Showing posts with label swings trading. Show all posts
Showing posts with label swings trading. Show all posts

Swings Trading ( Price Action Trading )



Swings ( waves ) are PA formations, described as an impulse, followed by a correction, during trends and counter trends. Every trend have ups and downs (swings ).

Best way to see the swings, is to draw them manually, connecting with lines the Higher Highs and the Lower Lows.



Now all we have to do is to mark the swings:

HH = Higher High
LL = Lower Low
LH = Lower High
HL = Higher Low



So for an UP Trend ( bullish ) we will have swings:

LL-HH-HL-HH-HL...

And for a DOWN Trend ( bearish ) we will have swings:

HH-LL-LH-LL-LH...

So based on the swings and PA, we might use the next strategies:

1. Trend Lines BO 

2. Support & Resistance Lines ( S/R Lines )
3. Channels

For trading the swings, SL should always be a large one ( previous HH or LL ).


Best Regards,
^^_Lord_Ice_^^





Moving Averages ( MA, SMA, EMA )


A Simple Moving Average is the average of a series of prices, over a period of time which is constantly updated by dropping the oldest value and then adding the newest value and recalculating the average.

For Exponential Moving Average, the formula is changed and the last prices count more than the oldest ones.

MA is used for trading, as a "mobile" Trend Line or S/R Line ( range market ), because every time a new candle is closed the "line" is drawing that change in PA.

Also, MAs, even if there aren't used as crossing strategy, can be used as trend indicator ( like a TL, adjusted every time a new candle is formed ).

There are many ways we can use it as trading strategies, too.

1. One Moving Average BO

For example we can use 50 SMA, like this.



1. Always use the direction of the MA to establish trend for swing
2. When 50 SMA point UP, look to BUY only, when 50 SMA point DOWN look to SELL only.
3. After trend is confirmed ( SMA pointing UP or DOWN ), you can open a buy ( in our example ), after PA closed above 50 SMA. SL would be the LL of the candle that made the BO or the previous LH ( we are in a uptrend now ).
4. After that, you can add more positions ( BUY ) on every retest that failed to break below 50 SMA or other crossing ( from below-above ) between PA and 50 SMA. SL would be previous LH or the LL of the candle that made the BO (crossed the 50 SMA ).

2. Two or more Moving Averages Crossing

This is the common use of MAs for trading. For example we can use 20 SMA, 100 SMA, like this.



1. Previous down trend is over, 20 SMA crossed above 100 SMA, we look to BUY opportunity.
2. PA retested the SMA 100 = BUY, SL would be @ previous LL.
3. Candle closed above 20 SMA, you can also BUY , the next candle opening. SL would be @ previous LL.
4. After the BO of the new formed HH, move the SL to next HL ( our entry ) until BE, or use trailing stop.
5. You can also add more BUY positions on every crossing UP ( 20SMA over 100 SMA ), or new closed candle above 20 SMA ( when changing directions again from pointing DOWN to pointing UP - rejection from 100 SMA)

In this way you can also add the 3rd SMA and add positions to the crossing of first 2 ( 20 and 50 ) and use SMA 100 for trend direction confirmation.



If in this example, 20 and 50 SMA, cross below 100 SMA, the long trend is over and we look for sell opportunities only.

3. Moving Averages and TL or S/R Lines

As I said, MAs are also good for indicating ( pointing ) the main trend.



But another way you can use 50 SMA is to confirm BO. One of the best ways to do it is to trade TL's BO on the main swing trend like this.



To read more how to setup the trades using TL's BO systems, SL and TP, go here.


4. 200 EMA using multi TF


This is one of the best trading strategies. Very simple and yet so effective ( you will never be against the trend ).



1. Daily chart, PA is below 200 EMA
2. H4 chart, PA is below EMA
3. M15 chart "bucking" the trend and must also go below 200 EMA.
4. For filtering the entry, on M15, you can use Stochastic oscillator crossing from top to bottom ( crossing 80% - oversold level )
5. SL would be previous @ LH ( down trend ).


Best Regards,
^^_Lord_Ice_^^


Channels



Channels are basically 2 parallel TL drawn on the chart, that contain LL and HH of PA's last swings. There are many ways to trade channels.

1. The common use of channels is to trade it as Trend Lines BO or Pullback ( rejection ).


2. Also, when the formed channel is horizontal we can trade it as S/R Lines BO or Pullback ( Rejections ).



3. BO Boxes Channel Trading Strategy

After we found a channel on higher TF we can lower the TF to M30 to find our first BOX. Then we can use it to keep add positions or to move SL until BE.



Also using same technique with boxes, you could of predict the drawn channel forming since beginning. All you have to do is to find first pullback and make a box of it.



Sl would be opposite BOX direction. You can add positions, move SL ( BE ) when it's BO of the BOX, or use Trailing Stop = BOX pips. ( HH-LL ).

From my experience this work better on London's opening and no important news in that day for the pair you trade.



Best Regards,
^^_Lord_Ice_^^

Support & Resistance Lines ( S/R Lines )

Support & Resistance Lines ( S/R Lines ) are horizontal lines connecting at least 2 previous HH or LL of PA on the chart.



To draw S/R Lines we can use HH/LL or close price, as our R Line from the chart above.

The common mistake of trading these S/R Lines, is to consider them ...lines. S/R Lines are actually Zones.

Normally second R Line is a LH on the chart ( is a resistance when we connect at least 2 previous HH/LL ).




In this example using zones, we could connect our second R Line with previous LL/HH. ( since there are sometimes 10p-20p difference, between those levels ). Using only a line we can't connect them properly.
 
Every broken Support, becomes Resistance and every Resistance broken, becomes Support.

There are many ways to trade S/R Lines.

1. S/R Lines BO Strategy.

After a candle broke a S/R Line and close below you can entry on the next candle opening, with a SL above the candle's high ( our example is a short one ).



For TP you may use Trailing Stop, BE ( moving SL after each further BO ) or find the next Support Zone pullback. ( rejection ).

2. S/R Lines Pullback Strategy ( rejections )

If you look carefully at our previous chart, you will see that was a false BO of the S Line on the bottom of the chart. If we would of drawn a Line, we might of trade it as a BO of S Line.

But since we've considered a S Zone ( connecting the last previous low and the last one ), we look for a candle to close above to entry. ( rejection )



3. S/R + TL BO Strategy


An interesting idea of trading S/R Lines is to combine it with TL.





For trading it like this all we have to do is to lower the TF ( we used H4 and now we entry on H1 - for proper entry and a tight SL ).


4. Pending Order @ Retest previous BO of S/R Strategy

This is one of the best and yet simpliest trading strategy I've ever found.




Ypu can use pending order for this ( after previous BO ), or use rejection from R Zone.
Your SL would be @ new formed HL. For TP you can use previous LL, BE or Trailing Stop.


Best Regards,
^^_Lord_Ice_^^

Trend Lines I ( TL )

A Trend Line is formed by a diagonal line, connecting at least 2 pivot points ( HH or LL ).





I know there are many traders that draw these TL between closing/opening price, but I prefer to draw them by connecting HH/LL. ( with some exceptions when starting with 2 HH/LL and the next taps are fake BO's of the TL ).

So there are many ways of considering an entry using TL.
1. TL's 3rd tap strategy 

Considering an entry by waiting another touch of this TL ( also known as "3rd tap").

If the candle touched the TL and didn't closed below, in our example ( fail to break ), we can open a long position on the next candle open area. SL would be @ previous HL and TP @ previous HH, or Trailing Stop.





For exit you may also use opposite TL broken like in the next example.

2. TL's BO Strategy.

Another common use of trading the TL is to trade the BO.





As you can see in our example, we have 3 opportunities to enter the trade:

Entry 1 - @ retest ( pullback ) of the broken TL.
Entry 2 - @ new formed "HL" of the PA.
Entry 3 - @ the real "HL" of the PA ( since the PA failed to break the HH and formed a LH in top of the chart )

For exit the trade we may consider Trailing Stop or the opposite TL BO.




