Investment Concepts

Whether you are a new or experienced investor, investing in a modest or sizable portfolio, understanding certain key investment concepts is important. Principal Mutual Fund brings to you a primer to help understand concepts such as - diversification, time value of money, rupee cost averaging and others - as a foundation to form a sound investment strategy.

Inflation

Inflation refers to a continuous rise in general price level, which shrinks the value of money or purchasing power over a certain length of time. It is calculated in terms of per cent change in the value of price index consisting of a range of goods or services. An inflation rate of 8% means that the general level of prices of goods and services has increased by 8% over the previous period.

In other words, purchasing the same amount of goods and services will cost you 8% more than what it would have cost you in the previous period. Thus, Inflation can also be explained as a decline in the real value of money - a loss of purchasing power in the means of exchange, which is also the monetary unit of account.

There are several inflation measures available in India – the most commonly used are based on Consumer Price Index (CPI) and Wholesale Price Index (WPI). Within these, there are several sub-indices (e.g. CPI for Industrial Workers, CPI for Urban Non Manual Labourers, etc.) as well. These sub-indices are designed to see how price increases affect different set of people. Since WPI is available on a weekly basis, inflation based on that is the most commonly referred inflation measure in India.

Risk & Return

Risk is defined as the uncertainty or deviation in the return expected from an asset class. This risk could be measured in terms of standard deviation of an asset class. Risk can be classified as below:

Systematic Risk

Systematic risk is defined as a risk that takes place in all the risky assets because of macro-economic factors like earthquakes, floods, war, etc. However, it cannot be eliminated through diversification.

Unsystematic Risk

Unsystematic risk is defined as a risk that is unique to a particular asset class and can be eliminated or reduced by diversifying a portfolio.

A security's return is calculated by its holding-period return: the change in price plus any income received, expressed as a percentage of the original price. An improved measure would be to take into consideration the timing of dividends or other payments, and the rates at which they are reinvested.  The total return on an investment has two components: the expected return and the unexpected return. The unexpected return comes about because of unanticipated events. The risk from investing stems from the possibility of an unexpected event.

Relationship between risk and return

A simple relationship exists between risk and return – the higher the potential return, the higher the level of risk involved. Whilst everyone would like to maximize return and minimize risk and would prefer to have a return every year of approximately 15-20% with no opportunity of investments falling in value, the reality is that these investments do not exist. As a common rule, the bigger the potential investment return, the higher the investment risk and the longer the investment time horizon. 

Asset Classes

An asset class is a specific category of investment such as stocks, bonds, real estate or cash. Investing is a trade-off between risk and expected return. Depending on the risk appetite of an individual, he can choose to invest in a combination of asset classes that would optimize his returns. Some of the most common asset classes are as follows:

Cash

Cash assets comprise of near currency assets viz., T-Bills, commercial paper, money market instruments, and short-term government bonds that are liquid (i.e. they can be easily converted to hard currency at short notice).

Equity

Equity (also known as a stock or share) is a portion of the ownership of a company. A share in a corporation gives the owner of the stock a stake in the company and its profits. As the individual buys more stocks, he increases his ownership stake in the company. Stocks are generally more risky; along with providing an opportunity to earn significant returns, they also carry the risk of part or complete loss of the invested amount.

Bonds

A bond is a formal contract that obligates the borrower to repay the borrowed money with interest to the issuer of the bond. In India, the corporate bond market mainly consists of issuers of three different categories – government-owned financial institutions (FIs), government-owned public sector undertakings (PSUs) and private corporate entities.

Real Estate

Recently, investing in real estate has become increasingly popular making it a common investment vehicle. Although the real estate market has plenty of opportunities for making significant amounts of money, real estate as an asset class is not readily accessible to the retail investor. However, with the introduction of real estate mutual funds (REMF), investors across various sections of the society will be able to take advantage of the growth in this sector.

Gold

Of all precious metals, gold is the most popular as an investment. It is renowned as a hedge against inflation and has limited downside risk.

Diversification

Diversification indicates building/ creating an investment portfolio that includes securities from different asset classes. It spreads risks across various financial investments, reducing the impact that poor returns from any one investment are likely to have on the overall portfolio. The prices of shares, bonds, listed property and other investments often do not rise and fall in tandem. When one type of investment is on the rise, another may be on the decline. The result is that your portfolio's overall performance is likely to be less volatile. The objective of diversification is to reduce the risk involved in building a portfolio. Diversification reduces the risk for an investor because all investments may not move in the same direction in the same proportion at the same time.

A diversified portfolio should be constructed to reflect your personal goals and individual risk tolerance. There are many ways to diversify across several asset classes. Asset allocation is a method of strategically dividing your investment portfolio among stock, bond and cash investments to help protect your portfolio from the rise and fall in any one investment.

Diversification will help to:

• Ease potential risk to overall portfolio
• Improve chances for attaining consistent returns
• Avoid the downside that can come from regularly readjusting your portfolio to follow current market developments

Power of Compounding

Compounding refers to the reinvestment of earnings at the same rate of return to constantly grow the principal amount, year after year. It is a technique of making your money work harder for you and is perhaps the most powerful tool that an average investor can use to plan for many of life’s financial goals, including retirement.

