A trading strategy is a pre-determined method of planning and executing trades that help traders make a profit. There are two crucial requirements for becoming consistently profitable: a set of sound trading strategies and an excellent money management system.
The importance of a trading strategy:
- An effective trading strategy reduces market noise. It allows traders to concentrate on their entry and exit levels.
- A strategy provides traders with predetermined entry, exit, and trade size levels. Before entering a trade, professional traders understand what they are risking and what they could gain.
- Techniques for controlling your emotions. They enable you to be more structured in terms of leverage, risk management, and realistic entry and exit points.
We can divide trading strategies roughly into two: fundamental and technical.
What is the fundamental trading strategy?
Fundamental analysis is a broad term that refers to trading solely based on global factors that influence the supply and demand for financial assets. In the stock market, fundamental traders focus on company-specific or economic events to determine which financial instrument to purchase. This strategy is more closely associated with a buy-and-hold strategy than with short-term trading.
A fundamental approach for the S&P 500 includes looking at general economic data. This includes employment figures, interest rates and GDP among others.
Some key factors are:
- Central banks are probably one of the most volatile fundamental trading sources. They have a wide range of options; they can raise interest rates, lower them (even into negative territory), keep them constant, indicate that their stance will change soon, or even devalue the currency. Fundamental analysis of central banks is a process of poring over central bankers’ statements and speeches. Investors sometimes also attempt to think like them to predict their next move. Shifts in central bank tone may cause selling pressure and make investors shift from equities to bonds.
Economic indicators: Trading economic releases can be a perilous and unpredictable endeavour. Even the brightest minds have difficulties predicting what an economic release will be. Retail and professional investors are likely to follow the consensus, which is where the market usually moves. However if the consensus is wrong, then the market moves in the direction of the actual result.
That is, if it was better than the consensus, usually a positive reaction occurs, and vice versa if the results were worse compared to the consensus. Some of these indicators are: non-farm payrolls (estimate the net number of jobs gained in the US in the previous month), Consumer Price Index (measure of inflation) or consumer and business sentiment report.
Geopolitical tensions: Geopolitical risks can cause increased risk aversion among investors. Tensions tend to negatively impact stock market returns in all advanced economies, causing a shortage of assets. They can also have a negative impact on tradeable goods by altering supply or even demand for specific products.
Seasonality: Seasonality refers to specific time periods during which stocks/sectors/indices are subject to recurring tendencies that produce patterns in investment valuations. For example, at the end of the fiscal year, investors will sell stocks which depreciated in price to deduct capital losses from their taxes. On the other hand, investors typically return to equities in January, which is called the “The January Effect”. This also implies that many investors believe that January sets the tone for the rest of the year, i.e. that the year is likely to perform like January. Moreover, at the end of the month, businesses selling products in many countries look to offset their currency hedges. This practice is known as “Month-End Rebalancing.”
- Understanding of the economy: Fundamental analysis seeks to understand trends in the economy, business sectors, and companies. This analysis aims to determine whether stocks are priced fairly in current economic conditions.
- Possibility of accurate forecasting: stock prices are determined by the performance of the company and its prospects for profit. As a result, investors making accurate forecasts and predictions about future profits and the economy have the possibility to generate high returns in the market.
- Disregarding behaviours in the market: If used on its own, fundamental analysis doesn’t take into consideration emotional phenomena such as herd mentality. For example, share prices are usually driven by company earnings. However in the short term, momentum can be quite influential. If some stocks are considered market darlings, and to a certain degree, it doesn’t matter what their quarterly results are. Fundamental analysis doesn’t include this irrational behaviour.
- Historical data: Financial analysis forecasts future earnings based on expected growth rates using historical financial data. After three months or more, the historical data is published. It is well-known among investors that past performance doesn’t guarantee future performance.
- Lagging indicators: Fundamental indicators are lagging indicators. The market could often than not be ahead of a fundamental investor at least for the short and mid run.
What is the technical analysis trading strategy?
Unlike fundamental analysis, technical analysis focuses on price and volume. The main goal of technical analysis is to find specific price trends in the market. They examine how supply and demand for a security affect price, volume, and implied volatility changes. This approach attempts to forecast the price movement of any asset that is subject to supply and demand forces such as stocks, bonds, futures contracts, and currency pairs. Some regard technical analysis as the study of supply and demand forces as reflected in a security’s market price movements. Technical analysis is most used to track price changes, but some analysts track other numbers as well. An example of this can be trading volume or open interest figures.
In general, technical analysts look at the following broad types of indicators:
Price trends: The direction and momentum of a security or other asset’s price. For example, a security is said to be on a downward price trend if its price is trending primarily downward with only a few inconsistent gains.
Chart patterns: Distinctive formations on a chart by the movement of security prices. A pattern is defined by a line connecting common price points, such as closing prices, highs or lows, throughout a given time period.
Volume and momentum indicators: Volume indicators show how volume changes over time, and how many units are bought and sold. Examples are the Relative Strength Index (RSI), Stochastic, Average Directional Index (ADX): A momentum indicator (oscillator) is a technical indicator that displays the direction of the trend. Moreover, it evaluates the rate of price variation by comparing current and previous values.
Oscillators: An oscillator is a technical analysis tool that creates high and low bands. It is between two extreme values before constructing a trend indicator that swings within these boundaries. The trend indicator aims to identify short-term overbought or oversold circumstances.
Moving averages: Moving averages are used by investors to assess the direction of a trend. It averages the data points of a financial asset over a particular time period. This is realised by adding all data points and dividing the total by the number of data points. It is referred to as a “moving” average since it is constantly updated using the most recent price data.
