Effect of the Business Climate In Price Valuation

The same forces that affect the value of a business have an
impact on the price of currencies. In fundamental terms, a
company is valued on the basis of its balance sheet and current
or future income as well as intangible factors that will
affect that future income, including business model and plan,
management and leadership, competitive advantage, and
adherence to laws and regulations. External factors that affect
a company’s value include the valuation of the industry in
which it competes, the company’s rank or market share in that
industry, interest rates, and current or pending legislation that
will affect regulation of the industry. If a company’s products
or services are selling at a profit and are expected to continue
doing that and if other market conditions are favorable, that
company’s value, or stock, should go up. It is said that the

company is fundamentally sound in those circumstances, and
the market reflects that value. If sales slow, expenses are
higher than expected, or external factors affecting profitability
change in a negative direction, the stock price should go
down. If sales are steady and the company makes no appreciable
gains, the stock may go sideways.

Similar concepts apply to countries and geographic unions. In
very simplified terms, if the companies and citizens in a country
are producing more than they spend and taxes are sufficient to
cover expenses, increased income in the form of tax receipts flows
into government coffers. Because most businesses continually
seek to improve, there is increased competition for money, or
funding, as individuals and businesses borrow money to expand.
An increased rate of borrowing money leads to increases in interest
rates, which will attract capital from investors seeking a
higher yield for their savings and investments and thus cause an
increase in tax receipts. Job growth is healthy when businesses
are spending money to stay competitive. In a healthy worldwide
environment, the stronger an individual country’s economy is,
the more demand there is for stocks and other investments
denominated in that currency, the more pressure there is for
higher interest rates, and the stronger the currency is. Conversely,
the slower the economy is, the more pressure it puts on stock
prices as investors exit investments in search of higher yields and
on central bankers to lower interest rates, further decreasing the
return on investments valued in that country’s currency; in that
case, the country’s currency becomes weaker.

To generalize about the impact of a positive global business
climate, it can be said that higher interest rates mean a stronger
currency and that a weaker currency leads to lower interest

rates. The most direct link between interest rates and currency
values is the level of business activity. If business activity is
growing, there is room for higher interest rates created by
demand for more money and thus a stronger currency. If business
activity is contracting, higher interest rates are a threat to
commerce and interest rates may have to be lowered, with the
effect being a weaker currency.

In times of global economic uncertainty and recession, however,
traders and investors favor lower-yielding currencies
because governments and businesses in those countries will be
relatively less handicapped by lower borrowing costs (interest
rates) in a slowing economic environment. In summer 2008 we
saw a good example of this as global stock markets turned lower,
erasing the gains of the previous two years. Investors around the
world went from thinking about the return on their investments
to being concerned about the return of their investments. With
governments, businesses, and individuals all trying to exit their
previously higher-yielding investments at the same time, currencies
with higher-yielding interest rates fell sharply as money
poured out of the British, European, Canadian, Australian, and
New Zealand currencies and into the lower-yielding U.S. dollar
and Japanese yen. The sharp reevaluation of currencies in the
third and fourth quarters of 2008 also pointed out the fact that
the currency market is a self-correcting mechanism. What
strengthens a currency initially also can weaken it as interest
rates become too high and currency valuations become too
inflated relative to those of competing countries and unions.

Although Canadian citizens felt proud as their currency rose
from 0.60 to 0.80 against that of their U.S. neighbors, Canadian
businesspeople felt concern and then fear as the looney kept

on strengthening from 0.80 to 1.00 against, or on par with, the
U.S. currency. This 40 percent increase in the looney made it
very easy for American farmers and manufacturers to take
business from their Canadian counterparts because the cost of
American feed and products was so much lower compared
with the Canadian than it had been just three or four years earlier.

As business shifted away from Canada, the looney turned
and was sold off, and the Canadian government cut interest
rates accordingly. Like a pendulum that has swung too far, it
can be said that the weight of a stronger currency can cause its
value to swing lower. It is this characteristic of a free enterprise
system with floating currency values that ideally ensures that
the best products and services at the most competitive prices
are what will set economic standards going forward, not political
or nationalistic considerations.
Source: Mastering the Currency Market: Forex Strategies for High and Low Volatility Markets

The Reality Of Price And Volume

There is no greater reality in trading than price and volume. These are facts, not opinions, and they cannot be distorted or misrepresented. They are what they are and what you see is what you get, as Flip Wilson used to say. WYSIWYG—isn’t that an acronym in computer land these days? Anyway, what you will begin to see as you study the ART system and reality-based trading is that price and volume are your most valuable tools in reading the market.

WHY ARE PRICE AND VOLUME REALITY?
Price and volume are the reality of the market; everything else is a man made measuring device that will most likely form destructive opinions. Some people believe that measuring devices form a road map. However, do we have a road map of our life in advance of our life? I don’t think so. We may have a plan or fantasy about where we want to go, but until it happens, it is still just a fantasy.

THE CASE FOR SIMPLICITY IN A TRADING SYSTEM
The number of trading indicators, oscillators, and information sources available today is astounding. The reality is that “less is more.” If you allow yourself to be inundated with unnecessary information and clutter, you will be drawn further away from the “truths” of the market—price and volume.

Simplicity will be the secret to your success. The ART system will simplify your trading and add structure, which helps to lessen anxiety that can lead to emotional trading.

The ART software is sophisticated, taking into account complex market dynamics and performing highly intricate calculations to deliver highprobability trades. Its genius lies in the way it illustrates this information with clear trade entries and exits.