PA also failed to BO the LL of the chart ( forming a double bottom ) that offer a great exit opportunity. But normally we can use the BO of bearish TL.

3. TL's BO Strategy, following the main trend

Drawing a TL on a higher TF like H1, then lowering the TF to M30, offer us many entry opportunities in the same direction of the main trend.




SL for all those entries might be the BO candle lowest or the last swing HL ( since we have a bullish trend in our example ).


Best Regards,
^^_Lord_Ice_^^

Elliot Wave Principle

The Elliott Wave Principle is a form of technical analysis that some traders use to analyze financial market cycles and forecast market trends by identifying extremes in investor psychology, highs and lows in prices, and other collective factors. Ralph Nelson Elliott (1871–1948), a professional accountant, discovered the underlying social principles and developed the analytical tools in the 1930s. He proposed that market prices unfold in specific patterns, which practitioners today call Elliott waves, or simply waves. Elliott published his theory of market behavior in the book The Wave Principle in 1938, summarized it in a series of articles in Financial World magazine in 1939, and covered it most comprehensively in his final major work, Nature’s Laws: The Secret of the Universe in 1946. Elliott stated that "because man is subject to rhythmical procedure, calculations having to do with his activities can be projected far into the future with a justification and certainty heretofore unattainable." The empirical validity of the Elliott Wave Principle remains the subject of debate.



Overall design

From R.N. Elliott's essay, "The Basis of the Wave Principle," October 1940.


The Elliott Wave Principle posits that collective investor psychology, or crowd psychology, moves between optimism and pessimism in natural sequences. These mood swings create patterns evidenced in the price movements of markets at every degree of trend or time scale.

In Elliott's model, market prices alternate between an impulsive, or motive phase, and a corrective phase on all time scales of trend, as the illustration shows. Impulses are always subdivided into a set of 5 lower-degree waves, alternating again between motive and corrective character, so that waves 1, 3, and 5 are impulses, and waves 2 and 4 are smaller retraces of waves 1 and 3. Corrective waves subdivide into 3 smaller-degree waves starting with a five-wave counter-trend impulse, a retrace, and another impulse. In a bear market the dominant trend is downward, so the pattern is reversed—five waves down and three up. Motive waves always move with the trend, while corrective waves move against it.

Degree

The patterns link to form five and three-wave structures which themselves underlie self-similar wave structures of increasing size or higher degree. Note the lower most of the three idealized cycles. In the first small five-wave sequence, waves 1, 3 and 5 are motive, while waves 2 and 4 are corrective. This signals that the movement of the wave one degree higher is upward. It also signals the start of the first small three-wave corrective sequence. After the initial five waves up and three waves down, the sequence begins again and the self-similar fractal geometry begins to unfold according to the five and three-wave structure which it underlies one degree higher. The completed motive pattern includes 89 waves, followed by a completed corrective pattern of 55 waves.

Each degree of a pattern in a financial market has a name. Practitioners use symbols for each wave to indicate both function and degree—numbers for motive waves, letters for corrective waves (shown in the highest of the three idealized series of wave structures or degrees). Degrees are relative; they are defined by form, not by absolute size or duration. Waves of the same degree may be of very different size and/or duration.

The classification of a wave at any particular degree can vary, though practitioners generally agree on the standard order of degrees (approximate durations given):

    Grand supercycle: multi-century
    Supercycle: multi-decade (about 40-70 years)
    Cycle: one year to several years (or even several decades under an Elliott Extension)
    Primary: a few months to a couple of years
    Intermediate: weeks to months
    Minor: weeks
    Minute: days
    Minuette: hours
    Subminuette: minutes

Elliott Wave personality and characteristics

Elliott wave analysts (or Elliotticians) hold that each individual wave has its own signature or characteristic, which typically reflects the psychology of the moment. Understanding those personalities is key to the application of the Wave Principle; they are defined below. (Definitions assume a bull market in equities; the characteristics apply in reverse in bear markets.)

Five wave pattern (dominant trend)

Wave 1: Wave one is rarely obvious at its inception. When the first wave of a new bull market begins, the fundamental news is almost universally negative. The previous trend is considered still strongly in force. Fundamental analysts continue to revise their earnings estimates lower; the economy probably does not look strong. Sentiment surveys are decidedly bearish, put options are in vogue, and implied volatility in the options market is high. Volume might increase a bit as prices rise, but not by enough to alert many technical analysts.

Wave 2: Wave two corrects wave one, but can never extend beyond the starting point of wave one. Typically, the news is still bad. As prices retest the prior low, bearish sentiment quickly builds, and "the crowd" haughtily reminds all that the bear market is still deeply ensconced. Still, some positive signs appear for those who are looking: volume should be lower during wave two than during wave one, prices usually do not retrace more than 61.8% (see Fibonacci section below) of the wave one gains, and prices should fall in a three wave pattern.

Wave 3: Wave three is usually the largest and most powerful wave in a trend (although some research suggests that in commodity markets, wave five is the largest). The news is now positive and fundamental analysts start to raise earnings estimates. Prices rise quickly, corrections are short-lived and shallow. Anyone looking to "get in on a pullback" will likely miss the boat. As wave three starts, the news is probably still bearish, and most market players remain negative; but by wave three's midpoint, "the crowd" will often join the new bullish trend. Wave three often extends wave one by a ratio of 1.618:1.

Wave 4: Wave four is typically clearly corrective. Prices may meander sideways for an extended period, and wave four typically retraces less than 38.2% of wave three (see Fibonacci relationships below). Volume is well below than that of wave three. This is a good place to buy a pull back if you understand the potential ahead for wave 5. Still, fourth waves are often frustrating because of their lack of progress in the larger trend.

Wave 5: Wave five is the final leg in the direction of the dominant trend. The news is almost universally positive and everyone is bullish. Unfortunately, this is when many average investors finally buy in, right before the top. Volume is often lower in wave five than in wave three, and many momentum indicators start to show divergences (prices reach a new high but the indicators do not reach a new peak). At the end of a major bull market, bears may very well be ridiculed (recall how forecasts for a top in the stock market during 2000 were received).

Three wave pattern (corrective trend)

Wave A:
Corrections are typically harder to identify than impulse moves. In wave A of a bear market, the fundamental news is usually still positive. Most analysts see the drop as a correction in a still-active bull market. Some technical indicators that accompany wave A include increased volume, rising implied volatility in the options markets and possibly a turn higher in open interest in related futures markets.

  
Wave B: Prices reverse higher, which many see as a resumption of the now long-gone bull market. Those familiar with classical technical analysis may see the peak as the right shoulder of a head and shoulders reversal pattern. The volume during wave B should be lower than in wave A. By this point, fundamentals are probably no longer improving, but they most likely have not yet turned negative.

Wave C: Prices move impulsively lower in five waves. Volume picks up, and by the third leg of wave C, almost everyone realizes that a bear market is firmly entrenched. Wave C is typically at least as large as wave A and often extends to 1.618 times wave A or beyond.

Pattern recognition and fractals

Elliott's market model relies heavily on looking at price charts. Practitioners study developing trends to distinguish the waves and wave structures, and discern what prices may do next; thus the application of the wave principle is a form of pattern recognition.

The structures Elliott described also meet the common definition of a fractal (self-similar patterns appearing at every degree of trend). Elliott wave practitioners say that just as naturally-occurring fractals often expand and grow more complex over time, the model shows that collective human psychology develops in natural patterns, via buying and selling decisions reflected in market prices: "It's as though we are somehow programmed by mathematics. Seashell, galaxy, snowflake or human: we're all bound by the same order."



Elliott wave rules and guidelines

A correct Elliott wave "count" must observe three rules:

    Wave 2 always retraces less than 100% of wave 1.
    Wave 3 cannot be the shortest of the three impulse waves, namely waves 1, 3 and 5.
    Wave 4 does not overlap with the price territory of wave 1, except in the rare case of a diagonal triangle.

