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How to Trade Some of the Most Conspicuous Price Phenomena: Gaps and Windows

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Overview

“Gaps” (as they are called in the West) and “windows” (their Japanese counterparts) have always attracted the attention of technicians – most probably because they are nearly impossible to be missed on a price chart. After all, a trading session lying completely outside of the prior day’s range, which is what gaps and windows are by definition, must carry some kind of predictive power. However, a critical question remains – are gaps and windows indicative of the beginning of a new trend (as it was the case for AAPL in Figure 1), or are they simply an overreaction and are subsequently quickly filled (as it was the case for MMM in Figure 2)? Notice how in the former case the gap stayed opened (and it still is) for more than a year, whereas in the latter case the gap was filled/closed within two months (i.e. subsequent price action in September completely overlapped the range of the gap).

Figure 1. AAPL Daily

Figure 2. MMM Daily

Note, from here on, only the term “gap” is used, even though there is an important difference between the two – “gaps” look at intraday prices when determining if they are “filled”, whereas “windows” only look at “closing” prices. At the bottom of the article, you can find references to several works on the price phenomenon, in which the difference between the two variations is discussed in-depth.

Given that gaps occur quite frequently (see referenced materials for details), it is easy to understand how any “gap” strategy can be depicted to have predictive power. Most traditional books on technical analysis include a list of gap trading strategies followed by a few stellar charts that are supposed to prove the strategies’ validity (charts similar to Figures 1 & 2). Furthermore, given gaps’ conspicuous nature, most traditional trading strategies have their “entry” on the day the gap occurs (or Gap Day). For example, proponents of gaps being a continuation pattern would suggest that taking a position in the direction of the gap on Gap Day is profitable. On the other hand, technical analysts who believe that “all gaps get filled” suggest taking a position on Gap Day in the opposite direction of the gap. In both cases, action is taken on Gap Day.

After trading and analyzing gaps for many years, I was certain that traditional theories do not work the way they are described to. Probably the most illogical stipulation made by various technical authors was that “the gap itself should serve as support or resistance” and “once filled, gaps become insignificant”. On the contrary, I had found that the gap itself is rarely a strong support or resistance and that very often the most significant gaps are those that have already been filled. This is when, in 2016, I developed a new theory on gaps (“K-Divergence), which significantly “diverges” from traditional theories.

Before discussing what the K-Divergence theory entails, an explanation of the most popular traditional theories is presented.

Traditional Gap Theories

1. A gap is a continuation pattern.

Strategy – taking a position, on Gap Day, in the direction of the gap.

This theory is based on the idea that if, on any given day, prices jump/fall significantly enough to never touch the prior session’s price range, something significant must have occurred and changed the market’s sentiment on the company. In this case, on Gap Day, prices are assumed to reflect the changing opinion of the stock only partially, and thus, further movement in the direction of the gap is expected. In the case of AAPL’s gap (Figure 1), on February 1, 2017, the company reported better-than-expected 1Q17 earnings on the heels of record breaking iPhone sales. Subsequently, the price continued moving higher in a swift fashion, leaving the up-gap behind it. Often, proponents of this theory use support and resistance levels, or technical indicators, as a confirmation that the gap has occurred at an important juncture and that it can be trusted. For example, zooming out and looking at the stock’s price action since 2015 (Figure 3), traders who utilize gaps as continuation patterns can claim that “the breakout occurred above the interim high of the multiple bottom formation, and therefore, carried high predictive power”.

Figure 3. AAPL 2-Day Chart

2. A gap is an overreaction.

Strategy – taking a position, on Gap Day, in the opposite direction of the gap

Advocates of this theory are convinced that gaps are a result of market participants overreacting to news (or “noise”) and that once participation subsides, the gap is expected to get filled. The famous adage “all gaps get filled” is often used in an attempt to support this supposition. Similar to the previous strategy, support/resistance levels and technical indicators are expected to provide further confirmation if the particular gap is to be filled. For example, looking once again at the MMM chart (2-day chart – Figure 4), one may say that the down-gap took prices close to a well-established uptrend (green trendline) and to a key moving average (100 SMA – yellow line). Also, to further support the thesis that prices will reverse, one may point to the positive reversal in RSI (not to be confused with a positive divergence), which indicated that the correction has taken the stock to oversold levels during the uptrend (i.e. RSI making a lower low, while prices making a higher low).

