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Trading 101

Trading 101: Moving Averages and Moving Average Strategies

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What are Moving Averages?

Moving Averages are among the most popular trend indicators in Technical Analysis. They provide a simple, yet powerful visualization of the ongoing trends in an asset. They are used for a wide variety of reasons, primarily for trend following and reversal strategies.

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Simply put moving averages are connected points calculated for every day (or whatever the timeframe is). The calculation itself is simple; you take a given number of previous days and calculate their average. Of course, you don’t have to do the calculations yourself. All basic charting software and trading platforms do the math for you and plot the moving average (or up to dozens of averages for that matter) on the chart of the asset.

How to Interpret Moving Averages?

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If you want to know what a moving average means, just think about that it is nothing else but a smoothed way of describing the price movement itself. So, if the MA is rising that means that the price trends upwards on the given time-frame. It is that simple. Also, if the current price is above a certain MA that usually means that the trend on that time-frame is still intact.

Now the interesting part is when you use the MAs for comparisons. You can compare two MAs with different time-frames or simply compare the value of the MA to the price itself. This might be helpful for plenty of reasons, but the most important conclusion that you can make is the alignment of a short-term and a longer-term trend. Like this, you can spot trend reversals, pull-backs, and exact entry and exit points. How? Let’s see some examples.

How to use it Trading?

Moving averages can be used in virtually unlimited ways, but as always, keeping your strategies simple is advisable. So let’s see the basic but most robust applications:

1.     Determine the ongoing trend by comparing the price and a certain MA, and its direction.

This is as simple as it gets; first, you take the direction of the MA, then you take a look at the price and see whether it is above or below the MA. If the MA is rising and the price is above it then it is confirmed up-trend. According to that, you should only trade on the upside on that particular time-frame, as trading against the trend is usually not a wise thing to do. So, to take an example, you can see a clear up-trend on the chart below with the 200-day MA rising all along.

The simplest strategy is to go long when the price crosses above the rising moving average, and sell the position when it crosses below it (this works of course with a declining MA and a short position, but with the price crossing below the MA).

Moving Average Strategy 1.

2.     Compare two different MAs for determining the trend and reversals.

The second, and probably the most popular strategy for moving averages is the so-called “cross-over” strategy.  The steps are similar to the first strategy; just instead of the price, you use a short-term MA as the “trigger” for the trades, as you can see it on the chart below. A lot of traders use the additional condition that the long-term average must be advancing for this strategy.

Moving Average Strategy 2.

3.     Identify pullbacks to enter trends more precisely.

This approach the most advanced of these simple strategies and it can be helpful to capture a larger portion of market “swings” than the two prior frameworks. The idea is to take the conditions of the first or the second strategy but wait for a pullback before actually entering the trade.

But what does a pullback mean? Well, that depends on the interpretation, but the basic definition is for the price to touch the given MA in the case of the first strategy. As for the second strategy, a useful way of defining a pullback is to wait for the price retrace to between the short and the long-term MA, just as you can see it on the chart below. This way you will enter to an already established trend with the additional benefit of not getting in a short-term overbought position.

Moving Average Strategy 3.

When does it work?

As it is the case with every indicator, moving averages have their strengths and weaknesses. By knowing when to use these very useful indicators you can avoid the common mistakes that traders make. The most important thing is that MAs work the best in trending markets.

On the contrary, in sideways price action, these averages can give false entries or cause overtrading through too frequent signals. Applying the direction of a longer-term MA as a condition (for example having a rising long-term MA as a requirement for long positions) can be helpful to prevent these problems.

Also, it’s wise to wait for confirmation before entering a trade. As an example, if you are entering a trade using the first strategy, wait for the second close above (or below for a short position) the MA before “pulling the trigger”. This way you can steer clear of “price-spikes” that are an integral part of the forex and cryptocurrency markets.

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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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4.5 stars on average, based on 231 rated postsTrader and financial analyst, with 10 years of experience in the field. An expert in technical analysis and risk management, but also an avid practitioner of value investment and passive strategies, with a passion towards anything that is connected to the market.




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Stocks

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).

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Figure 1. AAPL Daily

Figure 2. MMM Daily

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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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Trading 101

Trading 101: How to Use Fibonacci Numbers in Trading

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Fibonacci trading

Fibonacci is an extremely popular tool to use among all types of traders, be it professionals, amateurs, stock traders or crypto traders. It works in all markets and serves many different purposes for traders, far beyond just finding good entries and exits.

