Introduction to Fibonacci Numbers & Trading

In the field of mathematics, Fibonacci numbers (alternatively called the Fibonacci Series or Fibonacci Sequence) are the numbers featured in the following integer series:

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584, 4181, 6765, 10946, 17711, 28657, 46368, 75025, 121393 ……. and so on.

This particular integer series was first discovered by Leonardo of Pisa, who was also known as Fibonacci. The Fibonacci numbers display a recurrence relation, a series of Fibonacci numbers is started with a 1 which is then followed by a 1, with the third number being calculated from the first two (1+1) and so on. So for example in the sequence above the fourth number (3) is calculated by adding the second and third number together (1+2).  Which is easy enough to understand.

This Fibonacci numbers are then interpreted in a rather interesting way. If you begin measuring the ratios of each number next to one another you will get what are often called Fibonacci ratios. These ratios are the same numbers that often used in various forms of technical analysis. The ratios are as follows:  0.236, 0.382, 0.500, 0.618 and 0.764. These ratios are used in a number of different Fibonacci tools which are meant to help the trader predict changes in market direction.

Those who endorse Fibonacci ratios simply assert that you just need to understand how to use this magic ratios alongside technical analysis. With it being claimed Fibonacci ratios can be used to identify both support and resistance levels. Why are these ratios supposed to operate as both resistance and support levels? Well, there is no clear reason why this should be the case. However it has been asserted by some that we subconsciously seek out these so called golden ratios. A more plausible but hardly believable explanation may be that we are not psychologically comfortable with particularly long trends meaning that particular ratios or numbers often signal the end of trends.

There are five different types of trading tools which are derived Fibonacci’s discovery namely Fibonacci arcs, fans, retracements, extensions and time zones. All of which I will outline at a later date. The lines created by these different methods of using Fibonacci ratios are often believed to signal changes in trends when prices draw close to them.

Some have contended that Fibonacci tools can predict market movements with accuracy rates of above 70%. Many believe the use of Fibonacci numbers is both risky and time consuming though recently a number of tools have been developed to help traders easily calculate things such as Fibonacci retracements. However many traders struggle reading and implementing the results which means many would better of not using Fibonacci as compulsory support and resistance levels.

I am personally of the opinion that the majority of the alleged effectiveness of the Fibonacci, is down to the influence that Fibonacci studies have had on many traders and are not down to any real market driving forces. During times when the market is relatively quiet the Fibonacci tools work effectively due to the fact that there are thousand of traders who are putting their faith in these tools. With a cascade of traders artificially creating these resistance and support levels. This characterization seems particularly accurate as it appears that Fibonacci tools work better when trading Forex than other instruments. This I contend is partly due to the fact that Forex traders generally have a greater faith Fibonacci tools, therefore creating a self fulfilling prophecy.
In conclusion it appears that Fibonacci tools could be useful tool. However there are not a tool which should be overly relied on. The best approach being to use Fibonacci tools in combination with other methods. In future I will outline how one can use the different Fibonacci tools to help identify changes in market direction.

How did Karl Popper Influence George Soros’s Trading Philosophy

Who is George Soros

George Soros was one of the most successful money managers of the 20th Century whose funds consistently outperformed the S&P500.; Soros from very humble beginnings has acquired a huge amount of wealth, with his net worth estimated to be around \$22 Billion. Soros is most famous for his involvement in Black Wednesday when the British Government was forced to leave the Exchange Rate Mechanism as they were unable to maintain their currency peg against the strong Deutsche Mark. It is estimated that Soros made a billion dollars on that day alone. He is also known for his support of the Open Society Institute founded by Soros himself this foundation expounds a political philosophy influenced mainly by 20th Century Philosopher Karl Popper. What is less often recognized is the role that Karl Popper’s thought played in George Soros’s trading philosophy.

Karl Poppers Thought on Soro’s Trading Philosophy
Karl Popper was primarily interested in the philosophy of science, with the problem of demarcation and induction remaining at the forefront of Popper’s thought. Popper thought rather than trying to verify a theory by looking for instances that confirmed a hypothesis, science advanced by attempting the refutation of theories. This became known as falsification. There are two reasons why Popper thought falsification was superior to verification. One it avoided the problem of induction, which states that induction cannot be proven by experience nor can it be proven by reason as it is not analytic. It also avoids stops scientists and pseudo scientists from simply adding ad hoc sub hypothesis. The case can be clearly demonstrated with psychoanalysis which Popper held to be a pseudo science, Freud held that sex was dominant motive behind human behavior was sex, it is possible to take any behavior and rationalize it in a way which makes it coherent with Freud’s hypothesis. This is similar to some of the contentions made by many offering trading strategies or systems which then begin to become unprofitable. They then ad hoc assert that the system is only suitable for certain market conditions or currency pairs etc, or that it should be selectively used. Their are many instances in Popper’s own wealth management career when he actively looked for ways to falsify his own beliefs, rather than just look for instances which verified them. For a good account of George Soro’s wealth management career check out the book More Money Than God