A common guideline observes that in a five-wave pattern, waves 2 and 4 will often take alternate forms; a sharp move in wave 2, for example, will suggest a mild move in wave 4. Corrective wave patterns unfold in forms known as zigzags, flats, or triangles. In turn these corrective patterns can come together to form more complex corrections.

Fibonacci relationships

R. N. Elliott's analysis of the mathematical properties of waves and patterns eventually led him to conclude that "The Fibonacci Summation Series is the basis of The Wave Principle". Numbers from the Fibonacci sequence surface repeatedly in Elliott wave structures, including motive waves (1, 3, 5), a single full cycle (8 waves), and the completed motive (89 waves) and corrective (55 waves) patterns. Elliott developed his market model before he realized that it reflects the Fibonacci sequence. "When I discovered The Wave Principle action of market trends, I had never heard of either the Fibonacci Series or the Pythagorean Diagram".

The Fibonacci sequence is also closely connected to the Golden ratio (1.618). Practitioners commonly use this ratio and related ratios to establish support and resistance levels for market waves, namely the price points which help define the parameters of a trend.  See Fibonacci retracement.

Finance professor Roy Batchelor and researcher Richard Ramyar, a former Director of the United Kingdom Society of Technical Analysts and Head of UK Asset Management Research at Reuters Lipper, studied whether Fibonacci ratios appear non-randomly in the stock market, as Elliott's model predicts. The researchers said the "idea that prices retrace to a Fibonacci ratio or round fraction of the previous trend clearly lacks any scientific rationale". They also said "there is no significant difference between the frequencies with which price and time ratios occur in cycles in the Dow Jones Industrial Average, and frequencies which we would expect to occur at random in such a time series".

Robert Prechter replied to the Batchelor–Ramyar study, saying that it "does not challenge the validity of any aspect of the Wave Principle...it supports wave theorists' observations," and that because the authors had examined ratios between prices achieved in filtered trends rather than Elliott waves, "their method does not address actual claims by wave theorists". The Socionomics Institute also reviewed data in the Batchelor–Ramyar study, and said these data show "Fibonacci ratios do occur more often in the stock market than would be expected in a random environment".

It has been suggested that Fibonacci relationships are not the only irrational number based relationships evident in waves.

After Elliott

Following Elliott's death in 1948, other market technicians and financial professionals continued to use the wave principle and provide forecasts to investors. Charles Collins, who had published Elliott's "Wave Principle" and helped introduce Elliott's theory to Wall Street, ranked Elliott's contributions to technical analysis on a level with Charles Dow. Hamilton Bolton, founder of The Bank Credit Analyst, provided wave analysis to a wide readership in the 1950s and 1960s. Bolton introduced Elliott's wave principle to A.J. Frost, who provided weekly financial commentary on the Financial News Network in the 1980s. Frost co-authored Elliott Wave Principle with Robert Prechter in 1978.

Rediscovery and current use

Robert Prechter came across Elliott's works while working as a market technician at Merrill Lynch. His prominence as a forecaster during the bull market of the 1980s brought the greatest exposure to date to Elliott's work, and today Prechter remains the most widely known Elliott analyst.

Among market technicians, wave analysis is widely accepted as a component of their trade. Elliott's Wave principle is among the methods included on the exam that analysts must pass to earn the Chartered Market Technician (CMT) designation, the professional accreditation developed by the Market Technicians Association (MTA).

Robin Wilkin, Ex-Global Head of FX and Commodity Technical Strategy at JPMorgan Chase, says "the Elliott Wave principle ... provides a probability framework as to when to enter a particular market and where to get out, whether for a profit or a loss."

Jordan Kotick, Global Head of Technical Strategy at Barclays Capital and past President of the Market Technicians Association, has said that R. N. Elliott's "discovery was well ahead of its time. In fact, over the last decade or two, many prominent academics have embraced Elliott’s idea and have been aggressively advocating the existence of financial market fractals."

One such academic is the physicist Didier Sornette, visiting professor at the Department of Earth and Space Science and the Institute of Geophysics and Planetary Physics at UCLA. In a paper he co-authored in 1996 ("Stock Market Crashes, Precursors and Replicas") Sornette said,

    It is intriguing that the log-periodic structures documented here bear some similarity with the "Elliott waves" of technical analysis ... A lot of effort has been developed in finance both by academic and trading institutions and more recently by physicists (using some of their statistical tools developed to deal with complex times series) to analyze past data to get information on the future. The 'Elliott wave' technique is probably the most famous in this field. We speculate that the "Elliott waves", so strongly rooted in the financial analysts’ folklore, could be a signature of an underlying critical structure of the stock market.

Paul Tudor Jones, the billionaire commodity trader, calls Prechter and Frost's standard text on Elliott "a classic," and one of "the four Bibles of the business":

    [Magee and Edwards'] Technical Analysis of Stock Trends and The Elliott Wave Theorist both give very specific and systematic ways to approach developing great reward/risk ratios for entering into a business contract with the marketplace, which is what every trade should be if properly and thoughtfully executed.

Criticism

The premise that markets unfold in recognizable patterns contradicts the efficient market hypothesis, which states that prices cannot be predicted from market data such as moving averages and volume. By this reasoning, if successful market forecasts were possible, investors would buy (or sell) when the method predicted a price increase (or decrease), to the point that prices would rise (or fall) immediately, thus destroying the profitability and predictive power of the method. In efficient markets, knowledge of the Elliott Wave Principle among traders would lead to the disappearance of the very patterns they tried to anticipate, rendering the method, and all forms of technical analysis, useless.

Benoit Mandelbrot has questioned whether Elliott waves can predict financial markets:

    But Wave prediction is a very uncertain business. It is an art to which the subjective judgement of the chartists matters more than the objective, replicable verdict of the numbers. The record of this, as of most technical analysis, is at best mixed.

Robert Prechter had previously stated that ideas in an article by Mandelbrot[16] "originated with Ralph Nelson Elliott, who put them forth more comprehensively and more accurately with respect to real-world markets in his 1938 book The Wave Principle."

Critics also warn the wave principle is too vague to be useful, since it cannot consistently identify when a wave begins or ends, and that Elliott wave forecasts are prone to subjective revision. Some who advocate technical analysis of markets have questioned the value of Elliott wave analysis. Technical analyst David Aronson wrote:

    The Elliott Wave Principle, as popularly practiced, is not a legitimate theory, but a story, and a compelling one that is eloquently told by Robert Prechter. The account is especially persuasive because EWP has the seemingly remarkable ability to fit any segment of market history down to its most minute fluctuations. I contend this is made possible by the method's loosely defined rules and the ability to postulate a large number of nested waves of varying magnitude. This gives the Elliott analyst the same freedom and flexibility that allowed pre-Copernican astronomers to explain all observed planet movements even though their underlying theory of an Earth-centered universe was wrong.

source: www.wikipedia.org


Best regards,
^^_Lord_Ice_^^

How to add an indicator over the oscillator on the MetaTrader 4 ?


If you will need to add an indicator over an oscillator you have to follow those simple steps:

1. Click on the navigator button .

2. Select from the Indicator menu the one you want to add. Let's say you want to add MA on RSI.



3. Select MA by click - drag & drop on RSI.

4. In the section " Apply to" select "First Indicator's data" and press Ok.


5. Now you will have a MA over the RSI Oscillator and looks like this:



Best Regards,
^^_Lord_Ice_^^

How to install an EA (Expert Advisor) on the MetaTrader 4 ?


To install an EA we need same files as for installing an indicator.




Copy those files to :C:\Program Files\Meta Trader 4\experts

 * Meta Trader 4 folder, usually has the name of the broker. 

Restart the platform, and open navigator menu by clicking on the .

Click on the Expert Advisor tab    then click on the EA installed + drag & drop to chart.


In the top right corner will look like this:




 


To activate it, you must have a "smilly face" instead of a "sad face". To do that: right click on the chart - Expert Advisors - Properties.






Best Regards,
^^_Lord_Ice_^^

How to install an indicator on the MetaTrader 4 ?


