My trading process is essentially technical, in that I will not trade against a trend. The reason for this is that I do not believe in fighting the market. If you do that then there is always a risk, however good your analysis, that you will suffer losses on losing positions that far outweigh the advantage enjoyed by the contrarian, that of being in a new trend right at the start. Further, I will trade if there is a clear trend even if there are reasons to be cautious, because I believe that the continuation of a trend in the face of contrary data is a sign that the market has either already discounted that data or is yet to focus on it.

This line of thinking naturally leads to the question: what, then, is the point of thinking about the fundamental situation, aside from the fact that it keeps me entertained? Or, if you like, how can fundamental views be combined with a technical process to yield a higher risk-adjusted return?

At present, I use fundamental research (in which I include monitoring of the newsflow — anything that it not pure technical analysis) for two reasons. First, I use it to help me enter new trends early, before there is a clear technical trend. For example, I shorted EUR/USD in December 2009, when I said this:

Market focus is on problems of the Eurozone vs. US recovery story which is likely to persist for a while owing to political origins of Euro woes… market action suggests a break in trend in several markets — this could be a turning point.

Second, I use fundamental research to keep me out of moves that are not trends. For example, I did not buy the recent rally in EUR/USD because I thought inflation concerns were overstated and the ongoing Eurozone crisis was likely to keep interest rates low (although whether this was the right decision remains to be seen).

After a string of losses in January and early February, I have focused anew on the question of fundamental research. I have had three kinds of losses. First, I have been stopped out of new trades because of bad luck: the market has briefly pulled back beyond the stop level before moving on. This will always happen and is not a cause for concern. Second, I have gone into trends at the top, and the trend has subsequently turned around. Again, I am not overly concerned about this. Trend-following is a strategy that tends to lose money at turning points. Third, I have been stopped out by more significant, but still temporary, reversals in the trend. I have been wondering whether this is a place where fundamental thinking has a place and, in particular, whether excessive optimism about a trend is a useful warning sign. It certainly was in some of my recent trades. Since changes of trend can begin as significant reversals, avoiding the third type of loss would also help in avoiding the second. Reading back over my old trade sheets, I find I have used this approach successfully in the past. For example, shortly before the latest spike in wheat, I avoided shorting a downside breakout. I said at the time:

There is no news in wheat, but there is macro news. A breakout for no reason might be interesting, but a breakout because of potential weaker demand (based on European news) is pretty limp.

So what is the point of fundamental research? I can point to three things:

  1. It may get you in early when there is a change of trend. This requires both a reading of the newsflow and an understanding of the fundamental situation.
  2. It may stop you going in when there is a short countertrend move; in other words, it may help to distinguish between a short-term pullback and a change of trend. For this, an understanding of the fundamental situation is of primary importance.
  3. It may stop you going in when the market is overextended. Here, a reading of the newsflow is the most important thing.
Thus, there are two situations, each with its own questions:
  • Possible change of trend.
    • Could there be a turnaround in the fundamental situation?
    • Or is the fundamental situation unchanged?
  • Continuation of trend.
    • Is the newsflow excessively optimistic?
    • Has anything new happened to support further optimism?
I need to make an effort to think within this framework.
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