2Bull Forex Blog

In our daily reports, we comment on the background and outlook for the gold price, but from time to time we refer to other precious metals. One of these that can be traded using CFDs is platinum, and various contracts are available, as well of course as companies with interests such as Johnson Matthey and Aquarius Platinum, which have long appealed to stock market investors.

The metal itself

As gold is rare than silver, so platinum is around 35 times rarer than gold and is less widely found. Its main exploration areas are South Africa and Russia, and then Zimbabwe, Canada and South America.

Less than 90 tonnes of platinum are turned into jewelery, compared with 2,700 tonnes of gold, and it takes eight weeks and ten tonnes of ore to produce an ounce of platinum, against three tonnes mined to produce the same amount of gold. The current price (as shown by the January 2008 CFD) is $1401 per ounce, which is very close to an all time high.

Uses of platinum

Platinum has several unique properties which have led to its increasing industrial use, as well as for jewelery. It is found in the automotive, aerospace, electronics and chemical industries, most notably in catalytic converters, where Johnson Matthey is a world leader.

It also has major uses in medicine, as it is not affected by the oxidization reaction with blood. It has excellent conductivity, and is compatible with living tissue, making it ideal for use in pacemakers.

Its density makes it more durable than many other metals, and is extremely inert, being resistant to heat and acids with a melting point of 1,768ºC.

From a jewelery standpoint, the metal does not wear away, and although it can scratch, this is simply a displacement of the metal with no volume lost, which is not the case for gold.

Despite its super strength and density, platinum is highly pliable, and one gram can be drawn to produce a fine wire over a mile in length.

The outlook

Platinum is enjoying a major bull market in line with the rest of the precious metals sector. The usual supply demand arguments apply, with the long lag in developing new mine capacity being one of the main reasons why the sector is expected to continue to be rerated, as well of course of the simple rarity value in a world of expanding demand.

From that demand point of view the outlook remains extremely positive, and the three biggest markets are now China, Japan and North America.

The bridal sector is an important market for jewelery, as in Japan platinum is still used in almost all engagement rings and over 80% of wedding rings. In the USA, platinum’s share of the bridal market was non-existent twenty years ago, but is approaching 50% now.

Fuel cell technology

There has been a dramatic interest in fuel cell technology mainly as a result of increasing concerns about environmental degradation. Fuel cells do not burn fuel, which eliminates the air pollution associated with fossil fuels.

Almost all prototype fuel cell vehicles are powered by the proton exchange membrane fuel cell, which uses platinum as the primary catalyst, and all major automobile companies have expanding fuel cell programmes.

Demand is so far quite small, but the expectation is for gradual medium to long term growth, first in stationary fuel cells and later with the commercialization of fuel cell vehicles.

CFD traders will often hear the phrase ‘yield curve’ used in long and short term evaluation of investment trends, and it is seen as important as one barometer for the outlook for the economy, and thus the stockmarket. The curve itself shows the structure of interest rates plotted over different maturities as measured by government bond prices, from the shortest dated bonds, which usually are related to short term interest rates, to long-dated i.e. 30 year plus maturities.

This enables investors firstly to be able to compare the yields offered by short-term, medium-term and long-term bonds. As there is usually a higher risk involved in choosing a longer dated maturity, typically the yield curve should slop upward, but it is the actual slope that is of interest. This also has relevance for forex investors as it reflects one part of longer term currency risk evaluation.

The three shapes of the curve

The yield curve usually takes one of three shapes. If short-term yields are lower than long-term yields, the line of interest rates will slope upwards, and this is seen as normal.

If short-term yields are higher than long-term yields, the line then slopes down (at least at the beginning), and this is referred to as an inverted or negative yield curve.

Occasionally, a flat yield curve reflects hardly any disparity between short-dated and long-dated yields.

What bonds are plotted?

It is very important that only bonds of similar risk are plotted on the curve, as the gap between low and high risk bonds itself is another factor for longer term investors to examine when choosing investments. In the US, the most common type of yield curve plots Treasury securities because they are considered risk-free and are used as a benchmark for determining the yield on other types of higher risk debt. The yield curves are calculated and published by The Wall Street Journal, the Federal Reserve, and a variety of other financial institutions.

In the UK, gilt stocks are used in the same way and it is simple to compile current yield curves from the Financial Times.

The importance of the yield curve

As mentioned above, when the yield curve is positive or sloping upwards, this indicates that investors require a higher rate of return for the added risk of lending money for longer periods of time, which is normal.

If the yield curve shows a steep upwards slope, this indicates to some commentators that investors are looking at strong future economic growth and potentially higher future inflation, which might lead to higher interest rates.

Changes in the shape of the yield curve can also have an impact on portfolio returns by making differently dated bonds more or less valuable relative to other bonds, so analysts and investors need to study yield curves carefully.

