Previously I discussed different divisions within the trading world. One of those divisions is between technical traders and fundamentals traders. I summarized the distinction as:
- Technical traders base their trading decisions on numeric information about the price and trading volume of one or more securities over time. This can include addition information like order book/depth of market (DOM) and tick/time and sales tape information about individual trade executions. Most technical traders use various types of charting and mathematical or visual indicators to make additional sense of this information. Quantitative (“quant”) traders are a subset of technical traders who put more emphasis on sophisticated mathematics to analyze data.
- Fundamentals traders base their trades on economic information, usually betting that over the long run certain known economic relationships will hold. They frequently pay little information to chart studies or previous price and put more emphasis on determining what the price of a security ought to be based on the totality of information about it.
I also mentioned that my personal bias is towards technical trading, although I’ve done both. That’s not to say there’s anything wrong with trading on fundamentals, but technical trading is much more suited to my temperament and skill set.
I’ve come to realize, based on feedback to this blog, that some people have a dislike or distrust of technical trading. Once upon a time this position was common on Wall Street as well, exemplified by the mantra “I’ve never met a rich technician.” Over time, the Street perception has changed, but I still occasionally hear vestiges of the old anti-technical mantra. Now, I have no interest in telling you how you should trade – what you do with your capital is your own business. But I do think technical trading has substantial advantages, particularly for small, non-institutional traders. Here are some of the reasons I prefer it:
- Lots of firms are getting rich off technical trading and have done so for a long time. The idea that there are no rich technicians (either individuals or firms) is simply absurd at this point. Nearly all market making activity is technically driven. Arbitrage and program trading is technically driven. High frequency trading (HFT) is all technical. Those three bins make up the majority of the Street’s trading activity. Thus the majority of trading profits generated by Wall Street result directly from technical methods. If you’ve never met a rich technician, you haven’t looked very hard.
- The majority of short term price movement has technical drivers. Or at least it doesn’t have fundamental drivers. How do I know this? Most of the time there is little or no new fundamental news or data – major data releases occur at the rate of a few per day. Yet the price of nearly all securities changes more or less continuously. If that change isn’t based on new fundamental information, it must be based on something else. That something is order flow and spread trading between instruments. These are things technical analysis has tools to understand. The percent of price movement attributable to technical causes is heavily dependent on time frame – at the shortest time frames (high frequency trading) I’d say price change is almost 100% technically driven. By the time you get to the longest frames, it’s approaching 100% fundamentals driven. Your approach should be based on the time frame of interest.
- Technical trading solves timing problems inherent in fundamentals trading. Fundamentals analysis identifies market irrationality. A security is priced at X and it “should” be priced at Y. You expect that at some point price will move from X to Y and rationality will reign again. But when? The market has already proven it’s happy to be irrational. That state could continue for a long time. How long? You don’t know – it could be years. What if the irrationality gets worse before it gets better? This is exemplified by the old dictum “The market can remain irrational longer than you can remain solvent.” Technical trading, since it’s an analysis of what has happened in the past and is happening right now (avoiding concerns about what ought to happen in the future) is less vulnerable to this problem.
- Sometimes economic theories are wrong. And fundamentals trading doesn’t provide for a graceful exit when you’re on the wrong side of a trade. Economics is called the ‘dismal science’ for a reason – it’s wrong more frequently than a science ought to be. In and of itself, that’s not a big problem – it’s possible to make good money by being right only slightly more frequently than random. But in order to realize those profits, you have to get lots and lots of trades in, and exit the losers in a timely manner. Fundamentals trading works against this. When the market is irrational the fundamentals trader enters a position expecting a return to rationality. But what if the economic theory is wrong, and the trade starts to move against you? Now the situation seems even MORE irrational – the justification for the trade is even stronger than it was before. Logic says you should keep your position, or even add to it. So instead of getting in lots of trades on a small edge, you end up with the bulk of your account tied to a single trade that’s moving against you and may be based on faulty theory in the first place. That way lies the poor house.
- Technical trading handles non-public information gracefully. Fundamentals trading does not. There fact of the matter is that there are people who know things about nearly every security that the public doesn’t. Companies have insiders. Countries have government officials who know things about their bond and currency policies. Major commodities producers, consumers, and storage facilities know things about commodity supply and demand. While it’s illegal to trade insider corporate information in the stock market, most other markets do not have that prohibition. In the commodity, bond and currency markets trading non-public information is normal, legal and ethical. Since all major markets are correlated, non-public information from those other markets affects stocks as well (sometimes dramatically). Fundamentals analysis is severely limited by not having this information – good analysis on bad data gives bad results. In contrast, technical trading is just as capable of observing and learning from the trades of insiders as from the trades of the general public. So it sometimes allows you to react to insider activity and join them on the right side before the information becomes public. This is a huge advantage.
- It’s easier to create useful new technical information than useful new fundamental information. If you want to create new technical knowledge, you follow the trading system development process. It’s not exactly easy, but it does work and does produce profitable trading strategies. And it doesn’t require and extreme resources – one person with a computer and data feed can do meaningful work. Creating new fundamentals knowledge is much harder – you either have to create a new economic theory (likely to be dismally wrong), or gather new economic data that hasn’t been collected yet. New data is possible – I remember one firm that sent observers to retail store parking lots during Christmas shopping to count customers, and then used that information to predict sales (and thus price moves when sales numbers were announced). It worked well enough, but it was difficult and expensive – it involved 10s or even hundreds of employees and I think the stores being observed sued.
- Technical trading prowess stems from what you know. Fundamentals prowess often stems from who you know. Since it’s legal to trade non-public information in most markets, extreme fundamentals-based success in those venues is most effectively achieved by knowing the right people and getting them to tell you things. You want to know Treasury department officials, members of the Federal Reserve, their equivilent in other countries, oil and agriculture ministers and their flunkies. You hang out with lots of people like that, right? Oh wait, you don’t and neither do I. Fundamentals trading is network based, and if you’re in a position where you can access that network I suggest you do. But if you’re not, the intellectual meritocracy of technical trading has to look pretty attractive in comparison.
- Technical trading mitigates the problems of world-wide correlation and information glut. Trading at heart is a task of information reduction and synthesis. You have to reduce all the information about your trading instrument into just one three way decision – long, short, or flat. This reduction process is hindered by an excess of information. Unfortunately, fundamentals trading tends to multiply the amount of information available. Since all major markets are at least somewhat correlated, it’s difficult to understand the behavior of any one without understanding the others. This can easily lead to “trading the world” where you need huge amounts of information to make good decisions. Collecting that information is not necessarily impossible, but it is aided by having a big research staff available to you – something the institutional guys have and readers of this blog likely lack. Technical trading has the nice property that anything you care about will ideally show up in the price of your security (if it doesn’t affect price, you probably don’t care about it). This gives you one source for information, admittedly a greatly reduced one. But reducing the amount of information is your goal.
I don’t want this post to come across as me bashing fundamentals trading. In certain circumstances (long time frames, very large amounts of capital) it’s the only feasible approach. But as a means of achieving my goals it’s a poor choice and technical analysis is much more useful. I suspect this is true for many Off-Road Finance readers as well.