Sameer and Sanjay are friends, just started their career at 20 and plan to retire at 65. Sameer starts saving 5,000 every year from age 20 and continues to do so until he is 35 years old, after which he stops making any further investment. Sanjay, on the other hand, starts saving 12,000 every year from the age of 35 and continues to do so until he retires at the age of 65. If both earn, say, 12% per annum on their investments, which of them would be wealthier when they retire at 65? Sameer! Surprising, isn't it? At 65, Sameer would have accumulated 36.43 lakh whereas Sanjay's wealth would have been lower at 32.44 lakh.

The result would be the same even if one considers a one-time investment. For example, assume that Sameer invests 10,000 at the age of 20 in an instrument that fetches 15% per annum. Sanjay, on the other hand, invests 100,000 at the age of 40 in the same instrument. When both turns 60, Sameer's 10,000 investment would have grown to 26.78 lakh, while Sanjay's 1 lakh would have grown to only 16.37 lakh.

Thus, the longer you stay invested the more money you will make. The best way to take benefit of compounding is to start saving and investing wisely as early as possible. The earlier you start investing, the greater will be the power of compounding.

Power of Triggers

Trigger facility is an additional, optional feature provided in mutual fund schemes, which enables investors to book profit automatically at a pre-defined time or value. In another words, the fund declares a dividend, redeems and/or switches the units automatically on behalf of the investor on the date of the event.

Principal Mutual Fund has introduced the option of Triggers in its funds. You can specify a specific event, which may be related to time or value, in advance and when this event takes place the trigger is activated. Thus, this facility enables you to keep track of your investments without having to put in time and effort to track portfolio movements on a regular basis. It also helps you maintain a disciplined investment approach that ensures that you meet your investment goals. Triggers are of three types –time-based, value-based and event-based.

Time-based triggers

Time-based triggers are activated on a particular date that you have specified. For example, if you wish to gift some units to your mother on her birthday, a trigger can be set for that date.

Value based triggers

These triggers are based on the change in value of your investments. For example, you need 7.5 lakh for meeting the expenses of son's higher education after 5 years and you have invested 5 lakh in an equity scheme for this. If you set a trigger for change in investment value by at least 50%, the money is shifted to a low risk scheme as soon the value reaches that figure. In this way, the dream of your son's higher education will not go sour even if the market turns bearish.

Event-based triggers

You can also set triggers based on the occurrence of a particular external event that affects the value. For example, you want to set the Sensex value of 20,000 as a trigger. If the Sensex is less than 20,000 on the date of allotment, the trigger would be activated when the Sensex closes above 20,000. However, if the Sensex is more than 20,000 on the date of allotment, the trigger would be activated when the Sensex closes below 20,000.

Duration

Duration measures a bond's sensitivity to changes in interest rates. It is a measurement of how long, in years, it takes for the price of a bond to be pay off by its internal cash flows. The longer the bond has until maturity, the greater will be its duration. The longer a bond's duration, the more responsive it is to changes in interest rates. Duration constantly adjusts as coupon payments are made over the life of a bond.

If an investor expects interest rate to fall during the course of time the bond is held, a bond with longer duration will be preferred as the bond’s price would increase more than comparable bonds with shorter durations. On the other hand, an investor, who is concerned about wide fluctuations in the principal value of bond holdings should consider a bond with short duration. Investors who are comfortable with fluctuation and are confident that interest rates will fall should look for a longer duration bond.  

Yield Curve

Yield curve is a chart consisting of the yields of bonds of the same quality but different maturities. This is used as a measure to assess the future of interest rates. Here, the time value is plotted on the X-axis and yields on the Y-axis. The curve graphically demonstrates the rate at which market participants are willing to transact debt capital for the short term, medium term and long term. The yield curve is positive when long-term rates are higher than short-term rates; however, the yield curve is sometimes negative or inverted.

Types of yield curve

Normal Yield Curve

When long-term interest rates are higher compared to short-term interest rates, the shape of the yield curve is upward sloping.

Steep Yield Curve

This curve is normally observed at the beginning of an economic expansion or just at the end of a recession. The slope of the yield curve increases as the difference between long-term yields and short-term yields become wider. The inherent assumption behind such a curve could be that while short-term economic conditions warrant lower rates, factors like inflation, etc. could rise in the medium / long-term justifying much higher long-term rates.

Flat Yield Curve

When there is no change in market outlook on interest rates, we get flat yield curve. This is because yields are almost same across tenors.

Inverted Yield Curve

When short-term interest rates are higher than long-term interest rates the shape of yield curve takes downward sloping. This happens when markets expect high volatility in the near future however long term story remains same. 

Time Value of Money

One of the most fundamental concepts in finance is that money has a “time value.” That is to say, money in hand today is worth more than money that is likely to be received in the future. For example, if you are offered the choice between having 10,000 today and having 10,000 at a future date, you would prefer to have 10,000 now. By accepting 10,000 early, you can put the money in bank and earn some interest. Thus, the time gap allowed helps us to make money. This incremental gain is time value of money.

The Time Value of Money concept is grouped in two areas: Future Value and Present Value. Future Value is the method of discovering what an investment today will grow to in the future. Present Value on the other hand is the process of determining what a cash flow to be received in the future is worth in today's value.