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Drawing Fibonacci retracements

To get things straight, let’s first say that there are no hard rules regarding how to use the various Fibonacci tools. Keep in mind that Fibonacci levels are based on percentages, meaning that you do have some flexibility when drawing them.

The first thing you need to do to use the Fibonacci retracement tool is to identify a certain price movement between two points on the chart, A and B, to measure. Both of these points should be tops or bottoms in the chart, also known as swing highs and lows, with price moving in a clearly defined trend between them, as in the examples below:

Fibonacci chart

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What you do next is simply to find the Fibonacci retracement tool in your charting platform, select point A and drag the tool to point B.

In TradingView, which is the platform I have used here, the Fibonacci retracement tool is found in the menu to the right of the chart. Click on the third button from the top (the pitchfork button) and you should be able to see it among many other drawing tools.

Once you have found the market top and bottom, the next step is to identify your retracement point, which we will call point C. This is the point where the reversal/retracement ends, and price resumes to the previous trend direction (as between point A and B).

Fibonacci as support/resistance levels

One important thing to realize here is that price movement don’t necessarily reverse at a Fibonacci level. However, the levels often serve as support and resistance levels, where price could potentially reverse. This can clearly be seen in the screenshot below where we have highlighted some points where Fibonacci levels acted as support and resistance, as the price resumed to its original trend.

Fibonacci retracement

With that said, the main use of Fibonacci retracements is probably as an entry indicator. For example, a trader could use the Fibonacci levels as re-entry levels during pullbacks once we have left point C and the price is moving in its original direction again.

Fibonacci as profit targets

Another important use for Fibonacci levels is for placing profit targets when swing trading. We are then talking about Fibonacci extensions rather than retracements.

The rules here vary wildly from trader to trader, but as a start, it is generally agreed that a 38.2 retracement often ends at a 138 Fibonacci extension. Likewise, a 50, 61.8, or 78.6 level Fibonacci retracement will often go to the 161 level extension.

The basic idea behind all uses of Fibonacci tools is the notion that a countertrend movement is likely to return back to the overarching trend in the market. In this context, the Fibonacci numbers can be helpful as a tool to add confluence to our initial bias of where the trend will resume, for example in combination with major support & resistance levels or other technical indicators. This way, we take a much more careful approach to the use of Fibonacci levels while we still make sure that we are always aware of where the levels are and thus where price reactions can be expected.

Featured image from Pixabay.

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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4.3 stars on average, based on 28 rated postsFredrik Vold is an entrepreneur, financial writer, and technical analysis enthusiast. He has been working and traveling in Asia for several years, and is currently based out of Beijing, China. He closely follows stocks, forex and cryptocurrencies, and is always looking for the next great alternative investment opportunity.




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Trading 101

As Stock Market Peaks, These are the Best Alternatives for Growth

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The stock market’s epic rally may have run its course, according to Morgan Stanley. The bank has warned that U.S. equities have already peaked for the year, which means investors shouldn’t expect a return to record levels anytime soon. The return of volatility certainly corroborates their view. Rising interest rates and an escalating trade war also signal the possible end of the Trump reflation trade – at least, for now.

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Although a massive correction hasn’t been priced into Morgan’s forecast, investors should be considering ways to diversify away from stocks if they haven’t done so already.

The End of the Meltup

After a blistering start to 2018, stocks have struggled to regain their glory since an early-February rout wiped $5.2 trillion from global markets. Although markets have recovered, volatility appears to be a mainstay for the first time in at least two years.

The CBOE VIX, Wall Street’s preferred measure of volatility, has traded between 15 and 20 over the past month. That’s right around the historical average. The VIX spiked by the most on record in early February, ending a multi-year stretch where it traded in the single and low double-digits – basically, around half the historic average.

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Michael Wilson, chief U.S. equity strategist at Morgan Stanley, explains what this means:

“We think January was the top for sentiment, if not prices, for the year. With volatility moving higher we think it will be difficult for institutional clients to gross up to or beyond the January peaks,” he said in a weekly note on Monday, as reported by MarketWatch. “Retail sentiment indicators also look to have peaked in January and we do not see anything on the horizon to get retail investors more bullish than they were following a tax cut.”

