In the financial markets, the first thing to realise is nearly all the major players are operating from very similar information. They are all staring at the same sets of price series, they are all digesting the same set of economic reports and they all follow the same soap opera of reports provided by Bloomberg, Reuters, CNBC and other financial institutions. In the financial markets, the first thing to realise is nearly all the major players are operating from very similar information. They are all staring at the same sets of price series, they are all digesting the same set of economic reports and they all follow the same soap opera of reports provided by Bloomberg, Reuters, CNBC and other financial institutions. Very rarely are they accessing any information that the rest of the financial industry aren’t easily able to access (unless they are insider trading). Their trading edge comes from what they do with all that information.
Very few major players, if any, will focus on technical analysis alone. In these circles, fundamentals are the most important and technicals are often frowned upon. There are legends of whole trading teams being sacked because of their over reliance on technical analysis. Furthermore, no one would ever imagine the head of the Fed waking up in the morning and go oh look there is a hammer formation, I should lower interest rates today. The Fed digests the outcomes of the beige book before making a decision. As a trader you need to look at a wide number of aspects of the market and not just focus on technical analysis alone.
Trading on technicals alone is like going into a boxing ring with one arm tied behind your back. Sure if you are a really good boxer facing a weak opponent you will probably fare pretty well; but if you are dealing with a seasoned pro you want to have both arms. Similarly, if you are trading a market where the trend is well defined, then technical analysis is probably enough; but if you are making trades in markets where the character of the trend is a bit grey, then you need extra tools in your analysis toolkit otherwise you risk misunderstanding how the major players are positioning themselves.
Many traders shy away from fundamental and sentiment analysis, perhaps because they don’t understand it, perhaps they fear it is too subjective or some author they respect told them that all the information they need to know is contained in the price action. This last point just makes no sense. If all the information was reflected in the price action, then technical analysis would be by definition totally useless, because the efficient market hypothesis would by definition hold true and technical analysis would have no forecasting ability.
Technical analysis is about trying to characterise the price action and is also a tool to help you plan trades by finding logical entry and stop points in the markets. I really dislike viewing technical analysis as a predictive tool, as at best all it can tell you is how the market has behaved in the past, what its current state is and it might give you hints about where clusters of conditional orders might be sitting. On a deeper level, a field of technical analysis called intermarket analysis cannot be underestimated in its importance, as it is one of the few tools that can help you understand the underlying dynamic of how large players are shifting their cash around global markets.
Fundamental analysis is about studying the underlying economic supply and demand factors driving the market. On one level, fundamental analysis is quite a dry and dismal science about reviewing economic indicators, trying understand how the economy is performing and how it will affect the market in the long term. From a more short term perspective, which is where things get more interesting, it is about understanding how the market players are pricing in their second guesses about future federal government and central bank macro-economic policy decisions.
Sentiment analysis is about trying to understand the crowd’s opinion on the general direction of the market (e.g. will the trend continue?, will it continue the correction?, will the market continue to range?). On a quantitative level it can be about looking at things like Commitment of Trader (COT) reports or put/call option ratios. On a qualitative level sentiment analysis is about listening to the general chatter about the market on CNBC, in the finanical news papers, popular news letters, etc.
Sentiment analysis is quite useful for spotting turning points in the market. For example, major shifts in commercial positions on the COT report can indicate a turning point in the market. Similarly, cover stories in major magazines and local news papers about the market is usually a good sign the trend is over as the market has stopped buying the rumour and is now selling the fact.