Rupee Cost Averaging

Rupee cost averaging is an approach in which you invest a fixed amount of money at regular intervals. This in turn ensures that you buy more shares of an investment when prices are low and less when they are high. By investing on a fixed schedule, you avoid the complex or even impossible duty of trying to figure out the exact best time to invest. The rupee cost averaging effect - averages out the costs of your units and hence lessens the results of short-term market fluctuation on your investments.

Getting started on a rupee cost averaging strategy

• Decide on the amount you can invest on a regular and long-term basis
• Select an investment you want to hold for the long-term
• Invest at regular intervals (weekly, monthly or quarterly)

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Mutual Funds

What is a Mutual Fund?

A mutual fund is a professionally-managed trust that pools the savings of many investors and invests them in securities like stocks, bonds, short-term money market instruments and commodities such as precious metals. Investors in a mutual fund have a common financial goal and their money is invested in different asset classes in accordance with the fund’s investment objective. Investments in mutual funds entail comparatively small amounts, giving retail investors the advantage of having finance professionals control their money even if it is a few thousand rupees.

Mutual funds are pooled investment vehicles actively managed either by professional fund managers or passively tracked by an index or industry. The funds are generally well diversified to offset potential losses. They offer an attractive way for savings to be managed in a passive manner without paying high fees or requiring constant attention from individual investors. Mutual funds present an option for investors who lack the time or knowledge to make traditional and complex investment decisions. By putting your money in a mutual fund, you permit the portfolio manager to make those essential decisions for you.

How is a mutual fund set up?

A mutual fund is set up in the form of a trust that has a Sponsor, Trustees, Asset Management Company (AMC). The trust is established by a sponsor(s) who is like a promoter of a company and the said Trust is registered with Securities and Exchange Board of India (SEBI) as a Mutual Fund. The Trustees of the mutual fund hold its property for the benefit of unit holders. An Asset Management Company (AMC) approved by SEBI manages the fund by making investments in various types of securities.

The trustees are vested with the power of superintendence and direction over the AMC. They monitor the performance and compliance of SEBI regulations by the mutual fund. The trustees are vested with the general power of superintendence and direction over AMC. They manage the performance and compliance of SEBI Regulations by the mutual fund.

How does a mutual fund operate?

A mutual fund company collects money from several investors, and invests it in various options like stocks, bonds, etc. This fund is managed by professionals who understand the market well, and try to accomplish growth by making strategic investments. Investors get units of the mutual fund according to the amount they have invested. The Asset Management Company is responsible for managing the investments for the various schemes operated by the mutual fund. It also undertakes activities such like advisory services, financial consulting, customer services, accounting, marketing and sales functions for the schemes of the mutual fund. 

What is Net Asset Value?

Net Asset Value (NAV) is the total asset value (net of expenses) per unit of the fund and is calculated by the AMC at the end of every business day. In order to calculate the NAV of a mutual fund, you need to take the current market value of the fund's assets minus the liabilities, if any and divide it by the number of shares outstanding. NAV is calculated as follows:

For example, if the market value of securities of a Mutual Fund scheme is 500 lakh and the Mutual Fund has issued 10 lakh units of 10 each to investors, then the NAV per unit of the fund is 50.

What are the different types of mutual fund schemes?

Based on the maturity period

Open-ended Fund 

 

An open-ended fund is a fund that is available for subscription and can be redeemed on a continuous basis. It is available for subscription throughout the year and investors can buy and sell units at NAV related prices. These funds do not have a fixed maturity date. The key feature of an open-ended fund is liquidity. 

Close-ended Fund

A close-ended fund is a fund that has a defined maturity period, e.g. 3-6 years. These funds are open for subscription for a specified period at the time of initial launch. These funds are listed on a recognized stock exchange. 

Interval Funds

Interval funds combine the features of open-ended and close-ended funds. These funds may trade on stock exchanges and are open for sale or redemption at predetermined intervals on the prevailing NAV.

Based on investment objectives

Equity/Growth Funds

Equity/Growth funds invest a major part of its corpus in stocks and the investment objective of these funds is long-term capital growth. When you buy shares of an equity mutual fund, you effectively become a part owner of each of the securities in your fund’s portfolio. Equity funds invest minimum 65% of its corpus in equity and equity related securities. These funds may invest in a wide range of industries or focus on one or more industry sectors. These types of funds are suitable for investors with a long-term outlook and higher risk appetite. 

Debt/Income Funds 

 

Debt/ Income funds generally invest in securities such as bonds, corporate debentures, government securities (gilts) and money market instruments. These funds invest minimum 65% of its corpus in fixed income securities. By investing in debt instruments, these funds provide low risk and stable income to investors with preservation of capital. These funds tend to be less volatile than equity funds and produce regular income. These funds are suitable for investors whose main objective is safety of capital with moderate growth. 

Balanced Funds 

 

Balanced funds invest in both equities and fixed income instruments in line with the pre-determined investment objective of the scheme. These funds provide both stability of returns and capital appreciation to investors. These funds with equal allocation to equities and fixed income securities are ideal for investors looking for a combination of income and moderate growth. They generally have an investment pattern of investing around 60% in Equity and 40% in Debt instruments. 