If there is a flat curve this generally indicates that investors are unsure about future economic growth and inflation.

The inverted yield curve

This has been quite topical in recent months as inverted yield curves have been seen in many economies after the period of steadily tightening monetary policy up until this summer.

Where there is an inverted yield curve this suggests that investors expect slowing economic growth and potentially lower inflation. The inference here is lower interest rates to stave off possible recession, and this is what we have seen in the US earlier this month when the Federal Reserve lowered rates by 50 basis points.

There have been many studies that have found that inverted yield curves tend to precede recessions, but this may be subject to revision given the prevailing fiat monetary policies in much of the developed world currently.

Yield curve theory

There are three main theories that attempt to explain why yield curves are shaped the way they are, and it is for the long term investor to decide whether these are relevant or superfluous to the prevailing shape of the curve.

The expectations theory states that expectations of rising short-term interest rates are what create a positive yield curve and vice versa.

The liquidity preference hypothesis states that investors always prefer the higher liquidity of short-term debt and therefore any deviance from a positive yield curve will only prove to be a temporary phenomenon.

The segmented market hypothesis states that different investors confine themselves to certain maturity segments, making the yield curve a reflection of prevailing investment policies.

One of the great themes of investment, whether it is stockmarket, commodity, foreign exchange or indeed any financial instrument, is whether or not what you are trading is in a clear trend. The reason this is so important is that trading a trend creates much bigger opportunities than trying to second guess moves within a trading range.

The problem is that for certain instruments, trends do not occur very often. Indeed for some shares, a clear trend is in place perhaps for less than 30% of the time.

Looking for the extra returns

Depending on what you read and your own observation of charts or other analysis, there are times when it is hard to decide if what you want to trade is in a trend or trading a range.

As a starting point for CFD trading, this distinction is absolutely crucial because many popular indicators that are used throughout all market conditions simply don’t work all the time. These indicators are of course used as predictive tools, so it is essential to know when they are useful and when they are not.

As with fundamental analysis, you have to look deeper under the surface if you want the extra returns. It is plainly dangerous to rely on dividend yields, p/e ratios, sales to market capitalisation ratios etc., as stand alone reasons to buy a share on a valuation view.

Likewise it is foolhardy to simply use RSI crossovers, MACDs or stochastics and so on without a thorough assessment of the merits of each within a certain type of market.

This paper is not designed to tell you which indicator works and when, because the answer is ‘some of them do’ and ‘some of the time’. The aim here is to impress on you the need to look for trading opportunities in a detached manner with the information that is in front of you, and then make a trade using a defined set of rules. One of which is simply: “go with the trend”.

Relying on one indicator

Many newer investors tend to find one technical indicator that they feel comfortable with, and stick with it during all market conditions. From a very long term point of view, this approach may have some validity, but in the short term, indicators tend to ebb and flow in their edge over other approaches.

You can of course use indicators to highlight certain set ups, but bear in mind there are millions of people around the world who can tap into any number of free financial websites giving every conceivable indicator.

You may be part of a big crowd with the same information but it is the ability to sift that information that gives the best opportunities. A computer can do this very fast and you actually do not need indicators, although they of course have their uses (see our various other papers).

The reason is that chaos theory tends to negate the benefits of an initial edge – the more people that know about something that works, the more influence that has on pricing to the point where it negates the original benefit. This is standard human nature, even though the cycle no doubt returns in due course.

What is more, there is a school of thought that believes that if you gave a trader a proven system that worked over time, together with the suggested entry points and trading methodology, they would never do as well as the system. Why? Because humans recoil from events outside the norm, and you can be guaranteed that at some stage they will not take all the signals. So we return to going with the trend, and this will focus the mind.

Benefits of finding a trend

The best 90% of market returns are made only 10% of the time, and those usually happen when there is a clear and major trend in place. It is therefore essential to isolate markets, currencies, commodities or whatever is ‘hot’ and ensure that you are participating where you can as a trader only in these issues.

If a share price oscillates but ends up the same price as when you first started watching it, it’s not easy to win consistently, and win a lot. But if you are focussing your trades on stocks or markets with a clear and strong trend, it is possible to ride any number of profitable trends, and win consistently over time.

How many times have you looked at something that appears ludicrously expensive and looked for a short trade when the trend was clearly up? Not only are you missing the big, big uptrend, but you will be emotionally worn out when the downtrend returns.

So, stand back and look at your charts from a distance – does it look as though it’s going up or down? – if you’re not sure, it’s not in a trend.

Long before CFDs became commonplace, we lived in a land of early programme trading, extended settlement and mainly phone based dealing, and almost twenty years to the day occurred what is now known as ‘Black Monday’

This was the session on Monday, October 19th 1987, when the benchmark Dow Jones Index fell by a 508 points, which was then 23% and the biggest one day percentage decline in stock market history, with huge drops also seen right across the world’s equity markets.

