In terms of market capitalization, the New York Stock Exchange is the largest stock market in the world. That's why it's also termed „the Big Board.“ Located at Broad and Wall Streets, it is called the „Sunshine Market“ because the public can always view its trading floor through gallery windows. CNBC and other financial television networks televise the busy floor each morning.

The NYSE lists more than 3,000 companies, representing in excess of 253 billion shares of stock, valued at over $11 trillion. These equities are referred to as „listed stocks“ and most have large market capitalizations. „Market cap“ is measured by an equity's number of shares outstanding (shares available to the public not held by corporate insiders) multiplied by the price of a single share of stock. For example, as of this writing, industry titan General Electric (OE) has 9,908 million s~ares outstanding. The price per share is approximately $50. So GE's market cap is a whopping $495,400,000,000!

You may have heard GE referred to as „the bluest of the blue chips.“ Trivia lovers take note: The term „blue chip,“ a moniker applied to the thirty stocks that make up the Dow Jones Industrial Average, comes from the game of poker. Of the chips used to represent dollar valuations, the blue chip has the highest value of all: $500.

Within the New York Stock Exchange, a number of major indices give us daily clues as to the inner workings of the market. The most famous, of course, is the one just mentioned, the Dow Jones Industrial Average.

The 105-year-old „Dow,“ as we call it in Street short-speak, started with twelve stocks and now consists of thirty reigning icons of American industry. Traditionally, only NYSE stocks were appointed to the Dow. In the last couple of years, however, Intel (INTC) and Microsoft (MSFT), two of the 800-pound tech gorillas that led the Nasdaq to dizzying heights in the late 1990s, were appointed to the index.

Other important indices within the NYSE are the Dow Jones Transportation Index, consisting of twenty leading transportation stocks, and the Dow Jones Utility Index, comprised of fifteen utility stocks.

The NYSE operates on a centralized auction system. Different „posts,“ each representing a different stock, pepper the floor of the exchange. At each post, a specialist (read „auctioneer“) conducts a two-way auction between buyers and sellers and provides a market for that. stock. Only one specialist represents each stock; for example, GE has only one specialist. Specialists, however, can represent more than one stock.

Where You Come In

Say you want to buy 100 shares of Citicorp, Inc. ©. Basically, your order can be filled one of three ways:

1. You call your broker or you place the order through your online broker. The broker sends your order to the floor of the NYSE. A floorbroker representing your broker takes your order to the post where Citicorp is traded and asks the Citicorp specialist for a market. The specialist announces the „size“ of the market, or the number of Citicorp shares offered for sale at the best price, and the number wanted to buy at that best price. Your order is filled, and your broker confirms the price to you.
2. You give your broker the order by phone or Internet, and he or she enters it onto a SuperDOT (designated order turnaround) machine, an electronic system that routes your order to the specialist. (SuperDOT handles about 80 percent of all orders entered on the NYSE.) The specialist fills it and shoots it back to the clerk. The clerk informs your broker of the „fill“ (the number of shares and the price at which your order was filled), and your broker informs you.
3. You execute the order yourself on your direct-access trading (DAT) software system. This zaps the order from you to the specialist, and you usually receive the fill information in less than a minute.

When we say the specialist announces the „market“ in Citicorp, an example would be „48.88×49, size 5,000×10,000“ (the „x“ meaning „by“). Translation: A buyer, or buyers, is waiting to buy a total of 5,000 shares of Citicorp and is willing to pay $48.95 per share. A seller, or sellers, currently offers (wants to sell) a total of 10,000 shares at $49 per share.

The price difference between the best (lowest) price you can purchase the stock for and ~e best (highest) price you will receive if you sell it is called the „spread.“ In the previous example, it would come to five cents per share. If stocks were people, NYSE stocks would bear the reputation of being haughty statesmen and dignitaries. Perhaps, because their specialists are charged with keeping „a fair and orderly market,“ listed stocks may have rapid price changes, but most tend to step up and down their price ranges in a mannerly fashion.

If you're new to the stock market, I recommend you target NYSE issues for your first trades. You'll be less prone to the eye-bugging, stomach-clutching attacks that can be brought on by Nasdaq high-flyers.