Figure 4. MMM 2-Day Chart

The above two strategies are a perfect example of technical analysis being more of an “art” than “science”, where it is up to the technician’s discretion to decide what action to take after observing a gap. While, after testing both strategies (see K-Divergence section), I found that neither the simple continuation nor reversal strategies are profitable on a systematic basis, there are definitely specific situations where the probability of a gap reversing is higher and vice versa. Unfortunately, the next strategy, the one found in almost any TA book, is one of the reasons why technical analysis has a bad name among most non-technicians.

3. A gap could be either a continuation pattern or an overreaction based on its “classification”.

Strategy – an ambiguous one based on hindsight

As it had become evident that gaps cannot be all “continuation patterns” or “overreactions”, the popular gap classification system was born – where gaps are categorized as either “breakaway”, “continuation/runaway”, “exhaustion” and “common”. This classification is based on two criteria – 1) the location of the gap relative to preceding price action and 2) whether the gap gets filled or not. However, as one can imagine, there is no way to know on Gap Day whether a gap will be filled in the future. That is, the classification system is based on hindsight. Let’s prove this point by looking at an example. Figure 5 shows an up-gap after a prolonged uptrend. Based on the widely-used classification system this gap can be “runaway” (if the gap does not get filled and prices continue higher), “exhaustion” (if prices quickly reverse, fill the gap and continue lower) or even “common” (if prices fill the gap but do not reverse or consolidate). Given the colour of the candle and the long upper wick, it seems like it is an “exhaustion” gap, right?

Figure 5. Daily Chart (real chart, ticker hidden)

Clearly, it is only in hindsight that this gap can be classified. In this case, the gap turned out to be of the “runaway” type as it did not get filled and the stock (MSFT) continued propelling higher (Figure 6). The point is, the classification system is futile for making decisions on Gap Day.

Figure 6. MSFT Daily Chart

K-Divergence (K-Div) Theory

4. Most gaps occur after prices have moved away from a significant support or resistance levels.

Strategy – taking a position in the direction of the gap, only after prices have returned to pre-gap levels

More specifically, the theory suggests that in most cases an up-gap transpires after prices have already jumped from a key support level and a down-gap – after prices have already fallen from a key resistance level. The theory is based on the premise that before a gap occurs prices have already reached a key level and have bounced from it. It is only later on, after most market participants agree on the direction of the next move and take positions in the same direction that gaps occur. This means that it is not the gap itself that should serve as a support or resistance, but rather the range of prices preceding it (pre-gap range). The most important implications of the theory are – 1) the gap itself should not serve as support or resistance and 2) a filled gap is not “insignificant”.

So why does the K-Divergence make sense from a technical point of view? After all, if prices gapped due to “news” that nobody was aware of, this would mean that gaps are nothing more than prices adjusting to the new information. Any such conclusion should render fundamental and technical analysis useless, for it would imply that no analyst is able to purchase a security before news gets disseminated. On the contrary, the K-Divergence assumes that the most astute market participants (i.e. the best fundamental and technical analysts, quants and even “insiders”) are able to trade in advance of the gap occurring. Therefore, true support and resistance levels lie prior to the gap transpiring and subsequent filling of the gap does not render it “insignificant”.  It is best to illustrate this with an example. I will use one of my most recent predictions based on the theory, which was sent to one of my clients. First, I will describe the rational in detail with an updated chart (Figure 7), which will be followed by screenshots from the day the signal was given.

After the close on February 1, 2018, Google reported its 4Q18. The next day, the stock opened sharply lower and continued falling into the close (Feb 2 – Down Gap in Figure 7). The stock continued falling along with the market until the Feb 9 low was set. Subsequently, while NASDAQ was making new highs in early March, GOOG reached the pre-gap range (Bearish K-Divergence Range – violet horizontal trendlines) and started stalling. Due to the strong bounce by the broader markets, the stock recovered and filled the gap. However, when the stock started trading at the pre-gap range, market participants were given a second chance to sell the stock for the same price it was trading at before the 4Q18 earnings were released. Price action confirmed the bearishness of the set-up (GOOG March 13 & 16 – Figures 8 & 9).