The other major element of Karl Poppers thought adopted by Soros in his trading pursuits comes from Popper’s political thought. In the book the Open Society while outlining his complaints against Plato, Marx and Hegel who he criticizes for promoting totalitarian ideas. He introduces the concept of piecemeal social engineering. Popper believes when we want to make societal changes for the better, they should be very small and precise so it can be monitored what role the change makes in the grand scheme of things. If changes are too stark and radical it is impossible to tell which one of the changes made the difference. As it is impossible to tell which changes played causal role in the grand scheme of things. Soros took this idea and applied to trading. Often when Soros made changes to his outlook or position, he would make small change to his trading style or the positions held. Making slow changes until his convictions became firmer and then making a more full scale commitment or change to his position. This can be seen in both his shorting of the Thai Bait and his shorting of the Pound.

What Character Traits make a successful trader?

You often find people discussing and debating what character traits make for a successful trader. It seems to be a very difficult to pin down what differentiates those who are hugely successful traders and those who are not. Part of the difficulty in making such a distinction seems to lie in the fact that the world of finance is filled with a eclectic array of characters. Those who have been very successful in the world of finance range from those who are hugely instinctive and those who are deeply academic and analytic. This is partly due to the wide range of trading strategies, with some traders basing their judgments on sentiment, others technical indicators, others underlying fundamentals and those who combine various techniques. It is also clear that the various activities traders and investors undertake differ significantly with the basis for entering a trade being hugely different. With the activity of a pit trader being unrecognizable to those who adopt a fundamental approach to trading and investing.

Some who adopt the efficient market hypothesis or versions of the random walk hypothesis, will reject the idea that there are particular characteristics that differentiate those who are successful traders from their less successful counterparts. This is due to the fact that any long term success is down purely to luck with some traders being lucky while others are not. At first glance this hypothesis seems to be intuitively false. But once you examine the number of players trading any given market the hypothesis becomes more plausible as you can see how it would be statistically possible for a given trader to hit a long winning streak due to pure luck alone.

Personally I don’t believe those who expose such theories. Though I do hold that it is likely that some traders do genuinely have long running streaks that can be attributed to nothing more than luck, it is clear to me that when you study the character and personalities traits of successful traders their seem to be several characteristics that are prevalent in the vast majority of these individuals. Today I’m going to outline what I believe these particular traits are.

1. Love of Knowledge
One thing that can witnessed in many top traders is their love of knowledge. Often those who have been extremely successful traders have a love of knowledge both for its instrumental and intrinsic value. The financial market places are a complex and ever fluctuating place, where relationships and correlations are breaking down and forming all the time. For anyone to remain successful in such a dynamic market place constant study and research is required. It would be foolish to belief that any strategy will really stand the test of time. A prime example of such a love of knowledge can be examined in the eminent hedge fund manager and investor George Soros who has been deeply influenced by the philosophy of Karl Popper in both his political and trading activities. Popper promotes the notion of falsification which means that we should attempt to falsify our hypothesis rather than verifying them and this idea has played an important role in Soros’s trading strategy and philosophy throughout the years.

2. Self Discipline
One of the most important characteristics I believe to be present in all those who are successful in the long term is a healthy dose of self discipline. Every aspect of trading takes discipline, even entering a position based on your trading strategy of philosophy takes discipline. Sometimes you will also have to recognize your mistakes and be able to exit a losing trade in order minimize the potential loss. Trading can effect the psychology of a trader in similar way to Gambling effects the gambler and avoiding falling into this trap takes serious discipline and will (Analogy between Gambling and Trading based on Skinner’s Psychology research into the effect of random payouts on the behavior of pigeons and humans). I would challenge anyone to find a trader who has a long history of success who also doesn’t exhibit self discipline at least within the realm of trading the financial markets.

