What are the different approaches to trading?

Traders make profits and losses by forming a theory about whether price will move higher or lower and then testing the theory by placing a trade.  There are as many ways to formulate a theory about trading as there are traders, but it can be broken down into several different broad approaches.

A Technical Approach

Technical traders use mathematical models to make sense of the market’s price movements.  The models fall into several groups:

1.Price Action.  

Using price action is perhaps the most basic of technical analysis.  It involves being able to look at the movement of price and forming a theory based on the patterns of individual price bars/candles or the pattern formed be a series of candles.

There are many described patterns although care needs to be taken in using a pattern recommended by someone else and simply applying it.  It is important that you fully understand the exact pattern being examined and the statistical outcomes of what might happen when a pattern forms.

2.Indicators. 

Indicators are known to all technical traders and use defined equations to create a secondary chart that attempts to create a simpler, less ‘messy’ and more predictive view of the market.  Using this approach, traders can make predictions about the direction of the market or when it might be turning.

3.Support and Resistance. 

Traders can identify historical prices where price has seemingly stopped and reversed to form resistance (if price was moving higher but then turned down) or support (if price was moving lower but then turned up).  Areas of support and resistance are identifiable, and an identified support or resistance level may be important when price moves to that area on multiple occasions in the future.

Technical traders tend to fall into two camps:

1.Systematic Traders.

Systematic traders create well defined systems or trading rules that allow for a history of trading results based on past data.It is then assumed that the results will be repeatable in the future.The repeatability of the markets is the area where most systems strike difficulty.A system tested in a trending market will often have difficulty in restricted or range bound markets and vice versa.

2.Discretionary traders.

Discretionary traders monitor price charts to identify patterns that they predict will be profitable.This approach creates some difficulty identifying to a theoretical history to support future results, but the other hand, they are also more flexible and will be able to adapt their approach to changing market conditions.

Algorithmic Trading

Algorithmic traders evolve from systematic methodologies.  Since most technical trading techniques can be reduced to a mathematical model, they can also be used in computer programs which can monitor current price and use programmed equations to make trading decisions.

The use of computers in trading has become increasingly widespread, a product of the increasing power of computing.  It is used by institutions and small retail traders though the sophistication of the analysis, software development and computers used may be vastly different.

Fundamental Analysis

Fundamental analysis does not require a price chart.  Instead, the analyst will examine the underlying factors that affect price and then form a theory about whether the instrument will become more or less valuable over time. 

Once a theory has been formulated, it may be possible to compare a ‘theoretical value’ to a real, current value and make some assessment about whether the current price represents a good opportunity to enter the market or not.

Having formed a theory about where price is likely to head, the fundamentals trader will aim to take a position in agreement with the theory and hold it until the fundamental situation has become unfavourable.

Social Trading

This is the newest approach, and its results are unproven.   The underlying idea is that price will generally follow the direction of the majority of traders. For example, if there are 1,000 traders in a given market at the same time, and 700 of them have short orders (to sell) and only 300 have long orders (to buy) then it is more likely that price will fall since there are more sellers than buyers. 

The social trader then is aiming to follow the group and trade with the crowd.  This approach tends to move against the conventional wisdom that trading with the group means that even though you might get the direction right, it will last for only a short time as the move runs out of momentum.  The technological development allowing many users to share information automatically and virtually instantaneously may allow the trader to know how other traders’ orders might affect the market’s price quickly, but it ignores the fact that the majority of the market is not hooked into this type of information sharing.  Commercial and institutional traders in particular provide the majority of trade volume and will not be providing this information to social trading forums.

A Hybrid Approach

Each of the approaches above will have their own advantages and disadvantages but none of them have the whole picture in their corner.  A student of trading who has a knowledge of multiple approaches has the advantage of being able to analyse the market in a less rigid manner.  For example, a fundamental trader might decide to enter long but then wait for a technical level to enter the position and reduce the chance of drawdown and possibly maximise the profit potential.