In making decisions about where and when to take a position, investors, traders and analysts use two different approaches: fundamental analysis and technical analysis. Fundamental analysis is the appreciation of the economics underlying a particular trade. If you want to know where to invest and why, you use the techniques of fundamental analysis. Technical analysis is concerned with the when and the how of placing money. It determines the optimal timing for a position and its conclusions about how long to stay in a particular trade have significant importance for the kind of derivatives structure one may use to take a position.
For a foreign exchange trader, fundamental analysis is focused on the macroeconomics of the particular currencies involved, including the implications of the current account, the GDP growth rate, domestic consumption, domestic production and other political factors that influence the currency's relative value. As we move into more company-specific investments such as individual equities, fundamental analysis becomes more preoccupied with microeconomic questions related to the firm. Such an investigation might look at price/earnings ratios, debt/equity ratios, cash flow forecasts and similar data from financial statements, press releases and competitors.
Technical analysis is an art in which quasi-statistical techniques and formal statistics are used to determine the existence and strength of trends in financial time series and to identify turning points in these trends. If you can do this with a reasonable degree of accuracy, then you can improve your chances of making a profitable trade. Technical analysis is important in the structuring of derivative products because of the leverage involved and because of the inclusion of such features as barriers and compound strikes. Timing is everything.
EXAMPLES OF TECHNICAL ANALYSIS
There are two kinds of technical analysis.
First, there is the design and use of "indicators", changes in which present implications about the existence, strength or change in the trend of the financial time series in question. An indicator is a function of the time series and some parameters that the analyst chooses.
Second, there is the use of more primitive hands-on techniques such as the drawing of "support" and "resistance" lines on a chart, the violation of which is deemed to be a significant technical event. In its more complex manifestations, "patterns" are interpolated from market behavior with conclusions for future price evolution based upon the historical consequences of such patterns.
There is a growing voice in technical analysis that argues against this second school of thought. The argument against interpolating lines and patterns comes from a basic assumption about the psychology of money. In order for technical analysis to be successful in forecasting future price movements, the analysis must be objective. Otherwise, the analyst will see what he wants to see. I myself have seen traders, especially ones with large positions that have started to lose money, fool themselves into thinking that they can justify their current positions with some lines on a chart. Hope is the principal obstacle to profitable trading.
Presume then that derivatives traders who use technical analysis stick firmly to the first school, the use of indicators.
Advances in computer technology make it easy to automate this analysis by programming what are called expert rules. This obviates the problem of seeing what one wants to see quite clearly. And it allows the analyst to customize the indicator to time series in question in order to get the most optimal results.
For example, a momentum indicator is a simple formula involving the most recent price and some historical price that gauges the speed of the move in the financial time series.
A moving average is simply an average over the last few periods for the time series. Construct two moving averages with different periods and you have a trading signal when they cross. When the moving average with the longer indicator crosses the moving average with the shorter indicator, you have a good indicator of a trend in place.
By using contemporary software such as Omega Research's (see http://www.omegaresearch.com) SuperCharts, the analyst can choose the two periods for the two moving averages that produce the optimal results. This will vary between different time series because every time series has its own peculiar quirks. The Canadian Dollar against the US dollar moves much more differently than the Japanese Yen against the US dollar. Reasonably, we would expect them to have different parameters for our moving average crossover trading signal.
Another indicator might track the "Stochastics". This is another crossover indicator that is more suitable for a non-trending market.
Indicators are typically suited for a particular kind of market, usually delineated by whether or not the market is trending.
There are many good resources for Technical Analysis, including books by John Murphy. Check out the Financial Pipeline bookstore.
TECHNICAL ANALYSIS AND DERIVATIVES IN PRACTICE
In practice, there are quite a few indicators that we can look at and that we can automate to produce trading signals when the rules we specify are triggered. For example, we could design an Expert System that produces a trading signal every time our Moving Average Crossover system indicates that the two moving averages intersect.
The more indicators we have the better our picture will be. Some indicators are more suited for trending markets while other indicators are oriented towards consolidating markets.
If we can have a set of indicators that produce a consistent trading signal, then we have reduced the probability of being wrong about the trade.
If we have five automated trending signals, all of which indicate that our stock is in an upward trend that is a pretty interesting result.
It is even more interesting if the technical analysis confirms the picture our fundamental analysis paints. If the fundamental analysis suggests that this company is seriously undervalued, we would feel even more comfortable buying it.
If the technical indicators about the speed of the trend suggest an explosive move, we could use a structure with a highly leveraged payout for an explosive move to the upside. For example, we could use a very low delta call (i.e. a highly out-of-the-money call) on the stock if we thought its price would explode to the upside out of a well-defined range. Not only would we make money on the direction of the spot and the convexity of the spot movement but we would also make money from the rise in implied volatilities.
Or, we could attach a barrier on the downside to our out-of-the-money call if we were confident that spot would not move below a certain level before going higher. This would make the option cheaper and increase the leverage in the structure.
Or, we could attach a binary to the option enabling us to get the out-of-the-money option for free as long as spot did not close below the binary level at maturity.
One can see very quickly how flexible derivative products enable our investing approach to be.
The corollary to this argument is that it is dangerous to put on such derivatives structures without some combination of technical and fundamental analysis. Derivatives have the potential for tremendous gains but they require much more homework because of the leverage of the structures, the possibly reduced liquidity and the larger bid/offer spreads involved in transacting them.
Technical analysis and fundamental analysis are tools that the analyst and the trader can use to reduce the uncertainty involved in taking a position. The skilled trader will use these techniques to wait for the right opportunity and to structure the most profitable derivative strategy to take advantage of it.
Article by Chand Sooran, Principal Victory Risk Management Consulting, Inc.
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