Figure 7. GOOG Daily Chart

Figure 8. GOOG March 13

Figure 9. GOOG March 16

In order to validate the theory, I developed two trading strategies based on it (one with the gap and one with the window variation) and backtested them along with 5 variations of the traditional gap strategies discussed above. Figure 10 shows the 1-, 2-, 5-, 10-, 20-, 30- and 44-day period returns of the 7 strategies (#6 & 7 being the two based on the K-Divergence theory) and Figure 11 shows the annualized returns for the those same periods. The backtest took into account a total of 14,219 gaps over nearly a 2-year period.

Figure 10. 1-, 2-, 5-, 10-, 20-, 30- and 44-day period returns

Figure 11. Annualized 1-, 2-, 5-, 10-, 20-, 30- and 44-day period returns

The two K-Div strategies were profitable throughout all periods. The only other consistently profitable strategy was “Fading the Gap” strategy which entailed taking a position in the opposite direction of the gap on Gap Day, but closing it immediately after the gap was filled. This once again goes against traditional theories which suggest that once a gap is filled, prices should continue going against the gap’s direction as, supposedly, an important support/resistance was breached.

It is noteworthy that the K-Divergence theory does not suggest that all gaps have occurred after important support/resistance levels or that they can all be traded profitably in a similar fashion as the GOOG example. Rather, it provides a framework for analyzing the gap phenomenon, on that all active investors/traders should believe in, which assumes that some market participants are able to act ahead of major moves (i.e. prior to the appearance of gaps). Furthermore, it eliminates the use of the “hindsight” gap classification system.

For more on gaps, I recommend reading Julie R. Dahlquist and Richard J. Bauer’s “Technical Analysis of Gaps” book, where they conduct, one of the first on the topic, objective investigations of the phenomenon. For a much more in-depth coverage of the K-Divergence and my research on gaps, you can view my thesis for the Master of Financial Technical Analysis (MFTA) Program, published in the 2018 IFTA Annual Journal.

Conclusion

In the future, regardless of whether you look for opportunities to trade gaps on Gap Day (strategies 1 & 2) or decide to use the K-Divergence as part of your trading arsenal, I hope this article would make you think more critically the next time you hear terms such as the “runaway” gap. And even more importantly, will push you to analyze gaps even after they have been filled, and according to traditional theory, have become insignificant.

Happy gap trading.

Featured image courtesy of Shutterstock. 

Important: Never invest (trade with) money you can't afford to comfortably lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here. Trade recommendations and analysis are written by our analysts which might have different opinions. Read my 6 Golden Steps to Financial Freedom here. Best regards, Jonas Borchgrevink.

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    Analysis

    FedEx Goes Looking for New Lows

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    By Dmitriy Gurkovskiy, Chief Analyst at RoboMarkets

    At a recent Federal Reserve meeting, the market was made clear that interest rates were going to rise, which means that the burden on business in the form of interest on borrowed funds will increase. The ‘cheap’ money has run out, and now overvalued companies will be heading to their real quotes. If you look at the market, the corrections are already beginning, and there is a decline in each sector. Under these conditions, stocks will be forming ranges, although in most cases they are already here. If the price is at the lower boundary, then we should expect an even greater decline, as new support levels will be formed lower.

    The ‘weak link’ under these conditions will be the companies that have shown a significant decrease in profits in the current quarter relative to the previous quarter and to similar periods of the previous year.

    Tips for trading here should be sought in technical analysis, since the fundamental one will not show negative trends in Q3, as reports will be provided for the previous period, and they will be compared with similar periods of last year, which in most cases will show a positive trend.

    In this situation, it is possible to consider trading for lowering overpriced companies, but the trader needs to be aware of the risk they will be taken taking, as due to the gaps at the opening, losses can be fatal.

    FedEx, a leading mailing operator, is among such companies that are set to decline in the near future. Quarterly reports show an increase in profits compared to the same period last year. With this in mind, it would seem, there is no reason for concern, as the fall in profits in Q3 this year was also observed last year.

