The Essentials of Trading

Information and resources to learn about trading and the markets

Technical/Fundamental analysis a child’s game

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A reader named nikesh posted a comment to yesterday’s Improving the Win Rate of Trend System With Oscillators entry. It brings up some things about my own approach to trading and the markets that I think could do with a bit of clarification.

i don’t want to do any effort to spill out your trading system public; but it seems that you don’t follow any MA, donchian channel sort of things (buying the strength and selling the weak), oscillitors or any thing which is so called a technical analysis. And I am almost sure that you are not trading on fundamental basis…

When you answer all these questions it seems that you have a system which is above all other things and other technical/ fundamental analysis seems a child’s game for you…

I said that i don’t want to do any effort … but still can you please give the readers some clue what exactly a successful trader like you is doing the market and making a good amount of money??????

First of all, I would refer nikesh to Can a Shared Trading Edge Still be Profitable?, which I posted the other day. That addresses my feeling on the “spill out your trading system” subject.

Don’t equate my writing to my trading
As for my not using technical analysis or fundamental analysis, nikesh has drawn an erroneous conclusion from what he’s read of my writings. When I write on this blog and otherwise discuss market analysis methods, styles of trading, etc. I intentionally try to take a neutral stance. I have things which work for me. They may or may not work for others. At the same time, things which work for others don’t particularly suit me. Unlike some commentators, I do not belittle methods I don’t particularly find useful because I realize that there is no one right way to trade or methodology to employ. I try to provide readers with the information they need to make decisions for themselves.

The reason technical and fundamental analysis may seem like “a child’s game” to me is because I’ve been at this for more than 20 years. I couldn’t even guess how much system research and testing I have put in over the years. I’ve done more analysis and trade strategizing – either for my own part or on behalf of readers of the professional products on which I’ve worked – than I care to think about. I’ve read loads of books and articles – some good, some not so much. In other words, through educating myself and application of what I’ve learned I have accumulated a lot of knowledge and experience. On top of that, teaching others creates a whole new level of awareness you can’t get in other ways. And I don’t plan on stopping any of that any time soon.

What I use in my trading
I most definitely use technical analysis in my trading. In some cases I also use fundamentals as well (primarily in my stock trading). One of the methodologies I like to employ, especially in shorter-term trading,  can be found in the Following the Quest for Value course I put together a while back. From a technical analysis perspective I could be put in the “price action” category in as much as I do not use indicators. I do keep an eye on volatility readings such as the width of the Bollinger Bands and Average True Range, but I do not use either specifically in my trading to pick trade points or stops or anything like that.

Crude Oil Prices and the Economic Stimulus Package

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In case you weren’t sure how much of an impact fiscal policy could have on the markets, you should take a look at this chart of July futures for Crude Oil.

Oil & Stimulus

One of my coworkers brought this to my attention the other day.

Of course you can’t necessarily say for sure that the economic stimulus plan triggered the latest big rally in oil prices. It’s an awfully interesting coincidence, though, don’t you think?

Why would there be a relationship? Because the stimulus package put about $150 billion back into the economy. Inflation comes in part from increasing money supply and partly from increased demand. The package was designed to accomplish both. The USD chart shows exactly that.

 Oil & Stimulus

Understanding the value of trade

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This post goes a bit off the normal path, but it’s something I’ve had on my mind for a while and needed to put in to writing. Think of it as a discussion of fundamental factors impacting the markets. 🙂

I got in to a discussion a little while back with someone who is quite a bit further to the left on the social/political spectrum than I am. The topic was that of trade. The point I was trying to make was that trade benefits everyone, but I made the mistake of phrasing it “trade increases wealth”. Mentioning the term wealth caused an unfortunate turn in the discussion. I found myself trying to bring it back, but instead faced the topic of whether wealth (defined by this person as having more than you need) was bad.

Later I realized that in place of the word wealth I should have instead used “utility”, which is definitely a classic term from Economics. You can think of it as usefulness. So restated, trade increases utility among those who trade.

Here’s an example. We have a Farmer and a Cobbler. For those who are too young to know, a cobbler is someone who makes shoes. Let’s say Farmer grows carrots. Now Farmer can only eat so many carrots and Cobbler can only wear so many pairs of shoes. In other words, they have very low utility (usefulness) for any extra they produce. If we quantify things it might look like this.