Let me tell you a little about my trading and how I came to develop the ART system. My story may even resemble some of your trading experiences.

When I started, I read every book and examined virtually every trading system imaginable. From oscillators to powerful neural network computers, I studied it all. The one thing I found was that most systems tried to predict the market—and most failed miserably!

It seems the more we try to predict the market, the more it can’t be done. Just as we cannot predict future life and world events, we cannot predict future market events. The fantasy that many traders believe in is that we can predict the future of price activity. The reality is that we cannot. Hopefully, I’m not bursting any bubbles out there, but better to hear it now than lose a ton of money later!

The most successful traders fully understand this concept, accept it, believe it, and implement it. They trade based on the current reality in the market versus the fantasy. Master traders grasp the concept of risk and probabilities in trading. They recognize and respect the concept of money management and stop-loss setting. In addition, they understand that trading is both a science and an art.

If trading were just science, you could buy a mechanical trading system, start it, walk away, and come back and be rich. If a “black box” system did exist, it would be so expensive that you and I could not afford to buy it. In fact, it would probably be kept so secret that we would not know it existed! Don’t get me wrong—there are some good technical science “tools” on the market today, but remember, they are tools only, not the “Holy Grail.”
Read More: The Reality Of Price And Volume

THE DOLLAR MOVES INVERSELY TO COMMODITY PRICES

A rising dollar is noninflationary. As a result a rising dollar eventually produces lower commodity prices. Lower commodity prices, in turn, lead to lower interest rates and higher bond prices. Higher bond prices are bullish for stocks. A falling dollar has the exact opposite effect; it is bullish for commodities and bearish for bonds and equities. Why, then, can't we say that a rising dollar is bullish for bonds and stocks and just forget about commodities? The reason lies with long lead times in these relationships and with the troublesome question of inflation.

It is possible to have a falling dollar along with strong bond and equity markets. Figure 5.1 shows that after topping out in the spring of 1985, the U.S. dollar dropped for almost three years. During most of that time, the bond market (and the stock market) remained strong while the dollar was falling. More recently, the dollar hit an intermediate bottom at the end of 1988 and began to rally. The bond market, although steady, didn't really explode until May of 1989.

COMMODITY PRICE TRENDS-THE KEY TO INFLATION

Turns in the dollar eventually have an impact on bonds (and an even more delayed impact on stocks) but only after long lead times. The picture becomes much clearer, however, if the impact of the dollar on bonds and stocks is viewed through the commodity markets. A falling dollar is bearish for bonds and stocks because it is inflationary. However, it takes time for the inflationary effects of a falling dollar to filter through the system. How does the bond trader know when the inflationary effects of the falling dollar are taking hold? The answer is when the commodity markets start to move higher. Therefore, we can qualify the statement regarding the relationship between the dollar and bonds and stocks. A falling dollar becomes bearish for bonds and stocks when commodity prices start to rise. Conversely, a rising dollar becomes bullish for bonds and stocks when commodity prices start to drop.

The upper part of Data compares bonds and the U.S. dollar from 1985 through the third quarter of 1989. The upper chart shows that the falling dollar, which started to drop in early 1985, eventually had a bearish effect on bonds which started to drop in the spring of 1987 (two years later). The bottom part of the chart shows the CRB Index during the same period of time. The arrows on the chart show how the peaks in the bond market correspond with troughs in the CRB Index. It wasn't until the commodity price level started to rally sharply in April 1987 that the bond market started to tumble. The stock market peaked that year in August, leading to the October crash. The inflationary impact of the falling dollar eventually pushed commodity prices higher, which began the topping process in bonds and stocks.

The dollar bottomed as 1988 began. A year later, in December of 1988, the dollar formed an intermediate bottom and started to rally. Bonds were stable but locked in a trading range. Data shows that the eventual upside breakout in bonds was delayed for another six months until May of 1989, which coincided with the bearish breakdown in the CRB Index. The strong dollar by itself wasn't enough to push the bond (and stock) market higher. The bullish impact of the rising dollar on bonds was realized only when the commodity markets began to topple.

The sequence of events in May of 1989 involved all three markets. The dollar scored a bullish breakout from a major basing pattern. That bullish breakout in the dollar pushed the commodity prices through important chart support, resuming their bearish trend. The bearish breakdown in the commodity markets corresponded with the bullish breakout in bonds. It seems clear, then, that taking shortcuts is dangerous work. The impact of the dollar on bonds and stocks is an indirect one and usually takes effect after some time has passed. The impact of the dollar on bonds and stocks becomes more pertinent when its more direct impact on the commodity markets is taken into consideration.

THE DOLLAR VERSUS THE CRB INDEX

In this article, the inverse relationship between the U.S. dollar and the commodity markets will be examined. I'll show how movements in the dollar can be used to predict changes in trend in the CRB Index. Commodity prices axe a leading indicator of inflation. Since commodity markets represent raw material prices, this is usually where the inflationary impact of the dollar will be seen first. The important role the gold market plays in this process as well as the action in the foreign currency markets will also be considered. I'll show how monitoring the price of gold and the foreign currency markets often provides excellent leading indications of inflationary trends and how that information can be used in commodity price forecasting. But first a brief historical rundown of the relationship between the CRB Index and the U.S. dollar will be given.

The decade of the 1970s witnessed explosive commodity prices. One of the driving forces behind that commodity price explosion was a falling U.S. dollar. The entire decade saw the U.S. currency on the defensive.

