The debate between fundamental and technical analysts has raged for decades. For novice readers, it may be important to clarify the difference before proceeding any further. Fundamentals, by definition, consist of the economic factors behind a commodity or financial instrument, such as supply and demand and the factors that affect, or could affect, supply and demand. For example, the fundamentals of cotton would include the size of last year’s crop, the amount of cotton left from that harvest that is still available for export or domestic use, the pace of exports this year, the progress of the upcoming crop, and projected weather that could affect its growth. These are all fundamentals, and if it looks like a lot of information to monitor, it is.
Assuming that one is able to monitor all these factors, the next task is to form a “big picture” of the market and then try to determine how these factors could affect price over the next three to six months. Doing this is a key task in selecting markets where option selling may be a favorable strategy and in determining strike prices that may be profitable.
Technical analysis, on the other hand, is the study of charts, chart formations, and an array of technical indicators that affect volume, price momentum, strength of buying or selling, and so on. Because technical trading is more concrete and tangible (e.g., buy when prices hit this line), it attracts both the mathematical and the statistical crowds along with novice traders. Pure technicians believe that all the current fundamentals are always priced into a futures contract at any given time and therefore that there is no use in studying the fundamentals—it’s all in the price patterns.
This may be true to a certain extent. All the current fundamentals probably are already figured into price. What the pure technicians overlook is that studying fundamentals is not done to determine how they are affecting price today, but rather it is done to project how these factors could affect price in the future.
Our opinion is that both should play a role in option trading. This book, however, focuses more on fundamental analysis for two reasons.
1. We believe that the fundamentals should be the determinant of which market to trade. Fundamentals will help you to determine the markets where conditions are appropriate for selling out-of-the-money strikes on one side (or both) of the market. We see technicals as more of a timing or optimization tool to be used in entering the trade after the market in which to trade has been decided.
2. Most books focus on technical trading. Therefore, there is already a wealth of information available to traders who want to learn to trade technically. Fundamentals are discussed much less in trading books and magazines, and we feel that it is time to give them their due.
The following story, told by James Cordier, is about one of his early experiences in learning the differences between technical and fundamental analyses and illustrates the importance of following both.
During the first few of my 20 years trading the commodity markets, one of the most commonly asked questions that I received from potential clients was “Are you a technical or fundamental trader?”
My answer was always the same, “Technical, of course.”
At any given moment, I could pick up the phone and be asked my opinion of cocoa prices, pork bellies, or even Treasury bonds and have the answer shortly after punching up the chart.
“Well, Mr. Duke, I can tell you right now that I would cover any short positions you might be holding in cocoa. I show a Relative Strength Index reading of only 12, and it looks like the slow stochastic could cross at anytime.”
“Interesting,” says Mr. Duke, “What about pork bellies? How do you see bacon prices faring?”
“As for bellies, stick a fork in um, they’re done! That’s a head and shoulders top for sure.”
“And Mr. Cordier, what about interest rates and the Federal Reserve? What do you see there?”
“Well, Mr. Duke, that one is a little tougher.” I would coolly reply, “But looking at the June bonds, I can’t remember ever seeing a market this oversold. I think I’ll give bonds a strong buy. Besides, Mr. Volker would not put us in a recession. Would he?”
It was at the first commodity seminar I had ever attended that the technical seed was sown. The home office in Chicago had decided that it would send the brass to help give our branch office 90 miles to the north a jump-start. The office had just opened and consisted of the owner, two managers, and four hungry kids who had just passed their Series 3 (commodity broker license) exams. This would be my first formal training in a business I had been dreaming about for many years.
One nice suit after another would approach the podium and, using the latest technology in overhead projecting, would point out the highs and lows of various price charts where a savvy investor could have made a small killing.
After listening to one analyst explain how easy it was to go long on the buy signals and take profits on the sell signals, it was time to hear about formations—bull flags and bear flags, double tops and double bottoms. Everyone there, including me, thought, “Okay, these could be the secrets to our future success!”
Turning to a fresh page, I drew the chart that was illustrated on the fuzzy screen above.