3. A Degree of Risk Adversity
Protection of capital is one of the traders key concerns and also one the key problems facing traders. In order to make profits when you are correct you must have the capital at your disposal to take advantage of such situations. Any trader who doesn’t take a sensible approach to risk and is to Gun-ho in regard to risk won’t be around for a long time. It can be show that scenarios that are taken to be highly unlikely happen more often than commonly thought. While self discipline is important factor in risk management, it is important to note that certain individuals seem more prone to rash irrational risk taking and research in psychology seems back up such intuitive claims. People who are prone to taking such risks would probably be better off avoid engaging in trading. A sensible approach to risk is vital to every successful trading strategy and trader something that cannot be stressed enough.

What is ETF arbitrage?

Today I am going to take a look at ETF arbitrage. For those who don’t already know what are I will give a quick explanation. ETF’s (Exchange Traded Funds) are funds that are composed of different asset classes and are designed to give exposure to a particular area. Whether that be Indices, Geographical areas or business sectors. The majority of ETF’s are related to Indices but a number of ETF’s are designed to give more niche exposure. For example the OIH Oil Service ETF provides exposure to companies that provide services for the Oil sector while the iShares EU50 gives exposure to 50 large cap companies across Europe.

ETF’s are generally used as either as an investment vehicle (attractive as they have lower fees than actively managed funds) or as a tool to take on exposure to particular niche’s or regions. In theory an ETF should trade around the NAV per Share (Net Asset Value), which is worked out by taking the total value of the assets held by the ETF and dividing this by the total number of Shares.  For example take an Imaginary ETF called the Luxury Fashion ETF which holds Shares in various fashion companies. The ETF holds £100 million pounds of assets at the close of trading on Friday, the total number of shares or units in the ETF numbers 12.5 million. So the Net Asset Value per Share will be £8.

But this commonly not the case, with many ETF’s diverging significantly from the NAV per Share. This can allow traders to take advantage of such divergences by Buying or Selling the ETF when such a divergence occurs. An example commonly sighted is the 2010 flash crash when the US Dow Jones plunged a thousand points in minutes. The magnitude of the flash crash was felt to an even greater extent in some of the ETF’s that are meant to track the S&P500.; At one point during the crash IVV ETF diverged -12.00% from the S&P500.; Meaning that the the IVV was significantly undervalued and a trader who purchased the said fund at the time was likely to earn a killing.

Of course these divergences are eventually corrected but recognizing these divergence and trading at the point of significant divergence can lead to significant profits for the arbitrage trader. Though there is the potential for profit from such arbitrage activities they also inherently involve certain risks. Part of the reason fro the deviations commonly encountered in ETF prices in comparison to the underlying value of the assets, is that ETF’s commonly have a lot less liquidity making it more difficult to enter and exit positions. In fact derivatives can offer benefits for those who wish to take advantage of such ETF arbitrage opportunities as some of the liquidity issues are not pressing, though the use of leverage increases the risk as well as the potential rewards. Successful arbitrage traders can expected to make significant returns on capital.

What are the Potential Dangers when using Expert Advisors?

While Expert Advisors (Metatrader) and other automated trading programs clearly represent a huge step forward in the world of trading. There are also several reasons to take a considerable degree of caution when using Expert Advisors to trade the financial markets. By taking a sensible approach to the use of Expert Advisors they can become a powerful tool in your trading arsenal.

Today I’m going to outline some of the things you should be wary about when using an Expert Advisor or other automated trading program.

Backward Optimization
Many Expert Advisers or other automated trading programs that are sold to the public or created and refined by yourself look better than they actually are. Take a claim about the performance of a particular program or Expert Advisor such as the program having reported a 230% return over the last six months. Digging deeper into the statistics may reveal that this performance only holds up when applied to one particular currency pair. Such reported results can be even more misleading if the currency pair has been on a long term rally, as a simple long biased indicator would perform brilliantly in these circumstances. So when either purchasing, using and testing try to determine how the program or expert advisor will perform in a variety of different market circumstances.

Correlations Breaking Down

Black Swan Events
A Black Swan event is essentially an extremely rare event, recent financial research has shown that these Black Swan events occur much more frequently than financial models take into account. While most programs have a clear get out when such an event happens (namely Stop Losses). There is still the problem that trading in such conditions may lead to your trading capital being significantly depleted. The key is to get out of markets when they may be undergoing a Black Swan event which your Expert Advisor may not be equipped to deal with. In practice this is much harder to do than first appears, but hopefully you will never have to experience such an event. It would be somewhat paradoxical to tell you to be aware of the unexpected.

Binary Options Regulation, a contentious issue?

