves up, its no given that the DAX or the FTSE will move up as well or to the same extend.
But in the currencies, it's a clear mathematical relationship. If E/U moves and U/Y moves I can tell you the value of E/Y to the tens of a penny. And be sure that's exactly where E/Y will be trading.
Thanks, Globetrader, for the excellent concrete example. Ziad has done a great job of explicating what we might call the "market making" view of trading, which emphasizes price, volume, bids, and offers: the essentials of the auction process that concern traders on the floor and screen traders who are liquidity providers (price makers).
At the other end of the spectrum we can identify the "portfolio management" view of trading, which emphasizes asset mispricings and inefficiencies. A casual look at the strategies that dominate hedge funds--event trading, long/short, stat arb, macro--finds that all of them involve a kind of relational analysis that goes beyond considerations of price/volume.
One of my observations is that where one stands on this continuum between "market making" approaches and "portfolio management" approaches depends, in part, upon one's trading time frame. This may explain why I see very little standard technical analysis at hedge funds, for instance. It also explains how scalpers at prop firms can make money without studying relationships among asset classes.
Thanks again to all for the excellent comments and stimulating discussion.
Brett
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