Money Market/ Liquid Funds

Money market/ Liquid funds invest in safer short-term instruments such as Treasury Bills, Certificates of Deposit and Commercial Paper for a period of less than 91 days. The aim of Money Market /Liquid Funds is to provide easy liquidity, preservation of capital and moderate income. These funds are ideal for corporate and individual investors looking for moderate returns on their surplus funds. 

Gilt Funds

Gilt funds invest exclusively in government securities. Although these funds carry no credit risk, they are associated with interest rate risk. These funds are safer as they invest in government securities. 

Some of the common types of mutual funds and what they typically invest in:

 

Type of Fund	Typical Investment
Equity or Growth Fund	Equities like stocks
Fixed Income Fund	Fixed income securities like government and corporate bonds
Money Market Fund	Short-term fixed income securities like treasury bills
Balanced Fund	A mix of equities and fixed income securities
Sector-specific Fund	Sectors like IT, Pharma, Auto etc.
Index Fund	Equities or Fixed income securities chosen to replicate a specific Index for example S&P CNX Nifty
Fund of funds	Other mutual funds

Other Schemes

Tax-Saving (Equity linked Savings Schemes) Funds

Tax-saving schemes offer tax rebates to investors under specific provisions of the Income Tax Act, 1961. These are growth-oriented schemes and invest primarily in equities. Like an equity scheme, they largely suit investors having a higher risk appetite and aim to generate capital appreciation over medium to long term. 

Index Funds

Index schemes replicate the performance of a particular index such as the BSE Sensex or the S&P CNX Nifty. The portfolio of these schemes consist of only those stocks that represent the index and the weightage assigned to each stock is aligned to the stock’s weightage in the index. Hence, the returns from these funds are more or less similar to those generated by the Index. 

Sector-specific Funds

Sector-specific funds invest in the securities of only those sectors or industries as specified in the Scheme Information Document. The returns in these funds are dependent on the performance of the respective sector/industries for example FMCG, Pharma, IT, etc. The funds enable investors to diversify holdings among many companies within an industry. Sector funds are riskier as their performance is dependent on particular sectors although this also results in higher returns generated by these funds.

What are the benefits of investing in a mutual fund?

Benefits of investing in mutual funds:

Professional Management

When you invest in a mutual fund, your money is managed by finance professionals. Investors who do not have the time or skill to manage their own portfolio can invest in mutual funds. By investing in mutual funds, you can gain the services of professional fund managers, which would otherwise be costly for an individual investor. 

Diversification

Mutual funds provide the benefit of diversification across different sectors and companies. Mutual funds widen investments across various industries and asset classes. Thus, by investing in a mutual fund, you can gain from the benefits of diversification and asset allocation, without investing a large amount of money that would be required to build an individual portfolio.

Liquidity

Mutual funds are usually very liquid investments. Unless they have a pre-specified lock-in period, your money is available to you anytime you want subject to exit load, if any. Normally funds take a couple of days for returning your money to you. Since they are well integrated with the banking system, most funds can transfer the money directly to your bank account.

Flexibility

Investors can benefit from the convenience and flexibility offered by mutual funds to invest in a wide range of schemes. The option of systematic (at regular intervals) investment and withdrawal is also offered to investors in most open-ended schemes. Depending on one’s inclinations and convenience one can invest or withdraw funds.

Low transaction cost 

 

Due to economies of scale, mutual funds pay lower transaction costs. The benefits are passed on to mutual fund investors, which may not be enjoyed by an individual who enters the market directly. 

Transparency

 

Funds provide investors with updated information pertaining to the markets and schemes through factsheets, offer documents, annual reports etc. 

Well regulated

Mutual funds in India are regulated and monitored by the Securities and Exchange Board of India (SEBI), which endeavors to protect the interests of investors. All funds are registered with SEBI and complete transparency is enforced. Mutual funds are required to provide investors with standard information about their investments, in addition to other disclosures like specific investments made by the scheme and the quantity of investment in each asset class.

What are the risks involved in investing in mutual funds?

Mutual funds invest in different securities like stocks or fixed income securities, depending upon the fund’s objectives. As a result, different schemes have different risks depending on the underlying portfolio. The value of an investment may decline over a period of time because of economic alterations or other events that affect the overall market. Also, the government may come up with new regulations, which may affect a particular industry or class of industries. All these factors influence the performance of Mutual Funds.

Risk and Reward: The diversification that mutual funds provide can help ease risk by offsetting losses from some securities with gains in other securities. On the other hand, this could limit the upside potential that is provided by holding a single security.

Lack of Control: Investors cannot determine the exact composition of a fund’s portfolio at any given time, nor can they directly influence which securities the fund manager buys.

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Uncommon Theory-Mathod

Chaos Theory'

A mathematical concept that explains that it is possible to get random results from normal equations. The main precept behind this theory is the underlying notion of small occurrences significantly affecting the outcomes of seemingly unrelated events. Chaos theory has been applied to many different things, from predicting weather patterns to the stock market. Simply put, chaos theory is an attempt to see and understand the underlying order of complex systems that may appear to be without order at first glance. 