“Here is an example showing a sharp rise in price that is followed by a period of consolidation, otherwise known as a bull flag,” the speaker continued. “The sharp rise in price is the pole, and the consolidation is the flag. Later, a break above the consolidation will project an equal increase in price as the pole itself.
“Wow, that seems easy enough.” I thought.
The next morning I went into the office armed with what could be the tools I needed to become a successful broker. The first thing was to back test what I had learned the previous night. Sure enough, after looking at just two or three charts, I found that there were pennants and flags and heads and shoulders everywhere! Shortly thereafter, out came the straight-edge ruler, and lines were drawn above and below support and resistance levels. Sprinkle in a few key indicators, and voilà!
“I will be technical trader, thank you.”
A few weeks later I was spending all my time studying the current issues of Commodity Perspective morning, noon, and night. For several hours each day I carefully paged through one commodity at a time, looking at each chart like a surgeon examining a patient until I finally found it. There it was right in front of me—December wheat, bull flag!
This chart had a flag formation so clear, so discernible, so absolutely perfect, that the only thing it was missing were the stars and stripes themselves. That weekend I started saying to myself, “Blue Horseshoe loves December wheat.”
Monday morning was here, and it was time to start on my road to riches. The grain markets were called to open steady, so I expected that I should be able to enter the trade I had studied all weekend long at the price I had hoped for. The flag formation consisted of a “pole” that measured 11 cents, followed by four days of consolidation. Buy here, and wait for the breakout to the upside, which should net us about a dime ($500 per contract). It was just like it said in my lessons. Now it was go time!
The opening bell rang at 9:30, and wheat started trading at $2.44, up½ cent from Friday’s close. I placed the order using a large red telephone that had no buttons, only a receiver. About ten minutes later, the floor was calling back with the fill, $2.44½, up 1 cent on the day. After a couple of hours had passed, trading had slowed considerably, this after what seemed like quite an active open. Corn and soybeans were both sporting modest gains, whereas wheat prices generally were steady to a shade higher. As the end of the trading day was fast approaching, grain prices started moving higher. With each new high, the sound of the clacker board seemed to get louder. At the close, December wheat settled at $2.46½, up 3 cents on the day and 2 cents above my entry price. What a great business!
After the dust had settled, I pulled out my charts and a pen to add a 3-cent bar to the December wheat. The breakout to the upside had started, and we should look forward to a payday in the next couple of sessions. “This technical trading really does work!” I thought.
As I was getting ready to leave for the day, I noticed my manager and another broker huddled in front of a screen.
“What do you see there, Jerry?” I couldn’t help but inquire.
“Well it looks like wheat will be heading higher. It crossed the wire that Egypt is rumored to be in the market for over 200,000 metric tons of wheat, and the sale could come as early as tomorrow”
Cha Ching! What a great business!
Driving home that night I kept telling myself, “Don’t be greedy. If the market is up 7 more cents in the morning, take the money and run. Stick to the program. Do your homework, and find the next trade.”
I decided after a long celebratory dinner that I would do just that.
Pulling out my charts, I started paging through the different commodities for hours that night. I was at it again. However, nothing looked as good as wheat did from a couple days earlier, and it was getting late, so I wrapped it up for the night. Besides, I had a big day ahead of me. My trading career was about to take off, courtesy of my new best friend, the chart book.
At 8:00 A.M. Tuesday, walking through the large double doors at the office, I could not wait to get the opening call. My manager was staring at his screen, so I poked my head into the often-opened door and asked, “Did the Egypt tender go through? Did they buy all two hundred?”
Jerry looked up at me with an unfamiliar smile and said, “Yeah, they bought their wheat.”
“Yes!” I thought. “But what is with him? Oh well, maybe he should study his charts a little closer.” I proceeded to my desk and pulled out my books and the phone numbers of my clients long the wheat. Soon, I would have good news to report.
It was almost 9:30. I was about to reap the fruits of my labor. Would the wheat market move up the additional 7 cents today, or might I have to wait a while longer?
Finally, the clacker board started clicking, first corn, and then soybeans. For some reason, wheat was taking longer. Then wheat opened. What? Down 4! Down 5! What was going on? What about the bull flag? It was perfect! What about Egypt?
The broker in the cubicle next to me stood up and asked in his usual calm voice, “Cordier, what is going on?”
