There are reasons assets rise and fall. If you don’t
understand those reasons, picking assets is like
throwing darts at a dartboard. It’s all a gamble. You
need not take those kinds of risks. Indeed, it’s essential
you understand the risks of trading and protect yourself
by staying within your risk tolerance. As you learn about
events and trends that move assets, you can become
better prepared to invest wisely.
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Market cycles and trends are used to help
investors predict the market. They are easy to see
looking back, but much harder to pinpoint as they
occur. Traders study technical analyses to try to
understand how the market will move next. For the
most part, professional investors follow the trend
until it changes. They have a saying, ‘The trend is
your friend.
What Causes a Market Cycle? The expansion and
contraction of business, earnings, ination, stability,
and politics all affect market cycles. Basic human
emotions and behaviors create market trends.
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People swing between fear and greed, between
focusing on the good news and worrying about
the negative. Markets react to the pendulum-like
swing.
Economic Cycle: The most generic of all cycles is
the economic one. It’s divided into four parts:
• Market bottom and full recession
• Bull market and recovering economy
• Market top when the curve levels out and there
is high expectation but less production
• Bear market with the economy falling toward a
recession
Kinds of Market Cycles: The length of a cycle and
its beginning and end point are especially hard to
see as they are occurring. The trend is easier to
determine as you look at charts and historical data.
A Bull Market is a series of up-trends. You see
higher highs and higher lows.
• A Bear Market is a down trend. It’s characterised
by lower highs and lower lows.
• A Revision to the Mean is the natural tendency of
securities to come back to the norm as shown on
long term charts.
A Sideways market is when the price bounces
up and down but stays within a channel. This may
show up at any point in a cycle. In the middle of a
trend, it’s called a consolidation
3.1 Understanding Market Cycles
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ALitman Gregory Team, ‘Market Cycles and Portfolio Positioning’, Advisor Perspective. 26 Apr. 2016 https://www.advisorperspectives.com/
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Companies may gain high valuations in a bull
market, or low ones in a bear market, but some
schools of thought believe secular cycles revert to
the dominant P/E ratio.
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Different investments can be in different cycles at
the same time. Often consumer staples will be in an
uptrend while technology is in a downtrend. Or the
financials may be trending up while commodities
are trending down. Savvy investors capitalise on
these trends by shifting their assets away from
a down-trending sector and into an up-trending
sector. But entering a trend too early or too late
will reduce profits and can result in losses.
Secular cycles can last decades. Cyclical cycles
range around four years and within each cycle
there will be many temporary dips or reversals. It
takes skill to know if these dips indicate a change
in the cycle or are just variations of the same trend.
Traders may buy and sell on these smaller changes.
Short cycles include things like:
• The January Effect
• Sell in May and Go Away
• Options expiration dates
Monthly reports on employment, ination, and
other data
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Long term investors exercise patience and
hold their course during the short reversals.
Understanding the basics of technical analysis may
help investors spot trends and places where the
market is likely to change direction.
Traders who are worried that the trend might
suddenly change sometimes may place puts,
calls or invest in a Contract for Difference (CFD)
as insurance against that change. or invest in a
Contract for Difference (CFD) as insurance against
that change.
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Easterling, Ed. ‘Understanding Secular Stock Market Cycles’, Crestmont Research, 7 Oct 16 https://www.advisorperspectives.com/
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‘Stock Market Cycles’, Wikipedia https://en.wikipedia.org/wiki/Stock_market_cycles
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Stocks, currencies, and commodities all respond
to news, both predicted and unexpected. Because
you understand that trends will eventually revert to
the mean, or back to the trend, you may be able to
take advantage of unexpected news. The knee-jerk
response of bad news may cause a sudden drop
in a security. Often it’s an overreaction and the
security will bounce back. But not always. Knowing
the fundamental value of the security will help you
know if a news-related dip is a buying opportunity
or not. Understanding the underlying strength or
weakness of a currency may guide your investment
decisions during a surprising change.