An indicator can be found in 2 formats (extensions): "name.MQ4" and "name.EX4". The MQ4 is the source code, and the EX4 is the compiled version of the code.



You don't need to use both extensions of the indicator. If you have only the EX4 extension of the indicator, it's fine, but you just wont see the MQ4 in the installed folder. If you have only the MQ4 extension, it will make automatically the EX4 extension in the folder of the platform. If you have both files, you can copy them directly in the next location:

C:\Program Files\Meta Trader 4\experts\indicators

 * Meta Trader 4 folder, usually has the name of the broker.

Restart now MT4 - click on the Indicators button - Custom - click on the indicator installed to attach it to the chart.





Best Regards,
^^_Lord_Ice_^^


Best color setup for my trading platform !


Trading for many hours every day, can be sometimes painful for your eyes. Specially if you are using multi-monitors like I do. That's why, after many years of testing different color setups, I have some conclusions to make.

If your trading on daily light, a few hours/day, in a lighter room you can use default colours. But if you use your trading platform more then 8 hours/day, mostly in the middle of the night, like I do, you need a special setup.

For colors setup options, right click on the chart - properties - colors.  


My default colors setup is like this:



From the common section, I've removed the grid. The chart is becoming too complicated when you add more tools for your technical analysis.

For the oscillators section, I use Dodger Blue colour.




Levels for all the oscillators, have the same colour as my grid:



In case I use the 3rd oscillator I use Light Sea Green colour:


In the end this is how it's looks like:


With this colors setup, I establish a personal record 48 h of trading, with no pain for my eyes. Of course with 10 min break, each 2 hours. 

Hope you'll find this useful for your day by day trading activity.


Best Regards,

^^_Lord_Ice_^^

Average Daily Range ( ADR )


If you are day trading, then it's always a good idea to be fully aware of the average daily range of the pairs you are trading. This is because you always want to know how much further a pair could realistically move given it's daily average in order to determine where you should set your stop loss and target price.

For instance if a pair has an average daily range of  200 points and during a given day it has been trading in a range of 200 points or more (and is trading at the top of this range with just an hour or so left), then you obviously would not want to be opening a long position because the odds are very much against you.

However if, for example, the range is currently 50 points and there is several hours left of the trading session, then a long position at the top of the range might be worth considering given the right circumstances because there is still room for a decent price move to take place.


Best Regards,

^^_Lord_Ice_^^




Pivot Points

A pivot point is a price level of significance in technical analysis of a financial market that is used by traders as a predictive indicator of market movement. A pivot point is calculated as an average of significant prices (high, low, close) from the performance of a market in the prior trading period. If the market in the following period trades above the pivot point it is usually evaluated as a bullish sentiment, whereas trading below the pivot point is seen as bearish.

Monthly pivot point chart of the Dow Jones Industrials Average for the first 8 months of 2009, showing sets of first and second levels of resistance (green) and support (red). The pivot point levels are highlighted in yellow. Trading below the pivot point, particularly at the beginning of a trading period sets a bearish market sentiment and often results in further price decline, while trading above it, bullish price action may continue for some time.

It is customary to calculate additional levels of support and resistance, below and above the pivot point, respectively, by subtracting or adding price differentials calculated from previous trading ranges of the market.

A pivot point and the associated support and resistance levels are often turning points for the direction of price movement in a market. In an up-trending market, the pivot point and the resistance levels may represent a ceiling level in price above which the uptrend is no longer sustainable and a reversal may occur. In a declining market, a pivot point and the support levels may represent a low price level of stability or a resistance to further decline.


* Monthly pivot point chart of the Dow Jones Industrials Average for the first 8 months of 2009, showing sets of first and second levels of resistance (green) and support (red). The pivot point levels are highlighted in yellow. Trading below the pivot point, particularly at the beginning of a trading period sets a bearish market sentiment and often results in further price decline, while trading above it, bullish price action may continue for some time.

Calculation

Several methods exist for calculating the pivot point (P) of a market. Most commonly, it is the arithmetic average of the high (H), low (L), and closing (C) prices of the market in the prior trading period:

    P = (H + L + C) / 3.

Sometimes, the average also includes the previous period's or the current period's opening price (O):

    P = (O + H + L + C) / 4.

In other cases, traders like to emphasize the closing price, P = (H + L + C + C) / 4, or the current periods opening price, P = (H + L + O + O) / 4.

Support and resistance levels

Price support and resistance levels are key trading tools in any market. Their roles may be interchangeable, depending on whether the price level is approached in an up-trending or a down-trending market. These price levels may be derived from many market assumptions and conventions. In pivot point analysis, several levels, usually three, are commonly recognized below and above the pivot point. These are calculated from the range of price movement in the previous trading period, added to the pivot point for resistances and KJKJKJsubtracted from it for support levels.

The first and most significant level of support (S1) and resistance (R1) is obtained by recognition of the upper and the lower halves of the prior trading range, defined by the trading above the pivot point (H − P), and below it (P − L). The first resistance on the up-side of the market is given by the lower width of prior trading added to the pivot point price and the first support on the down-side is the width of the upper part of the prior trading range below the pivot point.

    R1 = P + (P − L) = 2×P − L
    S1 = P − (H − P) = 2×P − H

Thus, these levels may simply be calculated by subtracting the previous low (L) and high (H) price, respectively, from twice the pivot point value:[1]

The second set of resistance (R2) and support (S2) levels are above and below, respectively, the first set. They are simply determined from the full width of the prior trading range (H − L), added to and subtracted from the pivot point, respectively:

    R2 = P + (H − L)
    S2 = P − (H − L)

Commonly a third set is also calculated, again representing another higher resistance level (R3) and a yet lower support level (S3). The method of the second set is continued by doubling the range added and subtracted from the pivot point:

    R3 = H + 2×(P − L)
    S3 = L − 2×(H − P)

This concept is sometimes, albeit rarely, extended to a fourth set in which the tripled value of the trading range is used in the calculation.

Qualitatively, the second and higher support and resistance levels are always located symmetrically around the pivot point, whereas this is not the case for the first levels, unless the pivot point happens to divide the prior trading range exactly in half.

Trading tool

The pivot point itself represents a level of highest resistance or support, depending on the overall market condition. If the market is directionless (undecided), prices will often fluctuate greatly around this level until a price breakout develops. Trading above or below the pivot point indicates the overall market sentiment. It is a leading indicator providing advanced signaling of potentially new market highs or lows within a given time frame.

The support and resistance levels calculated from the pivot point and the previous market width may be used as exit points of trades, but are rarely used as entry signals. For example, if the market is up-trending and breaks through the pivot point, the first resistance level is often a good target to close a position, as the probability of resistance and reversal increases greatly.




*5-day pivot point chart of the SPDR Gold Trust (GLD) for intra-day trading in October 2009


Many traders recognize the half-way levels between any of these levels as additional, but weaker resistance or support areas. The half-way (middle) point between the pivot point and R1 is designated M+, between R1 and R2 is M++, and below the pivot point the middle points are labeled as M− and M−−. In the 5-day intra-day chart of the SPDR Gold Trust (above) the middle points can clearly be identified as support in days 1, 3, and 4, and as resistance in days 2 and 3.

source: http://en.wikipedia.org/wiki/Pivot_points

Best Regards,
^^_Lord_Ice_^^

Arbitrage

Etymology

"Arbitrage" is a French word and denotes a decision by an arbitrator or arbitration tribunal. (In modern French, "arbitre" usually means referee or umpire.) In the sense used here it is first defined in 1704 by Mathieu de la Porte in his treatise "La science des n├ęgocians et teneurs de livres" as a consideration of different exchange rates to recognize the most profitable places of issuance and settlement for a bill of exchange ("L'arbitrage est une combinaison que l’on fait de plusieurs changes, pour connoitre [conna├«tre, in modern spelling] quelle place est plus avantageuse pour tirer et remettre".)

Financial Arbitrage

In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit at zero cost.