The fall in the dollar accelerated in 1972, which was the year the commodity explosion started. Another sharp selloff in the U.S. unit began in 1978, which helped launch the final surge in commodity markets and led to double-digit inflation by 1980. In 1980 the U.S. dollar bottomed out and started to rally in a powerful ascent that lasted until the spring of 1985. This bullish turnaround in the dollar in 1980 contributed to the major top in the commodity markets that took place the same year and helped provide the low inflation environment of the early 1980s, which launched spectacular bull markets in bonds and stocks.

The 1985 peak in the dollar led to a bottom in the CRB Index one year later in the summer of 1986. I'll begin analysis of the dollar and the CRB Index with the descent in the dollar that began in 1985. However, bear in mind that in the 20 years from 1970 through the end of 1989, every important turn in the CRB Index has been preceded by a turn in the U.S. dollar. In the past decade, the dollar has made three significant trend changes which correspond with trend changes in the CRB Index.

The 1980 bottom in the dollar corresponded with a major peak in the CRB Index the same year. The 1985 peak in the dollar corresponded with a bottom in the CRB Index the following year. The bottom in the dollar in December 1987 paved the way for a peak in the CRB Index a half-year later in July of 1988.
Read More : THE DOLLAR MOVES INVERSELY TO COMMODITY PRICES

The Capital Asset Pricing Model

As MPT and EMT were maturing in the late 1960s, capital asset pricing theory was in its infancy. The capital asset pricing model (CAPM) that is most widely known today derives from MPT (and was pretty much invented by Markowitz’s co-Nobelist, Sharpe).

Like MPT, CAPM assumes that investors are risk-averse in the sense just described. In addition, CAPM assumes that investors have rational expectations concerning expected returns. Under this assumption, CAPM says that the expected return on an investment is equal to the risk-free rate of return plus compensation for the systematic riskof the investment in the sense just described.

The systematic riskis measured by the degree of variability of the individual investment versus the market as a whole. It relates the riskpremium associated with a particular stock (its return less the risk-free return) to that associated with the market as a whole.

That association for any stockis expressed by a number called the stock’s β (beta). Under CAPM, stocks with higher β’s are more risky than are stocks with lower β’s because they tend to swing more widely than does the market—their returns exhibit greater dispersion versus market returns.

Critique and Common Sense

On their own terms, there are several weaknesses in MPT and CAPM. First, in evaluating EMT, the need for a pricing model creates a joint hypothesis problem: No one can ever be sure in testing a model whether its failure is due to market inefficiency or to an inadequately specified asset pricing model.

Indeed, many of the anomalies in EMT mentioned earlier are attributed to deficiencies in the asset pricing model rather than to the presence of market inefficiency. These deficiencies are most often associated with imprecision in defining riskor , equivalently, in specifying β.

The joint hypothesis problem has an important implication for EMT skeptics. To disprove EMT requires proof that does not use an asset pricing model. However, any linear or nonlinear dependence in stockprice behavior is inconsistent with EMT itself. Thus, a discovery of linear or nonlinear dependence in successive stockprices (presented in the next chapter) means EMT is incomplete, period. It does not admit the alternative explanation of a “misspecified” asset pricing model.

In addition, CAPM says that expected returns from an investment are linearly related to expected returns on the portfolio of which that investment is a part. The linear relationship is given by β and is in turn dictated by CAPM’s rational-expectations assumption.

If human behavior is itself inconsistent with the rationalexpectations assumption, there is no reason to believe in such a linear relationship. This is another way of saying that the stockmar - ket is nonlinear rather than linear. In that case, β will not be an accurate measure of risk.

Finally, the rational-expectations assumption used in the CAPM requires that investors have homogeneous return expectations; this in turn requires that investors evaluate and understand information in identical ways. Heroic as that sounds, it would also require all investors to evaluate investment opportunities over identical time horizons. The patent dubiousness of these requirements recently has become an important aspect of the literature criticizing CAPM. The literature demonstrates that demand for particular stocks is sensitive to price changes, just like demand for most other goods.

Investors have different appetites for particular stocks as their prices change. Thus, markets do not depict the right price of a stock because there is no such thing. Even rational people are not homogeneous automatons; they interpret information differently, and their judgment about the present value of a business’s future cash flows will vary even if they are all rational.

As Francis Fukuyama has pointed out in another context, the neoclassical economic model of rational self-interested behavior with which EMT is ultimately linked is right only about 80% of the time.18 Its devotees forget Adam Smith, the father of their thought, who emphasized that economic life is embedded in social life and that economic actors make decisions that vary from pure economic calculus as a result of social habits and contexts. That is why in Smith’s day his field was called “political economy” rather than, as it is today, simply “economics.”

If the rest of social science should be returned to economics, it is even possible to add some physics from the hard sciences. Recall that the random walkmodel got that name because public capital markets seemed to obey the principles of Brownian motion, which specify that molecules in motion behave randomly. Although molecules lacksentience, prices are strictly creatures of the ultimate sentience, human behavior.

Common sense thus suggests that the price-molecule parallel should not hold. More powerfully, current thought in physics concerning nonlinear dynamics and chaos theory extends well beyond Brownian motion and suggests further reasons to doubt and reconsider the validity of the analogy.

The next chapter shows how that analogy has been turned upside down and inside out. Before going on, though, pause to consider whether common sense supports β as a measure of risk. What β really measures is the price volatility of a stock. If you insist on associating the word “risk” with that measure, it at most means that β captures the riskof stockprice gyrations. For a market analyst, that measurement may be of some interest.

But for a business analyst, price gyrations are useless analytic tools, and so therefore is β. What matters in business analysis might be called “business volatility,” the gyrations in earnings or cash flows a business has experienced as grounds for gauging its future business performance. The earnings and cash flows are what give a business value and what are of interest; market prices do not, and β is therefore of no interest to a business analyst.

