Fundamental teaching from a profitable trader

Supply and demand

Ask a man on the street about economy and they will probably slip “supply and demand” as a catchphrase. Even the war on drugs is explained away by “supply and demand.” For example, the lay press or media (and thus a man on the street) might say that drug users are encouraging drug producers and drug gangs and subsequent murders and gang crime. Therefore a cannabis smoker is responsible for the death of some underprivileged family. I'm not going to go into it too much, but it is not that simple. Demand does not directly lead to supply. There might be hundreds of millions of people who want the cure for cancer, but it doesn't mean that it is in ready supply. Demand does not lead to supply. Quite equally, and obviously, supply does not lead to demand, although some lay people might imply this when they eloquently rabbit “supply and demand” when talking about economics.

How I see it is that demand or willingness to pay increases the price of a commodity because a party is willing to go through a transaction at a higher price. The more the person doing the demanding is willing to pay, the higher the price the supplier can offer. If the demand is great, but the demander is unwilling to pay more than $1 (lets say through a trade union) then the price will stay the same. This extends to insurance, shipping, etc. The fact that demand only affects price is very important. For example the demand for torrented movies and albums may be huge – but if the demanders are unwilling to pay anything (which is normally the case when people torrent intellectual property) then the price will not increase and the supply will not increase. In fact, in the case of the record industry mass pirating caused the price to reduce and for record labels to sign less musical acts in effect reducing supply.

If we look at the reverse angle, is supply going to affect demand? For instance, is having 1 million extra copies of a film going to increase demand or reduce it? The answer of course is that it depends entirely on the price. If the price that the supplier is willing to supply at is the same, then the demand will be the same. It is only when the supplier is willing to lower the price then demand will change. If the price is lowered enough, then the 'demand' may actually increase even as the supply increases.

The idea that 'its just supply and demand' is inherently wrong. It would be more accurate to state that supply, price and demand are the cornerstones of the market. Excluding knowledge of the price that the participants are willing to pay makes supply and demand an incomplete concept.

Where supply and demand are met at an equivalent price is sometimes termed 'fair value' (although again, I do not like this phrase because it implies other valuations). Whenever price stops then it can where supply has met demand at a certain value – this is the nature of a transaction and trading. If the price differs from supply to demand then the price will change.

So as traders I am looking for those occasions where supply and demand will differ significantly to cause a price movement that we can speculate on and make money - and this information is not exclusive to candlesticks, trendlines or support and resistance lines.

**caught up with cut and pasting now**

Really enjoying this goldenmember! A very refreshing post so far!

Identifying Supply and Demand

The market just happens to be the place where we trade. For insurance this can be online at a broker, or it can be at a supermarket that sells insurance. We can buy shipping at the post office, online, or via a corner shop. We can lay bets at a bookies or online, or we can lay bets with our friends and work colleagues. There is a physical place where we are trading the insurance, the shipping or the bets. This physical place will pass our trades onto the market or match our requirements on their own books. When we are trading stocks and shares, we are trading through an intermediary broker, which again either trades it on their own books or passes it onto another broker, or the centralised stock market. For many of us, it happens to be the forex market. I don't actually think that it is the optimum place to trade for many different reasons. Certainly there are more predictable markets, more volatile markets, and markets that are just as leveraged.

When you are looking at a market, any market, remember that you take a look at opportunities. You can make money trading technically, and I have assessed that most technical methods will net 1-2% per month with a x10 drawdown (means 2% per month will require a 20% drawdown expectation give or take a few percent - if it hasn't reached this point then it hasn't been traded long enough - psychological factors, pressures, overleveraging and expectations cause accounts to blow up). Or you can look at areas where there is clear demand. This requires you to look at the prospective investment critically as an investor. Be a smart investor who asks questions and makes the correct investments as opposed to a dumb investor who places his money without any idea why he is putting money down.

You should look at each trade you make as a trade you would make as a businessman. It's a huge cliche of 'treating trading like a business' and most people just cram that on the end of their informercials. But have you thought what really treating trading as a business actually means? It actually means that you should work out how much your operating costs are on a trade, and how much you can potentially make. Risking your entire account for '5 pips' is not really a sound business decision for example. Imagine that you ran a electronics business. With 100k of capital would you risk 100k to make 1%? Put this another way: would you really buy $1000 worth of electronics to sell them at $1010 on ebay (minus fees)? Of course this is a bit of a broad view - if you definitely knew you had a buyer for your electronics at $1010 then it's a reasonable business decision. But if you are uncertain who is going to buy then it is a bad decision. For instance you could look at someone buying 2 playstation 4s pre order. If they had a reasonable guess that the preorders were oversubscribed, and that PS4s would be a popular in demand then its a reasonable business decision. But if you were buying something you knew nothing about, or you were just buying because a blog told you its a good idea then it's a poor decision.

