End Year Market Illiquidity

Does year end illiquidity really cause technical analysis to become less accurate?

In short, yes.

One has to remember that one of the basic requirements for technical analysis is that there is mass psychology. Mass psychology means that all market participants are active, reacting to price movement and generating turnover which in turn contributes to the structure of classic chart patterns. On average it is estimated that daily Forex turnover is in excess of US$ 2 trillion, by far the largest of all global financial markets.

By the middle of December many players are beginning to close their books for the year resulting in a much lower level of turnover. This decline in turnover means that large trades tend to have a greater impact than in normal trading volumes. Market traders prefer to remain square or carry small positions since they do not want to suffer losses from such abnormal movements, effectively increasing the level of illiquidity.

Let me give you an example of a market with normal levels of liquidity. Some years ago the trading room I worked in heard of a large transaction in Dollar-Canada of around US$300million. This sort of size, however well it is handled by a trading desk is likely to cause some movement and one might expect at least 25-40 points. The Treasurer took a position of US$10 million in the direction of the order and indeed the rate edged higher by 10 points. Before being able to close the position the rate suddenly reversed and dropped by 50 points.

What had happened? By coincidence there was an order for US$500 million in the opposite direction. It highlights how there is no such thing as market manipulation in Forex and no such thing as insider trading.

I therefore argue that in comparison to other financial markets which have a much smaller daily turnover and are subject to insider trading and the ability of one large participant to have a more significant affect on price direction, Forex is probably the only true market which is perfect for technical analysis. It truly reflects mass psychology.

Returning to the subject of end-year illiquidity, what happens to technical analysis?

Well, I work heavily with Fibonacci and harmonic relationships which I utilize to help identify which movements are related. These produce both retracement targets in corrections and also projected targets for future movements running from 5 minute charts through to monthly charts. All shorter term movements should work within the framework of the longer term movements. During December and the early part of January is that these relationships get pushed out of whack. The wave structures are more erratic and without easy to identify relationships it is difficult to recognize which moves are related.

This most certainly occurred over the last two week in December in particular and it is only this week that there is a stronger build up of more normal wave movements. All in all these do fit into the daily and weekly moves but given that these longer term charts can see a variety of patterns the limits of the support and resistance are wider and the stronger accuracy of normal markets becomes more vague.

Thus, when considering your own analysis and trading do be aware of the attendant risks during these illiquid periods. December and early January are the most affected but there can be similar dips in liquidity, but not quite so extreme around major holidays or financial year ends such as end March, Easter and quite often in August. Try and keep your positions during these periods to the minimum and trade less.

"Vibrating Prices" and the Trading Philosophies of W.D. Gann

William Delbert (W.D.) Gann is regarded as one of the pioneers of technical analysis and market behavior. He wrote several books on stock and commodity trading and developed the well-known "Gann angles" and "Gann Fans."

Gann was born on a farm near Lufkin, Texas, in 1878. His rise to trading fame is a remarkable story. He was the oldest of many children on the farm, and did not even finish grade school. Back then, it was not uncommon for the oldest boy to quit school at a relatively young age and stay at home to help out on the farm.

However, W.D. did not want to be a farmer. He wanted to be a businessman. For a short period of time he worked for a brokerage in Texas while attending business school at night. He then set out for New York City in 1903.

In 1919, at the age of 41, Gann quit his job with a stock brokerage and set out on his own. He began publishing a daily market newsletter called the "Supply and Demand Letter." The newsletter covered both stocks and commodities and provided traders with his annual market forecasts.

In 1924, Gann's first book, "Truth of the Stock Tape," was published. A pioneering work on chart reading, it is still regarded as one of the best books ever written on the subject.

Gann's market forecasts during the Roaring Twenties were reportedly 85% accurate. The stock market in the 1920s was skyrocketing, but Gann didn't think the bull run would last. In his forecast for 1929, Gann predicted the stock market would hit new highs until early April, then experience a sharp break, and then resume with new highs until early September. Then it would top and afterward would come the biggest stock market crash in history.

After around 20 years in New York City, Gann moved to Miami, Florida for reasons of both health and personal preference. His "How to make Profits in Commodities" book came out shortly thereafter.

Following are the general tenets of Gann's trading philosophies and methods. I won't go into great detail on his specific methods in this feature. If you want to learn more about Gann's specific trading methods, I suggest you read his books, or books written about Gann, some of which are available at www.amazon.com.

Gann designed several unique techniques for studying price charts. His main theory uses three parameters to project changes in price trend and market direction. They are: Pattern, Price and Time. These parameters can exert their influence individually, with one or the other being more determinate under different conditions. But they are best applied in a balanced manner. The basic idea is that specific geometric price patterns and angles have special properties that can be used to predict future prices.

He believed the markets are geometric in design and in function, and they follow geometric laws when they're charted. All of Gann's techniques require that equal time and price intervals be used on the charts. Thus, a rise of one price unit over one period of time (1 x 1) will always equal a 45-degree angle. Gann believed that the ideal balance between time and price exists when prices rise or fall at a 45-degree angle relative to the time axis. This is called a 1 x 1 angle.