“Wheat—the wheat is down almost 6 cents!” I said.
Steve replied, “Well, you know that Egypt bought wheat last night and . . .”
“I know they did, so why is it falling?” I demanded.
“It was French. Egypt bought 210,000 metric tons of wheat from France.”
“French! Schmench! What difference does that make!” I blurted, incredulous.
Steve, who got his start in commodities at a grain elevator, then said to me in what was almost a whisper, “You . . . have a lot to learn.”
As it turned out, December wheat had rallied days before, when rumors surfaced that Egypt could be in the market with a large purchase. Consolidation then followed as traders waited for the announcement.
In this case, the market move of December wheat was predicated totally by the origin of the wheat that Egypt was about to purchase. An Egyptian purchase of U.S. wheat may have been positive for Chicago Board of Trade (CBOT) wheat prices. A purchase from France was benign. It was a disappointment for U.S. wheat traders, and therefore, prices fell. It was my first lesson in the world of fundamental trading, and things have never been the same since.
It was a huge eye-opener to me to discover that there was a whole other world of trading information beyond my charts, measurements, and indicators. The technical charts reflected what was going on with prices and how they were moving. The fundamentals were the reasons why they were moving.
As I discovered, relying on my charts alone to try to predict market movement was like trying to put together a puzzle with only half the pieces.
Throughout this book, we have repeated a central theme of how important it is to know the fundamentals of a particular market before positioning in that market. However, we also have pointed out that this knowledge should not be used as a substitute for technical analysis. Rather, it should be used in conjunction with technical indicators to optimize one’s overall option-selection process. For pure fundamentalists, using technical indicators can greatly enhance your performance by helping to determine optimal entry and exit points. For pure technicians, knowing the fundamentals can help to boost returns by giving you a better feel for which breakouts, reversals, and buy and sell signals are more likely to be the real deal and which are false signals.
For instance, let’s assume that two markets, orange juice and live cattle, are trading in a narrow trading range. The U.S. Department of Agriculture (USDA) has just released a report showing that the most recent Florida orange harvest yielded the largest crop in five years. Frozen orange juice supplies in storage are at a 12-year high. The market is awash in juice. Cattle, on the other hand, have been projected for months to soon be experiencing a drawdown in supply based on last year’s 50-year low in the calf crop.
Both markets break out to the upside. Both markets indicate buy signals on key technical indicators. Which market is more likely to start a sustained uptrend, and which is likely to fall back into the range or lower?
The simple answer is that the cattle market is more likely to experience a sustained move higher, whereas the orange juice market is more likely to fall back down. However, this may not be the case, at least in this particular example. For unknown reasons, the opposite could be true. Additionally, both markets could rally, or both could fall back down. Over the long term, however, taking the fundamentals into account should help you to select more winners and cull more losers.
The pure technical trader would buy both on the breakout and give little regard to the fundamentals. However, given the exact same situation over different markets 10 times in a row, the technician who only takes the buy signals in markets with favorable fundamentals almost surely will outperform the pure technician. It simply adds another, very potent tool to the screening process.
We suggest selecting potential markets in which to sell premium by studying the fundamentals first. Once a select group of markets has been placed on a “watch list” consisting of markets with very bullish or very bearish long-term fundamentals, these markets then can be monitored for technical buy and sell signals.
The point is that fundamental traders can benefit by incorporating technical analysis into their trading, and technicians can benefit greatly by incorporating fundamentals into their selection process.
Novice traders often will favor technicals because they are much quicker and more tangible to learn. There are formulas and measurements and rules. Although the realm of technical trading is immense, a trader can learn one simple indicator, and Bingo, he has an instant trading system. He’s ready to go at it.
Studying the fundamentals and how they are likely to affect price is more abstract. It requires independent thinking. It takes time, education, judgment, and experience. The argument that fundamentals are already “priced in” may be something that pure technicians tell themselves in order to free their minds from the burden of having to study the economics of a particular market.
On the other hand, fundamental traders who would attempt to trade the market without some sort of technical guidance almost surely would be shooting in the dark. Markets can make large moves against the fundamentals and at times may even move up and down randomly as technical factors sway it back and forth. Large fund traders are mostly technicians and can move markets for short periods on technical buy or sell signals. These moves sometimes can fly in the face of the existing fundamentals. A trader would be foolish to ignore technical trading completely.
