Business

Examples    of    client-imposed    constraints    would be restrictions that specify the types of securities in which a manager may invest and concentration limits on how much or little may be invested in a particular asset class or in a particular issuer. Where the objective is to meet the performance of a particular market or customized benchmark, there may be a restriction as to the degree to which the manager may deviate from some key characteristics of the benchmark.

Crucial to both flow and technical analysis is the idea that financial markets are not in fact inherently efficient and that the past can in fact impact the future. With flow analysis, one is dealing with trends in order flow. With technical analysis, one is analysing past pricing to make predictions about the future. At its most basic, technical analysis uses such concepts as “support” and “resistance” to denote points of dynamic market tension between supply and demand for an exchange rate, equity, bond or commodity. At a more sophisticated level, technical analysis relies on patterns in mathematics to suggest they may be reproduced in market pricing. Fibonacci, Elliott Wave and Gann analysis are examples of these.
“Charting” remains a controversial subject for some within the financial and academic communities who appear to regard it as little more than voodoo. In the real world of trading, hedging and investing however, nothing counts except results. Unlike in the economic world where the quality of the story is seen as important, almost irrespective of its accuracy, for traders, investors and corporations the bottom line is the bottom line. To that end, while classical economics has failed to explain short-term exchange rate moves on a sustained basis, flow and technical analysis have stepped into the void. Just as in economics, there are “good” and “bad” chartists or technical analysts. The profession of technical analysis however has consistently outperformed the returns generated by random walk theory and frequently also those by economists. In analysing exchange rates, currency market practitioners who do not use technical analysis in addition to fundamental analysis are hampering their own ability to produce consistently high returns.

As barriers to trade and capital have broken down in the last two decades, so capital flows have become increasingly important, both in terms of their impact on the economy and in turn on the exchange rate. At USD1.2 trillion in daily volume, the currency markets trade the equivalent of annual global merchandise trade every day of the year. Like any market, the currency market is affected by demand and supply, which in this case is reflected by order flow. It has been found that tracking order flow can provide both a useful explanation of past price activity in currency markets and — more importantly — can be used as a predictor of future price action. The basic premise behind this is that changes in order flow, if sufficiently large, can have predictable and sustainable impact in the currency markets in terms of price action. There are several short- and medium-term flow indicators which the reader should be aware of. Short-term flow data:
The IMM Commitments of Traders report Medium-term flow data:
US Treasury “TIC” capital flow report
Euro-zone portfolio report
IMF quarterly report on emerging market financing
IIF capital flows report
In addition to flow data provided by the trading exchanges as in the case of the IMM and by official sources as with the TIC and Euro-zone reports, there are also proprietary flow models created by commercial and investment banks to analyse client flows going through the bank’s currency dealing rooms.
Order flow/sentiment models
Flow data and models provide direct evidence of the effect of order flow on market pricing. A more indirect but no less useful to way to do that is to look at market sentiment indicators such as:
Option risk reversals
These are a very useful gauge of the market’s “skew” or bias towards an exchange rate. Analysing risk reversal trends over time relative to the spot rate may allow one to make predictions as to future spot rates based on the risk reversal.

Let’s focus on currency speculators who use technical analysis, either primarily or solely in order to determine their trading in the currency markets. Again, I have found that it surprises some economists that such people exist, not least because it flies in the face of the view that markets are efficient and that pricing is therefore irrelevant. My answer and more importantly the answer of the technically-based currency speculators themselves is that markets are not perfectly efficient, though they are predictable to an extent and technical analysis helps with that. There are a number of schools of thought within technical analysis, such as Elliott Wave, Gann and Fibonacci. A good technically-based currency speculator would use a number of types of technical analysis, not least to test their core view before executing the position. As with other types of currency trading, technical traders can be short or long term in their approach. More generally however, all are looking for trading opportunities using existing market pricing, either for or against the existing trend.