I hope you are well.

This week I thought I’d touch on an aspect of trading that doesn’t get as much attention as charting and all the usual technical analysis.

Commercial trading systems seem to focus on technical rule based systems, such as buy when X moving average crosses Y moving average. Nothing wrong with this at all; it’s relatively simple to get to grips with, its tangible, its visible and it can be largely automated through trading programs.

What’s not to like?

The trouble with pure technical trading is that it makes no appreciation of news flow and economic fundamentals.

The pros and cons of technical trading

The debate rages in trading about the pros and cons of technical analysis vs fundamental analysis. As a quick recap, technical analysis involves looking at charts and using indicators, while fundamental analysis involves looking at economic and sometimes company fundamentals. Fundamentals might be interest rate announcements, unemployment numbers, or the results of an individual company like a bank.

There are some die hards in both camps. Some technical analysts refuse to even look at the news, while some fundamental analysts think that technical analysis is a load of hocus pocus nonsense.

The truth, as usual is somewhere in between.

At this point it’s probably worth me sticking my two pennies worth in. For short term day trading I don’t really pay much attention to the news flow other than being aware of major announcements that could spike me out of a trade.

There’s no point trying to out ‘news trade’ the big boys with their super fast bloomberg terminals. By the time the news is out, the big boys have already moved the market.

For me, fundamental analysis is more useful for intermediate to long term moves. For trades lasting a day or more, I like to combine technical analysis and fundamental analysis. It depends on the market I trade, but I have a set of technical rules that give me my potential set ups. I then either take the trade or not depending on how fundamentals are stacking up.

In his excellent book called Market Wizards, Jack Schwager interviews genuinely successful traders. The one thing he found was that most of them didn’t have a set system that they followed rigidly, but a strategy that they adapted based on market conditions.

Incidentally, you can download a free video of Jack Schwager speaking here: http://www.newmarketwizards.net/.

How to read the news

What I’ve learned over the last few years is that the news itself isn’t important, what is important is the markets reaction to the news.

US markets have just rallied by nearly 25% from the lows in February, but the bad news continued to keep coming. At another point in time, the same news flow could have sunk markets lower, so what happened?

My take (for what it’s worth) is that technically markets were oversold, encouraging the bargain hunters to step in. Markets started to rally and they kept going even when bad news came in like higher unemployment. Markets developed a teflon coating and no amount of bad news was able to sink the rally. Arguably, things are a bit more balanced at the moment.

You can talk about it being illogical or a false rally, but you couldn’t deny that markets were in rally mode and while that was happening, it would have been dangerous to fight it. When markets continue to go up on bad news it is usually a very good sign until they reach stretching point.

As well as reading the news, I also use some excellent sites that track market sentiment itself. More details on these below.

Here’s some thoughts on trading the news and reading market sentiment:

* Don’t try to predict news items like unemployment figures or interest rates. Bank analysts paid lots of money are much better at it than you or I ever could be.

* Instead of predicting individual news events, step back and consider the bigger picture. Watch how the market reacts to news event and think about how this fits into the general sentiment flow. What is the reaction telling you about market sentiment?

* Financial markets are forward looking machines – the bad news is usually discounted before it happens. If a company announces the worst results for 5 years, but profits come out as slightly less worse than expected, the stock might rally. The reason is that in the weeks leading up the announcement, traders will have moved to price in the terrible results, so if they are not as bad as thought, the share price will rise, even though the results are still dire.

* The FTSE and other European markets will generally follow the US, so do most of your reading on the US economy. Imagine a party, the US markets are like the popular guy that everyone wants to listen to, there’s a crowd around him as he tells a story. European markets will be the guys listening to the popular guy and laughing along with his jokes. Every now and then European markets will get some attention and lead things, but the vast majority of the time, it is the US that is in control of things.

* The FTSE will trade slightly stronger or weaker than other markets due to UK economic news, but ultimately, unless the news from the UK is absolutely shocking, if US markets rally, so will the FTSE and vice versa.

* The most important market is the S&P 500 in my opinion.

* There’s no magic formula when it comes to getting in sync with market sentiment. It takes a while to figure out what people are talking about and what the main issues are.

* I worked with a successful trader a while back and we analysed the difference in performance with the trades he labeled as being ‘in sync’ with markets and those that were based on individual technical analysis. The difference was significant, the in sync trades were highly profitable, while the other trades were little better than break even.

* I personally find it very hard to read the fundamentals on the forex market and find it much easier to get in tune with stock markets. There is a whole host of undercurrents affecting the forex markets such as the US dollar being a reserve currency which means that forex markets are harder to read from this perspective. Other people will have a completely different experience, but this is what I have found personally. For this reason, I tend to pay less attention to the news flow when trading forex. You might find you are able to read this market really well.

What are the major issues to be aware of right now?

This is just my two pennies worth, but I believe the major events affecting fundamentals now and in the future will be:

* US company earnings – We’re coming up to earnings season and analysts have priced in some pretty dire results from US companies, but have they priced in enough bad news? Will company results be even worse than expected?

* The banks – Sentiment is still hanging on the banks. The recovery has largely been down to renewed confidence that things have settled down on this front, but has the risk of further problems been fully appreciated? My hunch says no.

* Government/Central bank action – Interest rates cant go much lower, but stimulus plans and bailouts could still shake things up over the next few months.