Over the long term, however, a market’s price ultimately will be determined by its fundamentals. For this reason, you should gain at least a basic understanding of what the key fundamentals are for the markets you are trading. It is one of the key advantages that you have over the large fund traders. They are slaves to their systems. You can use technical indicators while retaining the ability to think for yourself.
You will find that the fewer key factors that go into price makeup of a particular commodity or futures contract, the more benefit fundamental analysis can be. You will find that most physical commodities, such as soybeans, unleaded gasoline, and coffee, will have three to five key fundamental factors that affect most of their price moves. Financial contracts, on the other hand, can have many factors that can or could affect price, many that cannot be forecasted with any degree of accuracy (e.g., government decisions or votes). It may be true then that fundamental analysis is more of a benefit to traders of physical commodities. When trading financial contracts such as bonds, currencies, or even gold (considered a financial), you may have to rely more on technical savvy because fundamentals often appear very cloudy or mixed at any given time.
There is one final, albeit key, reason why we feel that incorporating fundamentals is so important in selling options. Technical trading is all about forecasting and measuring where and when prices might move. It promises nothing in forecasting where prices will not go. As an option seller, this is your primary concern.
Granted, it would be nice if prices moved immediately away from your strike as soon as you sell your options, providing fast deterioration and profits. However, most of the time, this probably won’t be the case. In the end, it doesn’t matter if your strike is $3 out of the money or 3 cents—your option will still expire worthless, yielding the same profit. Therefore, you are mainly concerned with selecting a price level that the current market will not reach. Fundamentals can be tremendously helpful in this regard.
It is our opinion that using fundamentals to determine where prices will not go is not only more effective but also ultimately easier. This is a key concept of this book and one that we hope you will remember. We are not going to take a side in the ongoing fundamentalist versus technician debate. The debate is always about which is a more effective price forecasting model. Which one is more effective in determining where prices will go? There is, of course, no correct answer. Either way, it is very difficult to determine where prices will go.
However, in determining where prices won’t go, if forced to choose one over the other, we’d have to take fundamentals. Why?
Let’s use an example to answer this question. Suppose that you have been following the development of this year’s U.S. soybean crop. At midsummer, the market has already priced a certain sized crop into the market (as most technicians argue it should). During the course of a week, rumors begin to surface of a strange disease eating away at leaves in certain growing regions. Traders are unsure to what magnitude it has spread or what effect it will have on yields. The following week, the talk continues to swirl. More outbreaks are reported, and some people start to suggest that the fungus on the plant is stunting the growth of the new soybeans.
At this point, the market has already started to move higher on the uncertainty. Nobody knows how this could affect yield or, ultimately, price. However, it is probably safe to assume that yield at least will be slightly affected. It could turn out to be the blockbuster story of the summer, causing major crop damage and a sweeping price rally. Or it could fade into obscurity, gaining only occasional mention as a factor causing a minor reduction in yield. It is uncertain what will happen or how high prices will move to factor in the reduced yield. Trying to buy a futures contract here or purchase a call option to take advantage of higher prices could be very tricky.
However, how likely is it that prices would move below the level at which they were trading before this disease was announced, when normal yields were being assumed? If prices a few weeks ago were reflecting a certain amount of anticipated supply and now that supply has been reduced (to what degree, we do not know), does it not follow logically that prices would have to be trading somewhere higher than they were a few weeks ago to account for this shortfall?
In other words, you may not be able to determine fundamentally how high prices could go, but it seems like a pretty good bet that prices are not going to fall back to where they were a few weeks ago because it appears that supply is smaller now than it was then. All the option seller has to do is sell puts below where the price was a few weeks ago and wait.
This example is simplified of course, but it demonstrates how a key fundamental development can be exploited by an option seller where it may be more difficult for a futures trader or option buyer to profit.
