TRADING INSIDER: Technical Knowledge Can Be A Trader’s Secret Weapon, But Is It Art Or Science?

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There are many types of traders out there these days: fundamental traders, technical traders, algo traders, scalpers. There are traders who hold for the tiniest fraction of a second, those who trade intra-day, and those who see themselves as longer term players, as investors.

Most traders, though, fit into two categories – fundamental and/or technical.

Fundamental traders are those that like to focus on what you might call “real world” factors, such as a company’s earnings, the strength of the sector in which they operate, and their product offerings.

A fundamental trader will also be interested in competitors, the overall economic conditions in their market or country, and in the global economy. They’ll look at consumer sentiment if they are in retail. China if they sell iron ore. The climate change debate if they are a coal producer or electricity ultility.

All these things then filter into earnings and cashflow acronyms like EBIT, EBITDA and so on.

Fundamental traders believe that by the judicious study of these and the raft of myriad other factors that are observable at a company, competitor and economic level they can ascertain which stocks will do well, which poorly and, after conducting their analysis they can discern value.

This tells them what stock, currency, commodity, bond or other investment they should buy, hold or sell.

Fundamental traders, like accountants, believe in the numbers.

Technical traders on the other hand believe that they don’t need to study stuffy fundamentals. They believe that this is all superfluous and, like efficient-market aficionados, that the price carries all the information they need.

While the efficient markets crowd believes that it’s the fundamentals that are reflected in the price, technical traders differ. They believe all the relevant information is in the price but believe they can use a vast array of “patterns” that occur and recur in markets as signals of what to buy, hold and sell.

The language of a technical traders is one of waves, of Fibonacci levels, of overbought and oversold, relative strength indexes, Bollinger bands, moving averages, moving average cross overs, stochastics, moving average convergence-divergence, candlesticks, clouds, point and figure, – the list is almost endless.

It’s a foreign language that fundamental traders often sneer at as soothsaying and witch craft. But it is a language that any active trader should be aware of.

I started out life as a fundamental trader. I was only 18 when I started on the Retail Money Market desk at Westpac back in the 1980’s. I hardly knew anything about fundamentals let alone technical, which without the computer power of today was still often done by old men with hand drawn charts.

Fast forward 10 years and I’m managing many billions of dollars in Cash, Bonds and Foreign Exchange funds at the NSW State Superannuation Board. I’m sitting across from one of those old men with his hand-drawn charts and I have been learning the art of technical trading from him for the best part of 5 years.

Still not convinced – not entirely anyway – the Asian crisis gave me a chance to see whether or not these “technical” actually worked.

Asian currencies like the Indonesian Rupiah, the Phillipine Peso, Malayasian Ringit and the Thai Baht, which had been fixed against the US dollar for years, were suddenly set free after the central banks in each of these nations ran out of cash defending the US dollar peg.

At that time it was my observation that traders seemed to watch price movements towards – and either their rejection or extension at – what are called Fibonacci Levels.

As obscure as it may seem, Fibonacci Levels are based on a number sequence introduced by Leonardo Pisano, Fibonacci, in his classic 13th century book Liber Abaci. This series is essentially a pattern of reproduction of a pair of rabbits at the end of one period and goes in the following order;

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89…

Each number is a product of the two preceding numbers. Once you get past the first few numbers, there is a set ratio of the product of the two previous numbers to any two numbers.

  • 55 is 1.618 times 34
  • 34 is 61.8% of 55
  • 21 is 38.2% of 55

  • The ratios in this number series are related to the “Golden mean”, the ancient Greek ratio responsible for the mathematical number Pi. The numbers are seen in the growth pattern of a nautilus shell, on the head of a sun flower seed and many other places throughout nature. Soothsaying, indeed!

    Back to the Asian currencies. The surprising thing was that when they floated clear of the dollar peg, traders had little to guide them as to how weak the Baht, Ringgit or Peso should get.

    But they did know about Fibonacci ratios. I observed the markets respected these levels by either pulling up in front of them or accelerating once they broke.

    It was, and remains, one of the “light bulb” moments of my trading and investment career. It set me on the path to become the behavioural economics and finance guy I am today.

    It didn’t matter whether technicals were art or science – I didn’t need to prove that to myself. What I had proven, to my satisfaction, and which was subsequently backed up by former New York Fed Staffer and now Brandeis University Professor Carol Osler in subsequent research, was that traders watch technical levels.

    That’s all I needed to know – simply that if eyes were on these levels and traders were going to react to them then these levels need to be part of my trading and investment armoury.

    They should also be part of yours. We’ll identify four key technical indicators all traders should watch in the next article in this Trading Insider series.

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