The Science of Analysis and the Art of Trading

• Posted by DynamicHedge
• on October 17th, 2012

Have you ever noticed that there are some analysts that always have an “angle” on what any particular news release means and how it will impact a company and fifty other derivative plays?  They know every shred of news and every analyst opinion.  At the drop of a hat they’ll spew forth statistics regarding a Thai autoworker strike that will somehow flap butterfly wings and impact semiconductor prices.

CNBC Anchor: It looks like Electronic Arts has another record breaking release with Grand Theft Auto 22.  Talk to us about a trade you like here.

Fundamental Narrator: Men are going to be spending a lot more time gaming which should lead to some good demand for snackfood.  I wouldn’t go out and buy $PEP, instead I like $MON and $POT for the corn exposure vis-a-vis Doritos.  I would hedge that with a long in $NRTI.  ALL PRICED IN YEN.  This is a classic trade we’ve been calling the “Samurai BMI” trade due to exposure of both Japanese central banker’s failure to curb Yen appreciation and a ballooning domestic body mass index.

Who cares?  Does playing a high stakes game of “Six Degrees of Kevin Bacon: Stock Market Edition” really generate alpha?  Are any of these derivative plays serious suggestions?  Don’t get me wrong, there are plenty of smart players out there making money of macro analysis but there’s usually inverse correlation between how much you enjoy rattling off connect-the-dots trading ideas and the results of your trading.  When it comes to pulling the trigger and managing the brilliant Samurai BMI trade — they’re TERRIBLE.

There’s a second group of guys that literally have no clue about fundamentals or news.  They could care less about what people are saying about the stocks — just so long as they keep saying them.  Discussion and confusion in a sector or stock is just an excuse for the chart to dance along the axis.  Stocks exist for the sole purpose of being three or four letters that add money to their brokerage account.  Sometimes these guys don’t even really know anything about technical analysis.

Stunned Co-worker: Why did you buy $HAL this morning after that news announcement?  It was crashing!

Technical intuition trader: I dunno, it looked like it had gone down… enough.  Wait, what news?

The same way that the fundamental narrator can explain every data point but can’t trade his way out of a paper bag, the 3-letter jockey can’t even really explain to you why he did something — but somehow seems to put up good numbers everyday.  He doesn’t let news scare him into or out of trades.  He is a technical trader, but he doesn’t mean he lets pesky thing called technical analysis get in the way of a good trade!  Otherwise he might end up with stretched bollinger bands indicating a fade conflicting with a declining 13.5 period exponentially weighted moving average (lagged 4 periods).  Why dig too deep into technicals when his type of knowledge could freeze him up at the critical moment.  His lack of care towards macro event and their impact on the markets means that once in a while he has a BIG giveback.

Yes, these are two extreme examples, but they’re not made up.  They’re drawn from real people that I know.

Fact is, everyone wants the same thing out of the energy they put into analysis and trading: to make money.  Unfortunately, life isn’t fair, and there isn’t a linear correlation with how much effort you put into analysis and how much profit you extract from the market.  Most people don’t exist on the far edge of the bell curve in intuition or intellect.  We need a bit of both.  You need some knowledge about intermarket relationships and fundamental drivers but you also need some intuition with regard to supply and demand and market behavior.  The question is, how do you find the sweet spot between the science of analysis and the art of trading?

There are countless ways to brush up on your macro knowledge and tighten up your game.  You may never elevate yourself to an elite level, but you can improve, nonetheless.  Understanding price action and supply and demand is not something that can be taught very easily.  Street knowledge and intuition is usually forged in the fire of losses.  While it takes years of practice and screen time to hone the skill, shortcuts do exist.  The pattern recognition software that my trading partner and I have put together offers one such shortcut.

As an example, imagine you’re trading the broad market against an economic event.  Let’s say Option Expiration day (for the sake of randomness).  Imagine that you could input Option Expiration day into a filter and you could see every intraday chart of the last year of the Friday when equity options expire.  Now apply further technical filters like an overall uptrending market that gapped up that day, etc.  Now you’ve isolated an event and the conditions surrounding it.  You could sift through the data and print the charts out one by one.  That might be helpful if you’re trying to internalize price action.  But imagine if you could have an algorithm that crunched through the data for you and identified the dominant patterns and presented them to you in order of importance?  Now you’ve got intuition about how the market trades on Option Expiration days when the market gaps up.  All the collective information about how supply and demand has met and reacted in every similar situation is presented in an easy to digest format.  Trust me, the intuition is powerful.  Here is that chart (remember it for Friday):

Now take it a step further and instead of analyzing the broad market you input a home builder like $LEN against an economic number like New Home Sales.  I’ll raise you another.  Take something company specific, like earnings.  Look up every time $AAPL releases earnings and match that with the current technical conditions of the stock.  You think there’s any power in that?  Do you think history ever repeats itself?

This is what great Technical traders do inside their head.  They visualize price because they’ve internalized it.  Our aim is to digitize price action and create a shortcut to intuition.  Combine the ability to visualize price action with whatever other edge you already posses and imagine the possibilities.

This analysis is not always about being right.  Even when the actual occurrence is VASTLY different than what the analysis suggests (it happens, you can’t control the market) there is still huge value in KNOWING WHEN YOU ARE WRONG.  It allows you to get out of a trade knowing that you are exiting based on quantitative data and not just emotion.  I’m just scratching the surface here.  Stay tuned.

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