Related to financial markets, proponents of chaos theory believe that price is the very last thing to change for a stock, bond, or some other security. Price changes can be determined through stringent mathematical equations predicting the following factors:
1) A trader's own personal motives, needs, desires, hopes, fears and beliefs are complex and nonlinear.
2) Volume changes
3) Acceleration of the changes
4) Momentum behind the changes
Chaos theory is highly controversial and extremely complicated.

 The science of chaos has given us a couple of principles that are applicable in the financial markets:

• You, your nails, your market orders follow the path of least of resistance

• The path of least resistance is determined by the always underlying (and typically unseen) structure

Let us say you have a river running down the mountain. The behavioural decisions that the river makes does not depend on the mind of the river but the riverbed itself. So if you have a riverbed that is shallow and narrow that river is going to go down in rapids. If you have a riverbed that is wide and deep you are going to have a calm pond. So if you want to change the flow of that river you can get buckets and start a bucket brigade or go up to the start of the river where the force of the water is still so slow that it only takes replacing a few rocks to change the direction and it will change everything.

Then there is this thing called the butterfly effect.

That theory simply says that somewhere in South America there is this little Monarch butterfly that flaps its wings as it is flying around looking for some pollen and it sees a flower over here and as he is going there he sees a better flower somewhere else and decides to change its path. As he changes his mind, that is a fractal. The change in his path sets up a little air current and that air current sets up another air current that sets up another air current that keeps the high level winds off of the Antarctica which causes a hurricane like the El Niño, which causes a drought next year in the bean belt and we are going to have beans in the teens because of this little Monarch butterfly that changed his mind.

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So how do we trade fractals and what do they look like on a chart? 

• A fractal is a trend change
• A swing top or a swing bottom is a fractal
• The end of every Elliot wave is a fractal
• A fractal requires a minimum of five bars
• Fractals show the path of least resistance
• A fractal trading system works in all time frames

In the example below you have the market going up as evident by the highs. All we care about here is the highs and not the open, high, low and close. Any time you have a sequence of five bars where you have one bar that has two preceding lower highs followed by two preceding lower highs you have a fractal.

If you have a fractal whose middle finger is parallel to the top, the second one does not count. They both count as one (as in the case below where you have two candles whose highs are identical). In the chart below you see how the market started trading up, changed its mind and now it is going down. Coming up, the left leg must be longer than the right leg for a buy fractal to be valid.

 

After the buy fractal triggers a long position, the sell fractal is negated. For a new sell fractal to set up you will need to see a high, followed by three lower lows and two higher lows, none of which can trade through the high of the first bar. When you have a fractal in one direction which is followed by a fractal in the other direction you have an Elliot wave of one degree or another.

 

So this market started trading up the page, changed its mind (like the Monarch butterfly) and traded down the page. It then changed its mind again and traded through the previous high, just following the path of least resistance. By religiously taking trades only when fractals break, we effectively rule out fighting the market. The challenge, of course, is to avoid double tops/bottoms and not get caught long on up thrusts and short on springs.

 You always hear that what goes up must come down but one of the things that chaos teaches us is that Newton's laws of motions do not apply universally. They apply to man-made things. Market fundamentalists have a fundamentally flawed conception of how financial markets operate. They believe that financial markets tend toward equilibrium.

Equilibrium theory in economics is based on a false analogy with physics. Physical objects move the way they move irrespective of what anybody thinks but financial markets attempt to predict a future that is contingent on the decisions people make in the present. Instead of just passively reflecting reality, financial markets are actively creating the reality that they, in turn, reflect. There is a two-way connection between present decisions and future events, which George Soros calls reflexivity.

So having said all that; when do I want to be in a trade?

• when I can make the most amount of money in the least amount of time
• when volatility explodes and ranges expand
• when odds increase of a directional move
• when risk:reward is favourable

You do not want to put your hard earned cash at risk in a market that just moves about randomly but get onboard a market that has clearly signalled that it is done consolidating and now ready to move.

Look for inside candles (range contraction) and then a break uptown or downtown (range expansion). As a rule of thumb, the longer the timeframe the rarer the trade but the more powerful the signal will be.

Also the more inside candles within inside candles the more powerful the signal will be. The reason is that the more time traders have to build positions the bigger the effect as these positions are unwound.

Below is a great example of how just by looking at candles you can pinpoint the most opportune time to get in.

Only imagine how many traders looking at overbought indicators either sold out too early or faded the move.

 

Fractals 

 Many people believe that the markets are random. In fact, one of the most prominent investing books out there is "A Random Walk Down Wall Street" (1973) by Burton G. Malkiel, who argues that throwing darts at a dartboard is likely to yield results similar to those achieved by a fund manager (and Malkiel does have many valid points). However, many others argue that although prices may appear to be random, they do in fact follow a pattern in the form of trends. One of the most basic ways in which traders can determine such trends is through the use of fractals. Fractals essentially break down larger trends into extremely simple and predictable reversal patterns. This article will explain what fractals are and how you might apply them to your trading to enhance your profits.

