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This is a guest post by Stephen Hill, a successful proprietary trader. Stephen uses these strategies to trade in the foreign exchange market.
There are two different methods at a trader’s disposal when analyzing financial assets (stocks, bonds, options contracts, futures contracts, spot currencies, etc.) and real assets (land, machinery, equipment, physical commodities, etc.) being traded in the financial markets.
The first is fundamental analysis, which identifies whether a specific security (claim on assets or income from assets) is over-valued (over-priced) or under-valued (under-priced) based upon economic reports or news.
The second is technical analysis, which values a security based solely upon past price information.
Fundamental Analysis
Fundamental traders analyze news from a rational standpoint. To provide a simplistic example, let us imagine that you read an article entitled “Steve Jobs Receives Five-Year Prison Sentence.”
As a fundamentalist, you would apply IF-THEN logic to this type of headline. You would posit “IF the creative and brilliant C.E.O. of Apple no longer runs the company, THEN the company may not produce the same level of profits, or earnings, as it did when he was running it successfully.”
You would then short (sell) Apple’s stock with the expectation of a fall in price. If price did fall as expected, you would make money because you would have sold high and bought low. It is important to realize that your source of profit is based upon the differential between the price at which you bought, or went long, and the price at which you sold, or went short.
You do not necessarily have to follow any particular order as you can buy first and sell later (profit occurs if price rises) or sell first and buy later (profit occurs if price falls).
Technical Analysis
Technical analysis involves the assessment of statistical data. To provide a
simplistic example, let us imagine that you are examining an Apple price chart that shows you price action (where price travels or moves) over the last three years.
simplistic example, let us imagine that you are examining an Apple price chart that shows you price action (where price travels or moves) over the last three years.
You observe that every time Apple’s price hits $600, it bounces down to a lower price level. As a technical analyst, you subscribe to the philosophy that past price action or data serves as a reliable indicator for future price movement. You would then make the assumption that on the next occasion in which Apple’s price reaches or moves up to $600, a profitable trade might consist of shorting, or selling, shares at that price.
If the price did fall as expected, you would make money because you would have sold high and bought low. As a market technician, you do not believe that the market is rational. Therefore, applying IF-THEN logic to describe the actions of market participants is nonsensical to you. You believe that the psychology of the traders in the markets follows the rules of “crowd behavior.” In other words, people buy and sell because of fear and greed, as oppose to logical conclusions.
Fear and greed form certain mathematical patterns in terms of price action, and these patterns repeat themselves frequently enough to profit by identifying them correctly.
Discretionary Traders
Discretionary traders are perhaps the best kind of traders because they combine both fundamental and technical analysis to make investing decisions. To utilize both of the aforementioned examples, you, as a discretionary trader, would read the headline about Apple’s C.E.O. and apply the IF-THEN logic.
Instead of trading solely based upon this information, however, you would analyze an Apple price chart and look for patterns that might give a better indication of whether or not this type of news would adversely affect the security, or stock. If price was at the $600 level at the time, and you observed that this level usually serves as resistance (price cannot push past it), then you would have more confidence in shorting, or selling, Apple at that time.
Again, you can only profit if the price did indeed fall due to the fact that you sold first in order to buy back later (sell at $600 and buy at $500 = $100 profit per share). As a discretionary trader, you have a balanced perspective of financial markets. You believe that the market has the ability to react to news rationally or emotionally, and this reaction is based upon economic theory (logical models) AND price data (mathematical measurement of emotion).
So there you have it: a basic overview of
the three types of traders (fundamental, technical, and discretionary) that participate in the financial markets. These traders all differentiate from each other in terms of their approach to the market so it is good to know how they analyze assets if you would like to profit from the depreciation (fall in value/price) or appreciation (rise in value/price) of these assets.
the three types of traders (fundamental, technical, and discretionary) that participate in the financial markets. These traders all differentiate from each other in terms of their approach to the market so it is good to know how they analyze assets if you would like to profit from the depreciation (fall in value/price) or appreciation (rise in value/price) of these assets.
Photo Credits: http://www.fxdailywatch.com/fundamental-forex/fondamentalist-vs-technicions/
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