As the vogue of mathematical investing approaches raged in the late 1960s, Ben Graham declared that treating volatility in price changes as the meaning of riskis “more harmful than useful for sound investment decisions because it places too much emphasis on market fluctuations.” EMT sought to neutralize that objection by saying that market fluctuations were simply rational price changes reflecting information changes. Just so. Yet some things are not that simple. Charlie Munger is fond of quoting Einstein on this point: Everything should be made as simple as possible, but no more so. Graham continues to be right.
Read More : The Capital Asset Pricing Model

Bond Prices and Yields

The reader will notice that we’ve gotten to this point without specifically addressing the subject of a bond’s yield—that which Inside the Yield Book is presumably all about. A bond’s yield-to-maturity (YTM ) is that discount rate which generates a PV equal to the bond’s price. In our flat world of a single market discount rate, the bond’s price would always be set by that discount rate, so the YTM would always just be this discount rate itself.

One of a bond’s basic attributes is its par value, which (roughly) corresponds to the initial funds received by the issuer. In the most idealized bond with neither call features nor sinking funds, the final “principal payment” at maturity will also be generally equal to this par value. The par value is typically set at $1,000, with the bond’s price and coupon payment then expressed as a percentage of this $1,000 standard. Thus, for a coupon rate that coincides with our fixed market discount rate of 8%, the PV of $1,000 would just match the par value, the price ratio would just be 100% and the bond would be called—not surprisingly—a “par bond.”

For coupon rates higher than the discount rate (generally, for bonds that had been issued earlier during a higher rate environment), the PV would exceed the par value, so the price ratio would be greater than 100%, and such a bond would be called a “premium bond.” Similarly, lower coupon rates and lower PVs would give rise to price ratios below 100%—hence, “discount bonds.”

Now, all this is pretty old hat. Why go through this entire discussion of a flat discount world only to come to these standard descriptions of the three bond types? The point is that these characterizations are really somewhat misleading. All these bonds are fairly priced in the sense that their PV corresponds to their market price. A “discount bond” is not a bargain, nor is a “premium bond” really worth more than a par bond. Only when some differentiating features are incorporated into the analysis does any investment look cheap or dear to a specific investor.

To really understand the YTM, our flat-world assumption must be replaced by the more realistic situation where bond prices are based on a host of differentiating factors such as credit quality, maturity, coupon level, sinking funds, call features, market liquidity, and so forth. In this environment, one can argue about whether the bond’s price or the YTM is the primary determinant of value. The basic fact is that a bond’s price, and its YTM, are defined in a circular fashion.7 Thus, for any given bond, the YTM is the specific discount rate that generates a PV equal to the bond’s market price. Different pricing effects can then also be expressed as different YTMs. Over the years, this YTM approach has proven to be a very convenient comparative yardstick. For example, it has now become commonplace to characterize the incremental return of corporate bonds in terms of their YTM “spread” over the U.S. Treasury bond curve.
Read More : Bond Prices and Yields

The Meaning of Prices

 Highs and lows, opening and closing prices, intraday swings and weekly ranges reflect crowd behavior. Our charts, indicators, and technical tools are windows into the mass psychology of the markets. You have to be clear about what you are studying if you want to get closer to the truth.

Many market participants have backgrounds in science and engineering and are often tempted to apply the principles of physics. For example, they may try to filter out the noise of a trading range to obtain a clear signal of a trend. Those methods can help, but they cannot be converted into automatic trading systems because the markets are not physical processes. They are reflections of crowd psychology, which follows different, less precise laws. In physics, if you calculate everything, you’ll predict where a process will take you. Not so in the markets, where a crowd can always throw you a curve. Here you have to act within this atmosphere of uncertainty, which is why you must protect yourself with good money management.

The Open The opening price, the first price of the day, is marked on a bar chart by a tick pointing to the left. An opening price reflects the influx of overnight orders. Who placed those orders? A dentist who read a tip in a magazine after dinner, a teacher whose broker touted a trade but who needed his wife’s permission to buy, a financial officer of a slow-moving institution who sat in a meeting all day waiting for his idea to be approved by a committee. They are the people who place orders before the open. Opening prices reflect opinions of less informed market participants.

When outsiders buy or sell, who takes the opposite side of their trades? Market professionals step in to help, only they do not run a charity. If floor traders see more buy orders coming in, they open the market higher, forcing outsiders to overpay. The pros go short, so that the slightest dip makes them money. If the crowd is fearful before the opening and sell orders predominate, the floor opens the market very low. They acquire their goods on the cheap, so that the slightest bounce earns them short-term profits.

The opening price establishes the first balance of the day between outsiders and insiders, amateurs and professionals. If you are a short-term trader, pay attention to the opening range—the high and the low of the first 15 to 30 minutes of trading. Most opening ranges are followed by breakouts, which are important because they show who is taking control of the market. Several intraday trading systems are based on following opening range breakouts.

One of the best opportunities to enter a trade occurs when the market gaps at the open in the direction opposite your intended trade. Suppose you analyze a market at night and your system tells you to buy a stock. A piece of bad news hits the market overnight, sell orders come in, and that stock opens sharply lower. Once prices stabilize within the opening range, if you are still bullish and that range is above your planned stop-loss point, place your buy order a few ticks above the high of the opening range, with a stop below. You may pick up good merchandise on sale!

