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Beginning Traders

The Power of Understanding Inter-Market Relationships

The video is a webinar from Trade Station, presented by Michael Burke in a series called Future Trading. This lecture is hosted by Dan Gramza, President of Gramza Capital Management, Inc., and DMG Advisors, LLC. It focuses on answering questions regarding the fundamentals of inter-market relationships, what causes them, how they can be identified and how they can be used by traders to get ahead.

Dan Gramza is the founder and CEO of Gramza Capital Management, Inc. and one of the most knowledgeable people in the futures trading industry, not just in technical and fundamental analysis, but in a broad understanding of how things work.

Introduction

Gramza gives more information on himself before starting his talk: he started on the exchange floor, trading upstairs and has over 25 years of experience in trading futures, options on futures, stocks, stock options and cash markets globally. He says the way he’ll be exploring futures trading is the way he’ll be thinking from the floor point of view, without having to be on the floor. He’s had the opportunity to interact with traders around the world, and what’s interesting is that these relationships are something everyone needs to work on.

Trading is a 24-hour business, giving traders an advantage to position themselves before the market opens and closes, manage risks and more. For example, a trader in Chicago can take a look at what’s going on in Asia before going to bed and night to find opportunities. Then upon waking, there’s Europe and the movement happening there to consider. There are many ways information can be used now that was not accessible before modern technology made them possible. Trading in different parts of the world gives users many opportunities to explore market relationships around the world and see which works best for them.

Drivers of Individual Stocks Impact the Stock Market

The first inter-market relationship to consider is drivers of individual stocks impact the stock market. There are two major categories under drivers of stock. One is the characteristics of the individual stock or non-systematic behavior. In other words, it’s whether it is a good company or not on its merit. The second is systematic behavior or the behavior of the market on the stock. It’s a symbiotic relationship; the stocks have an impact on the index, and the index can have an impact on the individual stock.

As an example, Gramza cites from personal experience. One of the US companies he had previously worked for had a South American division that would invest stocks in local markets and the United States. When the Mexican peso fell, stock markets in Spanish-speaking markets dipped as well. A company, which was in Argentina, went from $60 to $20, and the Mexican peso was the only reason why. Nothing had changed within the company, but its value went down solely because of the currency. So when does someone buy stocks? In this case, the US company began buying at $24 a share in the Argentinian company and when the smoke cleared, the stocks had gone back up to their higher value, giving the buying company a significant profit.

This is something traders should be sensitive to when it comes to fundamentals. When you see an event occur, what does that event represent? Is it something that is happening now and will forever change things and have a direct impact now or is it an event that the market is anticipating to happen? An example is Brexit before the vote happened – people were looking for a big day down, and that would be an example of an event that the market is anticipating but hasn’t occurred.

Or we could look at a shock fundamental, which is an event that no one saw coming. Is the market reacting to that or is it a fundamental economic change that we know represents behavior that can have a lasting effect? An example here is a supply-demand situation. In the 1990s, for instance, there was not enough wheat in the world to meet the supply due to droughts. No countries were exporting, so wheat prices were going up. This is a whole different trend than the markets going up in anticipation of an event.

More currently, it’s soybeans. Rain is necessary to grow soybeans in the USA, and drought is predicted to affect production, raising the prices of soybeans even though harvesting of the beans is not going to happen for a while yet. So is the market moving up on economic reality? Not really. It is moving up on the anticipation that there might not be enough rain to produce enough soybeans. In that kind of movement, you would want a tight stop because the market could easily come back down. On the other hand, if there were accurate data showing that soybeans would fall short of global demand, then you would want a looser stop in that kind of market environment.

When it comes to the fundamentals of the individual stocks or the individual markets, think about it regarding how the market is digesting the fundamentals and what the fundamental represents. Stocks have an impact on the stock index, but moving on to other things under drivers of individual stocks are the economic drivers of the stock market.

Economic Drivers of Stock Markets

Looking at the USA’s current economy, consumer prices are unchanged, home building is up, housing prices are at a steady high, wage growth is up, and overall economic stability is good. So that would imply that the Central Bank could do something about interest rates, but they haven’t. This is because markets do not sustain a trend change based on anticipation, or based on concern. If you see something on the news saying things like, “The market is concerned about so and so,” it means something is not very sustainable.

