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Main » Articles » Forex for Beginners

Does the global economy need a (Hammer)?!

Our dear reader, in our article here, we will sail together on a technical and fundamental analysis boat, trying to find out together the benefits from catching a technical formation or rather known (a technical pattern) whether it's positive or negative, bullish or bearish, attempting to link it with the contemporary economic circumstances.

 We all know that the market itself isn't gambling; so that we always see those who are playing the coins flipping game with the market, tend to fall down easily and so quickly.

 Of course, to catch a pattern you need to read the chart technically; alongside with a good background of fundamental analysis because we do believe here in ecPulse that both readings are needed as well.

 The pattern is just an indication, which identifies the winner of the battle between bulls and bears. We also know that, the chart determines the high, low, open and close. 

When the conflict occurs between buyers and sellers over the time frame we see what is recognized as the close point, which lots of trader or maybe all of them are starting to read the battle form their point of view, resulting in making decisions, which may make profits or losses. 

We chose the candlestick patterns to explain the purpose of why many people spend a long time to learn technical analysis. 

Before we start any deep studies about the Japanese candlesticks, we will focus on the definition and the historical root of these candles.

 

World of the candlesticks:

The candlestick chart is another type of chart used by analysts to help determine the trend of equities or securities in the markets over time. This chart is derived from the line and bar charts and helps tell the range of movements within a specific time interval. 

History:

It all started in the 17th century as the legendary Japanese trader, Munehisa Homma, alongside other traders were using this technique to trade rice. The charting technique was able to provide them with open, high, low and close prices for the specified time interval.

Munehisa was the youngest son of the Homma family yet despite his trading techniques and expertise, he was able to inherit the family business and move the trading firm to Tokyo. Continuing his researches and findings, he was able to develop a new set of rules known as the "Sakata Rules" through following historic price movements and weather conditions to later become the framework used by Japanese investors.

Throughout time and after developing his skills, Homma left the Osaka rice markets to expand and target Tokyo exchanges. His fortune grew as he was able to engage in over one hundred consecutive successful trades. As a result, this became the foundation for what is known as Japanese Candlestick analysis.

Although this trading method and technique was around for hundreds of years and ever since the 17th century in Japan, it just recently entered the US approximately 25 years ago as they believed that it was too difficult and too time consuming to understand. However now, it has become the most popular trading technique as computer software was able to develop a more advanced platform. This refined trading technique was then officially published in the US by Steve Nison in 1991 under a book titled "Japanese Candlestick Charting Techniques".

However, it is important to note that candlesticks were also picked up by Charles Dow during 1900 as his theory of technical analysis followed the same principles that included:

 

  • Buyers and sellers move markets based on expectations and psychology
  • Markets Fluctuate
  • All known information is reflected in the price
  • Price doesn't necessarily reflect the value of the underlying asset
  • The price action is more important than news, earning, etc.

 

Candlestick Layout:

 

The candlestick is composed of a body, black or white; and two shadows known as wicks and tails. The upper shadow shows the highest trading price whereas the lower shadow indicates the lowest trading price. As for the body, as seen in the above image, a black body shows the opening price at the top of the body followed by the closing price at the bottom of the body and vise versa for the white body. 

Patterns are single, double and also triple. The pattern defines if we will continue moving within the same trend or maybe reverse it to the other direction.

 

Among all patterns of the Japanese candlesticks, a single pattern has attracted traders just like honey attracts bees. It's the [Hammer].

The hammer is a single candlestick bullish reversal that looks like a square lollipop and it is always forming at the end of a downside trend. The price usually moves to the downside before rallying back to the upside to close below or above the price. The color of the body is of no significance. It reverses a specific trend, which should be bearish.

 

As a matter of technical fact, the length of the lower shadow and also the length of the upper shadow which some traders know them as (wick and tail) do signal the strength of the reversal, as the hammer without an upper shadow is always able to indicate a stronger reversal, giving a plus sign as seen on the example below.

