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If you want to be a smart trader, you have to be healthy to examine the market correctly and predict what the price movement is going to be. This is true no matter what you are trading, whether it be stocks, commodities, bonds, currency or any other form of security.

This type of analysis can be done in two different ways, with fundamental analysis or technical analysis.

With technical analysis, you study the prices. Your goal is to examine the history of the price movements in order to try to predict future prices.

Fundamental analysis, the other hand, is the study of one nation’s overall economic health. You might also think of this as “big picture” analysis. This focus is on the intent that the health of a nation’s economy will affect both the supply and demand for its currency. In turn, this will affect the price of the currency itself.

As example, if the US economy’s health is good and its economy is on the rise, one would anticipate that the value of US dollar will also rise and currency traders will want to invest heavily in it. This type of “bullish” behavior becomes a self-filling prophecy so that the US dollar does, indeed, rise in value.

Although it seems like a pretty simple concept, in fact, judging the “health” of a nation is not easy. There are many factors to be considered. Therefore, two traders might look at the same figures and interpret the data in different ways.

Fundamental analysts look at various economic indicators to see how strong the economy is. Some of these indicators they examine include the interest rate, unemployment rate, gross domestic product (GDP), and consumer price index.

Government and non-governmental agencies and bodies regularly release these types of reports; find schedules of upcoming releases for those you focus on and make note of them. Then, keep an eye on them and see what their effects are on currency prices for the country or countries you follow.

You should note, though, that the numbers contained in the report are not what have the greatest impact always. Rather, it’s the relation of the numbers in that report as compared to what had been forecasted previously.

In other words, a hike in interest rates might not have a significant impact if forecasters indeed thought this was going to happen. However, if they were anticipating interest rates to remain steady and there actually was an increase, this might in fact have a massive impact on currency prices.

There is a disadvantage to fundamental analysis, which is that it can be a tiny too broad-based. Even though it’s a wonderful tool to predict overall economic growth and price changes, it doesn’t give enough details for investors to target specific exit or entry points. This is why technical analysis is as valuable as “big picture” analysis is. Technical analysis does give you that “fine point” analysis.

Clinging on to Fundamental Analysis and stock picking software, only keeps you stuck in trading equities. Trading this way, compounds concentration risk in one quality class and fails to adequately diversify risks crossways Equities, Bonds, Currencies and Commodities.  There’s much more to stock option trading, than stock itself.

I cite Benjamin F. King’s study, quoted repeatedly since 1966, because it remains valid and has yet to be disproved to the point of dismissing its logic.

Market and Industry Factors, Journal of Business, Jan 1966:  “ Of a stock’s move …

31% can be attributed to the general stock market, 13% to industry influence, 36% to influence of other groupings, and the remaining 20% is peculiar to the one stock.”

There must be a more compelling reason for you to trade stock other than just for the movement, if only 20% is one-of-a-kind to the underlying equity in question.  Think about this, in context of the Fundamental Analysis or stock picking software that you purchased on a per $1 basis.  For apiece $1 dollar you spend, you “outsourced” the analysis at a cost of 80 cents, only to receive back 20 cents worth of work. Shouldn’t the 80:20 rule of “outsourcing” be the other way round? The problem is that you are still stuck with 80% of the work, to examine price movement!  Plus, the more you use FA techniques/stock picking software, the more trading capital is stuck in equities alone.

Now, you can state “special” research papers help you pick stocks.  Let’s have a look at some of the more common fundamental metrics in these research subscriptions:

1. Dividend Yield: the problem is in the variability of yields as firms are in different stages of their business development.  A Mature company that dominates in a well established sub-segment/sector is healthy to afford a different dividend yield; versus, a Young company in a growth-oriented field; versus, a Small firm in a growing area that might not be healthy to afford a dividend payout.  Bear in mind there is nothing special about firms that pay a dividend.

A company that gives away a portion of it’s retained earnings – which is what a dividend is – effectively gives away part of its valuation, which means it is not worth as much as a company that does need to give investors candy to commit capital to it.  So, a dividend paying stock has to be far better to a non-dividend paying stock for reasons other than the dividend.  If it is not, there’s no point looking for dividend paying products to trade, there are plenty of non-dividend paying Indexes to trade.