Relating this to trading oil, currencies or anything else, you need to identify opportunities. Let's take oil as an example. Most people know why oil is in demand. Traders should also know the main producers. If you knew that oil was produced in which countries for what price you should know essentially 'the low.' Of course price can fall lower than this (such as it did in 2008) but if you are buying oil at a lower price than it costs to produce then you are making a reasonable deal. Of course you still must use stop losses (which are essentially your investment) but you can be reasonably sure that you will make money. I notice that a lot of traders are critical of 'hold and hope' but the reality is there is a difference between holding a good trade (ie: cheap oil under the production price) and holding a bad trade (which many signal followers don't understand). Other than this production price for oil you can also find other opportunities. One example is the USA military, large airlines, shipping companies, oil fired power stations. Oil pipeline leaks, increased driving habits and many other factors are real world changes in supply and demand. Notice that none of this not mentioning pin bars, engulfing patterns, stochastics, support and resistance or anything else.

this world is like this, real gold tends to be ignored, why? the mining work is too damn difficult.

only a couple of readers so far, lol, ppl don't know what they are missing.

this thread is almost publishable as a book!

I was considering publishing something as an ebook - of course I need to make it more entertaining and readable. Unfortunately most traders prefer threads with lots of charts with lines written on them with "I made 40 pips with this trade." It's very similar to those informercials which state 'I made 3x the sales with this cool trick." - there is only a small proportion of the market that is interested in understanding business and trading.

i'm keeping a keen eye on your thread. many mistakes that you mentioned have tortured me before, and i also find a few that i didn't realised till reading your thread. very nice!

we are trying to kill as many mistakes as possible, then those left might be what's right, lol.

Thanks - one thread I have been keeping an eye on is the EURUSD thread lately... It's interesting to note that many many of the members post up their charts predicting what is going to occur - I note that not one of their predicted charts has come to pass - yet they still claim that their method is what they use to trade profitably (even though none of their predictions are correct). It's quite funny if you think about it.

Thanks goldenmember! As I said great thread so far! Really looking forward to seeing how you go about deciphering the huge amount of fundamental info out there. Personally I just find there are so many variables so really looking forward to hearing some more about your approach- Thanks!

It helps to look at things on a longer term. Most traders 'trade the news' - ie: they buy a 'good number' and sell a 'bad number' without thinking what it means on a long term perspective. For example a +10k NFP means nothing in a background of NFP misses. Its amazing that people still trade a single +0.5 German ZEW or -0.5 ZEW, because by itself it has little impact despite being coloured red on the forex calender. It's also worth noting that forex is one currency vs another, thus at least double the complexity of good news/bad news that you might get in stocks. Stop hunts do happen as the banks that provide liquidity like to make money, and if there is not a big buyer or seller they will constantly stop out retailers and this happens a lot when 'news that doesn't matter' is released. Speculators love to trade 'news that doesn't make a difference' just as they like to trade candlesticks. I limit my trading to factors that effect the overall impact and make plans and eventualities, not just make constant snap judgements. There are 100s of tiny little calendar releases and news every single day, with more that do not appear on the calendar - if you try and trade all of them you will just be gobbled up. The big 'picture' is what is important, and it's also important not to try and trade perfectly (ie: buying at 1.2 and expecting to hit 1.3 in a perfect cup and saucer pattern.

Great thread Goldenmember! I'm still snickering about the Grand Master Flipper. You know that guy is going to try to sell a book fast. "How I developed my Sixth Flipping Sense, in three easy steps"

Recognising supply and demand Part 2

So how else do you recognise when something is in 'supply' or 'demand'? Forget about currencies, forex etc, and just think about the basics and how you would recognise it in simpler everyday products. How about Sony Playstations and X Boxes. Or Apple products or jeans? If you decided to walk into a shop and looked at how many Sony Playstations were on the shelf or whether there was a sold out sign, you would have a good idea. Same with Apple products and jeans - if there are massive inventories or if you have to put in an order because they are sold out, you have an idea of demand. Price of Sony Playstations and jeans is very much a secondary indicator, If the retailer discovers that within a week he is only shifting one pair per day, or one playstation every other day, he is not going to immediately discount it down. Most retailers will give their products some chance before they discount it. It may be a month, half a season, or even a full season - but importantly, the price doesn't immediately tell you whether the pair of jeans is in 'supply or demand' - it is the fact the shop is full and no one is buying or everyone is buying that tells you this. For all those 'price action gurus' that claim price is a leading indicator, does not lag, and only price tells the truth - I would look at real world situations and ask yourself - can I tell more quickly if a pair of jeans is in excess supply or demand by a) looking at the price tag or b) walking into a few shops and looking?