In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical arbitrage, it may refer to expected profit, though losses may occur, and in practice, there are always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit margins), some major (such as devaluation of a currency or derivative). In academic use, an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows; in common use, it is also used to refer to differences between similar assets (relative value or convergence trades), as in merger arbitrage.

People who engage in arbitrage are called arbitrageurs such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.

Arbitrage-free

If the market prices do not allow for profitable arbitrage, the prices are said to constitute an arbitrage equilibrium or arbitrage-free market. An arbitrage equilibrium is a precondition for a general economic equilibrium. The assumption that there is no arbitrage is used in quantitative finance to calculate a unique risk neutral price for derivatives.

Conditions for arbitrage

Arbitrage is possible when one of three conditions is met:

    The same asset does not trade at the same price on all markets ("the law of one price").
    Two assets with identical cash flows do not trade at the same price.
    An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securities).

Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete. In practical terms, this is generally only possible with securities and financial products which can be traded electronically, and even then, when each leg of the trade is executed the prices in the market may have moved. Missing one of the legs of the trade (and subsequently having to trade it soon after at a worse price) is called 'execution risk' or more specifically 'leg risk'.

In the simplest example, any good sold in one market should sell for the same price in another. Traders may, for example, find that the price of wheat is lower in agricultural regions than in cities, purchase the good, and transport it to another region to sell at a higher price. This type of price arbitrage is the most common, but this simple example ignores the cost of transport, storage, risk, and other factors. "True" arbitrage requires that there be no market risk involved. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one and selling on the other.

See rational pricing, particularly arbitrage mechanics, for further discussion.

Mathematically it is defined as follows:

P(V_t \geq 0) = 1 and P(V_t \neq 0) > 0

where Vt means a portfolio at time t.

Examples

    Suppose that the exchange rates (after taking out the fees for making the exchange) in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo are ¥1000 = $12 = £6. Converting ¥1000 to $12 in Tokyo and converting that $12 into ¥1200 in London, for a profit of ¥200, would be arbitrage. In reality, this "triangle arbitrage" is so simple that it almost never occurs. But more complicated foreign exchange arbitrages, such as the spot-forward arbitrage (see interest rate parity) are much more common.

    One example of arbitrage involves the New York Stock Exchange and the Security Futures Exchange OneChicago (OCX). When the price of a stock on the NYSE and its corresponding futures contract on OCX are out of sync, one can buy the less expensive one and sell it to the more expensive market. Because the differences between the prices are likely to be small (and not to last very long), this can only be done profitably with computers examining a large number of prices and automatically exercising a trade when the prices are far enough out of balance. The activity of other arbitrageurs can make this risky. Those with the fastest computers and the most expertise take advantage of series of small differences that would not be profitable if taken individually.

    Economists use the term "global labor arbitrage" to refer to the tendency of manufacturing jobs to flow towards whichever country has the lowest wages per unit output at present and has reached the minimum requisite level of political and economic development to support industrialization. At present, many such jobs appear to be flowing towards China, though some which require command of English are going to India and the Philippines. In popular terms, this is referred to as offshoring. (Note that "offshoring" is not synonymous with "outsourcing", which means "to subcontract from an outside supplier or source", such as when a business outsources its bookkeeping to an accounting firm. Unlike offshoring, outsourcing always involves subcontracting jobs to a different company, and that company can be in the same country as the outsourcing company.)

    Sports arbitrage – numerous internet bookmakers offer odds on the outcome of the same event. Any given bookmaker will weight their odds so that no one customer can cover all outcomes at a profit against their books. However, in order to remain competitive their margins are usually quite low. Different bookmakers may offer different odds on the same outcome of a given event; by taking the best odds offered by each bookmaker, a customer can under some circumstances cover all possible outcomes of the event and lock a small risk-free profit, known as a Dutch book. This profit would typically be between 1% and 5% but can be much higher. One problem with sports arbitrage is that bookmakers sometimes make mistakes and this can lead to an invocation of the 'palpable error' rule, which most bookmakers invoke when they have made a mistake by offering or posting incorrect odds. As bookmakers become more proficient, the odds of making an 'arb' usually last for less than an hour and typically only a few minutes. Furthermore, huge bets on one side of the market also alert the bookies to correct the market.

    Exchange-traded fund arbitrage – Exchange Traded Funds allow authorized participants to exchange back and forth between shares in underlying securities held by the fund and shares in the fund itself, rather than allowing the buying and selling of shares in the ETF directly with the fund sponsor. ETFs trade in the open market, with prices set by market demand. An ETF may trade at a premium or discount to the value of the underlying assets. When a significant enough premium appears, an arbitrageur will buy the underlying securities, convert them to shares in the ETF, and sell them in the open market. When a discount appears, an arbitrageur will do the reverse. In this way, the arbitrageur makes a low-risk profit, while keeping ETF prices in line with their underlying value.

    Some types of hedge funds make use of a modified form of arbitrage to profit. Rather than exploiting price differences between identical assets, they will purchase and sell securities, assets and derivatives with similar characteristics, and hedge any significant differences between the two assets. Any difference between the hedged positions represents any remaining risk (such as basis risk) plus profit; the belief is that there remains some difference which, even after hedging most risk, represents pure profit. For example, a fund may see that there is a substantial difference between U.S. dollar debt and local currency debt of a foreign country, and enter into a series of matching trades (including currency swaps) to arbitrage the difference, while simultaneously entering into credit default swaps to protect against country risk and other types of specific risk.

Price convergence

Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency exchange rates, the price of commodities, and the price of securities in different markets tend to converge. The speed at which they do so is a measure of market efficiency. Arbitrage tends to reduce price discrimination by encouraging people to buy an item where the price is low and resell it where the price is high (as long as the buyers are not prohibited from reselling and the transaction costs of buying, holding and reselling are small relative to the difference in prices in the different markets).

Arbitrage moves different currencies toward purchasing power parity. As an example, assume that a car purchased in the United States is cheaper than the same car in Canada. Canadians would buy their cars across the border to exploit the arbitrage condition. At the same time, Americans would buy US cars, transport them across the border, then sell them in Canada. Canadians would have to buy American Dollars to buy the cars; and Americans would have to sell the Canadian dollars they received in exchange. Both actions would increase demand for US Dollars and supply of Canadian Dollars. As a result, there would be an appreciation of the US currency. This would make US cars more expensive and Canadian cars less so until their prices were similar. On a larger scale, international arbitrage opportunities in commodities, goods, securities and currencies tend to change exchange rates until the purchasing power is equal.

In reality, most assets exhibit some difference between countries. These, transaction costs, taxes, and other costs provide an impediment to this kind of arbitrage. Similarly, arbitrage affects the difference in interest rates paid on government bonds issued by the various countries, given the expected depreciations in the currencies relative to each other.

Risks

Arbitrage transactions in modern securities markets involve fairly low day-to-day risks, but can face extremely high risk in rare situations, particularly financial crises, and can lead to bankruptcy. Formally, arbitrage transactions have negative skew – prices can get a small amount closer (but often no closer than 0), while they can get very far apart. The day-to-day risks are generally small because the transactions involve small differences in price, so an execution failure will generally cause a small loss (unless the trade is very big or the price moves rapidly). The rare case risks are extremely high because these small price differences are converted to large profits via leverage (borrowed money), and in the rare event of a large price move, this may yield a large loss.

The main day-to-day risk is that part of the transaction fails – execution risk. The main rare risks are counterparty risk and liquidity risk – that a counterparty to a large transaction or many transactions fails to pay, or that one is required to post margin and does not have the money to do so.

In the academic literature, the idea that seemingly very low risk arbitrage trades might not be fully exploited because of these risk factors and other considerations is often referred to as limits to arbitrage.

Execution risk

Generally it is impossible to close two or three transactions at the same instant; therefore, there is the possibility that when one part of the deal is closed, a quick shift in prices makes it impossible to close the other at a profitable price. However, this is not necessarily the case. Many exchanges and idbs allow multi legged trades (e.g. basis block trades on LIFFE).