One of the approaches to determine or predict curency exchange rates is that involving the analysis of interest rate differentials (the Interest Rate Approach). This involves a number of different principles and we shall go through them briefly and in turn. The first principle involves the basic interest rate parity theory, which is that:

An exchange rate’s forward % premium/discount = its interest rate differential

Thus, for instance, the traditional forward discount on the dollar–yen exchange rate should equal the interest rate differential between the two currencies. This is seen as the equilibrium reflecting the relationship between the exchange rate and interest rates. Because forwards are a traded instrument and thus subject to supply and demand, the forward premium or discount can vary briefly from this equilibrium, but should always revert to norm. After all, if for argument’s sake the forward premium/discount for some reason did not equal the interest rate differential between the two currencies an arbitrageur could in theory make risk-free profits by borrowing in one currency, investing in the securities of the other currency and simultaneously opening a forward contract in the exchange rate for the same period as the initial loan. This is called covered interest rate arbitrage.

The theory of interest rate parity is a guiding principle for several economic and financial models. Under this theory, it is assumed that the expected (interest rate) returns of a currency should be equalized through speculation in another country once converted back to the first currency. This may sound like gibberish, but basically this is an interest rate version of PPP— and like PPP its results are decidedly mixed. Indeed, there can be significant violations of the interest rate parity theory for substantial periods of time without the immediate reversal that covered interest rate arbitrage might suggest. Not too surprisingly, this is a dismal predictor of exchange rates.

Indeed, before we go further into the theory, it is important to point out a practical flaw in the theory involving incentive, which is undoubtedly a key contributing factor to its poor predictive track record—the theory supposes an automatically causal relationship between interest rates and the exchange rate, yet in practice most currency market practitioners trade currencies with directional rather than interest rate considerations in mind. Even this statement is a generalization. On a simple numerical basis, the majority of currency market practitioners are made up of interbank dealers, thus it is important and necessary to look at their motivation for trading. Spot traders for the most part care not one whit about a currency’s interest rate, in part because they hold positions for too short a time for it to matter, in part because they are seeking to predict direction—and thus make capital gains on their position, not primarily to make interest income. Forward traders are a different breed entirely and more akin to money market or interest rate traders. Indeed, theway they hedge out their forward exposure frequently involves an array of interest rate-related instruments. Eventually, interest rate parity violations will be reversed, but there is little incentive to do so in the immediate term if you don’t care about the interest rate in the first place.

Returning to the theory for now, interest rate parity theory states that the difference between a spot and forward exchange rate expressed as a percentage should equal the interest rate differential between the two currencies. Yet, we know from the PPP principle that exchange rates and inflation rates are linked. Can we not link these also with interest rates? Indeed we can, thanks to the seminal work of the economist Irving Fisher. Thus, according to what has become known as the “Fisher effect:”

The difference in interest rates = the difference in expected inflation rates

Thus, we have gone from the difference between the spot and the forward exchange rate equating to the interest rate differential through the interest rate parity theory, which in turn equates to the difference in expected inflation rates through the Fisher effect. Yet, PPP tells us that absolute or relative price growth levels can be used to forecast future exchange rates.

Thus, through PPP we can extrapolate this one stage further to suggest that:

The difference in expected inflation rates = the expected exchange rate change

Bringing all these together, we get: (1) The difference in spot and forward rates = the difference in interest rates (Interest rate parity theory)

(2) The difference in interest rates = the difference in expected inflation rates (Fisher effect)

(3) The difference in expected inflation rates = the expected change in spot exchange rate (Purchasing Power Parity)

Logically from this, one may conclude that the difference between the spot and forward rates expressed as a percentage should equal the expected change in the spot exchange rate. This is known as the expectations theory of exchange rates.

Finally, there is the theory that: (4) The difference in interest rates = the expected change in the spot exchange rate (International Fisher effect)

On the face of it, the ideas presented above seem logical and follow a clear and persuasive train of thought. There is only one small problem—this clear train of thought rarely works in practice. More specifically, the difference in interest rates or expected inflation rates may be equal to the theoretical construct of the “expected change in the spot exchange rate”, but in practice it is of the future exchange rate. In line with this, the forward rate is also a very poor predictor of the future exchange rate, a fact that economists have labelled “forward rate bias” or the “forward premium puzzle”. As Bansal and Dahlquist confirmed in their exhaustive study, in contrast to the theory, empirical evidence suggests that in fact current interest rate differentials and future spot exchange rates are frequently negatively correlated. This is particularly the case within the developed economies, though the picture is somewhat more mixed within emerging market economies.

