28 Jan Which is weaker – the Rand or your analysis method?

The Rand trading at near five-year lows against the Dollar, Pound and Euro may not be your biggest problem in foreign currency trading, but rather a distraction that hides a much more “fundamental” problem.

You might be constantly asking questions like these:

• Will the Rand hit R12 to the Dollar?
• Is there a pullback imminent?
• How deep will the pullback be?
• Is a return to sub-R9 levels possible?

To answer the above questions we must enter the haphazard world of forex analysis and its diverse inhabitants – some you may know all too well, and others perhaps not so much:

First we encounter the Fundamental Analyst, who makes predictions about market trends and levels based on concrete and valid economic and financial data. This has been a leading approach to making sense of the exchange market and as such they have a very big following.

But consider for a moment the vast body of data that affects just the USDZAR pair, for example. We could make a list of several thousand events, trends, threats, fears, policies, across the spectrum of politics, trade relations, news sentiments, history, financial figures – the list goes on – that influences this one pair. And then the list may be supplemented with an even longer list of what we do not know, but that also influences this currency pair. The prevalent solution to this overload is to isolate those four or five factors that make most sense to the analyst, from which he then formulates his market view.

Now remember, hundreds of thousands of other analysts, like our analyst above, are simultaneously expressing their analytical views on market trends based on their respective chosen four or five factors.

And yet, price is determined by the actual currency traders as they buy and sell (supply and demand), often with total disregard for any logically sound fundamental view. It is therefore possible, and happens quite frequently, that EVEN THOUGH an analyst is 100% correct in their assessment and interpretation of financial and other news factors, if enough currency traders thinking differently, it would instantly render this “valid” view dead wrong.  (Have you ever experienced two or three fundamental analysts disagreeing perfectly on what is going to happen next? Now you know why.)

In effect the fundamental analyst says, “Let’s assume that I have ALL the relevant data that pertains to the currency pair I am analyzing. Let’s also assume that price moves logically based on these numbers. Then, assume that I know how ALL the millions of currency traders in the market will interpret these numbers. Now, here then is my prediction…” We say that is quite a lot to assume when you need to make trading decisions worth millions of dollars.

The reality is: a currency chart does NOT plot financial data, but rather mass psychological patterns of fear and greed (universal emotions), displayed by currency traders buying and selling that particular pair. This is an overtly human, emotion-driven reality. Price reveals the exact balance point between current supply and demand – to the fifth decimal place – extraordinary!

You will never make or lose or make money because of this or that snippet of financial news. You will lose or make money because PRICE has moved higher or lower. Sooner or later every consistently successful trader will realize this basic truth: Price is THE reality of the market.

Now we meet the Technical Analyst, who knows that price is the summary of all fundamental data, completely interpreted by all market participants, with all possible other influences already taken into account. Nothing moves faster than price. By the time influential news reaches you on the radio/television/internet; price has already discounted it long ago. The Technical analyst accepts that price, and ONLY price, is the ultimate reality of the foreign exchange market. And they are glad that a price chart plots emotional patterns, not financial ones, because if the price patterns were formed based on the latest financial, social and economic data there would be NO way to predict possible future movement. But, as price is driven by human emotions, and human emotions recur and form patterns, it becomes possible to search for, identify and then make predictions based on how human traders reacted in fear or with greed to similar situations in the past.

Where the fundamental analyst’s motto is “THINK what the market will do, and make a prediction,” the technical analyst’s motto will be, “LOOK what the market is doing, and align yourself with it.”

Technical analysts subdivide into two clear schools of thought:

The Discretionary Technical Analyst study price charts and draws his levels and trend lines on the chart to make his predictions based on these lines and patterns. Some of these patterns have become well known:

• Head-and-shoulders
• The wedge
• The pole and flag
• Triangles

As these patterns usually play out in a very specific way, the analyst can make accurate prediction about future price movement.

A serious shortcoming of this way of looking at price is that the creation of these lines and levels are subject to a lot of discretion on the part of that particular analyst. This means that four different discretionary analysts would draw their levels at slightly different prices on the same chart. They do this based on their experience, their own emotional state and their unconscious bias towards desired price movements. Being human, he is also inescapably subject to fear and greed, and will remain so, even after decades of employing technical analysis. The story is told of one of the best technical traders in the world working in windowless offices because he realized how much even the weather affected his outlook on the chart.  (Have you experienced the following: The technical charts in the technical section of newsletters from different banks differing significantly in their “key-levels”, line breaks and expected price targets? This is due to the interference of the analyst’s discretion.)

Finally we get to the Mechanical Technical Analyst, who also looks exclusively at price as the summary of EVERYTHING that happens in the market. As a technical analyst, he disregards the underlying reasons for the movement of price, either fundamental or emotional, and focuses only on the movement itself. But other than the discretionary analyst, he does not draw his lines and levels by the eye, but rather relies on computer algorithms that identify price levels and patterns mathematically. These calculations are based on strict criteria, unaffected by external influence. What the algorithm is programmed to identify is either present in the current market, or not. Four of the same algorithms running on the same data set will yield exactly the same results, every single time.

We are now moving away from discretionary, emotional predictions, away from the hope or gut-feel decision making models, to a sound, measurable, defensive, statistical model. Everything here revolves around probability. What now becomes important is to be profitable after a significant series of trades (usually 30 or more) rather than focusing on a single trade at a time.

Computers allow for fast testing of the accuracy of algorithms against market data for long periods of time.  Twenty years’ worth of data can be analyzed in a few seconds. Once an algorithm displays a consistent mathematical edge, such an algorithm can be used on live data feeds to provide a clear and unambiguous indicator of the most probable future movement. Exact, cold mathematics.

Where the Fundamental analyst is like the gambler studying the machines and making a bet, the mechanical technical analyst is the House. He only plays when he knows for sure that the probabilities are in his favor. He never thinks in the context of one trade or one trend in the market, but rather asks, “What is my profit/loss after  a 1000 trades?”

This enlightened trader no longer worries about losing trades or winning trades, but is concerned only about meticulously following every prediction of his mechanical system, knowing that the model’s mathematical edge will prevail in the end.

We meet with many companies each day and many of them are quick to say that they do not speculate with their forex exposure, but then we find that they will say things like:

• “Here we waited for price to drop. “
• “Price will never go higher than that level.”
• “We will just wait and price will come back. It always comes back again.”

These statements reveal that not only are they indeed speculating but more than this, basing their decisions on dreams and hopes and wishes, putting them in the category of the gambler who also holds his thumbs and watches the tables anxiously to see how the dice will fall.

We do NOT want you and your company to be like this. There are so much better methods out there.

So it comes down to:

• Do you have a measurable, repeatable system for your exchange decisions?
• Or do you shoot from the hip, with each decision a stand-alone event?
• Do you sometimes execute great, profitable trades, but then realize you do not know how you did it?
• Does your system have an EDGE in the market?
• Do you know what your edge is? (Can you easily explain it to someone else?)
• And is it a proven EDGE? Tested and measured over time and defending you in all possible market states?

If you have answered NO to any of the above questions we would highly recommend that you use 2014 to review the way you make your forex decisions and get solid systems in place to answer the WHEN question.

We hope this article was helpful, allowing you to stand back a few steps to see a bigger picture.

If you could relate to some of the issues and problems discussed in this article, we would highly recommend that you take a serious look at approaching the forex market in a more mathematical and systematic way.

We would love to hear your comments or questions.