 

Another condition, which may be capable of determining the strength of the reversal, is the ratio of the lower shadow versus the body, as the typical or ideal pattern always offers 2:1 or 3:1.

 

As far as the tail is longer, the reversal is stronger.

 

The low of the hammer shows that plenty of sellers remain. Further buying pressure, and preferably on expanding volume, is needed before acting. The heavy volume can serve to reinforce the validity of the reversal. 

Based on the length of the lower shadow, professional technical analysts and experienced traders can determine how far the reversal may go, using a convenient level for defining the end of this reversal according to the time frame they use.  

While this may seem enough to act upon, hammers require further bullish confirmation.

Such confirmation could come from a gap up or long white candlestick, commonly forming next to hammers or rarely two candles following it.

 

The examples below show the difference between the two cases. 

The first example shows a weekly hammer which has been formed on the USD/CAD pair in the first week of November 2007 and was followed by a direct confirmation. 

 

On the 23rd of July 2007 on the daily chart of the Greenback versus Swiss franc, the hammer has been captured but the confirmation was given later.

 

Hammers can mark bottoms or support levels.

After a decline, the low of the long lower shadow implies that sellers drove prices lower during the session.

However, the strong finish indicates that buyers regained their strength to end the session on a strong note.

Two important elements should be put in our consideration before the indication is confirmed; firstly the historical or the previous established support level.

What if it met the recorded low of the hammer?

Second, the angle of the trend as when the trend is closer to 45 degrees, the reversal gets additional strength and confirmation for starting a new ascending wave.

Most of traders play the game like this, buy near support and sell near resistance.

Of course the solo indication is always useless.

Therefore finding a support level will not be useful without being used in conjunction with other forms of analysis, what could be better than a hammer candlestick?

Check the following example.

 

As we explained above, the solo indication might cause a failure if the trader depends on it alone, but also there are some rare cases in which, the reversal of our detected hammer may fail.

These cases occur when the bears control the movement of the market and this action is represented on the chart with a bearish engulfing candlestick pattern, which takes the price below the recorded low of the hammer and brings downside rally resumption.

Note the following example for a case of failure:

 

Now dear reader, after discussing one of the most important technical reversal candlesticks and were able to pinpoint the exact result from it, let's combine both technical and fundamental analysis to see how this may affect growth in the global economy.

We won't drift off our main topic which remains the hammer, yet we will attempt to implement this singles candlestick on the current economic situation in several major economic powers that many believe are on the verge of crawling back out of a recession that resulted from the worst financial crisis since the Great Depression in 1930s.

The Hammer candlestick is simply a candle with specific characteristics that has the ability to end a downtrend and reverse it to the upside to reach specific targets depending on several factors discussed earlier.

Ok, looking back at the end of 2007, the global economy has been gradually declining from prosperity nearing the end of the completion for the first two parts: the downside wave and the hammer candlestick. However, do note that the candle is still forming and we are currently waiting for the close of the candle to confirm the final part of the cycle.

To begin with dear reader, let's discuss the two factors that have been completed before moving on to the result of the pattern; which to us is more important than the pattern itself, and that is the actual reversal to the upside to symbolize an economic recovery.

From the period between 2002 and 2007, the global economy witnessed a new phenomenon known as globalization which supported world trade to extend across the entire globe. With all the growth prospects, financial markets became more active as more and more traders were entering the markets day after day. The fatal attraction of large amounts of profits witnessed by some and the diversification of instruments in the markets was more than enough to lure the players needed.

If we focus on the world's largest economy, the US, we see that it too shined to prosperity during this period. However, looking at it at another point of view, financial markets were able to provide the support needed to help the economy as billions of dollars were constantly being pumped into the American markets as investors were targeting investments in what was known as the most stable market at the time.

The housing sector had the major role as it attracted the most due to the different derivatives and investment instruments that were provided from the sectors alongside the magnificent performance of the sector compared to others in the economy. House prices continued to surge which unfortunately mislead investors to believe that this incline will guarantee them profits.