And secondly - does the price tag on the jeans indicate - whether the jeans are in excess supply or demand, or does it indicate other pressures on the retailer - perhaps they did not buy enough jeans, or perhaps they did not have enough time to shift out the cargo pants - maybe this will cause a price adjustment?

There are other indicators of supply and demand as well for jeans. Is it in fashion? Is the media raving about them? Does your significant other already have a pair? Are people wearing them around work? In the case of the new XBox, are your friends having Xbox parties? Are they discussing the new game? Or do they have no interest in it at all? The lack of interest/interest should be apparent before the retailer slaps a 20% off price tag on the machine or even before X Boxes are being resold on ebay for a 50% mark up.

So how does this relate to trading? First of all, we can relate this to shares (this is less of a leap) - let's talk about companies. Many companies produce products. And selling these products/services will relate to profits. And increased profits can lead to increase demand for shares. Lots of steps, but you can see how the basic footwork of seeing demand or massive unsold inventories can tell you what is going to happen well before the earnings comes out and well before a 'candlestick' is formed on the charts.

yeah but how do you relate all of what your saying to trading currencys?

I mean what are the economic indicators that one should be looking for?

Is it something that can be done on a daily basis?

I think that what you look for depend on what is currently influencing the demand of the currency you are looking at. For example, the Euro crisis in 2011/12 was about unwillingness to lend to governments because of lack of confidence that they could pay back.

Give another example pertaining to now, recently , yesterday. What is the sentiment and what do you look for on a daily? where to look?

One if the examples I am currently looking for any signs of strength in the US manufacturing sector, lack of price stability in the Eurozone (since government lending is not an issue)

I have been asked quite a few times, what is my system, but the truth is that I don't use a single system. Trading is discretionary, and I use several systems, or set ups or situations which I think give a good return. All of these systems and methods are not useful if they are overleveraged or if there is no trade management. Moderate returns and managing trades is the way I have been able to perform in the markets.
So what are my methods and systems - I will talk about them in a general overview since they discretionary and require experience to be able to discern them. They are not buy a candlestick or buy a 61% fib line. I will list them:

Method 1 - Event based trading
Event based - there are plenty of events that cause large movements in the forex markets. So what do I classify as an event? I think of a series of events and rationalise the effect that they would have on the market. Several examples - US entry war in Syria would cause a rise in the price of oil because of military use. Reallocation of the Japanese pension fund would cause the yen to be sold to wherever the reallocation takes place, purchase of Astrazeneca would cause a reallocation of funds, nuclear plant building in the USA would cause another reallocation, as do earthquakes and natural disasters. This differs from events such as high unemployment, or weak retail sales which are essentially economic indicators rather than an event.

Method 2 - Unexpected economic events
A lot of traders watch the calendar and try to trade it. I once backtested through the economic calendar for several months and marked how often the price would go up or down 30 pips based on a better than expected or worse than expected result. The result was 50/50. Whether it was green or red (better or worse) half the time it would make the price go up, half the time it would make the price go down. This indicated to me that there was no point in trading these events as they did not predict price in isolation. The only way to predict the price with any degree after a calendar result is if the economic event differed significantly from expectations. The expectations on the calendar and provided by analysts is often obviously far off if you look at other economic data.

Method 3 - Pure technical support and resistance
There are a lot of methods to draw support and resistance - what I have found more effective is to only look for areas where the support and resistance is significant. M15 charts and M5 charts are not significant for me, although I am sure they could work. I don't predict price (ie: it will go from 1.34 to 1.36 and then retrace to 1.3560 and then complete wave 3) but I just trade the reaction from pure technical support and resistance if it is significant for a smaller amount of pips.

Method 4 - Combined technical support and resistance
There are always reasons why technical support and resistance are created - especially when there are unexpected events that cause technical support and resistance to be broken. Once these unexpected events result in technical support and resistance to be broken that support and resistance becomes significant in the future. This is essentially combining what some people note as fundamental analysis and technical analysis.