Company news: Companies distribute reports
and dividends on a calendar schedule. Options or
CFD traders often trade before the news based
on their estimate of the outcome. Volatility usually
spikes before earnings reports. If the equity trades
within the expected range, traders can capture
that premium as the volatility drops after earnings.
Options Expiration Dates: If the stock market
has made major changes, those who have shorted
equities may need to cover those shorts. It can
cause a temporary dip or rise in the equity price. In
a similar way, index funds rebalance their portfolios
on specific dates. This too, can affect the prices of
those equities held within the index fund.
Economic Calendar: There are many dates
where economic reports are delivered. Many of
these reports are used to assess the health of
the economy. Based on these measurements
or statements, the market tries to predict how
securities will move. Some of these include:
Commodities Future Trading Commission net
positions (CFTC)
• Consumer Confidence
• Consumer Price Index (CPI)
3.2 Trading the News and Economic
Calendar
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Federal Reserve Board minutes- affects U.S.
interest rates
• German Buba Monthly Report
• House Pricing Index
• Jobless Claims
• Markit Manufacturing PMI
• Producer Price Index- measures inflation for
businesses
• Retail Sales
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“You’re trading the largest markets in the world
with trillions of dollars being traded every day, it’s
you against the millions of other traders out there
and it’s the biggest challenge you will probably
ever face, to become one of the 5% who actually
make money from trading and that’s why I love it.
- fxchartstudies, eToro Popular Investor
You can find a more complete list at eToro’s
economic calendar.
When nations report on their gross domestic
production, their debt, employment, housing,
manufacturing, import/export levels, consumer
confidence, and more, investors gain understanding
about the direction of the economy. As financial
institutions comment on business trends such as
ination levels, interest rates, oil supplies, and cost
of goods, traders adjust expectations for business
growth.
When you invest, you’ll often find a trade-off
between risk and reward. Sometimes that trade-
off is obvious. Sometimes it’s hidden.
Traditionally, bank savings were viewed as the
most risk free investment. You would earn fixed
or various interest on the money you put into the
bank. However with negative interest rates and
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FX Street Economic Calendar https://www.fxstreet.com/economic-calendar
3.3 Risk vs. Reward
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increasing bank failures, banks may no longer be
considered risk-free.
Bonds have been another asset class that has
been labeled ‘low risk.’ If you purchase a bond
and hold it to maturity, you are guaranteed to get
your money back and the additional percentage of
interest paid. That is provided the holder has not
defaulted. Depending on ination, your bond may
or may not actually earn you any money.
Investing in blue chip stock companies has
also been considered fairly safe. These large,
international, well-funded companies produce
needed services and pay dividends. They most
often weather financial storms. The stock price
may uctuate, but traditionally, they have offered
good returns for the investor.
Smaller companies, those in emerging countries,
and those with larger debt offer added risks. Small
companies may not have the depth to weather
adversity. Emerging countries may face unrest,
shortages, or unfavourable exchange rates.
Companies with large debts may find they cannot
raise capital during a setback.
The more uncertainty, the more likely you are to
lose money or to lose your entire investment.
Statistic Brain Research Institute says only 37-58%
of start-up companies are alive in four years.
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If
the company fails, you lose all your money. On the
other hand, if the company becomes an Apple or
Google you stand to make many times your original
investment.
Commodities may offer the security of tangible
assets. But they are most frequently traded on
paper. CFDs can help capture the change in price
without the risk of physical storage. Different
kinds of commodities carry different risks. Cycles
inuence commodity prices.
21
Pryor, Kristin. ‘Here Are the Startup Failure Rates by Industry’, Tech.Co 12 Jan 2016 http://tech.co/startup-failure-rates-industry-2016-01
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Currency typically has small movements so it might
be deemed safer. But traders usually leverage their
trades to try for larger gains, which significantly
increases risk.