Interest Rates — Federal Reserve Policy

Next are interest rates and the Federal Reserve policy. There is one thing still missing that people feel could influence things: inflation. Take a look at the mandates of the Fed, which started in 1916. The system in place now is a hundred years old. The Fed’s job is to monitor and manage interest rates, money supply, and control prices for stability. The Fed also wants full employment – that’s their job. Have they done anything yet? No, because while they have commented on the current situation, their statement is that if the economy allows it, justifies it, then they will increase interest rates.

When it comes to rising interest rates, looking at their policies and Fed behavior for the past 25 years, inflation is always an essential component. So as inflation goes up, then interest rates go up. But as they do, this will suck up credit and slow down the economy. When they say they’re going to change interest rates, the market absorbs it instantly, but the economy doesn’t feel it for six to nine months. If you look at interest rates policies back in the late 1990s to the 2000s, they had started speeding up increases in interest rates.

US Dollar — Currency

The next area of importance is currency, in this case, the US dollar – how much does it cost to buy goods from a country? Currency and interest rates are tied together, too. A currency money manager in Germany would look at the world the same way a trader looks at his stock portfolio. It’s the same idea, but it just happens to be countries. But one thing they focus on in currency management is where they can get the best return on interest rates on deposit with the lowest amount of risk. That has a big impact on flows – the relationship between currency and interest rates is very close, and is one of the most powerful drivers.

Crude Oil

Another element is crude oil. If you’ll notice when crude oil goes up, so does the stock market. What’s interesting about the relationship is that it’s so multi-faceted. This is one of the things Trade Station allows users to do — see the complexity of these relationships. In the past, when crude oil prices went up, the market went down, because as the cost of energy went up, the cost of doing business increased as profit margins got squeezed. Now, though, it’s the opposite. When oil prices go up, it means the oil companies’ profits are going up, which in turn means they’ll be spending more money in explorations and operations, so the market rises too.

Crude oil is directly linked to currency. It is traded in the world in US dollars for the most part, with only a small number of countries trading in their currencies. But say there’s this country that produces crude oil and is paid in US dollars. The value of the US dollar is a big deal when it’s time to go to the bank to change the US dollars into local currency, essentially selling US dollars to buy local currency. If the US dollar is weaker, which means it will buy less of the local currency, the income goes down. So the US dollar is a driver of crude oil and serves as a barometer for prices.

Another driver for crude oil is OPEC – that’s production, which represents 45% of the market. Even if the US is a major producer of crude oil, it still needs to import some. The problem with OPEC is that there are some rumors on tamping down production in Russia and Iran now, which will affect the crude oil market. So crude oil is directly linked to currency, which in turn affects currency and economic drivers, which all go back to the stock market.

Gold

Another characteristic is gold and precious metals. Where do they fit? Gold is used in industrial applications and jewelry. It’s interesting that in the cellphone industry, there are around 1 to 2 billion cellphones made every two years with around 50 cents’ worth of gold each. This gold is not recycled, so that’s a large volume sitting there, not part of the current market. Gold is special, in that it has a unique relationship to the market. Gold is a perception of value – it’s not a demand and supply issue. Silver has a lot more industrial uses. But gold is used in times of uncertainty and in times of inflation, which goes back to interest rates. When the stock market starts falling, you can put some money in gold because it may be going up. In the current environment, especially, gold needs an excuse to do something.

Supply and Demand, Perceptions of Supply Disruptions

Supply and demand are the next drivers, which have a huge impact, as earlier discussed. A good example here is copper, which is an industrial metal. The largest consumers of copper are China, the USA, and Germany. If you look at those customers and the consumer patterns, supply is high, and demand is picking up in China. The stocks that these markets represent will have an impact on the stock index.

Then there is the matter of perceptions of supply disruptions, which is a dominant driver. Perception is what people often see in the market. If you see a market moving on the perception that something could happen, it will not be sustainable.

