The Fibonacci theory named so after a prominent Italian mathematician of the late twelfth and early thirteenth centuries gives ratios, which play important role in the forecasting of market movements. Fibonacci introduced an additive numerical series that has come to be called the Fibonacci sequence, which consists of following series of numbers:
1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89,144, 233, 377, 610, 987, 1597, 2584, 4181, (etc.)
These numbers exhibit several remarkable relationships, in particular the ratio of any term in the series to the next higher term. This ratio tends asymptotically to 0.618.
In addition, the ratio of any term to the next lower term in the sequence tends asymptotically to 1.618, which is the inverse of 0.618. Similarly constant ratios exist between numbers two terms apart, three terms apart, and so on. The ratio 0.618, referred to as the Fibonacci ratio, or the “Gold Spiral” which is observed in structures of many natural objects and events – from clam shell construction to the form of whirlwinds and hurricanes. The financial markets exhibit Fibonacci proportions in anumber of ways; particularly they are powerful tools for calculating price targets and placing stops. For example, if a corrective wave is expected to retrace 61.8 percent of the preceding impulse wave, an investor might place a stop slightly below that level. This will ensure that if the correction is of a larger degree of trend than expected, the investor will not be exposed to excessive losses. On the other hand, if the correction ends near the target level, this outcome will increase the probability that the investor’s preferred wave interpretation is accurate.
The trendline is a main initial element for the price chart analysis. While the market moves in any direction not along a straight line but along a zigzag, the mutual placement of upper and bottom points of those zigzags permits you to plot a line connecting the significant highs (peaks) or the significant lows (troughs) of an appropriate zigzag using technical tools of the computer program (See Figures 4.1 – 4.3). To draw a trendline only two points are necessary and the third one is the contact point confirmation. On a bullish trend chart it should be drawn using troughs, on a bearish trend chart – using peaks. The trendline and a line which is about parallel to it and drawn on the opposite side (through peaks on a dullish trend and through troughs on a bearish) form the trade channel. Both lines are then channel’s borders. Examples of trade channels are shown on Figures 4.9, 4.10.
Lines of support and resistance. The upper and the bottom borders of trade channels are called accordingly support and resistance lines. The peaks represent the price levels at which the selling pressure exceeds the buying pressure. They are known as resistance levels. The troughs, on the other hand, represent the levels at which the selling pressure succumbs to the buying pressure. They are called support levels. In an uptrend, the consecutive support and resistance levels must exceed each other respectively. The reverse is true in a downtrend. Although minor exceptions are acceptable, these failures should be considered as warning signals for trend changing.
The significance of trends is a function of time and volume. The longer the prices bounce off the support and resistance levels, the more significant the trend becomes. Trading volume is also very important, especially at the critical support and resistance levels. When the currency bounces off these levels under heavy volume, the significance of the trend increases. The importance of support and resistance levels goes beyond their original functions. If these levels are convincingly penetrated, they tend to turn into just the opposite. A firm support level, once it is penetrated on heavy volume, will likely turn into a strong resistance level (see Figure 4.11). Conversely, a strong resistance turns into a firm support after being penetrated (see Figure 4.12). In general, to evaluate the reliability (that is the possibility of a break) of the trade channel borders taking a decision to close or to save an existing position one should govern himself with following rules:
1. A channel is the more reliable the longer it exists. Hence, the “solidity” of very old channels (e.g. existing more than 1 year) decreased sharply.
2. A channel is the more reliable the more is his width (“It takes time to break channel”).
3. The resistance may be broken if it is bounced on the background of a growing volume (“It takes volume to break resistance”).
4. A steep channel is less reliable in compare to a gentle one.
5. The support may be broken independent on the volume (“under own weight”).
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Kinds of prices and time units. Charts for technical analysis are being constructed in coordinates, “price (the vertical axis) – time (the horizontal axis)”. The following kinds of currency prices represented on charts are being distinguished on Forex:
• open – a price at the beginning of a trade period (year, month, day, week, hour, minute or a certain amount of one from these units);
• close - a price at the end of a trade period;
• high – the highest from prices observed during a trade period;
• low – the lowest from prices observed during a trade period.
Providing the technical analysis one uses charts for different time units – from 1 year or more until 1 minute. For instance, the computer program Trading Intl. uses allows you to analyze price movement charts for 1 day, 4 hours, 30 minutes, 15 minutes, 5 minutes and 1 minute. The longer the time unit applied to plotting the chart, the longer the time span used to analyze price movements and to determine the major trend by means of the chart. For short trading, charts for smaller time units are more suitable.
Line chart. The line chart is plotted connecting single prices for a selected time period. The most popular line chart is the daily chart. Although any point in the day can be plotted, most traders focus on the closing price, which they perceive as the most important (see Figure 4.6). But an immediate problem with the daily line chart is the fact that it is impossible to see the price activity for the balance of the period as well as gaps (See chapter 4.6) – breakups in prices at joints of trade periods. Nevertheless, line charts are easier to visualize. Also, technical analysis goes well beyond chart formation; in order to execute certain models and techniques, line charts are better suited than any of the other charts.