The falls actually cascaded from the Far East, through Europe to the US and back again, and it felt to some like the end of the financial world was upon us, but of course the situation resolved itself after a few weeks of turbulence. Nevertheless, it was a momentous day in stockmarket history and worth looking back on for traders and investors alike.

It is interesting to note that the terms ‘Black Monday’ and ‘Black Tuesday’ were first coined after the days October 28th and 29th 1929, some fifty years earlier. These occurred after ‘Black Thursday’ on October 24th, which began the market crash of that year, but the falls on the Monday twenty years ago were much larger and quicker. So what happened exactly?

The background up to that weekend

There is some confusion associated with the 1987 crash, and it has often been seen as a one-of-a-kind event, but in truth the series of events that provided the background could just as easily conspire again, allowing for each market’s current trading limits before any suspension.

The actual cause of the crash has never been truly agreed upon, but what did happen differently to the falls in 1927 was how quickly the Federal Reserve and other central banks acted to put liquidity into the system to prevent further problems. Indeed, this process has continued ever since, and some have argued it has placed an artificial floor on stockmarkets, which might rebound on the bulls at some stage. Either way, the worst was over quickly, and the Dow Jones actually bottomed on day two, October 20th. Although it was volatile, that time could be seen in retrospect as an excellent long term buying opportunity.

In 1986, the growth in the US economy had began to slow down, resulting in a soft landing, and then corporate earnings began to pick up again, leading to a resumption of the bull market in 1987. During that year the Dow rose 44% by August, and then on October 14th it dropped 95 points to 2412.70, a record fall at the time, and fell another 58 points the next day, so it was already down over 12% from the August high. On the Friday, October 16th, it fell another 108.35 points to close at 2246.74 on record volume.

Over the weekend, Treasury Secretary James Baker had stated his concerns about the falling prices, and the crash began in earnest in Far Eastern markets during the morning of October 19th. Later that morning, two US warships shelled an Iranian oil platform in the Persian Gulf, but this simply added to the sense of panic, despite turning out to be of no consequence.

The main causes of the rapid decline

There were several main areas that were seen as significant towards causing the huge declines seen on the Monday, but many factors have often been quoted.

The first and most serious aspect was the effect of programme trading, which was blamed for exacerbating the declines.

US Congressman Edward J. Markey had been warning about the possibility of a crash, and stated afterwards that programme trading was the principal cause. What happened on the day was that computers performed rapid stock executions based on external inputs, such as the price of related securities.

There were several strategies that were used in programme trading including arbitrage, where for instance the index futures might be trading lower than the cash market, so the computers gave stock selling orders until the disparity was resolved. On the day, the futures market in Chicago was consistently lower than the stock market, and instead of buying in Chicago and selling in the New York cash market, which would be a normal response, instructions were given to sell into the falling market.

Portfolio insurance was another aspect of these strategies, whereby sell signals were given to reduce asset, sector and stock allocation as the value of these fell, in effect to act as insurance against further falls, which clearly did not happen. There were several accounts suggesting that almost half the trading on October 19th was a small number of institutions with portfolio insurance, and all that happened was that they continued to sell as the value of their equity dropped.

Other reasons

It has since been argued that although programme trading strategies were used primarily in the US, other markets fell just as hard, so there must have been other reasons. The crash actually began in Hong Kong, then spread to Europe, and hit the US only after many markets had already declined by a significant margin.

So other reasons have been put forward, and another possible cue for the crash was the simple overvaluation of equity markets which had put them at p/e ratios not seen since 1929. (It might be worth noting that p/e ratios in the last ten years have often been higher still). The view here was that value investors had already begun to bail out of the market during the late summer, and the crash was simply the end of the decline.

There were also some macroeconomic concerns at the time, which included international disputes about foreign exchange and interest rates, and fears about inflation, but these in themselves would have been unlikely to trigger such a derating so quickly.

Another common theory states that the crash was a result of a dispute in monetary policy between the G-7 industrialized nations, whereby the US, which desired to keep the dollar high to restrict inflation, tightened policy faster than European central banks.

An opposing argument stated that the crash happened because of the breakup of the Louvre Accord, which was a monetary pact between the US, Japan, and West Germany to keep currencies stable. Just prior to the crash, Alan Greenspan had said that the dollar would be devalued. You can take your pick from both of these somewhat contradictory arguments.

A final factor which affected the UK market was the Great Storm of 1987 in England, which occurred on the Friday before the crash. At that time, most dealing was done by phone, and brokers had to physically get to work in London to carry out deals. That morning, many routes into London were closed and consequently many traders were unable to reach their offices in order to close positions by the end of the week. This added to the panic selling which occurred on the following Monday on the FTSE 100 index, which fell around 250 points that day, and another 250 points on the Tuesday before a massive rally retraced some of the losses.

