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Sunday, May 29, 2011

Follow the leader


Follow the leader is the topic of the post. The theme should be known for those who have been trading financial markets for a long time and used trend trading strategy to make profit in trading.  I first found the concept when I was reading Jesse Livermore’s book “Reminiscences of stock operator”. Livermore was a famous technical analysis practitioner who searched for opportunities to capitalize on big trends. He waited for specific market conditions that would cause markets to go up or down and when he saw them he would start building his line of positions (long if he expected an uptrend and short if he expected a downtrend). 

While watching price action in stocks and commodities he noticed that some stocks formed tops (in an uptrend) and bottoms (in a downtrend) faster and also would be the first to start downtrend (after topping process was over) and uptrend (after bottoming process was over). He called those securities leaders and his idea was that you should place much bigger bets on leaders for they would bring you more profit and they would also signal that a general market trend is about to finish. 



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By looking at various securities you can notice the same phenomena, some securities breakout faster out of their ranges, others follow them after some time, yet others may stay in their ranges unable to break them. As you may understand it is much better to follow leaders in any financial market for they would bring you fastest and best profits. If you looked at currency markets now you would probably not see this phenomenon on mega trends. When a big trend up or down starts it usually starts on all currency pairs the same day. This is due to the fact that markets are global and what happens in one pair will most probably happen in the other.
So, if you want to see how the process works you want to start checking various markets, various stock markets and compare them. You will also see this phenomenon in commodities, for various factors affect this or that commodity, and the very same factors may not affect the price of that or this commodity. 

This may also be true about price action of currency pairs on smaller time frames. At any given moment one currency pair may be very weak and another one might be very strong. So if they both move against the third currency (which is the weakest at the time) the first currency will advance less than the second. 



So, you have to identify which currency will be stronger and trade it. We can take the most recent collapse in US dollar by looking how eur/usd and gbp/usd went up. You will clearly see that gbp/usd was much stronger and faster to clear the most recent high. On May 23rd eur/usd started reversing from its short term downtrend and made a high 1.4132 on May 24th. On the same day (May 24th) gbp/usd made its high of 1.6208. Now, gbp/usd was able to take out its previous high on the 25th of May (the next day), while eur/usd failed to do it and made a new high on the 26th of May. What does it say to us? It tells us that gbp/usd is much stronger and will be a better leader than eur/usd, so we should buy gbp/usd and leave eur/usd aside, or take smaller long position in eur/usd than we take in gbp/usd. And if you looked at usd/cad pair, you will see that Canadian dollar was so weak that it was not able to advance against US dollar and stayed confined in its three day range.

So, if you do analysis of various pairs try to see which pairs are the weakest now and which are the strongest. You should also see whether a particular group of currencies are going to reverse and then you should try to identify which pair will be the leader (the first to breakout). You should also have in mind that the currency which is the weakest now and in a short term downtrend will have a counter trend move and will be the strongest. Wait for these kind of moves too. 

So much about follow the leader! I will add to the post when I get more ideas and examples on the topic.
Read my previous post:

MACD



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http://www.etoro.com/A41516_TClick.aspx 


Disclaimer
Trading financial markets carries a high level of risk, and may not be suitable for all investors. All information on the blog is of educational nature and cannot be considered as advice, recommendation or signals to trade in any financial markets.