Competition in the marketplace can also create risks during arbitrage transactions. As an example, if one was trying to profit from a price discrepancy between IBM on the NYSE and IBM on the London Stock Exchange, they may purchase a large number of shares on the NYSE and find that they cannot simultaneously sell on the LSE. This leaves the arbitrageur in an unhedged risk position.

In the 1980s, risk arbitrage was common. In this form of speculation, one trades a security that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to be corrected by events. The standard example is the stock of a company, undervalued in the stock market, which is about to be the object of a takeover bid; the price of the takeover will more truly reflect the value of the company, giving a large profit to those who bought at the current price—if the merger goes through as predicted. Traditionally, arbitrage transactions in the securities markets involve high speed, high volume and low risk. At some moment a price difference exists, and the problem is to execute two or three balancing transactions while the difference persists (that is, before the other arbitrageurs act). When the transaction involves a delay of weeks or months, as above, it may entail considerable risk if borrowed money is used to magnify the reward through leverage. One way of reducing the risk is through the illegal use of inside information, and in fact risk arbitrage with regard to leveraged buyouts was associated with some of the famous financial scandals of the 1980s such as those involving Michael Milken and Ivan Boesky.

Mismatch

Another risk occurs if the items being bought and sold are not identical and the arbitrage is conducted under the assumption that the prices of the items are correlated or predictable; this is more narrowly referred to as a convergence trade. In the extreme case this is merger arbitrage, described below. In comparison to the classical quick arbitrage transaction, such an operation can produce disastrous losses.

Counterparty risk

As arbitrages generally involve future movements of cash, they are subject to counterparty risk: if a counterparty fails to fulfill their side of a transaction. This is a serious problem if one has either a single trade or many related trades with a single counterparty, whose failure thus poses a threat, or in the event of a financial crisis when many counterparties fail. This hazard is serious because of the large quantities one must trade in order to make a profit on small price differences.

For example, if one purchases many risky bonds, then hedges them with CDSes, profiting from the difference between the bond spread and the CDS premium, in a financial crisis the bonds may default and the CDS writer/seller may itself fail, due to the stress of the crisis, causing the arbitrageur to face steep losses.


Liquidity risk

“Markets can remain irrational far longer than you or I can remain solvent.” - John Maynard Keynes

Arbitrage trades are necessarily synthetic, leveraged trades, as they involve a short position. If the assets used are not identical (so a price divergence makes the trade temporarily lose money), or the margin treatment is not identical, and the trader is accordingly required to post margin (faces a margin call), the trader may run out of capital (if they run out of cash and cannot borrow more) and go bankrupt even though the trades may be expected to ultimately make money. In effect, arbitrage traders synthesize a put option on their ability to finance themselves.

Prices may diverge during a financial crisis, often termed a "flight to quality"; these are precisely the times when it is hardest for leveraged investors to raise capital (due to overall capital constraints), and thus they will lack capital precisely when they need it most.


Types of arbitrage:

Merger arbitrage

Also called risk arbitrage, merger arbitrage generally consists of buying the stock of a company that is the target of a takeover while shorting the stock of the acquiring company.

Usually the market price of the target company is less than the price offered by the acquiring company. The spread between these two prices depends mainly on the probability and the timing of the takeover being completed as well as the prevailing level of interest rates.

The bet in a merger arbitrage is that such a spread will eventually be zero, if and when the takeover is completed. The risk is that the deal "breaks" and the spread massively widens.

Municipal bond arbitrage

Also called municipal bond relative value arbitrage, municipal arbitrage, or just muni arb, this hedge fund strategy involves one of two approaches.

Generally, managers seek relative value opportunities by being both long and short municipal bonds with a duration-neutral book. The relative value trades may be between different issuers, different bonds issued by the same entity, or capital structure trades referencing the same asset (in the case of revenue bonds). Managers aim to capture the inefficiencies arising from the heavy participation of non-economic investors (i.e., high income "buy and hold" investors seeking tax-exempt income) as well as the "crossover buying" arising from corporations' or individuals' changing income tax situations (i.e., insurers switching their munis for corporates after a large loss as they can capture a higher after-tax yield by offsetting the taxable corporate income with underwriting losses). There are additional inefficiencies arising from the highly fragmented nature of the municipal bond market which has two million outstanding issues and 50,000 issuers in contrast to the Treasury market which has 400 issues and a single issuer.

Second, managers construct leveraged portfolios of AAA- or AA-rated tax-exempt municipal bonds with the duration risk hedged by shorting the appropriate ratio of taxable corporate bonds. These corporate equivalents are typically interest rate swaps referencing Libor or SIFMA. The arbitrage manifests itself in the form of a relatively cheap longer maturity municipal bond, which is a municipal bond that yields significantly more than 65% of a corresponding taxable corporate bond. The steeper slope of the municipal yield curve allows participants to collect more after-tax income from the municipal bond portfolio than is spent on the interest rate swap; the carry is greater than the hedge expense. Positive, tax-free carry from muni arb can reach into the double digits. The bet in this municipal bond arbitrage is that, over a longer period of time, two similar instruments—municipal bonds and interest rate swaps—will correlate with each other; they are both very high quality credits, have the same maturity and are denominated in U.S. dollars. Credit risk and duration risk are largely eliminated in this strategy. However, basis risk arises from use of an imperfect hedge, which results in significant, but range-bound principal volatility. The end goal is to limit this principal volatility, eliminating its relevance over time as the high, consistent, tax-free cash flow accumulates. Since the inefficiency is related to government tax policy, and hence is structural in nature, it has not been arbitraged away.

Note, however, that many municipal bonds are callable, and that this imposes substantial additional risks to the strategy.

Convertible bond arbitrage

A convertible bond is a bond that an investor can return to the issuing company in exchange for a predetermined number of shares in the company.

A convertible bond can be thought of as a corporate bond with a stock call option attached to it.

The price of a convertible bond is sensitive to three major factors:

    interest rate. When rates move higher, the bond part of a convertible bond tends to move lower, but the call option part of a convertible bond moves higher (and the aggregate tends to move lower).
    stock price. When the price of the stock the bond is convertible into moves higher, the price of the bond tends to rise.
    credit spread. If the creditworthiness of the issuer deteriorates (e.g. rating downgrade) and its credit spread widens, the bond price tends to move lower, but, in many cases, the call option part of the convertible bond moves higher (since credit spread correlates with volatility).

Given the complexity of the calculations involved and the convoluted structure that a convertible bond can have, an arbitrageur often relies on sophisticated quantitative models in order to identify bonds that are trading cheap versus their theoretical value.

Convertible arbitrage consists of buying a convertible bond and hedging two of the three factors in order to gain exposure to the third factor at a very attractive price.

For instance an arbitrageur would first buy a convertible bond, then sell fixed income securities or interest rate futures (to hedge the interest rate exposure) and buy some credit protection (to hedge the risk of credit deterioration). Eventually what he'd be left with is something similar to a call option on the underlying stock, acquired at a very low price. He could then make money either selling some of the more expensive options that are openly traded in the market or delta hedging his exposure to the underlying shares.

Depository receipts

A depository receipt is a security that is offered as a "tracking stock" on another foreign market. For instance a Chinese company wishing to raise more money may issue a depository receipt on the New York Stock Exchange, as the amount of capital on the local exchanges is limited. These securities, known as ADRs (American Depositary Receipt) or GDRs (Global Depositary Receipt ) depending on where they are issued, are typically considered "foreign" and therefore trade at a lower value when first released. Many ADR's are exchangeable into the original security (known as fungibility) and actually have the same value. In this case there is a spread between the perceived value and real value, which can be extracted. Other ADR's that are not exchangeable often have much larger spreads. Since the ADR is trading at a value lower than what it is worth, one can purchase the ADR and expect to make money as its value converges on the original. However there is a chance that the original stock will fall in value too, so by shorting it one can hedge that risk.