2. Price/Book Ratio: the problem is this metric varies crossways industries and from company to company, as the quality base and capital structures of companies change over time. It lacks cross sector applicability and bookkeeping complexity arises from a firm’s capital structure as it changes due to acquisitions/divestments/CAPEX for new product lines; or, product line cut-backs, as recently seen in the restructuring of major US automobile companies.

3.  Price/Cash Flow Ratio (the cousin of the P/E): bookkeeping laws on depreciation vary crossways Asia, Europe and US.  As bookkeeping rules are driven by tax codes, which change considerably crossways regions despite adoption of global bookkeeping standards, there is a demand of uniformity in homogenizing a fundamental ratio that will fit as a common benchmark crossways geographies.

These metrics change to help you compare state a Dell parented in the US to an Acer parented in Taiwan; but, is listed as an ADR in the US, even though both are competitors in the same sector as personal manufacturers.

Furthermore, the current dislocated cost of capital in credit markets, impairs the capability of corporations to optimize the operating cost of their equilibrise sheets.  In essence, corporations are left with the working capital cash flows remaining on their equilibrise sheets, as testament to their financial strength. Do not waste your money on Fundamental Analysis software or research paper subscriptions.

As there is a fundamental flaw in fundamental analysis and stock picking, how do you select trades? Trade the options of a broad-based Equity Index to replace single stock exposure.  To replace Fundamental Analysis, use the Relative Strength measure based on Point & Figure methods.

What is Relative Strength?  It is nothing more than taking one price as the Numerator, divided by another price as the Denominator, then multiplied by 100.  RS = (Price 1 / Price 2) x 100.  Typically, RS calculations use regular closing prices.  Though easy in its mathematical construction, RS is ingeniously powerful when it is applied not only within a sector; but, crossways sectors and between quality classes.

Let’s begin of within a sector.  For example, if you select 2 semiconductor stocks trading at different prices, how do you know if one stock is outperforming the other in the same sector, when the 2 stocks have price changes at different rates; plus, the sector’s price itself is also changing?

SOX = Semiconductor Sector Index, trades up from 452.24 to 467.81.

Numerator1:      Price1 = BRCM 33.15    RS1 = 7.33    Price2 = 33.80    RS2 = 7.23
Numerator2:      Price1  = TSM 9.91    RS1 = 2.19    Price2 = 13.43    RS2 = 2.87
Common Denominator:      SOX  Price 1 = 452.24           Price 2 = 467.81

BRCM’s RS1 = (33.15/452.24) x 100 = 7.33. BRCM’s RS2 = (33.80/467.81) x 100 = 7.23.  
TSM’s RS1 = (9.91/452.24) x 100 = 2.19.  TSM’s RS2 = (13.43/467.81) x 100 = 2.87.

BRCM’s price rises from 33.15 to 33.80 and TSM’s price also rises from 9.91 to 13.43.  Simply because BRCM is a larger stock, does that mean it benefits from the SOX trading up? No, the RS reading (RS1 compared to RS2) shows BRCM’s RS reading dropped (7.33 down to 7.23) against TSM’s RS reading, which increased (2.19 to 2.87).  RS confirms TSM as the outperformer rising in price strength versus BRCM’s weakened price.  RS is constructed on pure price rules.  Using an Index as the denominator, acts as a much more durable benchmark and is structurally more reliable, compared to any “magical” TA indicator; or, combination of income statements, equilibrise sheets and cash flow statements touted in stock picking programmes.

You can replace BRCM or TSM with Indexes or ETFs.  Using Indexes with Relative Strength enables a common denominator to compare Equities against Bonds, Commodities and Currencies, to crossover into quality classes other than stocks to trade.  It’s not that Relative Strength is infallible.  But compared to the fundamental metrics cited above, Relative Strength fails the least.  Break the mould on what you learnt about stock option trading.

Is there an example of an optionable and consistently profitable portfolio that trades using Relative Strength crossways multiple quality classes? Yes.  Follow the link below, entitled “Consistent Results” to see a retail online option trading portfolio that excludes the use of single stocks and Fundamental Analysis, using broad based equity Indices, Commodity ETFs and Currency ETFs.  There is no need to trade FX directly. Just trade the options of Currency ETFs.