For many, the end of the meltup isn’t a bad thing. Stocks have been richly valued for a long time, with much of the gains spurred on by hope of a Trump-inspired economic boom. Although the economy has performed better under the Trump administration, stock traders (i.e., the institutions) are now looking for more tangible evidence of a stronger recovery. Depending on who you ask, that might not materialize anytime soon.

Although Trump succeeded in lowering taxes, the cuts weren’t accompanied by an equal reduction in government spending. What they did do was spur on higher inflation expectations, which appears to be translating into actual price growth. In this environment, rising interest rates could spell trouble for indebted consumers who have already reduced their spending (as evidenced by the recent slump in retail sales).

What This Means for Investors

With U.S. stocks losing their luster, investors should already be considering ways to rebalance their portfolios. Given the current economic and political climate, the best vehicles for diversification are gold, cryptocurrencies and emerging markets.

Gold

The original safe haven is a natural bet in the current environment of rising interest rates and political instability. Although gold hasn’t made any news-shattering headlines recently, it has comfortably traded above $1,300 all year long. The signals we’ve gotten from the Federal Reserve is that interest rates will continue rising as inflation approaches and eventually crosses the 2% target. (Depending on which inflation measure you use, this has already happened.)

Interestingly, gold outperformed several major asset classes in 2017. As the following chart illustrates, silver is another commodity worth considering in the current economic climate.

Source: Mining.com.

Precious metals can be bought and stored outright or collected through various gold miner ETFs. With bullion trading well below record levels, the asset and its derivatives can still be had for cheap.

Cryptocurrencies

2018 has been a roller coaster for crypto investors, but those of use who’ve been in the market longer than 15 months know that volatility is nothing new. Recent price trends indicate there will be no V shaped rally, but that shouldn’t deter long-term investors (“hodlers”) from capitalizing on the cyclical downturn.

Market participants seem to agree that the vast majority of cryptocurrencies offer no long-term investment value (the phrase “shitcoins” is thrown around a lot to refer to these assets). But the cream of the crop certainly has a lot to offer. Bitcoin, Ethereum, Litecoin and Ripple seem to have the strongest fundamental indicators on their side. Stellar Lumens, bitcoin cash, OmiseGo and Zcash are also on the author’s watchlist of potential long-term gainers.

Although readers of Hacked don’t need a lot of convincing to buy more cryptocurrency, higher inflation could certainly make this asset class more attractive. As we mentioned above, higher inflation leads investors to consider other storehouses of value for protection. Bitcoin has been described by many as a storehouse of value that, despite volatility, is uncorrelated to other market developments.

Of course, there’s no guarantee bitcoin will rise because of inflation. We certainly aren’t speculating because of any historical precedent (inflation has been non-existent for much of bitcoin’s lifespan). But it’s certainly something to monitor given that bitcoin has behaved more like a commodity than a currency throughout its short history.

Emerging Markets

2017 was the year of the synchronized global recovery, but nowhere was this more apparent than in emerging markets. Emerging market funds outperformed Wall Street last year and are likely to do so again in the future.

If chasing growth is your strategy, then emerging markets are the first place to look. The International Monetary Fund (IMF) has forecasted emerging market growth of 4.9% this year and 5% in 2019. India is expected to top the list with a whopping GDP growth of 7.4% and 7.8% each year. Even Russia and Brazil – two countries hammered by the commodity downturn – are forecast to return to growth.

India’s economic potential has sent its small-cap stocks through the roof. In 2017, the Market Vectors India Small Cap ETF surged 65.4%. The iShares MSCI India Small Cap added 60.5%.

And say what you will about China’s economic slowdown, but its technology funds are soaring. The Guggenheim China Technology ETF returned 74% in 2017, while the KraneShares CSI China Internet ETF added 69.6%.

These are just some of the asset classes investors should be considering amid the latest downturn in developed market equities. Of course, this strategy depends largely on the path of inflation and corresponding monetary policy. The indicators we have now point to more robust price growth in the near future, which will require a gradual re-think of monetary policy in the Western hemisphere.

Disclaimer: The author owns bitcoin, Ethereum and other cryptocurrencies. He holds investment positions in the coins, but does not engage in short-term or day-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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4.5 stars on average, based on 348 rated postsSam Bourgi is Chief Editor to Hacked.com, where he specializes in cryptocurrency, economics and the broader financial markets. Sam has nearly eight years of progressive experience as an analyst, writer and financial market commentator where he has contributed to the world's foremost newscasts.




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