Over the long term, the interest rate parity theory is seen to work as enough market participants can be found to “discover” the opportunities available for covered interest rate arbitrage between currencies and interest rates, thus in the process eliminating such disparities. However, there are much longer lags than the theory might suggest is possible. Here again, the issue of incentive must be a focus. As noted earlier, it should behove the theorists to know that the majority of currency market practitioners are currency interbank dealers and moreover that the main incentive for these to trade is directional gain rather than interest income. Currency markets do focus on interest rate differentials for extended periods of time, but equally they focus on other factors, in many cases completely disregarding interest rates.

Real Interest Rate Differentials and Exchange Rates

Currency strategists do however use models comparing the real interest rate differential with either the nominal or the real exchange rate between two countries. The logic behind this relates to both the international Fisher effect and to PPP, where on the one hand the difference in interest rates should, if not be exactly equal to an expected change in the spot exchange rate, at least be an important driver of it, and on the other hand where nominal interest rate differentials are adjusted for inflation (i.e. domestic price growth) and thus relate to the exchange rate through the law of one price.

The link or correlation between real interest rate differentials and the exchange rate appears to have grown exactly in line with the gradual move since the end of the Bretton Woods exchange rate system to liberalize capital flows globally. As barriers to capital movement have fallen, so the overall importance of capital flow has grown exponentially relative to that of trade flow. Exchange rate models that focused solely on the current account no longer seemed appropriate in such a world, those that focused on capital flows seemed increasingly so. As capital flows have gained in importance, so their importance within overall currency market flows has grown and thus the correlation between the two increased. Thus, currency strategists across the market continue to track this relationship between real interest rate differentials and nominal exchange rates as one of many useful and important indicators of currency over- or undervaluation. Figure 1 compares the Euro–dollar exchange rate against the 10–year bond yield differential from 1996 through to the end of January, 2002.

Support and resistance are the actual outcome, or the result of, the interaction between fear and greed and supply and demand. Understanding how they all work together is like watching a magnificent, orchestrated dance. It also gives you a giant advantage for making money.

As you read, keep this statement in the forefront of your mind: for every action, there is a reaction.

Support and resistance will form the foundation for every trading decision. You can trade without oscillators and indicators and moving averages. You can even eliminate charts altogether from your financial decisions (although I wouldn't recommend it). But even floor traders in commodities pits who rarely see a chart will mentally compute where price resistance and support lie, even as they shout and use hand signals (called „open outcry“) to get their orders filled.

The concept behind support and resistance is a simple one, and once you digest it, you will have absorbed the basic premise underlying market moves.

Picture this: You're standing in the living room of a house, on the first floor. In your hands, you hold a ball. This ball equals the price of a stock. You toss the ball over your head. It soars upward, and hits the ceiling. The ceiling keeps it from rising higher, so the ceiling equals resistance. Now, the ball falls back down and bounces on the floor. The floor stops it from falling further, so the floor equals support.

Next, you spot a hole in the ceiling. You throw the ball as hard as you can, and it flies through the hole in the ceiling. It rises to the second-story ceiling and hits it. That ceiling equals resistance. Then, the ball falls to bounce on the second-story floor, which now forms support. Understand that the first-story ceiling supports the second-story floor. Result? Resistance becomes support.

Continue by running upstairs and grabbing the ball. Throw it back through the hole, down into the first-story living room. When it drops through the hole in the floor, it breaks through support. It falls to bounce on the living room floor, or previous support.

Then, it rises to hit the ceiling, or previous resistance. Run back down the stairs. Take the ball and toss it through a hole in the floor. The ball descends to the basement floor, which forms support. Then, it rises to bounce off the basement ceiling, resistance. Just above the basement is the living room floor, which uses to provide support. So now, previous support forms resistance.

The below figure illustrates support and resistance.

When the ball, which we'll now think of as a stock price, bounces off of support or resistance, we refer to it as a pivot point, which is illistrated in the below figure.

As you study support and resistance, remember, they are price areas. You will have to find a specific price to refer to, for example $54, but give it a little leeway. Picture yourself jumping on a trampoline. The trampolin.e supports you when you land on it, but the depth of your bounce varies a little each time. Also, just as heavier people stretch the trampoline base lower when they land, more volatile stocks need a little extra latitude in theif resistance and support areas.

Since you now know what support and resistance look like, let's quickly find out how they actually form. Go back to imagining the ball bouncing from floor to ceiling in the basement. Now, apply that to a stock in a Stage One, or basing price pattern. The basement floor is support, and we call it that because buyers are supporting the price. Were it to start lower, buyers (greed + demand) step in and accumulate, thus keeping the price from sinking lower.