The High Why do prices go up? The standard answer—more buyers than sellers—makes no sense because for every trade there is a buyer and a seller. The market goes up when buyers have more money and are more enthusiastic than sellers.

Buyers make money when prices go up. Each uptick adds to their profits. They feel flushed with success, keep buying, call friends and tell them to buy—this thing is going up! Eventually, prices rise to a level where bulls have no more money to spare and some start taking profits. Bears see the market as overpriced and hit it with sales. The market stalls, turns, and begins to fall, leaving behind the high point of the day. That point marks the greatest power of bulls for that day.

The high of every bar reflects the maximum power of bulls during that bar. It shows how high bulls could lift the market during that time period. The high of a daily bar reflects the maximum power of bulls during that day, the high of a weekly bar shows the maximum power of bulls during that week, and the high of a five-minute bar shows their maximum power in those five minutes.

The Low Bears make money when prices fall, with each downtick making money for short sellers. As prices slide, bulls become more and more skittish. They cut back their buying and step aside, figuring they’ll be able to pick up what they want cheaper at a later time. When buyers pull in their horns, it becomes easier for bears to push prices lower, and the decline continues.

It takes money to sell stocks short, and a fall in prices slows down when bears start running low on money. Bullish bargain hunters appear on the scene. Experienced traders recognize what’s happening and start covering shorts and going long. Prices rally from their lows, leaving behind the low mark—the lowest tick of the day.

The low point of each bar reflects the maximum power of bears during that bar. The lowest point of a daily bar reflects the maximum power of bears during that day, the low point of a weekly bar shows the maximum power of bears during that week, and the low of a five-minute bar shows the maximum power of bears during those five minutes. Several years ago I designed an indicator, called Elder-ray, for tracking the relative power of bulls and bears by measuring how far the high and the low of each bar get away from the average price.

The Close The closing price is marked on a bar chart by a tick pointing to the right. It reflects the final consensus of value for the day. This is the price at which most people look in their daily newspapers. It is especially important in the futures markets, because the settlement of trading accounts depends on it.

Professional traders monitor markets throughout the day. Early in the day they take advantage of opening prices, selling high openings and buying low openings, and then unwinding those positions. Their normal mode of operations is to fade—trade against—market extremes and for the return to normalcy. When prices reach a new high and stall, professionals sell, nudging the market down. When prices stabilize after a fall, they buy, helping the market rally.

The waves of buying and selling by amateurs that hit the market at the opening usually subside as the day goes on. Outsiders have done what they planned to do, and near the closing time the market is dominated by professional traders.

Closing prices reflect the opinions of professionals. Look at any chart, and you’ll see how often the opening and closing ticks are at the opposite ends of a price bar. This is because amateurs and professionals tend to be on the opposite sides of trades.

Candlesticks and Point and Figure Bar charts are most widely used for tracking prices, but there are other methods. Candlestick charts became popular in the West in the 1990s. Each candle represents a day of trading with a body and two wicks, one above and another below. The body reflects the spread between the opening and closing prices. The tip of the upper wick reaches the highest price of the day and the lower wick the lowest price of the day. Candlestick chartists believe that the relationship between the opening and closing prices is the most important piece of daily data. If prices close higher than they opened, the body of the candle is white, but if prices close lower, the body is black.

The height of a candle body and the length of its wicks reflect the battles between bulls and bears. Those patterns, as well as patterns formed by several neighboring candles, provide useful insights into the power struggle in the markets and can help us decide whether to go long or short. The trouble with candles is they are too fat. I can glance at a computer screen with a bar chart and see five to six months of daily data, without squeezing the scale. Put a candlestick chart in the same space, and you’ll be lucky to get two months of data on the screen. Ultimately, a candlestick chart doesn’t reveal anything more than a bar chart. If you draw a normal bar chart and pay attention to the relationships of opening and closing prices, augmenting that with several technical indicators, you’ll be able to read the markets just as well and perhaps better. Candlestick charts are useful for some but not all traders. If you like them, use them. If not, focus on your bar charts and don’t worry about missing something essential.

Point and figure (P&F) charts are based solely on prices, ignoring volume. They differ from bar and candlestick charts by having no horizontal time scale. When markets become inactive, P&F charts stop drawing because they add a new column of X’s and O’s only when prices change beyond a certain trigger point. P&F charts make congestion areas stand out, helping traders find support and resistance and providing targets for reversals and profit taking. P&F charts are much older than bar charts. Professionals in the pits sometimes scribble them on the backs of their trading decks.

Choosing a chart is a matter of personal choice. Pick the one that feels most comfortable. I prefer bar charts but know many serious traders who like P&F charts or candlestick charts.
Read More : The Meaning of Prices

What Is Price?

Each trade represents a transaction between a buyer and a seller who meet face to face, by phone or on the Internet, with or without brokers. A buyer wants to buy as cheaply as possible. A seller wants to sell as expensively as possible. Both feel pressure from the crowd of undecided traders that surrounds them, ready to jump in and snatch away their bargain.

A trade takes place when the greediest buyer, afraid that prices will run away from him, steps up and bids a penny more. Or the most fearful seller, afraid of getting stuck with his merchandise, agrees to accept a penny less. Sometimes a fearful seller dumps his merchandise on a calm and disciplined buyer waiting for a trade to come to him. All trades reflect the behavior of the market crowd. Each price flashing on your screen represents a momentary consensus of value among market participants.

Fundamental values of companies and commodities change slowly, but prices swing all over the lot because the consensus can change quickly. One of my clients used to say that prices are connected to values with a mile-long rubber band, allowing markets to swing between overvalued and undervalued levels.