Binary Options represent a growing area of the Over-the-counter financial product industry. But many of the players in the market place are not subject to regulation. This puts those who wish to trade Binary Options in a very precarious position, as Binary Options are a unique product that many people would be interested to trade. Especially as I feel that many of the options offered by these new start up providers may be mispriced. But I would be extremely nervous about trading with an unregulated broker.

Why is this new market widely unregulated? Well it appears that the regulators that are part of MiFID, do not wish to take responsibility for their regulation. A recent statement by CySec (one of the members of MiFID) has stated that they do not believe that Binary Options do not count as a financial instrument under law (Check question 6 here). This is patently absurd as they clearly are a financial instrument, this has lead many providers to base themselves in Cyprus in order to avoid regulation. Recently the French financial regulator issued a warning about unregulated Binary Option providers on their website (Can be found here). Update: 20th Feb 2013: On the 4th May 2012 CySec issued a statement regarding the regulation of Binary Options, you can read the full story here.

This leaves many providers taking the Gaming Route. It is much easier to become licensed as gaming firm in a European country such as Malta at the cost of about 40-100k. This is a somewhat unsatisfactory middle ground to take. A regulated gambling firm is clearly desirable to no regulation at all and is the route that was recently taken by Binary Options site OneTwoTrade.com. Though again I would prefer if a complicated financial instrument such as Binary Options fell under financial market regulation such as the case is with Financial Spread betting in the UK.

Well what are your options if you want to trade Binary Options but with Financial Regulation provided by a financial regulation. The answer unfortunately is their seems to be only one established provider and that is GFT whose Binary Options platform is regulated by the UK by the FSA. This regulation is provided by the FSA, as the Binary Options are provided in the form of CFD’s or as a Financial Spreadbet. Again not a perfect remedy to the situation but this seems the best that is on offer at the moment.

If you want to see more widespread regulation of Binary Options throughout Europe I suggest that you apply pressure to the regulatory regime in your country. By doing this more pressure will be placed on regulatory authorities and they may take heed and hopefully take action.

What is the Baltic Dry Index and why is it important to you?

The Baltic Dry Index is an index which is released daily by the Baltic Exchanges based in London, United Kingdom. The index provides shippers with an abasement of the price moving various raw commodities across 23 shipping routes worldwide. The price of the Baltic Dry Index is used to price many kinds of shipping contracts, much like how the LIBOR & LME prices are used to price various contracts. The Index figure is released everyday at 1pm GMT and the value of the index is reported widely in the financial media. The information can be found for free on the Bloomberg Website.

The Index has become widely followed in the financial world while most directly the index measures the demand for dry bulk shipping versus the global capacity for such shipping. But the Index is considered one of the best indicators of global economic activity. As the movement of raw materials is vital to precursor to production. The Index gives a real time look at the demand for raw materials. While it can be argued that such real time demand can be inferred by looking at commodity prices, their are number of things pollute the data. Futures contracts, speculation and hedging all play a role in setting commodity prices and may not reflect the real demand for the underlying commodity. The Baltic Dry Index, is traded on the Baltic Exchange which is only open to member companies, leading to significantly less speculation with only limited hedging activity occurring (different member companies take a different approach to hedging, some hedge significantly and while others minimally).

The price of the Baltic Dry Index can also be used as an indicator of potential inflation and cost increases for businesses. A rise in the price of the Baltic Dry Index gets passed along to producers who then pass these price rises onto retail businesses and eventually to the end consumer. The Baltic Dry Index only plays a limited role in this regard, as their are numerous factors at play when it comes to price levels in the general economy. Though some companies are effected more than others, as some companies rely more on globally shipped raw materials than others. If these cost increases aren’t passed along to consumers then margins will decrease.

While the Baltic Dry Index is a very useful tool for determining global demand. There are several other factors not related to demand for dry shipping that can effect the price of the Baltic Dry Index. So when making decisions on the basis of the price of the Baltic Dry Index, try and determine what other factors could possibly be at play. One possibly way to do this would be to monitor the news surrounding the Baltic Dry Index which can also be found on Bloomberg.

There are numerous dry bulk shipping companies listed both in the US and elsewhere. When investing in or trading these companies, your investment or position will be very highly correlated with the price of the Baltic Dry Index. Though as previously mentioned different dry shipping companies take different approaches to hedging, so the degree particular companies performance will be correlated with index varies.

Forex: Technical Analysis vs. Fundamental

For those who don’t know the dichotomy between technical and fundamental analysis, I will quickly outline it. Technical analysis is a method which uses the study of past market action as a method of predicting future price movements. Whereas fundamental analysis looks at the fundamentals of a particular currency, which include Government policy and supply and demand. A lot of trading strategies successfully combine the two, while others favor one or the other.