* US house prices – I say US house prices and not UK house prices because it is the US market that is at the epicenter of the credit crunch. All those fancy sub prime derivatives are tied to US house prices, so banks across the world are held hostage to some extent to the performance of the US housing market. Does the US housing collapse have further to go?

What to read & who to listen to

I do read the papers online, but be aware that at the end of the day, these guys are journalists who have to create a story. Journalists don’t always have the required expertise to go beneath the headlines and get to the truth of the matter.

Most online sites or blogs have a free newsletter sign up or feed alert through something called feedburner.com which means you don’t have to visit the site to get the latest stories.

Here’s my list of sites which offer hard hitting opinion and independent analysis:

* http://www.ritholtz.com/blog/ – Excellent Blog from Barry Ritholtz. Hard hitting analysis and great summaries from other research he’s picked up.

* http://bespokeinvest.typepad.com/ – Useful blog from Bespoke with some interesting technical studies.

* http://ftalphaville.ft.com/ – The FT’s own blog. Lots of interesting stories and sometimes breaking news that they cannot put in the full FT.

* http://www.calculatedriskblog.com – Excellent dissection of major US economic announcements

* http://dshort.com/ – Cool charts and long term market timing ideas

* http://www.thekirkreport.com/ – Neat summaries of the day’s action.

* http://www.sentimentrader.com – Brilliant Sentiment analysis. I read this every day and Jason’s work is my main sentiment barometer.

* http://www.quantifiableedges.com – Similar to Sentimentrader. Unique studies and trade ideas.

Who to listen to

These guys may not have a site, but their thoughts are well worth reading. You can set up a www.news.google.com alert for anything from them or search you tube for the latest videos.

* Nouriel Roubini – Called Dr Doom after he predicted the credit crunch.

* Meredith Whitney – Brilliant analyst who was one of the first to reveal how screwed the banks were.

* Nassim Taleb – Up his own derrière, but largely predicted the conditions that led to the credit crunch. This is a fascinating video if you are interested in psychology and the stock market like me (http://www.edge.org/3rd_culture/kahneman_taleb_DLD09/kahneman_taleb_DLD09_index.html)

Ultimately, you don’t have to read the news. Do what ever suits you best. For short term day trading, it doesn’t really matter too much, but it is certainly worth keeping an eye on major announcements in case they spike you out of a trade.

For longer term trades I find that reading fundamentals and sentiment helps me reduce the number of trades I make and increase my strike rate. Reading the news and sentiment won’t automatically turn around a terrible trading system, but it can help improve already reasonable systems. I might still take the same trades, but use a tighter stop if sentiment is looking a bit dodgy.

It is very difficult to predict markets from sentiment and news analysis alone, but what I have found personally is that using this analysis can finesse a technical trading strategy and increase your profits in the long run.

I don’t pretend to be an expert, you don’t need to be. My approach is to assimilate the views of my trusted sources and experts listed above and form a general picture.

Like I said, this is what works for me, other people may get along fine without doing this. I hope it helps you if you are interested though.

Mac user?

I’ve had an email from a reader who uses a Mac to run their trading software and is getting a little frustrated with the lack of trading programs with support for alternative operating systems such as the Mac or linux.

If you are in this camp, how have you got round the problem? Let me know. It would be great to be able to help out this member some way.

System watch

A few systems making the headlines at the moment include: the ridiculously named Forex MegaDroid (http://forex-megadroid.com) has gone into affiliate over drive with promotions from all the usual places. I’d advise you to stay clear. Firstly none of the previous robots the same guys have promoted have come anywhere near to being as successful as initially claimed.

The usual pattern goes something like this…

Teaser promotion hinting at the automated trading robot that it launching soon with amazing results.

Robot is launched to great fanfare, but 90% of the time, there is not a jot of evidence of there being any live trading. Why is this important? Because there is a world of difference between a theoretical back test and live results. For starters, you don’t know if you past results are curve fitted. More importantly, back tests cant take into account things like spread costs which in reality make or break a system.

There’s no evidence of trading in a live account with forex mega droid and the trades that I have seen look worrying. Two trades wiped out $15,000 worth of profit from $41,000 down to $26,000. That’s a whopping 37% of your account blown in two trades. That’s far too much risk, two more trades like that and that’s over three quarters of your account gone!

I was wary of FAP turbo, but had more confidence in it than usual because they were actually publishing live results. Recently, they have had some terrible trades but are still in the black since December, just. I’d leave it for now.

If you’ve got feeback on anything you’re using at the moment, please do get in touch at [email protected]

My trades

I took a small short on the S&P 500 yesterday. I think we’re more likely to see some chop over the next few weeks than a massive sell off, but the risk is still there in my opinion. I’m playing it small and may add to my position.

Not a bad week with my forex trades, but as I write this I’m a bit frustrated watching the euro tank against the dollar having missed out going short by a couple of pips. That’s trading sometimes!

This week’s hot trading buttons

We’ve got the rate statement from the MPC on Thursday. Analysts are currently expecting no changed from any of these meetings. In addition the minutes from the last FOMC meeting are released on Wednesday. Thursday also brings UK PPI and US trade balance figures. Friday is a bank holiday for most countries.

Trading wisdom

“Bear market rallies frustrate the shorts and make the longs feel good. However, when they end, the longs throw in the towel and the shorts return.” – Dave Landry