Ways to hone the tools of your trade
Simple technical or fundamental analysis alone may not lead to winning trades, but too much complexity is no guarantee of success either. Combining various types of analysis while not letting them get overly complicated can be the key to beating the markets.
The first problem with simple fundamental analysis is that everyone is doing it. A ton of equity shops use various forms of this research on which to base their buying and selling, and I can't name a single one that consistently beats the market.
Another issue with fundamentals is that they may work in the long term but do not take into account short-term volatility. So it may be fine for the Warren Buffetts of the world, but not for us mere mortals.
Technical analysis tends to draw sharp reactions, both positive and negative. There are those who say that it has no basis in reality and is far too subjective to be useful. Nevertheless, it appears that almost everyone that has anything to say about the markets, including large hedge-fund managers, incorporate technicals in their evaluations.
I know of a number of traders and funds that use fundamental analysis to decide what to buy and technical analysis to decide when to buy. But simple technical analysis usually doesn't work; if it did, you would see a lot more successful funds that used it.
Most "trend followers" use technical analysis and may be successful in the long term but have long stretches of underperformance. Advocates usually just add another level of technical analysis to their trading, but that is rarely successful either.
Even volatility analysis, an important tool that had long been underappreciated, is becoming more widely incorporated and therefore less reliable.
In the last couple of years I have shifted my analysis to incorporate volatility data, technical analysis, and some key fundamentals. This may sound dauntingly complex, but I use simple metrics from each of these categories. Those are then translated to a graphical grid that guides my buying and selling decisions.
It is a systematic approach, and my guidelines are clear and written down. I don't break those rules because, when I do, it is usually just for egotistical reasons that tend to lose money.
As I have stressed many times, it is crucial to maintain written rules at all times when trading. They should include specific entry and exit points while outlining how to take gains and losses.
The importance of rules--and sticking to them--is often overlooked. There is no Holy Grail in the market, and no combination of analysis techniques will always be right. But a combination of various disciplines will likely maximize your chances for success.
(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of Dec. 27.)
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