As an example Gramza gives is when he was teaching a course for some oil companies in the late 1980s. During the class, he was putting some trades on, which at that time meant having to pick up the phone to put a trade on. He thought he was flat, and he went home short – overnight, a North Sea oil platform had blown up, and they didn’t have a night session at that point. He didn’t realize he was short, as he had miscounted. He told his broker to play the tape, and whatever it says, he’ll honor it. When the market opened up, it opened higher because of the explosion, so there was uncertainty, but as Gramza talked to the oil companies in his class, they said it was not a big deal. As the market absorbed the information, it changed its behavior and started coming down as it realized that the explosion was in fact, not a big deal. So when you see a market moving, be aware of perception.

Terrorism and War

Terrorism and war both shock the market. What’s disturbing is how the market is reacting now to terrorism. In July in 2007, when London had the subway bombings, the market recovery was so quick that it surprised traders. Terrorist acts usually mean the British pound would go down, and the stock market would go down as a consequence because of the uncertainty. But by the end of the day, the stock market had come up, and interest rates went down –the market absorbed the event, and that was shocking because people had no idea how much more was coming. Now, the market doesn’t absorb terrorism as well as it did in the past, which may be because the world is getting used to it, which is disturbing.

War, on the other hand, is something that is usually planned and that people have an idea is coming, though there might be some elements of surprise such as sudden attacks. War also creates uncertainty because nobody knows the outcome, and wars can last a long time. If the initial phase of a US response is positive, typically the market will begin showing more confidence. For example, the nighttime Chicago market environment started going back up during the US invasion of Kuwait some years ago as military operations seemed to be going well. The market is watching human reactions to something, in this case.

Geopolitical Factors and Government Regulations

Geopolitical factors and government regulations also drive the market, especially the latter as these can have far-reaching and long-lasting impacts with just the stroke of a pen. Often, there is a knee-jerk reaction to these regulations caused by uncertainty.

Perceptions of Domestic and International Economies

Another driver is perceptions of the domestic and international economies, such as the idea that China’s economy is slowing down, even if in reality it’s increasing. The thing to remember is that the more money there is involved, the more difficult it will be to get the same returns as before. If, for example, $100,000 yields 15%, it’s not going to follow that $1 million will produce the same, which is why China appears to be slowing down.

Weather

Weather and storms also factor in. When hurricanes happen, it affects the production and therefore the price of crude oil, especially when areas hit by natural disasters are oil-producing.

Global Demand from Emerging Nations

There’s global demand, particularly from emerging nations. The best example is China as it has seen a gigantic shift in its economy in recent years. It has become one of the world’s top-consuming countries and importers, which is completely different from the China of 15 years ago. The thing for traders to do is watch the consumption of these countries and monitor them. Another country that people should pay attention to is India. Brazil is undergoing a lot of trouble, but India is on the radar as an emerging nation.

Behavioral Japanese Candle Consumption

For those familiar with Japanese candles, this is not the typical approach. The typical approach is identifying candle patterns – there are around 80 or so to look out for. It is tremendously helpful to think about things differently. This is the perception on the floor, where you get to see, by watching the broker’s hands, volume, and activity. The people in the pit are market makers and don’t have a sustained impact on trend. So the issue that you should follow are the hands of the brokers, and this is the approach that gives clues as to this behavior.

What drives price higher? The candle is represented by a vertical bar on a chart. In the first candle, green, the closing price is at the top, and the opening price is at the bottom, the box between called the body of the candle. The green candle represents buyers coming into the market. If the market opens up at 50, and more people want to buy this market than sell it, prices go up. So the price will go up and down throughout the session, then closes at 60. Why does it end at 60? It’s because buying order flow is driving the price.

The second candle is red, where the closing price is below the opening price, which represents sellers. When the high price and low price do not match the top and bottom of the candle, that difference is called a shadow. The size of the shadow gives the degree of rejection, while the size of the body gives the level of commitment.

Gramza gives viewers a look at the markets using a series of charts, all of which are daily charts. There is the US dollar, the euro, Swiss franc, Japanese yen and more. He applies what has been discussed with what is seen in the charts, specifically on crude oil and the impact a weaker dollar has on it. He also shows the chart for gold, which is showing consistent behavior. He likewise checks soybeans.

One last idea is to check spreads and compare the behaviors of individual markets. In this case, Gramza checks gold versus crude oil to view the monthly trends, monitor the increases and decreases, as well as pinpoint the probable reasons for these incidences.

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