    FedEx

    Meanwhile, the short float is as low as 2.01%. The debt to capital ratio is less than 1, which also indicates the company is good to invest into.

    On Oct 18, FedEx announced the acquisition of Manton Air-Sea Pty Ltd, a leading logistics service provider based in Australia. This will allow FedEx to increase its presence in the Australian market. The transaction is scheduled to be completed by the end of this year.

    Analyzing other financial indicators, the negative details can only be found in the discrepancy between the Q3 earnings per share predicted values, since the EPS expectations were at $3.80, and in fact it turned out to be just $3.46, which resulted in the company ending its trading session with a 1.7% decline.

    Without going into details, the company’s profit is growing, dividends are paid, and there is no reason to worry, especially when the index is being bought heavily during such falls. Let’s get back to the reports however, and we’ll see the profit in Q3 decreased by 42% compared to the previous quarter, although last year it was only by 16%.

    In July, Amazon announced its new project, Delivery Service Partners (DSP), as mentioned earlier in one of our analytic reports. This led to the largest international postal operator’s decline. The project by Amazon enables starting your own shipping business under Amazon brand. This project is already working and the goods, despite the problems that arise, are being shipped. This means that FedEx and UPS are guaranteed to lose some of their income. In the long term, the development of DSP will create an even more serious competition against postal operators.

    Amazon’s policy led to FedEx shares losing around 16%, after which the price tried to recover, but nothing came out of it, and now it’s trading around the year’s lows. Another negative fact is that the price went below the 200-day SMA, which last occurred in 2015. Last time, after the SMA breakout, the price fell by 36% from its highs. The last fall was accompanied with the largest trading volume over the last 2 years, which increases the likelihood of further price fall.

    The nearest support is around $200. Further decline may be news-driven and come later, as it often happens. A short-term price increase to the resistance at $240 USD is possible, but after that, a rebound and a more serious price fall to $200 may follow. With larger volumes or a consolidation range, a reversal may occur.

    To sum up

    According to the Federal Reserve’s latest meeting minutes, rate hikes are going to happen both this year and next. This will increase the cost of borrowed funds, which will lead to consolidation of the stock market and a possible sharp decline when approaching the highs. Some investors will close their positions on highs, trying to lock in as much profit as possible, after which they can move to less risky instruments such as bonds, whose yields will only increase with rate hikes.

    Yet another crisis coming is often a surprise for investors, because usually everything starts with a small correction, which then rapidly develops into a market collapse and leads to a massive fall in stock prices. For this reason, investing in companies at current prices is not a good idea.

    In this situation, it is best to look for small and unknown companies to buy, or to focus on those that are just starting their IPO’s.

    Disclaimer

    Any predictions contained herein are based on the authors’ particular opinion. This analysis shall not be treated as trading advice. RoboMarkets shall not be held liable for the results of the trades arising from relying upon trading recommendations and reviews contained herein.

    Important: Never invest (trade with) money you can't afford to comfortably lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here. Trade recommendations and analysis are written by our analysts which might have different opinions. Read my 6 Golden Steps to Financial Freedom here. Best regards, Jonas Borchgrevink.

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    4.6 stars on average, based on 15 rated postsHaving majored in both Social Psychology and Economics, I went on to continue my education in post graduate. Later I worked as a team lead of a tech and fundamental analysis lab in the Applied System Analysis Research Institute. This helped me to acquire all necessary skills and experience to become a successful trader and analyst, as well as a portfolio manager in an investment company. I'm a pro in the financial field and the author of articles for various international media. I also hold the position of Chief Analyst at RoboMarkets.




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    Analysis

    Boeing Still a Good Investment, but Not Now

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    By Dmitriy Gurkovskiy, Chief Analyst at RoboMarkets

    In one of our previous articles, we spoke about the rising demand of pilots and air transportation, which made us focus on relevant companies. Another important aspect here is aircraft, without which no air transportation is possible. So today, we’ll analyze one of the largest aircraft manufacturers out there, Boeing.

    Boeing Company (NYSE: BA) is a leading aircraft, military and space equipment manufacturer. Headquartered in Chicago, IL, the company mostly operates in Seattle, WA. Boeing is among the top three military equipment companies in the US by the yearly order volume. Around 50% of the company’s budget accounts for military orders.