Conclusion

As can be seen, the classic market crash was in retrospect the result of various inputs, and it is hard to pin down one trigger. Indeed, despite efficient market theory suggesting that falls of the magnitude seen on Black Monday are a once in a lifetime (possibly a millennium) occurrence, we have since seen some hefty falls on a daily basis in the last twenty years.

One point should be mentioned in particular, and that is that markets were already in short term downtrends before the crash started, so the drops did not occur without warning. This is food for thought for CFD traders in these uncertain and somewhat faster moving times, and provided stops are used, these happenings can present major opportunities for profit for the astute trader.

It is fair to say that some modes of technical analysis of the stockmarkets move beyond the purely mathematical and one of these is Gann analysis which has many devotees around the world despite its more esoteric appeal.

The body of work that has built up around WD Gann began with his own series of predictions in the early part of the 20th century which were uncannily accurate, and he soon built up a big following as one of the first real technical analysts. His analysis combined price and time studies to make what he described as the market time factor, and he believed that all market movements could be defined by a series of mathematical laws and the workings of the natural world.

The basics of Gann analysis

There were three starting rules:

1. Price, time and range are the only three factors to consider.

2. The markets are cyclical in nature.

3. The markets are geometric in design and in function.

Gann had three areas of prediction: His price studies included support and resistance lines, pivot points and angles, many of which are standard analytical techniques in modern day technical analysis. His time studies sought out historically reoccurring dates, and these were derived by natural and social means, which was more subjective. He also studied patterns to seek about potential market swings using trendlines and reversal patterns.

Price, time and the construction of Gann Angles

What Gann sought to do was to set out a series of geometric angles that could be used as rising support and resistance levels based on natural laws, and these are now known to analysts as speed lines.

Much of his work was empirical, which meant he developed the analysis based on experimentation and observation, but he was committed to the central 1*1 price against time line measured as a 45 degree line on a chart.

The second point was where to start the lines, and Gann discovered that major highs or lows made excellent starting points. He also then moved onto horizontal support and resistance levels using what he called “vibrations” or “price swings”, and again his evidence was empirical in nature using mathematical theories such as Fibonacci retracements (which we have discussed elsewhere).

Once the relevant price and time points were observed on a chart, Gann then drew in (modern software systems do this automatically) several important lines, of which the two most common patterns were the 1X1 line, the 1X2 line (which is a more gentle rate of ascent, and the 2X1 line (a steeper rate of ascent).

The idea would be that if the price of a stock broke through the ascending 1X1 line, the odds favoured a move down to the 1X2 line, and vice versa.

Aswell as these lines, he worked out a series of subdivisions that could be plotted on a chart as follows:

1 x 8 = 82.5 degrees
1 x 4 = 75 degrees
1 x 3 = 71.25 degrees
1 x 2 = 63.75 degrees
1 x 1 = 45 degrees
2 x 1 = 26.25 degrees
3 x 1 = 18.75 degrees
4 x 1 = 15 degrees
8 x 1 = 7.5 degrees

The patterns could be drawn in an ascending manner from major lows or descending lines from peaks, and in both cases they could be used as support and resistance points at any time.

Because all markets were seen to be cyclical in nature, the longer the line could be drawn connecting points along the way, the more important its overall influence would be (some commentators still point out a Gann speed line rising from the major 1982 low in US equity markets that is still in place for instance).

Benefits of Using Gann Angles

The main benefit to stockmarket investors is that the important speed lines act as support and resistance levels that are different to other trendlines connecting a series of lows or highs. It is a very straightforward method of observing rates of change when various speed lines are inserted into the chart of a share price.

Some investors use pullbacks to a rising speed line as an opportunity to add to already profitable positions.

Where a speed line interacts with a horizontal line of importance, the combination of time and price becomes more important and Gann showed that these points often forecast major turning points in the future.

Drawbacks

As with any empirically based technique, Gann analysis works differently for each investor and each stock as it depends on what is observed. Drawing the speedlines is clearly different in each market due to the inherent variable pricing of stocks.

There is some skepticism that ideas based on natural laws are more astrological than mathematical, and many analysts have dismissed the theory as mumbo jumbo, along with Fibonacci and Elliott wave theory for instance.

As with all technical analysis, though, there are no fixed right or wrong answers. It is not possible to predict the future, but it helps if one can add some element of probability theory to the analysis based on patterns of human behavior, and Gann analysis does that.

A final point is that at the time, WD Gann had the edge until his theories became widely known, and of course was able to show stellar returns on his trades. Chaos theory and the speed of computer systems these days suggest any new edge is much harder to find and sustain in terms of absolute buying or selling points. CFD traders and other investors would always do better to adopt an overall disciplined approach to the investment process to succeed.