Dual-listed companies

A dual-listed company (DLC) structure involves two companies incorporated in different countries contractually agreeing to operate their businesses as if they were a single enterprise, while retaining their separate legal identity and existing stock exchange listings. In integrated and efficient financial markets, stock prices of the twin pair should move in lockstep. In practice, DLC share prices exhibit large deviations from theoretical parity. Arbitrage positions in DLCs can be set up by obtaining a long position in the relatively underpriced part of the DLC and a short position in the relatively overpriced part. Such arbitrage strategies start paying off as soon as the relative prices of the two DLC stocks converge toward theoretical parity. However, since there is no identifiable date at which DLC prices will converge, arbitrage positions sometimes have to be kept open for considerable periods of time. In the meantime, the price gap might widen. In these situations, arbitrageurs may receive margin calls, after which they would most likely be forced to liquidate part of the position at a highly unfavorable moment and suffer a loss. Arbitrage in DLCs may be profitable, but is also very risky, see.

A good illustration of the risk of DLC arbitrage is the position in Royal Dutch Shell—which had a DLC structure until 2005—by the hedge fund Long-Term Capital Management (LTCM, see also the discussion below). Lowenstein (2000) [6] describes that LTCM established an arbitrage position in Royal Dutch Shell in the summer of 1997, when Royal Dutch traded at an 8 to 10 percent premium. In total $2.3 billion was invested, half of which long in Shell and the other half short in Royal Dutch (Lowenstein, p. 99). In the autumn of 1998 large defaults on Russian debt created significant losses for the hedge fund and LTCM had to unwind several positions. Lowenstein reports that the premium of Royal Dutch had increased to about 22 percent and LTCM had to close the position and incur a loss. According to Lowenstein (p. 234), LTCM lost $286 million in equity pairs trading and more than half of this loss is accounted for by the Royal Dutch Shell trade.


Private to public equities

The market prices for privately held companies are typically viewed from a return on investment perspective (such as 25%), whilst publicly held and or exchange listed companies trade on a Price to earnings ratio (P/E) (such as a P/E of 10, which equates to a 10% ROI). Thus, if a publicly traded company specialises in the acquisition of privately held companies, from a per-share perspective there is a gain with every acquisition that falls within these guidelines. Exempli gratia, Berkshire-Hathaway. A hedge fund that is an example of this type of arbitrage is Greenridge Capital, which acts as an angel investor retaining equity in private companies which are in the process of becoming publicly traded, buying in the private market and later selling in the public market. Private to public equities arbitrage is a term which can arguably be applied to investment banking in general. Private markets to public markets differences may also help explain the overnight windfall gains enjoyed by principals of companies that just did an initial public offering (IPO).

Telecom arbitrage

Telecom arbitrage companies allow phone users to make international calls for free through certain access numbers. Such services are offered in the United Kingdom; the telecommunication arbitrage companies get paid an interconnect charge by the UK mobile networks and then buy international routes at a lower cost. The calls are seen as free by the UK contract mobile phone customers since they are using up their allocated monthly minutes rather than paying for additional calls.

Such services were previously offered in the United States by companies such as FuturePhone.com.
These services would operate in rural telephone exchanges, primarily in small towns in the state of Iowa. In these areas, the local telephone carriers are allowed to charge a high "termination fee" to the caller's carrier in order to fund the cost of providing service to the small and sparsely populated areas that they serve. However, FuturePhone (as well as other similar services) ceased operations upon legal challenges from AT&T and other service providers.

Statistical arbitrage

Statistical arbitrage is an imbalance in expected nominal values. A casino has a statistical arbitrage in every game of chance that it offers—referred to as the house advantage, house edge, vigorish or house vigorish.

The debacle of Long-Term Capital Management

Long-Term Capital Management (LTCM) lost 4.6 billion U.S. dollars in fixed income arbitrage in September 1998. LTCM had attempted to make money on the price difference between different bonds. For example, it would sell U.S. Treasury securities and buy Italian bond futures. The concept was that because Italian bond futures had a less liquid market, in the short term Italian bond futures would have a higher return than U.S. bonds, but in the long term, the prices would converge. Because the difference was small, a large amount of money had to be borrowed to make the buying and selling profitable.

The downfall in this system began on August 17, 1998, when Russia defaulted on its ruble debt and domestic dollar debt. Because the markets were already nervous due to the Asian financial crisis, investors began selling non-U.S. treasury debt and buying U.S. treasuries, which were considered a safe investment. As a result the price on US treasuries began to increase and the return began decreasing because there were many buyers, and the return (yield) on other bonds began to increase because there were many sellers (i.e. the price of those bonds fell). This caused the difference between the prices of U.S. treasuries and other bonds to increase, rather than to decrease as LTCM was expecting. Eventually this caused LTCM to fold, and their creditors had to arrange a bail-out. More controversially, officials of the Federal Reserve assisted in the negotiations that led to this bail-out, on the grounds that so many companies and deals were intertwined with LTCM that if LTCM actually failed, they would as well, causing a collapse in confidence in the economic system. Thus LTCM failed as a fixed income arbitrage fund, although it is unclear what sort of profit was realized by the banks that bailed LTCM out.

source: http://en.wikipedia.org/wiki/Arbitrage


Best Regards,

^^_Lord_Ice_^^

Hedging



A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.

A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts.

Public futures markets were established in the 19th century to allow transparent, standardized, and efficient hedging of agricultural commodity prices; they have since expanded to include futures contracts for hedging the values of energy, precious metals, foreign currency, and interest rate fluctuations.

Etymology

Hedging is the practice of taking a position in one market to offset and balance against the risk adopted by assuming a position in a contrary or opposing market or investment. The word hedge is from Old English hecg, originally any fence, living or artificial. The use of the word as a verb in the sense of "dodge, evade" is first recorded in the 1590s; that of insure oneself against loss, as in a bet, is from 1670s.

Examples

Agricultural commodity price hedging

A typical hedger might be a commercial farmer. The market values of wheat and other crops fluctuate constantly as supply and demand for them vary, with occasional large moves in either direction. Based on current prices and forecast levels at harvest time, the farmer might decide that planting wheat is a good idea one season, but the forecast prices are only that — forecasts. Once the farmer plants wheat, he is committed to it for an entire growing season. If the actual price of wheat rises greatly between planting and harvest, the farmer stands to make a lot of unexpected money, but if the actual price drops by harvest time, he could be ruined.

If at planting time the farmer sells a number of wheat futures contracts equivalent to his anticipated crop size, he effectively locks in the price of wheat at that time: the contract is an agreement to deliver a certain number of bushels of wheat to a specified place on a certain date in the future for a certain fixed price. The farmer has hedged his exposure to wheat prices; he no longer cares whether the current price rises or falls, because he is guaranteed a price by the contract. He no longer needs to worry about being ruined by a low wheat price at harvest time, but he also gives up the chance at making extra money from a high wheat price at harvest times.

Hedging a stock price

A stock trader believes that the stock price of Company A will rise over the next month, due to the company's new and efficient method of producing widgets. He wants to buy Company A shares to profit from their expected price increase. But Company A is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the Company A shares were underpriced, the trade would be a speculation.

Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares × price) of the shares of Company A's direct competitor, Company B.

The first day the trader's portfolio is:

    Long 1,000 shares of Company A at $1 each
    Short 500 shares of Company B at $2 each

(Notice that the trader has sold short the same value of shares)

If the trader was able to short sell an asset whose price had a mathematically defined relation with Company A's stock price (for example a put option on Company A shares), the trade might be essentially riskless. In this case, the risk would be limited to the put option's premium.

On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. Company A, however, because it is a stronger company, increases by 10%, while Company B increases by just 5%:

    Long 1,000 shares of Company A at $1.10 each: $100 gain
    Short 500 shares of Company B at $2.10 each: $50 loss

(In a short position, the investor loses money when the price goes up.)

