Real Forex Trading pt.1

Burton Malkiel, an American economist once wrote, in the context of investing in the stock market, ‘Technical analysis is an anathema to the academic world’ (p.146). Forex trading is not investing, it is speculation, and as a consequence, Malkiel is speaking outside of his area of expertise. Investing is a reputable strategy to earn money, and it also is an important asset to the economy as a whole. It is true that speculation is less important in the order of things, but that does not mean that it is not academic. What Malkiel means is that technical analysis is anathema to the economic academic world. To understand the difference between speculation and investment, see Game Theory.

Instigated by his Ph.D thesis in the sixties, Eugene Fama, developed a concept known as the efficient market hypothesis. He argued that financial markets are informationally efficient, meaning that the value of shares or currencies etc have priced in all the currently known information that contributes to its value and as a consequence it is not possible to profit from any method that seeks to base the future value of a currency on previous historical data. The hypothesis was based on the concept that the values of stocks etc move according to a random walk and as a consequence cannot be predicted.

In its strictest form, this theory negates the profitable investment strategies adopted by popular investors like Warren Buffett and George Soros. In whatever form the efficient market hypothesis is taken, forex day trading is to be placed alongside alchemy; it is like trying to turn lead into gold. Fama’s hypothesis is problematic for one simple reason; it is humans that are trading. When trading, humans need something concrete to conceptually connect to and as a consequence, when financial data is released, they do not simply respond to the data, but they try to connect that data some form of reality that has gone before and that reality is found in historical graphs.

As I write, Britain’s housing market is looking increasingly precarious because house prices have become incredibly high. Fama would say that those prices reflect all the data in the market. A technical analyst would say that those prices do not conform to historic norms and as a consequence they must eventually come down… I have an inkling that both are correct in this context. Fama’s hypothesis doesn’t explain other features like stock market crashes. Also, if the forex market conformed to the concept of a random walk, how could there be lines of resistance and support in the graphs? These lines suggest an order to the graphs that goes against the random walk hypothesis.

What appears to be a better explanation is this; the market is informationally efficient in that the price of a currency etc reflects their current market value. However, there will be different schools of thought regarding its actual value, and as a consequence, different prices will prevail at different points in time, creating oscillations in the graphs. Due to the leveraged nature of forex trading, a speculator can identify these oscillations and trade them. On top of this, the majority of forex traders are seeking to profit from these oscillations (rather than being a broker and charging for the exchange). As a consequence, one should expect to see significant movements in the graphs as speculators seek to take advantage of the fact that another school of thought is prevailing in their opinion of a currency’s value.

‘Schools of thought’ can also be interpreted as the release of fundamental data. For example, it might be that inflation is getting worse, but retail figures remain stable, what will we see in the graphs? When the inflation data comes out, the price will swing one way, but when the retail figures come out, the price will swing another way and these tend to be revealed according to set patterns like channels in the graphs.

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Bibliography
Eugene Fama, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’, Journal of Finance, May 1970.
Eugene Fama, ‘Random Walks in Stock Market Prices’, Financial Analysts Journal, Jan-Feb 1995.
Burton Malkiel, ‘A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing’, W. W. Norton, 2003.