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Behavior of Stock and Forex Markets and The Characteristics of a Profitable Trading System


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Anyone who really follows these markets knows that the underlying prices fluctuate, often violently, due to changes, and equally effectively, due to rumors about changes in various factors. These factors include not only the company and sector-specific conditions, but also economic and geopolitical as well as the general market environment. Thus a nice looking trading system that promises to achieve a desired goal somewhere along the yellow brick road as long we follow the buy and sell arrows, may be totally misleading.

An example of where we are misled by some of the trading myths is the way of advertising a presumably sound method of controlling the losses. Such advertisements claim that we can never lose, for example, more than two percent in any trade when we put our stop loss limit at two percent below our purchase price. As explained in the following paragraph, the concept is not that simple in practice.

Let us say I buy one hundred shares of a stock at a price of one hundred dollars each, and put a stop loss limit of two percent below the purchase price. This means that the stock automatically sells at the market price when its price decreases to ninety-eight dollars or less. If the price gaps down to eighty dollars, which is very likely in any of the markets, it will immediately sell at a price of eighty dollars or less, resulting in a loss of at least twenty percent, and ruthlessly reducing my original investment of ten thousand dollars to at most eight thousand dollars less commissions. A similar experience is possible in the currency trading.

There are two major types of market analyses - fundamental and technical. The former analysis relies on the company's earnings per share, price earnings ratio, growth adjusted ratios, dividends, and forecasts of one or more of these measures as well as on the general market and economic conditions including the interest rate environment. The technical analysis applies both to the stock and forex markets, and examines statistics such as moving averages, relative strength indicators, cumulative distributions, price oscillators, stochastic measures and host of similar other factors. However, the market conditions may occasionally prove some or all of these measures to be somewhat irrelevant. The following paragraph briefly describes the application of moving averages.

A moving average (MA) is an average of prices over a period of time, and may be used to determine trend direction or to indicate support and resistance areas. Thus when the MA rises, it is a buy signal when prices dip near or bit below the MA. When the MA falls, it is a sell signal when prices rally towards or a bit above the MA. In addition, a rising MA tends to support the price action and a falling MA tends to provide resistance to the price action. There are two types of moving averages, a simple moving average (SMA), and an exponential moving average (EPA). EPA applies more weight to the more recent prices, and thus follows the prices more closely than SMA. Moving averages do not get us into a trade at the exact bottom and out of it at the exact top. They tend to ensure we're trading in the general direction of the trend, usually with a delay at the entry and exit, EMA resulting a shorter delay than the SMA.

A viable system for trading the markets, while based on a solid mathematical foundation, has to be dynamic enough to take into account the possibility of any of the unforeseen events. It should be designed to incorporate the latest possible information, and the support system should be flexible and continuous. There should be a provision to correct a wrong move before it becomes too expensive. It is always good to remember that past performance is not indicative of future results, and while there is potential for huge profits, it is also possible to lose money in each of these two markets.

[Source: Money and Investment page of http://onlinesalesplus.]


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