The trader might regret the hedge on day two, since it reduced the profits on the Company A position. But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash: 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since Company A is the better company, it suffers less than Company B:

Value of long position (Company A):

    Day 1: $1,000
    Day 2: $1,100
    Day 3: $550 => ($1,000 − $550) = $450 loss

Value of short position (Company B):

    Day 1: −$1,000
    Day 2: −$1,050
    Day 3: −$525 => ($1,000 − $525) = $475 profit

Without the hedge, the trader would have lost $450 (or $900 if the trader took the $1,000 he has used in short selling Company B's shares to buy Company A's shares as well). But the hedge – the short sale of Company B – gives a profit of $475, for a net profit of $25 during a dramatic market collapse.

Hedging Employee Stock Options

Employee Stock Options are securities issued by the company generally to executives and employees. These securities are more volatile than stock and should encourage the holders to manage those positions with a view to reducing that risk. There is only one efficient way to manage the risk of holding employee stock options and that is by use of sales of exchange traded calls and to a lesser degree by buying puts. Companies discourage hedging versus ESOs but have no prohibitions in their contracts.

Hedging fuel consumption

Airlines use futures contracts and derivatives to hedge their exposure to the price of jet fuel. They know that they must purchase jet fuel for as long as they want to stay in business, and fuel prices are notoriously volatile. By using crude oil futures contracts to hedge their fuel requirements (and engaging in similar but more complex derivatives transactions), Southwest Airlines was able to save a large amount of money when buying fuel as compared to rival airlines when fuel prices in the U.S. rose dramatically after the 2003 Iraq war and Hurricane Katrina.

More abou Fuel Hedging here and here

Types of hedging

Hedging can be used in many different ways including foreign exchange trading. The stock example above is a "classic" sort of hedge, known in the industry as a pairs trade due to the trading on a pair of related securities. As investors became more sophisticated, along with the mathematical tools used to calculate values (known as models), the types of hedges have increased greatly.

Hedging strategies

Examples of hedging include:

    Forward exchange contract for currencies
    Currency future contracts
    Money Market Operations for currencies
    Forward Exchange Contract for interest
    Money Market Operations for interest
    Future contracts for interest
This is a list of hedging strategies, grouped by category.

Financial derivatives such as call and put options

    Risk reversal: Simultaneously buying a call option and selling a put option. This has the effect of simulating being long on a stock or commodity position.
    Delta neutral: This is a market neutral position that allows a portfolio to maintain a positive cash flow by dynamically re-hedging to maintain a market neutral position. This is also a type of market neutral strategy.

Natural hedges

Many hedges do not involve exotic financial instruments or derivatives such as the married put. A natural hedge is an investment that reduces the undesired risk by matching cash flows (i.e. revenues and expenses). For example, an exporter to the United States faces a risk of changes in the value of the U.S. dollar and chooses to open a production facility in that market to match its expected sales revenue to its cost structure.

Another example is a company that opens a subsidiary in another country and borrows in the foreign currency to finance its operations, even though the foreign interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the foreign currency, the parent company has reduced its foreign currency exposure. Similarly, an oil producer may expect to receive its revenues in U.S. dollars, but faces costs in a different currency; it would be applying a natural hedge if it agreed to, for example, pay bonuses to employees in U.S. dollars.

One common means of hedging against risk is the purchase of insurance to protect against financial loss due to accidental property damage or loss, personal injury, or loss of life.

Categories of hedgeable risk

There are varying types of risk that can be protected against with a hedge. Those types of risks include:

    Commodity risk: the risk that arises from potential movements in the value of commodity contracts, which include agricultural products, metals, and energy products.
    Credit risk: the risk that money owing will not be paid by an obligor. Since credit risk is the natural business of banks, but an unwanted risk for commercial traders, an early market developed between banks and traders that involved selling obligations at a discounted rate.
    Currency risk (also known as Foreign Exchange Risk hedging) is used both by financial investors to deflect the risks they encounter when investing abroad and by non-financial actors in the global economy for whom multi-currency activities are a necessary evil rather than a desired state of exposure.
    Interest rate risk: the risk that the relative value of an interest-bearing liability, such as a loan or a bond, will worsen due to an interest rate increase. Interest rate risks can be hedged using fixed-income instruments or interest rate swaps.
    Equity risk: the risk that one's investments will depreciate because of stock market dynamics causing one to lose money.
    Volatility risk: is the threat that an exchange rate movement poses to an investor's portfolio in a foreign currency.
    Volumetric risk: the risk that a customer demands more or less of a product than expected.

Hedging equity and equity futures

Equity in a portfolio can be hedged by taking an opposite position in futures. To protect your stock picking against systematic market risk, futures are shorted when equity is purchased, or long futures when stock is shorted.

One way to hedge is the market neutral approach. In this approach, an equivalent dollar amount in the stock trade is taken in futures – for example, by buying 10,000 GBP worth of Vodafone and shorting 10,000 worth of FTSE futures.

Another way to hedge is the beta neutral. Beta is the historical correlation between a stock and an index. If the beta of a Vodafone stock is 2, then for a 10,000 GBP long position in Vodafone an investor would hedge with a 20,000 GBP equivalent short position in the FTSE futures (the index in which Vodafone trades).

Futures contracts and forward contracts are means of hedging against the risk of adverse market movements. These originally developed out of commodity markets in the 19th century, but over the last fifty years a large global market developed in products to hedge financial market risk.

Futures hedging

Investors who primarily trade in futures may hedge their futures against synthetic futures. A synthetic in this case is a synthetic future comprising a call and a put position. Long synthetic futures means long call and short put at the same expiry price. To hedge against a long futures trade a short position in synthetics can be established, and vice versa.
Stack hedging is a strategy which involves buying various futures contracts that are concentrated in nearby delivery months to increase the liquidity position. It is generally used by investors to ensure the surety of their earnings for a longer period of time.

Contract for difference

A contract for difference (CFD) is a two-way hedge or swap contract that allows the seller and purchaser to fix the price of a volatile commodity. Consider a deal between an electricity producer and an electricity retailer, both of whom trade through an electricity market pool. If the producer and the retailer agree to a strike price of $50 per MWh, for 1 MWh in a trading period, and if the actual pool price is $70, then the producer gets $70 from the pool but has to rebate $20 (the "difference" between the strike price and the pool price) to the retailer.

Conversely, the retailer pays the difference to the producer if the pool price is lower than the agreed upon contractual strike price. In effect, the pool volatility is nullified and the parties pay and receive $50 per MWh. However, the party who pays the difference is "out of the money" because without the hedge they would have received the benefit of the pool price.

Related concepts

    Forwards: A contracted agreement specifying an amount of currency to be delivered, at an exchange rate decided on the date of contract.
    Forward Rate Agreement (FRA): A contract agreement specifying an interest rate amount to be settled at a pre-determined interest rate on the date of the contract.
    Currency option: A contract that gives the owner the right, but not the obligation, to take (call option) or deliver (put option) a specified amount of currency, at an exchange rate decided at the date of purchase.
    Non-Deliverable Forwards (NDF): A strictly risk-transfer financial product similar to a Forward Rate Agreement, but used only where monetary policy restrictions on the currency in question limit the free flow and conversion of capital. As the name suggests, NDFs are not delivered but settled in a reference currency, usually USD or EUR, where the parties exchange the gain or loss that the NDF instrument yields, and if the buyer of the controlled currency truly needs that hard currency, he can take the reference payout and go to the government in question and convert the USD or EUR payout. The insurance effect is the same; it's just that the supply of insured currency is restricted and controlled by government. See Capital Control.
    Interest rate parity and Covered interest arbitrage: The simple concept that two similar investments in two different currencies ought to yield the same return. If the two similar investments are not at face value offering the same interest rate return, the difference should conceptually be made up by changes in the exchange rate over the life of the investment. IRP basically provides the math to calculate a projected or implied forward rate of exchange. This calculated rate is not and cannot be considered a prediction or forecast, but rather is the arbitrage-free calculation for what the exchange rate is implied to be in order for it to be impossible to make a free profit by converting money to one currency, investing it for a period, then converting back and making more money than if a person had invested in the same opportunity in the original currency.
    Hedge fund: A fund which may engage in hedged transactions or hedged investment strategies.

source: http://en.wikipedia.org/wiki/Hedge_%28finance%29


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