The normal behavior of the crowd is to mill around, make noise, and go nowhere. Once in a while a crowd becomes excited and explodes in a rally or a panic, but usually it just wastes time. Bits of news and rumors send ripples through the crowd, whose shifts leave footprints on our screens. Prices and indicators reflect changes in crowd psychology.

When the market gives no clear signals to buy or sell short, many beginners start squinting at their screens, trying to recognize trading signals. A good signal jumps at you from the chart and grabs you by the face—you can’t miss it! It pays to wait for such signals instead of forcing trades when the market offers you none. Amateurs look for challenges; professionals look for easy trades. Losers get high from the action; the pros look for the best odds.

Fast-moving markets give the best trading signals. When crowds are gripped by emotions, cool traders find their best opportunities to make money. When markets go flat, many successful traders withdraw, leaving the field to gamblers and brokers. Jesse Livermore, a great speculator of the twentieth century, used to say that there is time to go long, time to go short, and time to go fishing.


Read More : What Is Price?

ANALYZING PRICE BEHAVIOR AT THE LARGE QUARTER POINTS

The Quarters Theory recognizes that the direction of each Large Quarter
price move from one Large Quarter Point to another and the completion of
a Large Quarter are dependent on the success or the failure of the Large
Quarter Transitions. Every transition into a new Large Quarter always begins
at a Large Quarter Point that serves as a critical junction, marking the
end of a current and at the same time the beginning of a new Large Quarter
of 250 PIPs. Each significant price move starts at a Large Quarter Point
and always ends at a Large Quarter Point; therefore, when these important
price levels are reached, The Quarters Theory requires close examination
of the price behavior of currency exchange rates for signs of strength or
weakness that can be useful when attempting to forecast the outcome of
each attempt for a Large Quarter Transition and the direction of the next
Large Quarter price move.

The Large Quarter Points serve as constant and reliable support and
resistance levels. A Large Quarter Transition cannot occur unless the support
or the resistance of a Large Quarter Point is broken. The failure of an
attempt for a breakout above or below a Large Quarter Point is usually the
first sign of an unsuccessful Large Quarter Transition. Unsuccessful Large
Quarter Transitions are an indication that the currency exchange rate is
likely to remain in its current Large Quarter. When prices move higher and
manage to complete a Large Quarter but encounter resistance at the Large



Quarter Point targeted, there would be a greater probability that the next
Large Quarter move may be more likely to target the Large Quarter Point
below the Large Quarter Point that has served as resistance. The same is
valid for bearish price moves when currency exchange rates move lower
and produce a successful completion of a Large Quarter but encounter support
at the Large Quarter Point targeted. In such instances, there would
be a greater probability that the next Large Quarter price move may be
more likely to target the Large Quarter Point above the Large Quarter
Point that has served as support. Based on this premise, The Quarters Theory
establishes a set of two simple rules to identify signs of strength or
weakness in the price behavior of currency exchange rates in the vicinity
of each Large Quarter Point that may signal unsuccessful Large Quarter
Transitions:

Rule #1—Sign of Strength: Prices Sustaining
at or above a Large Quarter Point
This is the type of price behavior indicative of the unwillingness of the
market to see prices continuing to decline, diminishing the likelihood of a
breakout below the support of the targeted Large Quarter Point. Without
a breakout below a Large Quarter Point, there will be no Large Quarter
Transition of the currency exchange rate into a new 250 PIPs Range of
another Large Quarter below the current Large Quarter. A failed breakout
below a Large Quarter Point and a failed Large Quarter Transition cause
the exchange rate to remain within the current Large Quarter, normally
leading to a bullish price move in an attempt to complete the current Large
Quarter from the bottom up by targeting the Large Quarter Point above the
Large Quarter Point that has served as support.

Figure 2.1 shows a bearish price move in the GBP/USD pair’s exchange
rate, completing the Large Quarter 1.4500 to 1.4250 by reaching the Undershoot
Area/Small Quarter 1.4275 to 1.4250. Note that prices come short
of and never touch the exact number of the Large Quarter Point 1.4250,
diminishing the probability for a breakout below the Large Quarter Point
1.4250. Prices sustain above the Large Quarter Point—a sign of strength
that causes the exchange rate to remain within the current Large Quarter.
The lack of a breakout leads to an unsuccessful Large Quarter Transition
into another Large Quarter below the current Large Quarter 1.4500 to
1.4250. The unsuccessful Large Quarter Transition below the Large Quarter
Point 1.4250 is followed by a bullish price move in an attempt to complete
the Large Quarter from the Large Quarter Point 1.4250 that has served as
support, targeting the Large Quarter Point 1.4500.



Rule #2—Sign of Weakness: Prices Remaining
below a Large Quarter Point
This is price behavior that signals exhaustion and lack of strength in a
price move, reducing the likelihood of a breakout above the resistance of
the targeted Large Quarter Point. An unsuccessful breakout above a Large
Quarter Point would indicate an unsuccessful Large Quarter Transition
into a new 250 PIPs Range of another Large Quarter above the current
Large Quarter. As a result, prices would be likely to remain within the
current Large Quarter, normally leading to a bearish price move in an
attempt to complete the current Large Quarter from the top down by
targeting the Large Quarter Point below the Large Quarter Point that has
served as resistance.

