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Traders Need To Treat The Markets Like A Battlefield
Education | 20 March 2014

This article is written by Chris Westin from IG.

When trading you need an edge, something that gives you a statistical advantage over the other players within a market. It also means you have to have a tested plan and stick to it. More importantly, it means you need to understand the types of players that are in a specific market at any one time, so you can get a deeper understanding of the daily flows that are occurring and potentially why these flows are taking place.

There is a huge difference in the participation of each asset class and as a result this can greatly affect the way we should think about investments and trading. Take the equity market for example. There is a universal understanding around the ‘fair value’ of stocks, which we know to be the net discounted cash flow of future earnings.

Investment managers will look at this in great detail and the value focused community will buy when they recognise this value and cut back on positions when they feel valuations have become stretched. Naturally traders will also look at the same valuations, with more aggressive traders looking to get ahead of the curve and position themselves for a potential move from these big-money managers.

Of course then we have trend followers who will be a little later to the party, and require evidence that the market is thinking as one before jumping on a price rise (or fall), catching the body of the move and going with the idea of ‘buying high and selling higher’.

Ultimately the equity market is a mechanism for wealth re-distribution, but the bulk of participants are speculating to some degree. Trend traders feel they have the edge because they generally have a back-tested model, which they religiously stick too. While the investment community argue that if you buy a quality business with a strong balance sheet in the right sector, combined with a solid history of sales and earnings growth, then you are likely to see positive results.

In the bond market, investors will buy and sell bonds around the net discounted cash flows of future interest payments and principle. Like the equity market you will naturally get traders acting on either a fundamental view around where price (or conversely yields) should be, or on pure technical indicators, letting the market be their guide as to where price should be. Still, once again price discovery predominantly comes from participants trading around a view.

The fact that speculation in these two key asset classes is the significant driver doesn’t make life any easier to be profitable. However, we can get a good sense of what the long and shorter-term money is trying to achieve. In the forex market things are very different and in theory this is why trading and investing in forex markets can be more difficult, at least from a participation standpoint.

In reality there is no agreed model of ‘fair value’ in the forex market, although, in theory we know that an exchange rate reflects the relative price of goods and assets between two economies. Naturally misalignments can occur and this is what the speculators thrive on. However, speculation is only one sub-set within this massive $5 trillion a day market. We need to be consistent that there are exporters (real-money), investment banks hedging portfolios or looking to buy foreign assets, central banks buying and selling currencies for diversification purposes and many more players moving money around, creating capital flows, which is ultimately what the currency market is all about.

Speculation does play a role, but it is not the only role and this is what makes life much harder, as there are so many variables going on at one time. For example, we may see EUR/USD rally as an emerging market central bank buys Euro’s for diversification reasons. Naturally as retail traders we wouldn’t hear about this until it is reported weeks later.

It’s for this reason why we must respect and understand price action and therefore technical analysis should play a key role in any forex traders plan. Technical analysis rationalises human behaviour and tells us what is happening at any one time and when utilised with a sound risk and money management system can give anyone an edge over the market.

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