With all the capital in the markets and US housing sectors, it wasn't long before a bubble was formed that would eventually burst similar to the Dot Com bubble in 2001 and that back in the 30's which ended with the Great Depression. Due to investors insisting to pump more liquidity in the markets, stocks were heavily overvalued opposing fundamentals that were being released and the true performance of different companies. 

During the second half of 2007, European Banks that had invested abroad in the US realized that they couldn't tell the exact value of their investments and that the actual volume of investments was much less than all the securitization which simply meant that if shareholders, bondholders or any investors bearing any of the commercial papers/instruments were to ask for liquidity, the amount of cash on hand won't be enough to satisfy the amount of actual investments.

BNP Paribas was one of the first victims as it froze three major hedge funds in the US to trigger the largest credit crisis in the global market. We can't blame them for the current situation, but this is when investors realized the truth which resulted in a major sell off in the market dragging global stock indices to the ground to hit historical lows. Unfortunately, the crisis wasn't just contained within the US borders, but it eventually spread across the globe to hit several banks and financial institutions who were boggled with the true value of their investments in the US instruments.

Not long were the economies of the US, Europe, Japan and UK affected by the crisis as the it was obvious that the foundation that the US laid upon was no longer fit to support the economy unlike what was seen in China. From here, the negative effects on growth rates and company performance in the different sectors started to emerge.

By this we have safely highlighted the declining wave that dragged growth rates lower which accelerated after the collapse of Lehman Brothers in September 2008. The third largest investment bank in the US at the time failed to receive government aid which resulted in the bankruptcy of the bank and further deterioration in the economy.

Following this collapse, the US government stated that it would take over American International Group (AIG), the largest insurer in the world, due to the massive losses posted after guaranteeing mortgage backed securities. Ahead of the government take over, Freddie Mac and Fannie Mae, the mortgage giants were also threatened of bankruptcy where if deemed true, this could've been the end for the entire global economy and not just the US.

All this pushed banks across the globe were hoarding cash as they froze the credit markets and hence affect global trade that depends heavily on credit. In addition to that, waning demand battered emerging markets and dragged them into a recession as exports were weak after the US, Europe, UK and Japan all entered a technical recession. These economies served as the largest markets for many emerging nations that depended on them, and with them out of the picture, the emerging nations were soon to sink as well.

Amid all these developments, central banks and government were to come up with unorthodox measures that included interest rate cuts to record lows and pumping trillions of dollars in the markets across the globe in an attempt to slow the pace of deterioration in the financial markets. Sadly, this wasn't enough to help the economies as they continued to contract to post the worst growth rates that extended to the first half of 2009.

With the end of the first quarter in 2009, it's safe to say the declining wave has ended and the lower wick of the hammer reached the lowest level it could possible hit. The US witnessed a 6.4% contraction during the first quarter whereas the Euro Zone contracted 2.5%, the UK shrank 2.4% and Japan topping the list posting a 11.7% contraction. However, all these economies were able to show improvement in growth rates during the second quarter of the year despite the US, UK and Euro Zone failing to post positive readings unlike Japan which expanded 3.7%. It seems like economies are now on the right path to recovery.

Now with the obvious improvement in economic fundamentals and growth rates in the second quarter in specific, we can say that there is a battle between the economies and negative effects that resulted from the credit crisis which will symbolize the body of the hammer candlestick after the lower wick has been placed as it attempts to close as far away as possible from the lowest point seen in the first quarter.

We can't quite say that the shape of the candle has been constructed and that the second quarter is the closing of the candle especially as economies are still facing several challenges. However, we can say that the end of the year will definitely determine whether the closing is far enough from the lowest point or not to overcome all the economic tensions and instability witnessed recently.

Let's move on to what we referred to earlier as the most important part of the entire cycle and that is…the reversal. We first need the confirmation for the completion of the pattern which may emerge during the first quarter of the upcoming year according to several analysts across the globe. The first quarter of 2010 will be a clear cut sign indicating how well the global economy performed to crawl out of the recession.