    Over the last four years, Boeing’s yearly revenue is always somewhere near $90B, while the net profit is steadily growing.

    Since 2014, the company’s equity was going down, with the debt growing at the same time, and thus the debt-equity ratio is currently not the best one.

    Despite the debt, however, the investors get the dividends regularly, and those have been growing speedily since 2014: from $1.94 per share that year to $6.50 in 2018. Meanwhile, the growing demand led to Boeing supplying 763 aircraft in 2017. This was a record high, and the earnings went up from $4.985B to $8.197. The price per share also rose by over 100%, breaking out $300. In 2018, the company is going to supply 912 aircraft, or 20% more.

    Boeing Contracts

    Recently, Boeing got a contract for $62.7M which included maintenance and modification of F/A-18 и EA-18G. The contract is expected to be fulfilled by Sep 2019.

    Another contract won by Boeing is worth $805M and includes developing, manufacturing, testing, and supplying for pilotless aircraft to the US Air Force by 2024.

    The US Air Force also has yet another contract with Boeing, which is worth $9.20B and includes both aircraft and flight simulators. At the first stage, the company will get $813M to supply 351 Advanced Pilot Training aircraft and 46 simulators. The overall deadline is 2034.

    This is just to name a few, and still one could clearly understand Boeing has orders for at least the next 10 years.

    Boeing is also a significant player in the international military business; with the emerging countries increasing their budgets in the light of global geopolitical uncertainty, the company is sure to get more orders.

    Apart from military aircraft, Boeing is planning to launch an air taxi prototype next year, which would carry passengers for short distances, while the company is also determined to create an air transport management system within 5 years.

    All this makes the outlook perfect, with both dividends and share prices growing steadily. Technically, however, there is some extreme volatility, which shows investors are uncertain; some are closing their positions to lock in over 100% profit, others are, conversely, buying. This led to the price forming a wide range between $315 and $370. At this rate, it may well reach $400 and then bounce back to $300.

    Technical Analysis

    In 2016, Boeing shares started rising from $100, with the volumes growing, and reached the high at $350, i.e. those who bought at $100, started selling at $350. This means one should better wait for higher volumes and lower prices, as well as some good news, before buying, rather than going long straight away.

    Alphabet Inc (NASDAQ: GOOG) experienced a similar situation, when the price was between $1,000 and $1,200, and then, when good earning reports came out, it reached $1,270. Then, Google shares went down again, and are now trading at $1,150, while being fundamentally very strong. So, it may start rising again soon, but at lower levels.

    You remember an old saying ‘Buy rumors, sell facts’, of course. This is true with Boeing as well. The news on the company plans must be already priced into the shares, so before adding Boeing to your portfolio, you’d better wait for some lower prices.

    Disclaimer

    Any predictions contained herein are based on the authors’ particular opinion. This analysis shall not be treated as trading advice. RoboMarkets shall not be held liable for the results of the trades arising from relying upon trading recommendations and reviews contained herein.

    Important: Never invest (trade with) money you can't afford to comfortably lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here. Trade recommendations and analysis are written by our analysts which might have different opinions. Read my 6 Golden Steps to Financial Freedom here. Best regards, Jonas Borchgrevink.

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    4.6 stars on average, based on 15 rated postsHaving majored in both Social Psychology and Economics, I went on to continue my education in post graduate. Later I worked as a team lead of a tech and fundamental analysis lab in the Applied System Analysis Research Institute. This helped me to acquire all necessary skills and experience to become a successful trader and analyst, as well as a portfolio manager in an investment company. I'm a pro in the financial field and the author of articles for various international media. I also hold the position of Chief Analyst at RoboMarkets.




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    Analysis

    Investors Getting High on Cannabis

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    By Dmitriy Gurkovskiy, Chief Analyst at RoboMarkets

    A year ago, you would hardly find even the most financially illiterate person in the world that had not heard of Bitcoin or cryptocurrency. Regardless of whether they know what it was — at least they know you can earn money with it!

    Opportunities to earn easy money sometimes do appear, but they do extremely rarely, and in this light the crypto boom is often compared to the tulipmania that happened in the 17th century. At that time, speculators with no experience joined the tulip futures trading, which eventually led to a sharp increase in flower bulb prices, while a year later the overheated market collapsed, bringing huge losses to all.

