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FOREX STRATEGY

Fusing Fundamental and Technical Approaches

trading strategy fusing fundamental and technical approaches

It was November of 2004. I was sitting in a room surrounded by trading terminals glancing busily at the quotes streaming across the large ticker display hanging on the front wall – WTI crude oil: $51.00/bl…XAU/USD: $450/oz…S&P500: 1170. The screens directly in front of me were littered with charts, news, and positioning data for a myriad of commodities and currencies. It would be fair to assume that I was sitting on the floor of a major trading institution. However, that was not the case. Instead, this was the moment that started my affinity for trading.

I remember it as if it were yesterday, as most people do with moments that define their future career paths. It was lunch break during my senior year in college. Most of my friends had left campus to partake in our customary lunch get-togethers. I, however, had decided to stroll over to the mock trading floor - at the time there were only a few such facilities available on campuses nationwide. From that day on, I was frequently absent from lunch outings and much of my free time was spent within the confines of the trading room. The purpose for this personal anecdote is two-fold. First, it serves as my introduction to you, since I’m of the mindset that thinks personal experiences allow for a more intimate understanding of an individual rather than his/her career statistics. Second, it’s a reflection of an essential ingredient, in my humble opinion, to the development of a successful trading strategy – passion for studying, following and trading financial markets.

Approximately seven years have passed and here I sit at FOREX.com surrounded by trading terminals glancing busily back and forth between ticker displays and the multiple screens in front of me. Many things have changed since 2004, gold prices are in the quadruple digits; oil prices are in triple digit territory; and the S&P 500 was rocked to triple digits before recovering to current levels back up to quadruple digit territory. So too has my 20/20 vision which has deteriorated substantially from seven years of staring at multiple screens on a daily basis. My philosophy on trading, however, has experienced the most extensive changes along with the physical locale of my multiple screen set-up. Both have evolved from the many years of positive and negative experiences throughout my trading career. While I can’t promise that adopting what I believe to be the fundamental tenets in developing a successful trading strategy will be life-altering for all, I can speak for myself and confidently state that they were for me. 

Trading is a numbers game. During my fledgling years as a trader, I was focused on being right as much as possible. So much so that it skewed my outlook on markets and subsequently my bottom line. Eventually, I came to the realization that simple mathematics held the foundation to developing an efficient trading plan. The problem with an ‘accuracy-centric’ trading mentality, beyond the fact that it makes one directionally biased even when developing price action evidences otherwise, is that it only focuses on a part of the ‘equation’: Net P/L = (% Correct x Average Gain) + (% Incorrect x Average Loss).

The part of the equation that I had overlooked was simply placing trades that had a positive reward skew relative to risk. Consider the following scenario, for simplicity sake let’s assume Trader A places 100 trades within a given year on a $100,000 account. Trader A’s probability of being right (% correct) is 40% with an average risk/reward ratio of 2:1 and a maximum risk of -2% on any given trade. Inputting these variables into the ‘equation,’ [(40 x $4000) + (60 x -$2000]) = +$40000, yields an ROI of +40% on the year. This is a healthy return measured against any standards; although a +40% accuracy rate may not always be attainable. At an accuracy rate of 35%, the return on investment falls substantially to an annual yield of just +10%. While risk management depends on the economics of the individual trader, it’s hard to deny the significance of improving upon both key variables within the ‘equation.’

Making strides to the ‘accuracy rate’ variable is heavily dependent on the type of analysis being implemented. This is where the controversial debate between fundamental analysis and technical analysis comes to play. Fundamental types tend to downplay the predictive capacity of technical analysis while technicians view the study of historic rates as the more effective method to analyzing price fluctuations. My preference, however, is to fuse both methodologies. Initially, I turn to fundamental analysis – correlation studies and macro-economic drivers, to name a few – for determining direction. After developing a firm directional view, I implement a technical approach to effectively manage risk/reward ratios through the careful selection of entry and exit levels.

Following is an excerpt from a research note I authored for FOREX.com on January 11, 2011.  The purpose for its inclusion is to serve as an example of a practical application for the combined fundamental/technical analysis based approach:

 

Diverging interest rate expectations & technical developments constructive for sterling

“Recent developments in the UK (VAT tax hikes leading to near term upside price pressures) alongside negative data surprises in the US (mainly NFP) have seen diverging expectations for the future direction of interest rates between the two respective central banks. Futures markets are gradually pricing out Fed rate hikes for the latter part of 2011 since the disappointing NFP print while expectations for overnight UK rates have been marked forward to Q3 (expected rate hike was for 2012 just a few months back). A continuation of this emergent trend in diverging BOE/Fed interest rate expectations is likely to be cable supportive versus the buck.

On the technical front, GBP/USD has currently traded into a declining wedge formation within a broader triangle on daily charts (see charts below):

• Wedge resistance comes in at 1.5625, a key level on shorter term charts as well (see 60 min. chart).

• RSI has prematurely broken above its respective trend line for the same timeframe suggesting a correspondent move higher in price.

A break above declining wedge resistance (1.5625) would have a measured move objective towards triangle resistance & the neckline for a potential inverted H&S pattern above the 1.6000 figure.”

 

trading strategy fusing fundamental and technical approaches GBP USD

Since posting the note above, direction in FX has persistently been dominated by respective central bank policy outlooks. GBP/USD has subsequently traded above the technically implied measured move objectives to current levels, 1.6280 at the moment of writing, as expectations of policy directions between the Fed and BoE have continued down the path of divergence.

Admittedly, a trading strategy premised on the fusion of both fundamental and technical analysis does not always render such accurate results as evidenced by the preceding research note. However, there is not one strategy that is unconditionally flawless. We now exist in an era flooded with information. Advances in technology have resulted in market participants gaining access to data and techniques that were once reserved for a trading minority. With that in mind, it has become especially critical for market participants to adapt along with the trading environment on both a fundamental and technical level.  Such adaptations may take the form of constant observations of shifting fundamental relationships or consistent application of emergent western and eastern technical approaches. Nevertheless, taking part in such diligent upkeep would only result in equipping traders with a full arsenal of analysis techniques to better navigate the precarious waters of the current trading environment. 

Daniel Hwang