Consider the example in Figure 2.2, which shows the GBP/USD pair’s
exchange rate moving higher, completing the Large Quarter 1.4750 to
1.5000. Note that although the Large Quarter is completed successfully,
prices remain below the Large Quarter Point 1.5000, a sign of weakness signaling
exhaustion and reducing the likelihood for a bullish breakout above
the Large Quarter Point 1.5000. As prices stay below the Large Quarter

Point 1.5000, the exchange rate remains within the current Large Quarter
1.4750 to 1.5000. The lack of a bullish breakout above the Large Quarter
Point 1.5000 leads to an unsuccessful Large Quarter Transition into another
Large Quarter above the current Large Quarter 1.4750 to 1.5000. The unsuccessful
Large Quarter Transition above the Large Quarter Point 1.5000
leads to a bearish price move in an attempt to complete the Large Quarter
from the Large Quarter Point 1.5000 that has served as resistance, targeting
the Large Quarter Point 1.4750.
Read More: ANALYZING PRICE BEHAVIOR AT THE LARGE QUARTER POINTS

Pricing Models: An Overview

As mentioned earlier in this book, widespread use ofoptions did not occur
until there was a widely accepted approach to determining the value of
options. This goal was achieved with the introduction ofthe Black-Scholes
pricing model in 1972-1973. As one of the first pricing models, BlackScholes
is now considered inferior to more recent pricing models (such as
Cox-Rubinstein's binomial option pricing model). The Black-Scholes
model, although faster on a computer due to less-complex calculations,
did not take into consideration American-style options (that is, options
that enable early exercise). You can find an option-pricing calculator
online at www.marketcompass.com. or you can purchase them separately
as software from a variety of sources.

We return now to the function of our models. What we refer to as the
theoretical value of an option is the value determined by our particular
pricing model by using the six factors previously mentioned:
1. The price of the underlying stock
2. The option's strike or exercise price
3. The time until expiration of the option
4. The applicable interest rate
5. The anticipated volatility of the price movement of the underlying
security
6. Dividends (where applicable)

Entering values for the six (five if the company does not issue dividends)
required inputs into a pricing model will generate a theoretical
value for an option. A detailed discussion ofhow the various pricing models

work is beyond the scope of this book, and in the opinion of the
authors, this discussion is unnecessary for all but the most hard-core
market professionals. What is useful is a general discussion of how the
pricing formulas determine theoretical, or fair value and how the six factors
affect an options price. Furthermore, because each variable (except
for the strike price) is susceptible to change, you must be able to interpret
the values generated by the pricing model in order to understand how an
option price might react.

Although pricing models differ somewhat in the way in which they
assess data, they all essentially work the same way: Pricing models propose
a series ofpossible prices for the underlying security; assign a probability to
each price, and use this information to calculate the expected return
(expected value) as measured at expiration of an option that is purchased
with a particular exercise price. From this point, the model adjusts for any
applicable carrying costs (interest rate related) and determines a theoretically
fair value for the option. Your job, then, is to input the information
that you gather into the pricing model, acquire the probability-generated
fair value of the option, and find a bid/offer in the market place that will
enable you to establish an edge on that fair value.

Consider, for example, the odds that are associated with a game of
roulette. In roulette, the player attempts to pick one of the 38 slots on
which the ball will land. If the player chooses the correct slot, he or she
will win $36. For this opportunity; the casino charges $1. Each one of the
38 slots has an equal probability of hitting. The expected return on such
a bet played time after time is calculated by dividing the amount that is
capable of being won ($36) by the amount of probable outcomes (38). In
other words, we have 36/38 = .95. The resulting, expected return of the
bet is $.95; therefore, the fair value is $.95. In other words, a player who
pays $.95 to play will break. even over time. Hence, a player who pays less
than $.95 to play is getting a good deal-one that should produce a profit
over time. Paying more than $.95 to play is overpaying, which invariably
will result in losses over time. Casinos charge $1 to play because they
understand the mathematics of expected return.

Pricing Model Variables
Having reviewed the logic ofa pricing model and the procedures that are
necessary for using one, we now tum to the specific variables that you
will need to identify in order to set the pricing model in motion.
Underlying Stock Price. Obviously, the price of the underlying stock
is important for establishing the value of an option. Understanding how
future changes in the price might affect the value of an option will be a
significant factor in determining whether a particular option is an appropriate
investment choice, given the expectations that you might have for
the performance ofthe underlying security: We will discuss this aspect of
the pricing models in detail in our discussion of market risk. For now,
however, the Figure 4-4 indicates how a $1 change in the price of the

underlying security-with all other variables remaInIng constantaffects
the theoretical value of the 45 calls and 45 puts.

Strikel Exercise Price.
The exercise price is fixed throughout the life
ofthe option and will not change. Only in the case of a stock split would a
change to this value occur, and even so, this change would have no effect
on the theoretical value of an option.

Time until Expiration.
An option's price is directly related to the
amount of time until the option's expiration. When trading options, time
equals opportunity. Therefore, the more time that is attached to an
option, the greater its chance of finishing ITM. Consequently, a buyer is
willing to pay more for the added opportunity afforded by time on the
option. Consequently, the option seller will demand more for the added
risk that additional time requires him or her to assume. All else being
equal, then, an option that has more time is more valuable to an investor
and will therefore trade at a premium (as opposed to an option that has
less time remaining). Time until expiration is an important factor in
determining the next two factors affecting time premium: interest rates
and volatility.
For now, remember the following:
1. An option's expiration date is fIXed for the life of the option and will
not change.
2. Options that have a distant expiration date trade at a premium relative
to those that are approaching expiration.
3. As each day passes, the time to expiration decreases and the theoretical
value ofthe option erodes, thereby giving the option its status
as a wasting asset.
Read More: Pricing Models: An Overview

Factors Affecting the Price of an Option

The general context for discussing an option's price is always the current
price ofthe underlying security. Here, we refer to the intrinsic value ofan
option, which corresponds to the amount that an option is said to be ITM.
(Note that only ITM options have intrinsic value. Fortunately, we do not
need any computer programs to calculate intrinsic value; rather, we only
need a simple subtraction formula.) Figure 4-2 illustrates the formula
used to determine the intrinsic value of an in-the-money option.

