In this post, let us rise into the air to have a good view of the stock market. From this perspective, seemingly unrelated things all of a sudden become connected and patterns hidden by all the buzz and noise start to appear!

If you want to understand the big picture of technical and fundamental analysis, its relation to the payoffs of certain option strategies, and what this has to do with buy-and-hold, read on!

The financial markets are a playground for diverse strategies, each with its own unique perspective and methodology. Among these, technical and fundamental analysis stand out as two distinct yet profoundly interrelated approaches. By digging deeper, we find that these two techniques, though appearing different on the surface, are two sides of the same coin, creating a fascinating interplay that leads to a classic investment strategy: buy-and-hold.

Parts of this post were written with the help of ChatGPT-4, concept and ideas are my own. The payoff diagrams were created with R, you can find the code here: Financial X-Rays: Dissect any Price Series with a simple Payoff Diagram.

The Yin and Yang of Investing: Technical and Fundamental Analysis

First, let’s uncover the essence of these two approaches. On one side, we have technical analysis, which involves studying price movements and market trends. Technical traders rely on charts and various statistical measures to determine points of entry and exit in the market. They believe in the power of momentum, buying when prices rise and selling when they fall, under the premise that what goes up will continue to rise, and vice versa. This behaviour tends to make stock price movements in either direction more extreme.

On the other side is fundamental analysis, which seeks to evaluate securities by measuring the intrinsic value of a company. This is done by examining related economic, financial, and other qualitative and quantitative factors. When a stock’s price falls, fundamental traders see an opportunity: they believe the stock is undervalued, and that its price will revert to its fundamental value in the long run. This mean-reverting philosophy creates a stabilizing effect on stock prices.

The aforementioned approaches might seem diametrically opposed, but they are not. Instead, they offer two contrasting lenses through which to view the market. Let’s use an options trading analogy to illustrate this.

Technical traders can be likened to being long a call option. When you buy a call option, you have the right, but not the obligation, to buy an asset at a predetermined price within a specified period. It’s a bullish strategy, expecting the stock’s price to rise, similar to the momentum-driven philosophy of technical traders. When the stock falls below a certain point technical traders tend to sell illustrated by the flat line on the left, so that they won’t lose any more money, no matter how far the stock falls.

In contrast, fundamental traders can be thought of as being short a put option. When you look at the payoff diagram you see a cap on the right where you stop earning money from a certain point on, no matter how far the stock rises, which boils down to the same effect as selling the stock at that point. This resonates with the belief of fundamental traders that an undervalued stock will return to its fundamental value where they will tend to sell it.

The Symbiosis: Long the Stock

When we combine these two perspectives, an intriguing scenario unfolds.

The combination of long call (representing the technical analysis approach) and short put (symbolizing the fundamental analysis approach) results in being long the stock. This is a situation where the investor owns the stock and will profit if the stock’s price rises—a strategy commonly known as buy-and-hold.

The Synthesis: Technical + Fundamental Analysis = Buy-and-Hold

This takes us to an interesting conclusion: technical and fundamental analysis can be seen as two integral parts of a holistic investment approach. While technical analysis represents the momentum-driven, trend-following aspect (long call), fundamental analysis brings in the mean-reversion, value-investing perspective (short put). Together, they form the age-old, tried-and-true strategy: buy-and-hold.

In the next post, we will use these insights to build a full-fledged multi-agent simulation of the stock market with R, so stay tuned!

DISCLAIMER
This post is written on an “as is” basis for educational purposes only and comes without any warranty. The findings and interpretations are exclusively those of the author and are not endorsed by or affiliated with any third party.

(If you make any money though I would be happy if you would buy me a coffee… that is not too much to ask, is it? )