What Are Fractals? When many people think of fractals in the mathematical sense, they think of chaos theory and abstract mathematics. While these concepts do apply to the market (it being a nonlinear, dynamic system), most traders refer to fractals in a more literal sense. That is, as recurring patterns that can predict reversals among larger, more chaotic price movements. These basic fractals are composed of five or more bars. The rules for identifying fractals are as follows:

• A bearish turning point occurs when there is a pattern with the highest high in the middle and two lower highs on each side.
• A bullish turning point occurs when there is a pattern with the lowest low in the middle and two higher lows on each side.

The fractals shown in Figure 1 are two examples of perfect patterns. Note that many other less perfect patterns can occur, but the basic pattern should remain intact for the fractal to be valid.

Figure 1

The obvious drawback here is that fractals are lagging indicators - that is, a fractal can't be drawn until we are two days into the reversal. While this may be true, most significant reversals last many more bars, so most of the trend will remain intact (as we will see in the example below). Applying Fractals to Trading Like many trading indicators, fractals are best used in conjunction with other indicators or forms of analysis. Perhaps the most common confirmation indicator used with fractals is the "Alligator indicator", a tool that is created by using moving averages that factor in the use of fractal geometry. The standard rule states that all buy rules are only valid if below the "alligator's teeth" (the center average), and all sell rules are only valid if above the alligator's teeth.

More than 50% of retirement age individuals to not have enough savings

Figure 2 is an example of such a setup:

Figure 2

The obvious drawback here is that fractals are lagging indicators - that is, a fractal can't be drawn until we are two days into the reversal. While this may be true, most significant reversals last many more bars, so most of the trend will remain intact (as we will see in the example below). Applying Fractals to Trading Like many trading indicators, fractals are best used in conjunction with other indicators or forms of analysis. Perhaps the most common confirmation indicator used with fractals is the "Alligator indicator", a tool that is created by using moving averages that factor in the use of fractal geometry. The standard rule states that all buy rules are only valid if below the "alligator's teeth" (the center average), and all sell rules are only valid if above the alligator's teeth.

More than 50% of retirement age individuals to not have enough savings

Figure 2 is an example of such a setup: 

Figure 3

Here is a basic rule setup that is used when using a chart with a four-hour time frame:

• Initiate a position when the price has hit the farthest Fibonacci band, but only after a daily (D1) fractal takes place.
• Exit a position after a daily (D1) fractal reversal takes place.

Notice how the fractals pinpoint meaningful tops and bottoms? This helps to take the guesswork out of deciding at which Fibonacci level to trade - all we have to do is check to see if the daily fractal occurred. We should also note that the trend strength began increasing at the sell fractal, and topped at the buy fractal. Although we lose some pips with the confirmation, it saves us from losing out on mere market noise - 139 pips certainly isn't bad for three days!

Things to Consider Here are a few things to remember when using fractals:

• They are lagging indicators. They are best used as confirmation indicators to help confirm that a reversal did take place. Real-time tops and bottoms can be surmised with other techniques.
• The longer the time period (i.e. the number of bars required for a fractal), the more reliable the reversal. However, you should also remember that the longer the time period, the lower the number of signals generated.
• It is best to plot fractals in multiple time frames and use them in conjunction with one another. For example, only trade short-term fractals in the direction of the long-term ones. Along these same lines, long-term fractals are more reliable than short-term fractals.
• Always use fractals in conjunction with other indicators or systems. They work best as decision support tools, not as indicators on their own.

Conclusion As you can see, fractals can be extremely powerful tools when used in conjunction with other indicators and techniques, especially when used to confirm reversals. The most common usage is with the "Alligator indicator"; however, there are other uses too, as we've seen here. Overall, fractals make excellent decision support tools for any trading method. Resources These are the two main charting packages that contain fractals:

• MetaTrader 
• TradeStation for equities (via plug-in)

If you want to know more about chaos theory and its applications in the marketplace, an excellent book on the topic is "Profiting From Chaos" (1994) by Tonis Vaga.

Chaos Theory Market Fractals - By-Nadeem Walayat's.

Are Elliott Wave's Chaos Theory?

Whilst there are many elements to chaos theory, my focus that grew out of studying the Julia and Mandelbrot sets was fractals. In that clearly the stock and other market price action resembles fractal structures as the same structure appears to repeat on ALL time frames. At the time it seemed that Elliott Wave and Chaos theory were very similar of not the same thing, in that Elliott Waves are the fractals for market price action that appear to on ALL time frames as discovered in the 1930's by RN Elliott which was decades before Mandelbrot appeared on the scene.
However on spending many, many years going down this path I concluded that Elliott Waves and Chaos Theory are NOT the same. Elliott Wave theory is something ELSE, yes, it resembles Chaos Theory i.e. Fractals, but it is not Chaos theory Fractals.
Again they look very similar but in a way Chaos Theory is Elliott Waves without having to know the WAVES! That may sound confusing but that is actually how it is. In Chaos Theory all one would know is What is Impulse and What is Corrective, and that is it! None of the 5th of the 5th of the 5th or ABC or the rest matter, just Impulse or Corrective. Which is probably what many experienced elliotticians eventually conclude without ever having ventured into chaos theory that at the end of the day the only thing that matters is Impulse or Corrective and not What Elliott Wave implies i.e. that Stocks 1987 peak was the final 5th of the 5th of the 5th and then so were each of the subsequent bull market peaks right into the present days bull market.

