Derivatives analysis can focus on two different types of analysis; fundamental analysis and technical analysis. This article will outline both types with particular focus on technical analysis.
Types of Derivatives Analysis
Fundamental and Technical Derivatives Analysis
Fundamental Derivatives Analysis
Fundamental analysis is the appreciation of the economics and intrinsic value underlying a particular trade. If you want to know where to invest and why, you use the techniques of fundamental analysis.
For a foreign exchange trader, fundamental analysis is focused on the macroeconomics of particular currencies, 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 micro-economic 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 Derivatives Analysis
Technical derivatives 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.
Technical analysis is an art which involves quasi-statistical techniques and formal statistics that are used to determine the existence and strength of trends in financial time series and to identify turning points in these trends. 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.
Examples of Technical Analysis
There are two kinds of technical derivatives 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, traders will see whatever results they want to see in order to justify their position.
Presume then that derivatives traders who use technical analysis stick firmly to the first school the use of indicators. Indicators are typically suited for a particular kind of market, usually delineated by whether or not the market is trending or non-trending.
For example, an indicator might track the “Stochastics.” This is a crossover indicator that is suitable for a non-trending market. Advances in computer technology have made it easy to automate this analysis by programming what are called expert rules. This obviates the problem of seeing what one wants to see and it allows the analyst to customize the indicator to time series in question in order to get the most optimal results.
Technical Analysis and Derivatives in Practice
In practice, there are quite a few indicators that we can look at and automate to produce trading signals when the rules we specify are triggered. 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. For example, if we have five automated trending signals, all of which indicate that our stock is in an upward trend, we have an interesting result. It is even more interesting if the technical derivatives 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.
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.
Overview of Derivatives Analysis
In utilizing derivatives analysis, 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, Point Frederick Capital Management, LLC