Method 5 - Automated trading portfolios
There are plenty of automated systems that do work. Many of them rely on cost averaging and only provide very slight returns over time and cannot trade on high leverage. They also need to be managed. When there are significant 'trends' reducing or switching off your allocation to range bound automated traders should be limited, and when there are significant range bound markets, then reducing the allocation to break out and volatility strategies should be limited. Again, a single strategy automated is not useful. Combined with a rebate service (preferably one that does not widen the spread - this does happen so check with them before you do this) even if you make a small loss on the markets, you can end up taking money.

Method 6 - Cost averaging trades
Although traders love to be able to say that they caught the top, or caught the bottom, the overall purpose of trading is to make money rather than to show off how you can predict the future. I am not so much of a fan of cost averaging, but over recent months the low volatility in the market (about a third daily range from when I first started) has meant that cost averaging methods do work. Of course, if you did without knowing the background (ie: shorting EURJPY when the BOJ were doubling the monetary base) you could suffer - but as long as you have an exit strategy, and a reason for entering, plus use very low leverage in total, it can provide slight returns over time. But its important to stress that you do need to have a purpose for cost averaging - in my mind it is no good cost averaging a position for the sake of it.

Method 7 - Long term distribution and accumulation
Distribution and accumulation is one of the methods used in stock analysis on a long term basis. In forex for some reason people have attributed it to the 5 minute chart or 15 minute which is fundamentally wrong because movements on smaller timeframes do not reflect accumulation and distribution to an accurate degree in my estimation. This is because of the scales of small charts (I don't believe charts to be fractal unlike a few other traders). Long term distribution and accumulation can offer worthwhile position based trades.

Added to this are a few technical set ups and all the methods I don't use. Plus please note the trade management that I have harped on about. Note that this means that there are plenty of opportunities in trading, but I take very few of them on a discretionary basis so I limit my exposure to losses. As I have mentioned in all of my previous posts there is so much deception and bad trading advice out there. If you paid attention to none of it, you would be a break even trader (because you wouldn't take any trades - you might even collect interest on your deposit). If you pay attention to some of the bad methods, bad advice, fake news etc out there, you immediately start to lose money - making avoiding bad trading methods just as important as good trading methods. In fact, considering there are a lot more bad trading methods out there, it is easier to trade badly than to trade well. For all those profitable traders out there - just imagine if you hadn't listened to all the rubbish advice - how much further along would you be?

For those interested I am about to embark on managed accounts - there are more details on myfxbook, or you can contact me.

Some random commentary: (not a specific teaching point)

Low volatility seems to be a buzzword and certainly my returns have been suffering since I am a longer term trader, and the markets do not tend to be going anywhere in a hurry. If they do go somewhere, they come back the next day - a great environment for scalpers, especially those who increase their leverage, but very nasty for so called swing traders or those who are looking for markets to trend - if a trend finally comes, it has made a false break about 10 times. I've seen several ways people have coped - and some have coped very well. I have seen some traders scoop in for 5 pips and escape again - when the market is moving 5 pips per session there is little else you can do. I have seen some grids perform amazingly well - and in reflection that is a very good way to trade this environment. As I view it, it's simply not worth prizing one currency over another because the market doesn't appear to prize it. Translating it to real world terms - if the market was a wholesalers, the margins are simply not there to buy one thing and to sell it. I don't have any reasons to why this might be happening, although I have read some funny ones that I would share with you:

1. All head forex traders have been sacked therefore they don't trade anymore (this seems to disregard that mutual funds and starter funds that buy currency are more active than ever)

2. The market is settling down after the Euro Crisis and the 2007 crisis and therefore this is normal (one of my favorites from a blog that constantly produces rubbish - disregarding that the volatility was higher pre 2007)

3. The amount of QE has meant that there is more currency around so prices move less (I have no idea about this one - possible, if sudden)

I am not even sure if forex volumes have dropped - with some sites reporting that spot volume has dropped (thomson reuters) while reporting that FXall has gone up this year - in short I have no idea... but its certainly a trial to get through.

On another note (and an ulterior motive) I have opened a new website at www.bestpammaccounts.com (how modest) where you can read about my managed accounts. I have also rebranded into Tigris Equity since goldenmember was a random forum nickname. My new myfxbook can be found using that name. I know that this will probably boot me into the commercial section, but after the last conversation I had on trading with someone, I don't think I will miss posting on the forum very much! If you want to message me, it will have to be done through the website or myfxbook as I will be prohibited from sending PMs.