Fractal Theory

In a way Chaos Theory should really have been called Fractal Theory, because rather than chaos i.e. randomness it actually implies order and structure, and that structure is found in fractals.
The point about Fractals is that they give you a window into probabilities for price action on ALL market levels, i.e. hourly, daily, weekly, monthly, even yearly. I.e. fractals are akin to flexible pattern recognition, simple patterns that repeat and result in high probabilities given certain conditions which in themselves are flexible, so it unlike traditional chart patterns such as Head and Shoulders, the interpretation of market fractals is dependant upon changing conditions, such as trend, cycles, and volume.

What are Market Fractals ?

Simply put Market fractals are trend changes. A trend change is either a reversal of the Impulse trend or an end of the Corrective trend on ANY time frame.

Fractal Patterns

Fractal patterns are not complicated, you already know the more common ones, such as spike, double and triple tops and bottoms that occur on ALL time frames, what you don't know or have not studied are the conditions that increase their probabilities for particular markets at particular points in time, such as volume, preceding trend, and momentum oscillators (I use the MACD) once you factor these into the equation amongst your TRIGGER (Fractal) increases in probability exponentially, as it reduces the instances of its occurrence. Still it does requires HARD WORK for the market one trades to identify the current TRIGGERS (Fractals), especially when one starts going down the path of fractals of fractals i.e. in this example, a double top plus double top fractal. 

Trading Fractals

It all boils down to practice, knowing current fractal patterns and having them engrained in your mind, and then you WAIT for the FRACTAL TRIGGERS, and REACT in real time, just as as you trade traditional price patterns such as double and triple tops as identified in real time. Fractal triggers are not limited to Bar charts, as you can use other types of charts, my preference is for swing charts as illustrated in "How to Trade Commodities" by WD Gann (not to confuse with the rest of his work which in my opinion is a red herring).
Once you understand that Chaos Theory comprises fractals that give a high probability of an outcome given x, y,z condition then one starts to see fractals EVERYWHERE, for fractals ARE Nature. It is how our universe is constructed on every level, we are living in an unfolding fractal universe, nothing is fixed, everything is in motion, if you understand this then you will now know more truth than anything you will find in any ancient superstition.
The bottom line is this, that there is no black or white, no holy grail, everything has its basis in how we interpret the world around us is be it markets or the wider environment, fractals appear to offer the best window into a better interpretation of the world in our time, until the next innovation comes along.

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Combination of Trading Indicators

The combined trading methods provide an objective view of price activity. It helps you to build up a view on price direction and timing, reduce fear and avoid over trading. Furthermore, these methods tend to provide signals of price movements prior to their occurring in the market.

The tools used methods are moving averages and oscillators. (Oscillators are trading tools that offer indications of when a currency is overbought or oversold). Though there are countless mathematical indicators, here we will cover only the most important ones.

1. Simple and Exponential Moving Average (SMA - EMA)
2. Moving Average Convergence-Divergence (MACD)
3. Bollinger Bands
4. The Parabolic System, Stop-and-Reverse (SAR)
5. RSI (Relative Strength Index)

1. Moving Average

A moving average is an average of a shifting body of prices calculated over a given number of days. A moving average makes it easier to visualize market trends as it removes – or at least minimizes - daily statistical noise. It is a common tool in technical analysis and is used either by itself or as an oscillator.

There are several types of moving averages, but we will deal with only two of them: the simple moving average (SMA) and the exponential moving average (EMA).

A. Simple moving average (SMA)

• Definition The simple moving average is an arithmetic mean of price data. It is calculated by summing up each interval's price and dividing the sum by the number of intervals covered by the moving average. For instance, adding the closing prices of an instrument for the most recent 25 days and then dividing it by 25 will get you the 25 day moving average.
  Though the daily closing price is the most common price used to calculate simple moving averages, the average may also be based on the midrange level or on a daily average of the high, low, and closing prices.
• Advantages Moving average is a smoothing tool that shows the basic trend of the market.
  It is one of the best ways to gauge the strength a long-term trend and the likelihood that it will reverse. When a moving average is heading upward and the price is above it, the security is in an uptrend. Conversely, a downward sloping moving average with the price below can be used to signal a downtrend.
• Drawbacks It is a follower rather than a leader. Its signals occur after the new movement, event, or trend has started, not before. Therefore it could lead you to enter trade some late.
  It is criticized for giving equal weight to each interval. Some analysts believe that a heavier weight should be given to the more recent price action.
• Example You can see from the chart below examples of two simple moving averages - 5 days (Red), 20 days (blue).

B. Exponential Moving Average (EMA) The exponential moving average (EMA) is a weighted average of a price data which put a higher weight on recent data point.

• Characteristics The weighting applied to the most recent price depends on the specified period of the moving average. The shorter the EMA period, the more weight will be applied to the most recent price.
  An EMA can be specified in two ways: as a percentage-based EMA, where the analyst determines the percentage weight of the latest period's price, or a period-based EMA, where the analyst specifies the duration of the EMA, and the weight of each period is calculated by formula. The latter is the more commonly used.
• Main Advantages compared to SMA Because it gives the most weight to the most recent observations, EMA enables technical traders to react faster to recent price change.
  As opposed to Simple Moving Average, every previous price in the data set is used in the calculation of EMA. While the impact of older data points diminishes over time, it never fully disappears. This is true regardless of the EMA's specified period. The effects of older data diminish rapidly for shorter EMAs than for longer ones but, again, they never completely disappear.
• Example You can see from the chart below the difference between SMA (in blue) and EMA (in green) calculated over a 20-day period.

