Types of Trading System Analysis

A trading system may be based on any of the three following types of analysis:

  1. Sentimental Analysis
  2. Fundamental Analysis
  3. Technical Analysis

1. Sentimental Analysis

  • Goal: Tries to gauge the sentiments (feelings) of the traders in the market.
  • Method: Most sentimental traders rely on long trading experience or "gut feeling" to predict the market's next move.
  • Limitations:
    • Lacks solid trading rules.
    • Restricted only to very experienced traders.
    • Very risky trading method.
    • Traders are prone to lose discipline.

2. Fundamental Analysis

  • Goal: To determine the intrinsic value of financial instruments.
  • Method: Analysts study economic, political, and environmental factors that affect price.
  • Examples:
    • A high interest rate policy might cause the corresponding currency to surge higher.
    • An unstable political system could cause the corresponding currency to decline.
  • Valuation Principles:
    • If the market price is trading higher than the intrinsic value, the instrument is considered overpriced.
    • If the market price is trading lower than the intrinsic value, the instrument is considered underpriced.

3. Technical Analysis

Technical analysis is the study of market action, primarily through price charts, in order to identify the next trend as early as possible.

Core Principles of Technical Analysis

  1. Market action discounts everything.

    This means that all information, including fundamental analysis, is already reflected on the price charts.

  2. Prices move in trends.

    There are obvious trends on the charts, even though markets may move sideways sometimes and do not trend 100% of the time.

  3. History repeats itself.

    Chart patterns that performed well in the past are expected to work equally well today and into the future.

Choosing Your Trading System

Which concept is good for you to use in your trading system? The answer is simple: The one you are most comfortable with.


Detailed Summary

Trading systems are based on one of three types of analysis: Sentimental Analysis, Fundamental Analysis, or Technical Analysis. Sentimental analysis relies on trader feelings and experience but is risky and lacks solid rules. Fundamental analysis aims to determine the intrinsic value of instruments by studying economic, political, and environmental factors, concluding that instruments trading above intrinsic value are overpriced and those trading below are underpriced. Technical analysis studies market action, primarily via price charts, based on three core principles: market action discounts everything, prices move in trends, and history repeats itself. Ultimately, the best trading system is the one the trader is most comfortable using.

Key Takeaways

  • The three main types of trading system analysis are Sentimental Analysis, Fundamental Analysis, and Technical Analysis.
  • Sentimental Analysis relies on "gut feeling" and experience, but is risky, lacks solid rules, and is prone to indiscipline.
  • Fundamental Analysis seeks to determine the intrinsic value of financial instruments.
  • Fundamental analysts study economic, political, and environmental factors (e.g., high interest rates causing a currency surge).
  • In fundamental analysis, instruments are overpriced if the market price exceeds intrinsic value, and underpriced if the market price is lower than intrinsic value.
  • Technical Analysis studies market action using price charts to identify trends.
  • The core principles of technical analysis include: 1) Market action discounts everything (all information is reflected in the price); 2) Prices move in trends; and 3) History repeats itself (past chart patterns remain effective).
  • Traders should choose the analysis concept they are most comfortable with for their trading system.