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The obvious goal of a futures trader is to correctly forecast future price movement and thus profit. But how is this done? Futures traders use many different tools when trying to forecast price movement, and deciding which to use is often an arduous and confusing task.
But, the purpose of this lesson isn't to teach you how to use any particular tool. Instead, we'll define the two broad categories that all forecasting methods fall under and the pros and cons of each. Market analysis is broken into two broad categories: fundamental and technical. Some would argue that there is also a third type: contrarian.
We will discuss all three in this lesson...
Commodity prices move up or down depending upon supply and demand. Fundamental analysis is the practice of analysing the elements that affect supply and demand. If a commodity is in short supply or there is heavy demand (or both) then the price will rise. If a commodity is in plentiful supply or there is low demand (or both) then prices will fall. So, the fundamentalist studies data and information that indicates the future supply and demand of a commodity (or more specifically - expectations of future supply and demand).
The information that is examined in fundamental analysis ranges from reports by government agencies and industrial organizations to weather reports, planting intentions, and current surpluses. But, drawing conclusions from such a varied and vast amount of fundamental data makes it a very subjective practice. Forming actionable decisions from fundamental data is often difficult.
Suggested Reading on Fundamental Analysis:
Technical analysis focuses on fewer pieces of data in order to forecast price movement. This data includes futures prices, open interest, and trading volume. A technical analyst does not refute the fundamentalist's claim that supply and demand (or a market's expectation of supply and demand) ultimately affects prices.
However, a technical analysts believes that this information is revealed through price data. In other words, price data and chart formations give a current and up to date depiction of the fundamental factors, thus there is no need to analyse fundamental information.
The technical analyst pays very close attention to the geometrical patterns that are revealed by price charts. The most significant of these patterns are trends. Given the fact that an uptrend or a downtrend tends to continue for significant periods of time, technicians use many methods for discerning and acting upon these trending markets.
These techniques can be used for short term or long term trends. There are also non-trending markets and technical tools that are aimed at discovering when these markets are ready to "breakout" into a trending market.
Suggested Reading on Technical Analysis:
The Contrarian Approach
Contrarian traders focus on the psychological character of a market. They believe, correctly, that prices movement is ultimately determined by the buying and selling actions of traders. If there are more sellers than buyers the price falls, and vice versa. Thus, in order to predict future prices, one only needs to determine whether the trader sentiment is bullish or bearish.
Just determining bullish or bearish sentiment isn't enough though, because the market sentiment may reverse at any moment. Therefore, contrarians focus on determining when a market is overbought or oversold, indicating that the price is about to change direction. The contrarian uses the same data that technical analysts use, which is why many think the contrarian approach falls under technical analysis.
However, in forming their opinions about market sentiment, contrarians place heavy emphasis on the Committments of Traders Report (COT) - something that is often overlooked by technical analysts.
Suggested Reading on Contrarian Trading:
Pros and Cons of Each Approach
In general, the limited amount of data inputs used by technical analysts seems to make this approach more objective and certainly less confusing. However, discerning chart formations is not always straightforward. At the same time, the vast amount of fundamental data is often ambiguous, making it more difficult to use as actionable information.
In general, fundamental analysis seems to be better suited to longer term price forecasting, whereas technical analysis seems to be better at indicating price forecasting in the near term.
The adherence to one or the other form of analysis is usually a matter of a trader's individual style and personality. The fact is, few traders are completely committed to just one or the other.
The balanced trader typically uses fundamental analysis to determine general concepts about future price movements and then uses technical analysis as a refined approach to entering and exiting the market at opportune moments. Comparing the data from each against the other is often the wisest course.