Farmer
Pounds of Carrots:  1-5     Utility:  10/lb
Pounds of Carrots:  6-7     Utility:  1/lb
Pounds of Carrots:  8+      Utility:  0/lb

Cobbler
Pairs of Shoes:  1-5     Utility:  10/pr
Pairs of Shoes:  6-7     Utility:  1/pr
Pairs of Shoes:  8+      Utility:  0/pr

Let’s assume that the Farmer produces 6 pounds of carrots and the Cobbler makes 6 pairs of shoes. If you add up the figures, each ends up with a total utility score of 51 (5 x 10 + 1 x 1 = 51).

Now if we assume that Farmer and Cobbler have the same utility values for each other’s products (1 pair of shoes has a utility of 10 for Farmer and 1 pound of carrot has a utility of 10 for Cobbler) we can see how each benefits through trade. Look at what happens when Farmer gives Cobbler a pound of carrots in exchange for a pair of shoes.

Farmer: 5 lbs of Carrots + 1 pair of Shoes = 60 utility (5 x 10 + 1 x 10)

Cobbler: 5 pairs of Shoes + 1 lb of Carrots = 60 utility (5 x 10 + 1 x 10)

Notice how both Farmer and Cobbler now have a higher total utility than they had before the trade.

Trade is all about increasing utility among the parties involved. The Farmer/Cobbler example is obviously very simple. Even so, it makes the point.

Most trade these days has money on one side of the transaction. Money itself has little or no utility. After all, the electronic balance in your checking account isn’t something you can eat or wear. It does, though, represent the ability to acquire utility by exchanging it for things like food or clothing. Certainly, that adds a layer of complexity to trade in that the value of a currency is subject to change (which is why inflation is such a scary thing), but it helps to facilitate a level of trade that would not be possible otherwise.

International trade may be complicated by political issues, but the same basic idea as the Farmer/Cobbler example applies. Countries specialize in similar, if broader, ways as people. Some have access to physical resources like oil. Others have ample labor forces. They exchange what they have in surplus with each other and thereby improve everyone’s situation. That is why free trade is such a key part of global economic health and why protectionist and isolationist policies can be significant hindrances to that.

Ways to approach news events in your trading

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A question recently came up in regards to the impact of news on trading performance. The questioner was feeling a bit overwhelmed with the idea of trying to deal with all of the different sources of potentially impactful news and information that hits the markets. Let me share some thoughts on the subject.

Firstly, I can completely understand how mind-boggling it can be. There is seemingly a constant stream of data coming out. Forex traders in particular see loads of it each day as the various major industrialized countries put forth economic data and have prominent speakers on the schedule. Then too there are any number of things that can crop up anywhere in the world related to gold or oil, for example.

Here’s the first thing I would say in that regard.

It is possible to narrow significantly the list of scheduled items that are likely to have a significant impact on the market you trade. Clearly, a stock trader has to worry about earnings reports, but retail sales data may be completely meaningless. A forex trader has to worry about things like trade, but won’t concern themselves much with corporate earnings. An interest rate trader will certainly keep an eye on employment figures, but won’t worry as much about the speech by the head of the European Central Bank.

The implication is that you can generally pick and choose the calendar events that you need to focus on for your trading. Of course there are always going to be surprise events that happen, but you can only deal with that though a generally solid risk management approach.

Now, once you have identified the data releases and other events that are meaningful to the market you trade there are three ways to trade in relation to them.

1) Take positions ahead of the releases, speech, or whatever.
This is basically gambling and not recommended.

2) Make sure that you are flat ahead of the aforementioned events.
For most short-term traders this is generally the best approach. It keeps one out of the wildness that can come with unexpected results. That volatility makes meaningful trading very challenging, and not very profitable for most people. The majority of folks are better off waiting to see how the market settles out afterwards.

3) Trade in a time frame for which the kind of intraday swings created by news events are of no significant impact.
This generally means taking on positions with relatively wide stops that are expected to be held for at least several days, if not weeks or more. The approach here is to play the bigger price movements with the view that intraday swings are just blips.

You personal trading style will dictate the approach you take.

One other thing I would add in comes in the area of trading systems and their performance around news events. If a system has been tested over a sufficiently large data set relative to the time frame it trades then that means it would include any number of data releases and other news items, and thus their impact on prices. As such, the user of such a system, if the performance is deemed solid, should not concern themselves over much with releases. They are, essentially, factored in to the system’s performance.