Bar chart. The bar chart consists from separate histograms (See figure 4.7). To plot a histogram in coordinates price – time the points responding to high, low, open and close prices for a time period analyzed should be marked on the one vertical bar. The opening price usually is marked with a little horizontal line to the left of the bar; and the closing price is marked with a little horizontal line to the right of the bar. Bar charts have the obvious advantage of displaying the currency range for the period selected. An advantage of this chart is that, unlike line charts, the bar chart is able to plot price gaps. Hence, it is impossible to see on a bar chart absolutely all price movements during the period.
Candlestick chart. The candlestick chart is closely related to the bar chart. It also consists of four major prices: high, low, open, and close (See Figure 4.8). In addition to the common readings, the candlestick chart has a set of particular interpretations. The latter is possible thanks to the convenient visual observation of that chart.
The opening and closing prices form the body (jittai) of the candlestick. To indicate that the opening was lower than the closing, the body of the bar is left blank. Current standard electronic displays allow you to keep it blank or select a color of your choice. If the currency closes below its opening, the body is filled. In its original form, the body was colored black, but the electronic displays allow you to keep it filled or to select a color of your choice. The intraday (or weekly) direction on a candlestick chart can be traced by means of two “shadows”: the upper shadow (uwakage) and the lower shadow (shitakage). Just as with a bar chart, the candlestick chart is unable to trace every price movement during a period’s activity.
Technical analysis is used for the prediction of market movements (that is alterations in currencies prices, volumes and open interests) outgoing from the information obtained for the past. The main instruments of technical analysis are different kinds of charts, which represent currencies price change during a certain time preceding exchange deals, as well as technical indicators. The latter are obtained as a result of the mathematical processing of averaging and other characteristics of price movements. The instruments of technical analysis are universal and applicable to any Forex sector, any currency and any time span. Technical analysis is easy to compute what is important while the technical services are becoming
increasingly sophisticated and reasonably priced. They are available to all Forex participants independent of their trade plans, strategies applied and the time of position continuance.
Financial factors are vital to fundamental analysis. Changes in a government’s monetary or fiscal policies are bound to generate changes in the economy, and these will be reflected in the exchange rates. Financial factors should be triggered only by economic factors. When governments focus on different aspects of the economy or have additional international
responsibilities, financial factors may have priority over economic factors. This was painfully true in the case of the European Monetary System (EMS) in the early 1990s. The realities of the marketplace revealed the underlying artificiality of this approach.
The role of interest rates. Using the interest rates independently from the real economic environment translated into a very expensive strategy. Because foreign exchange, by definition, consists of simultaneous transactions in two currencies, then it follows that the market must focus on two respective interest rates as well. This is the interest rate differential, a basic factor in the markets. Traders react when the interest rate differential changes, not simply when the interest rates themselves change. For example, if all the G-5 countries decided to simultaneously lower their interest rates by 0.5 percent, the move would be neutral for foreign exchange, because the interest rate differentials would also be neutral. Of course, most of the time the discount rates are cut unilaterally, a move that generates changes in both the interest differential and the exchange rate. Traders approach the interest rates like any other factor, trading on expectations and facts.
For example, if rumor says that a discount rate will be cut, the respective currency will be sold before the fact. Once the cut occurs, it is quite possible that the currency will be bought back, or the other way around. An unexpected change in interest rates is likely to trigger a sharp currency move.
Other factors affecting the trading decision are the time lag between the rumor and the fact, the reasons behind the interest rate change, and the perceived importance of the change. The market generally prices in a discount rate change that was delayed. Since it is a fait accompli, it is neutral to the market. If the discount rate was changed for political rather than economic reasons, a common practice in the European Monetary System, the markets are likely to go against the central banks, sticking to the real fundamentals rather than the political ones. This happened in both September 1992 and the summer of 1993, when the European central banks lost unprecedented amounts of money trying to prop up their currencies, despite having high interest rates. The market perceived those interest rates as artificially high and, therefore, aggressively sold the respective currencies. Finally, traders deal on the perceived importance of a change in the interest rate differential.
Political crises influence. A political crisis is commonly dangerous for the Forex because it may trigger a sharp decrease in trade volumes. Prices under critical conditions dry out quickly, and sometimes the spreads between bid and offer jump from 5 pips to 100 pips. Unlike predictable political events (parliament elections, interstate agreements conclusion etc), which generally take place in an exact time and give market the opportunity to adopt, political crises come and strike suddenly. Currency traders have a knack for responding to crises. The traders should react as fast as possible to avoid big losses. They may not have much time to make decisions, often they have only seconds. Return on the market after a crisis is often problematic.