Support and resistance levels: ‘Support’ and ‘resistance’ are names that limit the market’s range of movement. The support level is where the price frequently stops dropping and rebounds back up. Whereas the resistance level is where the price frequently stops rising and falls back down.
. Includes irrational behaviour analysis: when examining charts, traders value herd mentality (market) more than the valuation of a publicly listed company.
- No financial knowledge needed: No knowledge of economics, finance or accounting is needed to understand a chart. Indeed, this form of research overlooks basic data. It also concentrates on share price changes as well as trade volume. Understanding technical analysis has little to do with one’s ability to evaluate the financial health of a firm.
- Ability to detect market timing signals: Technical analysis is more successful than fundamental analysis when predicting the right time to sell or purchase a company. Public firms are undervalued or overvalued by employing several financial parameters. Reading accounting data, on the other hand, does not help with predicting where the share price will go in the short run.
- Several tools: there is a variety of computer tools and applications that support traders with technical analysis. Unlike fundamental analysis, where it is difficult to investigate certain factors such as the company’s potential for future growth and the industry and branch situation, technical analysis allows one to obtain certain investment signals by simply entering the necessary parameters into the corresponding computer program.
- Inaccuracy: there frequently is a gap between the buying and selling signal. Moreover there is a gap between the greatest or lowest price, or even a reversal trend. Traders risk making bad decisions because of unpredictability and hesitancy.
- Technical analysis can only forecast the overall price trend for a specific time. It is difficult to know where the greatest and lowest price is in that period, and how long each increase or decline lasts.
Trading with One Signal’s strategy – contrarian investing based on sentiment indicators
ONE-SIGNAL was developed following extensive analysis of historical speculative bubbles in the financial markets. The development of these bubbles is attributed to three psychological factors: greed, envy and speculation. Conversely, fear, lack of confidence and disappointment cause bubbles to burst.
ONE-SIGNAL believes that sentiment indicators are the best metric to analyse stock market behaviour. They also predict price movements in every phase of the market and future price movements. This is based on years of proprietary research and successfully testing findings in the markets. ONE-SIGNAL identifies emotions (e.g., exaggerated fear or excessive optimism) in all market phases and thus the system recognizes sentiment trends (as indicated by sentiment indicators), i.e. investor mood and follows these until the reversal phase. Anyone who can interpret the market atmosphere also knows in which way the market is going. If fear begins to dominate the market, participants will sell their assets. If greed and optimism reign among investors, prices will rise. ONE-SIGNAL decrypts the emotional situation of the market on a daily basis and goes along with it, until an exaggeration phase is identified.
Being contrarian is more of a way of life than a strategy. It is more about independent thought than deviating from the majority. When herd behavior develops in the market, a contrarian asks questions about the rationality of the trend. Contrarians are not necessarily outsiders, but they are brave enough to do it alone. However, they are also intelligent, attentive, and flexible enough to know when the path taken is the wrong one. Sentiment indicators reconcile the behavior of market participants with their actions. Technical indicators only work once a balanced price prevails that considers demand and supply. They are inherently backward-looking and describe the behaviour of the masses in the past. The only meaningful use of technical indicators is the analysis and interpretation of past trends. Fundamental analysis is a very different approach that analyses companies using dozens of KPIs. Often the assumptions are not those prevailing in the market. Most notably, the share price of a given company can rise even if it is overvalued. Conversely, an undervalued stock will fall if the market prefers a different industry. It will also fall if the market uses a divergent investment style. Fundamental investors must be very patient since the market tends to exaggerate and be irrational.
What are sentiment indicators? Sentiment indicators quantify the future development of the market. This is based on the market participant’s behaviour. In doing so, sentiment indicators provide a reliable picture of the psychology of the market. Some sentiment indicators ONE-SIGNAL uses are:
- Sentiment surveys (AAII/NAAIM), which are usually held weekly. Members of given organizations are asked about their current investments and expectations.
- Volatility Index: This is a measure of fear. It is usually calculated using the implicit volatility on a respective index. Each major stock index has its own volatility index. The most famous one is the CBOE Volatility Index (VIX).
- Put/Call Ratio shows the relationship between purchased puts and purchased calls. It gives insights into the optimism or pessimism in the market.
Since its inception, ONE SIGNAL has outperformed the benchmark index almost every year. Between 2005 and 2020, the S&P 500 returned on average 7% p.a., compared to ONE-SIGNAL Xpress with 26.5% p.a. and 40.5% for ONE-SIGNAL Xpert. Some more recent examples: In Q3 2021, ONE-SIGNAL Xpress returned 7.17%, ONE-SIGNAL Xpert 5.35%, compared to 0.16% for the S&P 500, the benchmark index. When looking at Q3 YTD, ONE-SIGNAL also outperformed its benchmark index, which delivered 14.42%, compared to 22.5% for ONE-SIGNAL Xpress and 18.8% for ONE-SIGNAL Xpert.
We have seen that fundamental and technical analysis differ in many ways. Beginning with the assumptions upon which they are based, moving on to the methodologies utilized and the role they serve. These distinctions demonstrate that fundamental and technical analysis are fundamentally different approaches to making investing decisions. However, these do not always imply that they lead to different investment judgments. In truth, both approaches have benefits and downsides that may be combined to provide the best findings. ONE-SIGNAL’s distinct approach has proven to be successful over the past decades, constantly outperforming it’s benchmark.