Leveraging a trade means you use a lower
percentage of invested money to control a larger
amount of a financial instrument. This increases
your chances for both larger profits and larger
losses. You increase your risk. CFDs, Forex, and
short options trading use leverage. In these cases,
it’s possible to lose more than your total investment
and be left with a large debt.
When traders can afford to lose all their money,
they can trade with a higher degree of risk in the
hopes of making an outsized return. People who
cannot afford to lose their money should trade in a
more conservative way with lower risk instruments.
They exchange increased safety for lower returns.
On the other hand, many people, over the long
run, have made substantial returns on low risk
investments. So low risk does not always mean
low returns. Investment platforms may help you
find out the risk of the trade before you choose to
make it.
The Cost of a Loss: When you take a loss,
sometimes called a drawdown, it takes more gain
to recover. If a security drops 50%, it doesn’t just
take a 50% gain in the price to bring you back to
even. It takes a 100% gain to even you out. Here is
a chart of the gains needed to return to even on
unleveraged instruments.
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If you choose to invest in leveraged securities, the
required gain is much steeper. At 5x leveraging, a
10% drop will need a 100% gain to break even. And
a 25% drop would need a 300% gain to eliminate
your losses.
Ask yourself, how will I feel if I lose money on this
trade? How much can I afford to lose before it
affects my future, my retirement, or my emotional
well-being? This will help you assess your risk
tolerance. If you find yourself watching the prices
and sweating every time there’s a dip, you may
need to lower your risk tolerance and choose safer
investments. It should be fun, not stressful.
eToro offers a simple tool to assess the risk level of a
portfolio or investment. Click on your public profile
in your active trading site to see your Risk Score.
It tells you the level of risk in your investments. If
you have a private profile, you must make it public
to see your score. (A public profile shows what
you are investing in, but never the amount of you
investment.) You’ll also see this risk score in the
Popular Investor’s page so you can choose to copy
people with a similar risk tolerance.
Portfolio Loss
Gain needed to bring
back to even
-10% +11%
-20% +25%
-30% +43%
-40% +67%
-50% +100%
-50% +150%
3.4 Risk Score
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The Risk Score is a reminder that all trading involves
risk. You should only risk capital you're prepared
to lose. Also remember that past performance
does not guarantee future results. While these
traders may have produced outstanding results for
the past 12 months, you cannot assume the next
12 months will bring the same results. However,
as an investor, you are now better prepared to
understand the risks you are taking should you
trade alongside them.
This is another step eToro makes to be transparent
and keep investors informed. When you click on
a Popular Investor’s page, it will take you deeper.
You’ll see a chart with their past trades and the
risks associated with those trades.
When you scroll over a bar, a pop-up tells you the
maximum risk and the average risk of the trades
for that month.
The max drawdown below the graph shows the
highest historic losses the trader has incurred
during the previous 12 months, by day, by week and
aggregated yearly . This shows the performance
of the trader for you to consider if you are willing
to tolerate the risk for the potential upside gains.
The low risk scoring 4exPirate brought in 15.23%
profit over this trading period. The higher risking
Konstantin Trade profited 63.96% over the risk
period.
The Risk Score is created from a proprietary
algorithm that assesses the portfolio’s overall
exposure from each of the trades open. It takes into
account the daily movement of a security. Then it
multiplies the chances of volatility so the range will
be accurate 99% of the time. Leverage increases
the risk. But some combinations of securities
actually reduce risk. If you pair two currencies (for
example the EUR/USD and the USD/JPY) you hedge
the USD no matter if it goes up or down. These
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kinds of paired trades lower the overall portfolio
risk and so may lower the risk score.
eToro’s risk scores help you understand and
manage your risk in a less emotional and more
quantified way. When you understand how
the markets can cycle and how to control your
tolerance for risk, you gain the confidence to
trade and invest. The next step is to learn how to
research assets to be able to pick strong ones.
Your capital is at risk. Past performance does not guarantee future results. This information is for educational purposes and not investment advice.
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