One of our basic convictions in this book is that an option writer should select the market in which she would prefer to sell puts or calls based on a fundamental scenario that she feels will make the market biased toward moving higher or moving lower over the intermediate to long term. The trader then would look for favorable technical setups as opportunities in which to enter positions in these markets. Again, while this is not a book on technical trading, we will use a few simple indicators in the following examples to help illustrate our points.
In researching the fundamentals for live cattle in early 2008, trader John has determined that the fundamentals will favor the upside in cattle prices in the coming months. U.S. beef demand is near all-time highs and demand from developing economies has resulted in soaring exports. More importantly, global demand has pushed corn and soymeal prices (a primary feed source for cattle) to their highest levels in 12 years. John feels that the market may be significantly under-priced as the market has not yet adjusted to higher feed input costs. John considers this a very friendly fundamental setup. He begins to watch the charts for possible favorable points of entry.
In this case, one of John’s favorite technical indicators is a slow stochastic (shown in Figure 10.1), which is a measure of moving averages. The wavy lines on the bottom of the chart are what this popular technical indicator looks like. One line represents a moving average of prices for the last 30 days; the other represents a moving average for the last 10 days. When the 10-day moving average crosses the 30-day moving average at or near the bottom dotted line (this is known as oversold territory), technicians take it as a buy signal. When this same crossover happens at or near the upper dotted line, technicians take it as a sell signal.
Traders can set these moving averages to reflect whatever price periods they desire.
FIGURE 10.1 June 2008 Live Cattle Chart with Stochastic Illustrating “Buy” Signals
John sells puts below the market on technical buy signals in a fundamentally bullish market.
Since John’s fundamental bias is bullish (he believes that the existing fundamentals will pull prices higher), John will look for technical buy signals as opportunities to sell puts far beneath the market. He will not sell calls on the sell signals because his fundamental bias is to the upside. Therefore, he takes only the buy signals in this market and ignores the sell signals.
The problem with technical indicators is that they rarely look this simple when you are using them in a real trade. Technical analysis books always make it look very simple and easy because they use examples in which the indicator worked very well.
We used one here as well, but only to demonstrate how a trader can combine his fundamental judgment with his favorite technical indicator.
In most cases, the technical buy and sell signals may not be very clear, at least not until well after the move has already taken place. This is yet another reason why incorporating fundamentals into your thinking is so important.
We would suggest that after you have selected a market to trade based on what you feel are very clear long-term bullish or bearish fundamentals, you do a little historical testing with a few technical indicators (such as the stochastic, relative strength index, 100-day moving average, etc.) to determine if there is one that the market seems to be adhering to better than others.
Probably the easiest technical pattern to look for is markets that are trending. If you have a market with clear fundamentals, and it is already trending in favor of those fundamentals, you could have a great option selling opportunity. In the preceding example, the live cattle market was already in an uptrend by the time the second buy signal was issued in May 2008. John had three things in his favor on this trade: favorable fundamentals, a technical indicator indicating a buy, and a trend.
We make the assumption that most of the potential or current option sellers reading this book have most likely seen a price chart before and are at least initially familiar with basic chart patterns and possibly one or two indicators. If you are not, there are many free online tutorials from futures and stock brokerages (it is their favorite subject) and other sources that can teach you the basics. There are also many excellent books available for those that feel that it necessary to delve into the finer details and theory of technical trading (although we don’t feel that this is necessary to be a successful option seller).
We want to stress again that the timing of your option sales does not have to be perfect. Remember that in option selling, even if you mistime your entry or are even outright wrong on market direction, in many cases you can still end up making money on the trade.
Using technical indicators and/or chart patterns certainly can help you in the timing of your option sales. Using fundamental research can help you in selecting markets favorable to option selling. Combining the two can be a potent approach that produces winning option selling trades.
We feel so strongly about combining the two that, in our business, we continually research the fundamentals of the futures markets and screen out the ones that we feel offer the best option selling opportunities for our clients. Since many investors do not have the time to perform this research on their own, we also provide a technical analysis and opinion of the market to assist them with the timing of their positions.
Nonetheless, even if you are working with a broker who is well versed in fundamental analysis, it may help you to know some of the basic economics and key figures of individual markets that help to determine price direction (or nondirection). For those who may wish to learn the key fundamentals of some of these markets for selfstudy, Chapter 11 is for you.