When the price rises to the basement ceiling, it hits resistance. Resistance equals buyers who jam their hands in their pockets and refuse to pay a higher price for the stock. Also, resistance equals supply. At this point, some previous buyers, as mentioned before, revert into sellers. Afraid (fear) the stock will rise no higher, they offer their stock for sale, thus flooding the market with supply. If the stock falls here, the next time it rises to return to this price area, it may sell off again. Why? Because we have memories!

Say the stock shoots through the resistance (supply is absorbed). Maybe the sector it inhabits is in a favorable spotlight, the bulls are in control of the market, or the company itself enjoys a spurt of good news. The price will continue to rocket-maybe for hours or days-until a new factor suppresses it. When it „sells off,“ that pivot point creates fresh resistance. The stock then falls to the earlier resistance area, which is now the „floor,“ or support. It will hold there if buyers absorb the supply, and in so doing, „support“ it.

Support and resistance levels apply on every chart you'll ever see, whatever the time frame. In fact, you may have guessed by now that all the applications you'll learn about charts hold true on all time frames. That means the concepts you find in these pages pertain not only to swing-and-position trading, but also to strategies including active trading and traditional buy-and-hold investing.

The below figures show support and resistance areas on a weekly chart, a daily chart, and a fifteen-minute intra-day chart. As you study these charts and observe support and resistance levels, you may be amazed athow reliable they are!

The traditional exchange rate models, which are based on some form of equilibrium value, do offer an important and useful long-term guide towards exchange rate prediction. Indeed, without these long-term signposts, currency strategists might be quite lost in seeking to predict exchange rates past one year out. As a result, in terms of their usefulness to specific types of currency market practitioner, corporations, strategic “real money” investors or “macro” hedge funds with a multi-month or even multi-year perspective would probably find them most valuable as an analytical tool. On the other hand, these traditional exchange rate models are unlikely to be of more than passing interest or use to short-term speculators or interbank dealers whose time frame is far shorter.

The apparent weaknesses of traditional exchange rate models, I would suggest, adds to this case that such an integrated currency strategy framework be adopted. It has to be said that to date, when faced with the unsatisfying results that the traditional exchange rate models have produced as far as predicting exchange rates is concerned, the economic community has for the most part either ignored these inconvenient results or declared that it is impossible to forecast short-term exchange rate moves as they are determined by the so-called “random walk” theory. Occasionally, there has been a paper, illuminating in both its honesty as well as its intellectual acumen, which has “fessed up” to both the failure of these models as predictive tools and a lack of understanding as to why that may be the case. The majority of the time, however, the reaction to the obvious question has been denial or the random walk excuse. According to the latter, since traditional exchange rate models do not appear able to predict short-term exchange rate moves, it must follow logically that such short-term exchange rate moves cannot in fact be predicted at all and must therefore follow a “random walk” path, suggesting an equal probability of appreciating or depreciating over time. Fortunately, however, recent developments in technical and capital flow analysis have achieved significantly better results in predicting exchange rates than the random walk would imply. Thus, the correct approach to analysing and predicting exchange rates would seem to be to use market-based approaches such as technical and flow analysis for short-term exchange rate moves and the traditional exchange rate models for medium- to long-term predictions. This is certainly not the whole story in trying to create an integrated framework for analysing currencies, but it forms a good start in our understanding of how we should approach exchange rates.

Building on this, going forward, it seems logical to assume that traditional exchange rate models should be modified to suit the modern structure of currency market flows. More specifically, trade flows, which form the premise behind the PPP, Balance of Payments and External Balance Approaches, were once seen as the main driver of currency market overall flow. However, nowadays, they make up only around 1–2% of the USD1.2 trillion in daily volume going through the currency market. Hence, as the overall importance of trade to total market flow has declined, so to a degree has the relevance of those exchange rate models that rely solely on shifts in trade flow patterns. Meanwhile, just as the pre-eminence of trade flows has declined, so the importance of portfolio flows has grown exponentially as barriers to capital have been lifted over the past two decades. The Portfolio Balance Approach is clearly an attempt to focus on asset markets and specifically the bond market as a driver of exchange rates, yet this model remains unsatisfactory as a predictor of exchange rates for the reasons given. In order to try to get to a better answer of exchange rate movement over the short term, we have to define the main flow drivers of exchange rates:

1. “Speculative” flow (without an underlying attached asset)
2. Equity flow
3. Fixed income flow
4. Direct investment flow
5. Trade flow

By far, speculative flow is the main driver of exchange rates over the short term. It is not sufficient to suggest that speculative flows follow a “random walk” for the simple reason that both technical and flow analysis have discovered consistent patterns in short-term exchange rates which should not exist under random walk theory. Within asset market flow, equity and fixed income flows continue to do battle for pre-eminence. For instance, from 1998 to mid-2000, net inflows to the US equity markets were a key driver of dollar strength. Equally, as the US equity market began to falter, the resulting equity outflows from the US market weighed on the US dollar. Eventually, however, these flows were more than made up for by fixed income inflows to the US fixed income markets as the Federal Reserve continued to cut interest rates to support the economy. Direct investment is also an increasingly important driver of exchange rates, both in the developed economies and in the emerging markets, as barriers to inward investment have also fallen away. In 2001, the top five performing currencies in the world against the USD were the Mexican peso, Polish zloty, Czech koruna, Hungarian forint and Peruvian sol, all of which benefited from substantial direct investment inflows which had a significant impact on their exchange rates.

The importance of all of these flow types continues to fluctuate in line with market trends. What is clear however, is that until there is a specific exchange rate model which focuses on the main flow dynamic of the currency market, namely speculative flow, it is unlikely that exchange rate models in general will be able to improve upon their current accuracy to any significant degree. In the next chapter, this is in fact what we will try and do—to build a simple exchange rate model which focuses on speculative flow. In addition, we also examine how to use “currency economics”, or the bits of economic theory that are relevant to the currency market, in a practical manner for currency forecasting, trading and investing.

January, 2003

Know where the price support and resistance areas are on a chart. These are areas that have halted the movement of the stock in the past. The more times a particular price has stalled the stock's movement, the stronger that support or resistance area becomes. Price support lines can be drawn horizontally through lows on a bar chart where price tended to bounce up. Thus this price level is „supporting“ the stock. Price resistance lines can be drawn horizontally through highs on a chart which the stock: resists moving up through. Very often you will find that a support area which the stock penetrates to the downside will become a resistance area in the future. And likewise, a resistance area that a stock finally penetrates to the upside becomes a support area in the future.

The daily chart's support and resistance areas will help you better decide whether a trade setup is worth entering. If there is a lot of resistance just above where you would buy the stock, then you may want to pass up the trade. On the other hand, if a price resistance area is being broken or has recently been broken through to the upside, a buy trade setup has a better chance of success with the stock moving up further. Look for these areas on the daily and intraday charts to find the nearest upside resistance level up if you are buying or the next support level down if you are selling. If there is enough room for a 1 + point move, you have enhanced the odds for a successful day trade. Also, if the daily chart shows good support at a price level, and you have a „wide range bar w/extreme close“ or a „reversal bar“ setup long that held at a pnee support area, then this might present a strong buying opportunity. Remember not to impose your ideas on the market, but instead reacE to what it tells you with tiie daily and mtraday setup patterns. The S/R. levels will kelp you find the best trades to enter.

„Trading congestion“ is something to stay away from. If a stock is not trending, has narrow range daily bars (from high to low), or is just chopping sideways, then avoid it. Wait until it breaks out of congestion and begins some good daily price swing activity. This is when you look for the trade setups to act upon. Also, look at the recent average range of a daily price bar (from high to low). If that stock doesn't trade over a point or more on a regular basis then you probably won't want to trade it. Look for the bigger profit opportunities with stocks that are currently in a „trader-friendly“ mode.

You'll also notice that many times the 50 and 200 day moving averages act as price support and resistance. This is because many fund managers monitor these averages and use them in their buying and selling decisions. Being aware of where these lines are can aid your analysis. This is especially true if a stock has traded up or down to one of these averages at a point which also coincides with a price support or resistance level.

Support and resistance levels aid your decision making for day trades. They show how far a stock can be expected to move up or down on both an intraday and daily time frame. This is the final step (or filter) to confirm a potential trade, or to rule it out.

March, 2004

Industrialized economies progress through cycles of expansion, peaking, trough, and expansion again. It follows then that the major industries propelling those economies pass through four phases during their existence: introduction, growth, maturity, and decline. Those industries consist of separate companies, and of course, the securities issued by those companies tend to anticipate business cycles and move in the same direction.

When you look at a stock chart below, you can observe its price history and the cycles – or series of peaks and troughs – that it's completed so far.