The majority of over the counter retail traders seem to largely ignore the fundamentals behind a particular currency rather paying attention only to technical indicators. One of the key reasons behind this that over the counter traders are mainly opening positions to try and take advantage of short term movements in prices. The standard way most day traders decide what trades to place is by using various charting techniques. While this can be an effective strategy, many traders completely overlook the fundamental factors completely.

Why do the majority completely ignore fundamental factors? The main reason seems to be that a fundamental approach takes a much longer time to pan out. This doesn’t suit over the counter traders who are often trading using derivatives such as CFD’s and therefore have to factor in over night costs of keeping a position open for a considerable amount of time.  This costs could potentially eat away at any profit that might be made by taking a longer fundamental based approach to Foreign exchange. This is not a problem for a big institution such as a hedge fund or investment bank who can trade Forex on the international markets, unless the said institution is heavily leveraged.  For example George Soros’s Quantum Funds had to wait out a significant period for their short position on the Thai Bait in the 90’s to come to fruition.

While for most over the counter traders taking a long term fundamental approach has some serious and obvious downsides (roll over costs etc.). I contend that every trader should have an understanding of the fundamental factors at play when trading Forex. The reason that a lot of news stories cause price changes, is they either change the fundamentals behind the currency price or they give indications that the fundamentals may be changing. I would recommend that as Forex trader you go and research the fundamentals behind Forex prices, there’s a lot of good information out there for you to consume.

Understanding Parabolic SAR

The Parabolic SAR was originally created by the now famous technician Welles Wilder, who also happens to be the creator of the relative strength indicator. The Parabolic SAR is technical indicator which is used to determine the direction of an instruments price movement. While also being used to determine when this momentum as displayed by the indicator has a high probability of switching direction. This has led the Parabolic SAR to become known as the stop and reversal indicator.

The indicator is pretty simple to understand. Dots above the price are taken to be a bearish sign and dots below the current price are taken to be a bullish sign. As you can see on the chart above the Parabolic SAR lies below the price for a bulk of the chart which see’s a sustained rise in the price of the stock in question. It is also taken that the narrowing of the gap between the dot and the actual price represents as a sign that the current trend is about to end, with a switch momentum being a distinct possibility. It is important to take a minute to note that the Parabolic SAR is an accelerating system which allows a trader to watch a trend develop and establish itself in real time, while this works very well when there is a strong trend occurring. But the relationship seems to break down in sideways market places which sees the Parabolic SAR producing many fake signals.

While the Parabolic SAR is a favorite among many traders, partly due to it’s simplicity, it is often used in conjunction with technical indicators. This is in part to due the fact that the Parabolic SAR is known to provide it’s user with some false signals. One suggested signal to be used in conjunction with the Parabolic SAR indicator, is a relatively long term moving average as this can help establish trends more accurately. Though a variety of indicators have been suggested to be used alongside Parabolic SAR with various positives and negatives.

Understanding The Commodity Channel Index

Designed by Donald Lambert, the Commodity Channel Index first appeared in Commodities magazine in 1980. The Commodity Channel Index is a diverse indicator which can be used to identify new trends or act as a warning against extreme conditions. Donald Lambert originally created the Commodity Channel Index in order to identify new cyclical changes in commodity prices. But others have applied the Commodity Channel Index to instruments diverse as Indices, Stocks and various other securities. The Commodity Channel Index measures the current price level relative to the average price level over a selected period of time. Click on image to enlarge.

The Commodity Channel Index as calculated by Donald Lambert ensures that between 70 and 80 percent of Commodity Channel Index values should fall between -100 and 100+, though during longer time periods a larger number of values will fall outside the -100 and 100+ range. As the Commodity Channel Index measures the difference between an instruments recent price change relative to it’s average price change. A high positive reading indicates that prices are significantly above their average which can be taken as a sign of strength. While a low negative reading indicates that prices are below average and can be taken as a sign of weakness.

As previously mentioned in Donald Lambert’s original calculation 70 and 80 percent of the values should fall between -100 and 100+. The Commodity Channel index can be used as both a coincident or leading indicator. When used as a coincident indicator, a value above 100+ is taken to reflect strong price action which may signal the start of an upturn. While conversely a value below 100- is taken as a sign of weak price action that may signal a downturn. When one is using the Commodity Channel Index one should be careful in order to avoid the many whipsaws that occur with the indicator and I would personally suggest adding another indicator to the mix.