As we can see, then, the intrinsic value of an ITM depends upon the
relationship of the option's strike to the current price of the underlying

securit~ Because the option's strike price is a constant, the intrinsic value
of an option will fluctuate dollar for dollar with any price change of the
underlying security (as long as the option remains ITM). As soon as the
price ofthe underlying security moves below a call option's strike price or
above a put option's strike price, that option would become ATM or OTM
and would have no intrinsic value. To summarize:

1. The intrinsic value ofan option is the amount that an option is ITM.
2. OTM and ATM options have no intrinsic value.

Extrinsic Value
Although intrinsic value plays a fundamental role in determining the
price of an option, it alone is not responsible for the overall pricing of the
option. In fact, intrinsic value is only one component of the price of an
option. Stock options have both intrinsic and extrinsic value. The price of
an option is the sum of its intrinsic aDd extrinsic values.

The extrinsic value of an option is that part of its price that is determined
by certain variables other than the price ofthe underlying security
and the strike price. These variables are as follows:
1. Time to expiration
2. Interest rates
3. Volatility
4. Dividends of the underlying security (if applicable)


We will examine the impact of each of these variables on option pricing
separately: First, however, let's look at the simple formula for identifying
extrinsic value. Figure 4-3 is an example of the formula used to
determine the extrinsic value of an option.

Before proceeding, we should give you a few words about terminology:
In the industry, extrinsic value is frequently referred to in a number of
ways (such as time value, time premium, or premium value). Informally,
this concept is often referred to as the juice or fluff ofthe option. From this
point forward, we will use the term time premium interchangeably with
extrinsic value. But although we are using the word time premium, we
should keep in mind that extrinsic value is influenced by more than just
time until expiration. To complicate matters a bit more, an option's overall
(or total) price-its intrinsic and extrinsic values combined-is frequently
referred to in the industry as the option's premium. In this book,
when we refer to an option's premium, we are speaking about the overall
price of the option. When we talk about the time premium, on the other
hand, we refer to the extrinsic value of a particular option.

Having reviewed these basic formulas, we can now gain some insight
as to how the time to expiration, interest rates, and volatility impact the
price of an option. In the following example, consider how differing input
variables will affect the price outcome for options that are listed for two
different stocks.


Assume the following:
1. Stocks ABC and XYZ are both trading at $52.
2. ABC is an Internet company:
3. XYZ is a well-established, traditional retailer.
4. April options have 30 days until expiration.
5. May options have 58 days until expiration.
6. You are interested in purchasing stock in both ABC and XYZ.

Consider the role of interest rates and the time to expiration when
comparing the purchase of April 40 calls on both ABC and XYZ to buyingstock:
1. By buying the stock, you pay $52 per share now. Ifyou purchase the
April 40 call, you defer payment of the $40 per share exercise price
until you exercise the option. In the meantime, you can invest this
$40 per share and earn interest. The amount of interest earned
depends on the time until exercise and the interest rate that you will
be paid on the funds. This economic benefit has a value that will be
reflected in the price of the option. We need to make two important
observations here:
a. Benefit is the same for ABC and XYZ. This benefit is measured
solely by the amount of money involved ($40 per share in this
case), the interest rate, and the time until expiration. Therefore,
the benefit would be the same whether you were considering an
investment inABC or XYZ.
b. The more time until exercise, the larger the economic benefit.
You could earn more interest-in fact, approximately twice the
amount-by delaying exercise until May: Thus, the price of the
May 40 calls will include a larger fee for the right to earn interest
by investing the amount needed to exercise the calls until
option exercise.

2. In this example, consider the role ofvolatility and time to expiration:
a. If the stock plunges to $30 prior to April expiration (the anticipated
time that you would exercise your call), you would lose $22
per share if the stock were purchased (but only the price of the
call ifyou acquired that instead). This reduction in your risk has
a value that will also be reflected in the price ofthe option.
b. The benefit is different for ABC and XYZ. You would probably
assess that the risk of this significant price move prior to April
expiration is greater for ABC than for XYZ and would therefore
be willing to pay more for this risk protection in the case ofABC
than XYZ. Surely the seller of the April 40 calls would charge
more for assuming this risk of a large move in the price of the
stock prior to April option expiration in the case ofABC than for
XYZ. For this reason, the price ofthe ABC April 40 call will likely
be greater than the price of the XYZ April 40 call.
c. The more time until exercise, the greater the risk to the seller.


For the same, obvious reason that the premium on a 60-day
health insurance policy for an individual is greater than the premium
on the same policy for the same individual if the term is
only 30 days, the price of the May 40 calls in ABC will include a
larger amount that is attributable to the risk that the stock price
will move away from $40 by May expiration than the Apr 40 calls
by April expiration.

Without attempting to calculate the fair value of the benefits offered
by the April 40 calls over the immediate purchase of the stock, it should
now be clear that the factors of time, interest rate, and anticipated stock
price volatility all impact the price of an option. We will now turn our
attention to methods that are available for quantifying the value ofthese
and other factors in order to address the question posed at the beginning
of this chapter: "How can I tell if an option is fairly priced?"
Read More: Factors Affecting the Price of an Option