    The chance to earn huge profits for people who do not have a close connection with the markets does not appear so often. But for those who work with stocks, such opportunities arise almost every quarter.

    The price of bitcoin at the peak of its popularity, when almost everyone knew about it, went up by 2,000%. In the stock market, some companies can yield a return of 1,000% within a week or a month, and there is no need to wait a whole year around.

    The last sharp increase in share prices after an IPO, which broke all records this year, was shown by Tilray. Since the IPO on July 19 this year, the stock yielded a return of 1,300% over 2 months, and for those who follow the IPO, there was plenty of time to buy this stock, as the price was at about $20 for about a month.

    Tilray is a Canada-based company specializing in cultivation and sale of medical marijuana to consumers and pharmaceutical distributors.

    When a stock experiences such a rise, however, it usually falls afterwards, and Tilray was no exception as it lost 50% of its maximum value, although it continues to trade at 600% higher against the initial IPO price.

    2018 was a landmark for marijuana manufacturers, as in January California legalized the use of marijuana for recreational purposes. Currently, medical marijuana products can be consumed in 29 US states. It is expected that, by 2022, the marijuana market in the US and Canada will have grown by more than three times.

    Tilray is a clear indicator of investors’ interest in such companies. However, it’s not just traders who are interested in marijuana producers. Constellation Brands, one of the largest beer producers in the US, announced its intention to invest $4B into Canopy Growth, another Canadian company. This will allow it to increase its share in Canopy Growth from 8.70% to 38.00%. In the next 3 years, the US company will get the right to buy another 139.7M shares for $3.5B, thereby increasing its stake to the controlling one.

    Meanwhile, Microsoft has partnered with the Kind Financial, a US based startup company which develops software for government agencies that control the production and sale of marijuana.

    On September 17, rumor had it that Coca-Cola was negotiating with Aurora Cannabis to create a beverage containing cannabis. Most likely, this drink will be used to reduce inflammation, seizures, and as an anesthetic.

    All this confirms the interest of large companies and investors in marijuana manufacturers. At this rate, finding a marijuana company and investing your money in it could seem a good idea, but there is a risk of high volatility, just like in case of Tilray, which can put your deposit under serious threat. An easier way would be investing in an ETF with the same companies stocks.

    The most interesting ETF in the marijuana industry is ETFMG Alternative Harvest (NYSE: MJ).

    According to some sources, since August 22, this fund recorded a cash inflow of $112M, which is about 20% of the total value of its entire portfolio. With the money supply growing, the trading volumes increased up to 10M shares, which is 3 times higher than the volume in July.

    The interest towards this ETF was especially frantic when California passed the law early this year: at that time, ETF MJ price rose from $29 to $39. Then, in March, the price tried to go up further, but the volumes stayed low, so the price had to get back and even sank a bit. It was only in August when $27 got broken out, and then the price went well up to reach $45, this time also with increased trading volumes. Currently, the support levels are at $34 and $39. Given the increased volatility, the price is quite likely to go down to $34.

    ETF investment has always been considered less risky, and in case we are now on the brink of a marijuana boom, this ETF is certainly going to be the best investment vehicle.

     

    Disclaimer

    Any predictions contained herein are based on the authors’ particular opinion. This analysis shall not be treated as trading advice. RoboMarkets shall not be held liable for the results of the trades arising from relying upon trading recommendations and reviews contained herein.

    Important: Never invest (trade with) money you can't afford to comfortably lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here. Trade recommendations and analysis are written by our analysts which might have different opinions. Read my 6 Golden Steps to Financial Freedom here. Best regards, Jonas Borchgrevink.

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    4.6 stars on average, based on 15 rated postsHaving majored in both Social Psychology and Economics, I went on to continue my education in post graduate. Later I worked as a team lead of a tech and fundamental analysis lab in the Applied System Analysis Research Institute. This helped me to acquire all necessary skills and experience to become a successful trader and analyst, as well as a portfolio manager in an investment company. I'm a pro in the financial field and the author of articles for various international media. I also hold the position of Chief Analyst at RoboMarkets.




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