In order to determine the targets for the global economy, there is still one factor that we need to take into consideration. Despite the recent developments in most of the sectors during the second quarter, the only sector that continues to weigh upon the economies is the labor sectors. The labor market can be seen as the largest prey for the crisis as it continued to deteriorate alongside the waning demand and frozen credit markets that resulted in massive losses for many companies, whether financial or not, and forced them to cut back on expenses by firing employees.

Such lay offs took unemployment rates to the highest levels across the globe where in the US, companies continued to fire workers for 19 straight months taking the unemployment level to 9.7% marking the highest in 26 years which may possibly reach 10% by the end of the year. In the UK, unemployment hit 7.8% in June while reaching 9.5% in the Euro Zone and 5.7% in Japan, marking the highest in six years.

The spike in unemployment rates and the loss of jobs to people crippled the ability to spend in the economy as income was now limited for households where consumer spending in the US accounts for 2/3 the economy and more than half of the economy in Japan. This alone is enough to highlight the importance of this factor in supporting economic growth. 

Therefore, if we were to determine where the global economy is to go in the process of recovery, we need to first pinpoint the expected recovery to be witnessed in the labor market in general and to what extend will all the stimulus plans set by governments be able to support consumer spending so that companies can stand back up on their feet and start hiring once more. All this depends on the stability of the financial system and markets in the different nations to encourage businesses and individuals to invest once again.

There are two theories for recovery which we should discuss as debates across the globe have split opinions into two. Some believe that the economy is to recovery in a (V) shape which supports our outlook on what the hammer is to do; while others believe that it will take the shape of a (W) which then may contradict what we expect. Either or, we will explain both theories to you dear reader, and the choice is yours to pick…

Concerning the first theory in which recovery will follow the shape of the letter (V), this theory depended on trusting the measures taken by governments and policy makers in the world to support economic growth. Governments pumped $2.2 trillion in the markets to provide liquidity and ease the credit market freeze as well as support sectors that needed aid. Analysts see that these measures alone are enough to put the global economy back on track disregarding the time factor.

Those supporting this theory also believe that a lesson has been taught to policy makers and governments as they implement regulations to monitor company performances and alter certain developments in the financial markets in addition to the financial regulatory body in the great economic powers such as central banks will have a bigger role in implementing these regulations on financial markets in order to avoid falling in the same mistake.

Moving on to the second theory which supporters believe the economy is to take the form of a (W), they believe that the current improvement in the economic situation is only temporary and that the global economy is to deteriorate once again to near the bottom before rebounding and recovering at a quicker pace.

This theory shows that reviving from the current recession will take some time as they believe the negative effect in the long run for all the liquidity pumped in to the markets will result in higher inflation and hurt a country's budget.

Do note dear reader that in order to provide such amounts of liquidity in the markets, policy makers had to engage in desperate and unorthodox measures like quantitative easing which depending on buying long term government debt to provide the government with the liquidity needed to fund the stimulus plans. In other words, governments printed more money and issued more treasury bills to cover the excess notes.

The nation's budget will then carry the burden of such actions which pushed many analysts to expect another period of sluggish growth and economic deterioration that may drag currencies lower and affect inflation rates. And that is what is known as the (W) recovery.

We will leave it up to you dear reader to choose what best describes the current developments in the global economy; yet we still have important questions to address. Do you believe that the time has come to witness a recovery in the global economy? Or are the negative effects from the credit crisis still clouding us?

And if the economic recovery could hope to escape from the clutches of the crisis; do you think that will take long? Or will the repercussions of the global crisis be back into effect and take the globe into a deep economic downturn?

At the end, don't you think with me that, the global economy is in definite need for a hammer in order to make sure that the crisis is over and the market has already placed a real bottom? Or the bears will control the next movements, resulting in a long period of uncertainty?

http://www.ecpulse.com/en/Education/FundamentalAnalysis/

Category: Forex for Beginners | Added by: forex-market (2009-11-11)
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