2. MACD (Moving Average Convergence-Divergence)

The moving average convergence-divergence indicator (MACD) is used to determine trends in momentum.

• Calculation It is calculated by subtracting a longer exponential moving average (EMA) from a shorter exponential moving average. The most common values used to calculate MACD are 12-day and 26-day exponential moving average.
  Based on this differential, a moving average of 9 periods is calculated, which is named the "signal line".
  MACD = [12-day moving average – 26-day moving average] > Exponential Weighted Indicator
  Signal Line = Moving Average (MACD) > Average Weighted Indicator
• Interpretation Due to exponential smoothing, the MACD Indicator will be quicker to track recent price changes than the signal line. Therefore,
  When the MACD crossed the SIGNAL LINE: the faster moving average (12-day) is higher than the rate of change for the slower moving average (26-day). It is typically a bullish signal, suggesting the price is likely to experience upward momentum.
  Conversely, when the MACD is below the SIGNAL LINE: it is a bearish signal, possibly forecasting a pending reversal.
• Example of a MACD You can see from the chart below example of a MACD. The MACD Indicator is represented in green and the Signal Line in Blue.

3. Bollinger Bands

Bollinger Bands were developed by John Bollinger in the early 1980s. They are used to identify extreme highs or lows in price. Bollinger recognized a need for dynamic adaptive trading bands, whose spacing varies based on the volatility of the prices. During period of high volatility, Bollinger bands widen to become more forgiving. During periods of low volatility, they narrow to contain prices.

• Calculation Bollinger Bands consist of a set of three curves drawn in relation to prices:
  The middle band reflects an intermediate-term trend. The 20 day - simple moving average (SMA) usually serves this purpose.
  The upper band is the same as the middle band, but it is shifted up by two standard deviations, a formula that measures volatility, showing how the price can vary from its true value
  The lower band is the same as the middle band, but it is shifted down by two standard deviations to adjust for market volatility.
  Bollinger Bands establish a Bandwidth, a relative measure of the width of the bands, and a measure of where the last price is in relation to the bands.
  
  Lower Bollinger Band = SMA - 2 standard deviationsUpper Bollinger Band = SMA + 2 standard deviations.
  Middle Bollinger Band = 20 day - simple moving average (SMA).
• Interpretation The probability of a sharp breakout in prices increases when the bandwidth narrows.
  When prices continually touch the upper Bollinger band, the prices are thought to be overbought; triggering a sell signal.
  Conversely, when they continually touch the lower band, prices are thought to be oversold, triggering a buy signal.
• Example of Bollinger Bands You can see from the chart below the Bollinger Bands of the S&P 500 Index, represented in green.

4. The Parabolic System, Stop-and-Reverse (SAR)

The parabolic SAR system is an effective investor's tool that was originally devised by J. Welles Wilder to compensate for the failings of other trend-following systems.

• Description The Parabolic SAR is a trading system that calculates trailing "stop-losses" in a trending market. The chart of these points follows the price movements in the form of a dotted line, which tends to follow a parabolic path.
• Interpretation When the parabola follows along below the price, it is providing buy signals.
  When the parabola appears above the price, it suggests selling or going short.
  The “stop-losses” dots are setting the levels for the trailing stop-loss that is recommended for the position. In a bullish trend, a long position should be established with a trailing stop that will move up every day until activated by the price falling to the stop level. In a bearish trend, a short position can be established with a trailing stop that will move down every day until activated by the price rising to the stop level.
  The parabolic system is considered to work best during trending periods. It helps traders catch new trends relatively early. If the new trend fails, the parabola quickly switches from one side of the price to the other, thus generating the stop and reverse signal, indicating when the trader should close his position or open an opposing position when this switch occurs.
• Example of an SAR parabolic study You can see from the chart below in green the Parabolic System applied to the USDJPY pair.

5. Relative Strength Index (RSI)

The RSI was developed by J. Welles Wilder as a system for giving actual buy and sell signals in a changing market.

• Definition RSI is based on the difference between the average of the closing price on up days vs. the average closing price on the down days, observed over a 14-day period. That information is then converted into a value ranging from 0 to 100.
  When the average gain is greater than the average loss, the RSI rises, and when the average loss is greater than the average gain, the RSI declines.
• Interpretation The RSI is usually used to confirm an existing trend. An uptrend is confirmed when RSI is above 50 and a downtrend when it's below 50.
  It also indicates situations where the market is overbought or oversold by monitoring the specific levels (usually “30” and “70”) that warn of coming reversals.
  An overbought condition (RSI above 70) means that there are almost no buyers left in the market, and therefore prices are more likely to decline as those who previously bought will now take their profit by selling.
  An oversold condition (RSI below 30) is the exact opposite.
• Example of RSI You can see in red from the chart below the Relative Strength Index of the GBPUSD pair.

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