Gann angles are drawn between a significant bottom and top (or vice versa) at various angles. Deemed the most important by Gann, the 1 x 1 trend line signifies a bull market if prices are above the trend line, or a bear market if below the trend line. Gann felt a 1 x 1 trend line provides major support during an uptrend, and when the trend line is broken it signifies a major reversal in the trend. Gann identified nine significant angles, with the 1 x 1 being the most important.

Gann said each of his predetermined angles provide support and resistance depending on the trend. For example, during an uptrend the 1 x 1 angle tends to provide major support. A major reversal is signaled when prices fall below the 1 x 1 angled trend line. Prices should then be expected to fall to the next trend line (the 2 x 1 angle). As one angle is penetrated, expect prices to move and consolidate at the next Gann angle.

Prices have a way of repeating themselves--or "vibrating," as Gann put it. One can think of vibration in terms of periodic oscillation, the theory of waves, or cycles, as in cycle theory.

Gann said in his own words, "Through the law of vibration, every stock and commodity in the market place moves in its own distinctive sphere of activities, as to intensity, volume and direction. All the essential qualities of its evolution are characterized in its own rate of vibration. Stocks and commodities, like atoms, are really centers of energy, and therefore, they are controlled mathematically. They create their own field of action and power--power to attract and repel, which explains why certain stocks and commodities at times lead the market and turn dead at other times. Thus, to speculate scientifically it is absolutely necessary to follow Natural Law. Vibration is fundamental; nothing is except from its law. It is universal, therefore, applicable to every class of phenomena on the globe. Thus, I affirm, every class of phenomena whether in nature or in the markets, must be subject to the universal laws of causation, harmony and vibration."

There is no question that Gann's trading track record in the 1920s was truly remarkable. And, his trading methodology certainly has merit. However, I think the most important tenets of Gann's success were stated in a paper published by Gann's grandson, edited excerpts of which are below: "Delbert Gann of Lufkin, Texas, started with nothing. He and his family had no money, no education, and no prospects. But less than 40-years after overhearing businessmen talk on railroad cars in Texas, W.D. Gann was known around the world.

"Hard work pays. W.D. Gann rose early, worked late, and approached his business with great energy. Virtually all his education was self-administered. This teacher, writer, and prescient forecaster had a third-grade formal education. But he never stopped reading.

"Unconventional thinking may have its merits. W.D. was intellectually curious to an extraordinary degree. He was unafraid of unorthodox ideas, whether in finance or in other areas of life. He wasn't always right--none of us are--but he dared to pursue a better idea.

"And finally, the only lesson for traders I will venture to offer is W.D. Gann never stopped studying the market. Even after his forecasts happened, even after he achieved international acclaim. Although he believed in cycles, he also knew that markets are always changing and that decisions must be made based on today's conditions, not yesterday's."

W.D. Gann's personal characteristics, as related by his grandson, are strikingly similar to two other famous traders of Gann's same era: Jesse Livermore and Richard Wyckoff.

EMA's: Where They Belong in Your Trading Toolbox

The exponential moving average (EMA) is a less popular but more sophisticated version of the simple moving averages. You need a computer trading program such as FutureSource to employ an EMA indicator. With the EMA, more importance is put on the recent price action, but all the price data in the futures contract is used. I'll define the EMA below and then I'll discuss how I use and rank this trading tool in my "Trading Toolbox."

An EMA is another type of moving average. In a simple moving average, the price data have an equal weight in the computation of the average. Also, in a simple moving average, the oldest price data are removed from the moving average as a new price is added to the computation. The EMA assigns a weight to the price data as the average is calculated. Thus, the oldest price data in the EMA are never removed, but they have only a minimal impact on the moving average. The EMA calculation is achieved by subtracting yesterday's exponential moving average from today's price. Adding this result to yesterday's exponential moving average results in today's moving average.

The main use of the EMA indicator is its smoothing out function. In this way, the moving average removes short-term fluctuations and leaves to view the prevailing trend. This can be important because simple moving averages tend not to work well in choppy trading conditions.

Many trading programs display the EMA as a crossover trading system. For a crossover system, you may insert three different exponential moving averages. Generally, the lengths for these moving averages are short, intermediate, and long term. A commonly used system is 4, 9, and 18 intervals. An interval may be in ticks, minutes, days, weeks, or months; it is a function of the chart type. The closing price is used by most systems when calculating the exponential moving average. On many systems, however, you may specify a different price to use in the calculation (open, high, low, close, midpoint, or average price) by changing the computation of the EMA.

If the EMA crossover trading system is used, a buy signal occurs when the short- and intermediate-term averages cross from below to above the longer-term average. Conversely, a sell signal is issued when the short- and intermediate-term averages cross from above to below the longer-term average. Another trading approach is to use the "current price" method. If the current price is above the exponential moving averages, you buy. Liquidate that position when the current price crosses below your selected moving average. For a short position, sell when the current price is below the EMA. Liquidate that position when the current price rises above the EMA.

I use the EMA as one more "secondary" trading tool, along with most other computer-generated technical indicators that fall into that category. I use the EMA less often than simple moving averages. I use "secondary" trading tools to help confirm my ideas that are derived from my "primary" trading tools, which include trend lines, chart patterns, market psychology and fundamental analysis.