In making decisions about where and when to take a position, investors, traders and analysts use two different approaches: fundamental analysis and technical analysis. Fundamental analysis is the appreciation of the economics underlying a particular trade. If you want to know where to invest and why, you use the techniques of fundamental analysis. Technical analysis is concerned with the when and the how of placing money. It determines the optimal timing for a position and its conclusions about how long to stay in a particular trade have significant importance for the kind of derivatives structure one may use to take a position.
Technical analysis is an art in which quasi-statistical techniques and formal statistics are used to determine the existence and strength of trends in financial time series and to identify turning points in these trends. If you can do this with a reasonable degree of accuracy, then you can improve your chances of making a profitable trade. Technical analysis is important in the structuring of derivative products because of the leverage involved and because of the inclusion of such features as barriers and compound strikes. Timing is everything.
In practice, there are quite a few indicators that we can look at and that we can automate to produce trading signals when the rules we specify are triggered. For example, we could design an Expert System that produces a trading signal every time our Moving Average Crossover system indicates that the two moving averages intersect.
The more indicators we have the better our picture will be. Some indicators are more suited for trending markets while other indicators are oriented towards consolidating markets.
If we can have a set of indicators that produce a consistent trading signal, then we have reduced the probability of being wrong about the trade.
If we have five automated trending signals, all of which indicate that our stock is in an upward trend that is a pretty interesting result.
It is even more interesting if the technical analysis confirms the picture our fundamental analysis paints. If the fundamental analysis suggests that this company is seriously undervalued, we would feel even more comfortable buying it.
If the technical indicators about the speed of the trend suggest an explosive move, we could use a structure with a highly leveraged payout for an explosive move to the upside. For example, we could use a very low delta call (i.e. a highly out-of-the-money call) on the stock if we thought its price would explode to the upside out of a well-defined range. Not only would we make money on the direction of the spot and the convexity of the spot movement but we would also make money from the rise in implied volatilities.
Or, we could attach a barrier on the downside to our out-of-the-money call if we were confident that spot would not move below a certain level before going higher. This would make the option cheaper and increase the leverage in the structure.
Or, we could attach a binary to the option enabling us to get the out-of-the-money option for free as long as spot did not close below the binary level at maturity.
One can see very quickly how flexible derivative products enable our investing approach to be.
The corollary to this argument is that it is dangerous to put on such derivatives structures without some combination of technical and fundamental analysis. Derivatives have the potential for tremendous gains but they require much more homework because of the leverage of the structures, the possibly reduced liquidity and the larger bid/offer spreads involved in transacting them.
Technical analysis and fundamental analysis are tools that the analyst and the trader can use to reduce the uncertainty involved in taking a position. The skilled trader will use these techniques to wait for the right opportunity and to structure the most profitable derivative strategy to take advantage of it.