Part 1: Fundamental vs. Technical Analysis. (Futures 101)

By Talati, Jessica | Modern Trader, January 2002 | Go to article overview

Part 1: Fundamental vs. Technical Analysis. (Futures 101)


Talati, Jessica, Modern Trader


In the first of our head-to-head series, we take a look at the ins and outs of fundamental and technical analyses. An understanding of each approach will be helpful in deciding how to develop a trading system.(FUTURES 101)

It's an age-old question, one repeatedly debated by many traders, yet still it remains definitively unanswered. The merits of fundamental and technical analysis have been argued, disputed, pleaded and reasoned for years, but the novice trader is left void of an answer to the simple question of which is best.

The reason for a seeming lack of guidance? There is little agreement on the supremacy of one approach because the success of a trader's system is so dependent on the individual characteristics of each trader. The decision of which to choose is so important that it merits a full discussion of the options available to the beginning trader.

The fundamental approach centers on an analysis of supply and demand factors. Various determinants in some way will affect the price of a commodity through their effect on the balance of supply and demand. Fundamentalists take great pains to analyze endless amounts of economic data with the hopes of creating a clearer picture of the future direction of prices.

Technical analysis, on the other hand, is rooted in detailed analysis of past price action. The adage "history repeats itself is perhaps no more crucial to anyone else than it is to a technician. Relying primarily on the recognition of trends, technical traders seek to exploit their knowledge of past price activity to capitalize on future price direction.

While the two approaches are often portrayed as polar opposites, such a division isn't quite that clear. A mix of factors can blur the line between fundamental and technical analysis, such as time frames or certain markets. If one distinction is to be made between the two, it rests on a theoretical basis. Fundamentalists are concerned with why prices will move in a certain direction whereas technicians are concerned with when prices will move.

What they are Whether fundamental or technical, a trader's system relies heavily on bundles of analyzed information. It would be an understatement to say a fundamental trader must know his market inside and out. The more familiar a fundamental trader is with the market he is trading, the more solid his analysis of it will be. A fundamentalist's toolbox is filled with economic indicators. Supply and demand statistics, crop production reports, weather conditions and economic forecasts are meticulously analyzed to determine trading opportunities.

"In the fundamentals, I'm looking at supply and demand around the world. I'm looking country-by-country and seeing how the [United States] fits into that, what it means for U.S. trade, what it means for prices. Do we have a shortage? Do we have a surplus?" says David Bell, president of Bell Fundamental Futures, who uses a combination of fundamental and technical analysis to trade the agricultural markets. "The market place has a job to do, such as rationing tight supplies or buying more acreage for a certain commodity. There are different functions that price performs, and I'm analyzing that to determine what needs to be done and how I can take advantage of it."

A fundamentalist's task can vary, but in general terms, it is to achieve a sense of what the fair value of a certain commodity will be in the future by building a model based on supply and demand factors. Once an estimate of fair value is reached, fundamentalists compare that value to the value at which the futures market is trading at that moment.

"You're looking for a disequilibrium between what the futures market is priced at and what you sense is the fair value price in the future," says Jim Hoizer, a commodity advisor in the agricultural markets. "The greater the differential between the futures market and what your perception of what fair value is, the stronger your signal is to enter the market. …

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