Hedge funds are known for their often risky investment decisions. Managers are aiming to beat the indexes and generate excess returns and to achieve this they employ different types of analysis. Do hedge funds use technical analysis is a frequent question due to their already complex investment approach.
Surveys show that about 60% of hedge funds utilize technical analysis in their operations. It is not typically used as a stand-alone technique, but rather as a complementing tool in a wide strategy. While the rooted opinion is that technical analysis is used by day traders, it also has great use in long-term strategies.
The strategy was introduced by Charles Dow and it plays a crucial part in evaluating statistical trends in trading with a focus on price movement and trading volume. It is criticized due to its reliance on historical data which cannot be a good basis for future indications. By the end of this article, you will know how hedge funds incorporate technical analysis in their operations and with what success.
Key Takeaways
- Technical analysis is primarily used to predict future asset prices based on their value in the past. While it is commonly connected with day traders, it has extensive use with short-term-oriented hedge funds. To some extent, it can also be used by long-term investment horizon hedge funds.
- To find the best use of technical analysis it is crucial to know historical trade volumes and stock price fluctuations. Through it, institutional traders identify patterns that can help them make an informed guess about the security performance in the future.v
- Some of the tools used in technical analysis are moving averages, relative strength index, and Bollinger bands.
- Hedge funds that specialize in quantitative and technical strategies showed that technical analysis can be used with great success. Renaissance Technologies and D.E. Shaw are the best examples of successful traders who prove that trade based on technical analysis can generate long-term and consistent gains if used properly.
Hedge Funds Fundamentals
Hedge funds are complex alternative investment vehicles that utilize a wide range of investment strategies to generate high gains. To accomplish this they need to conduct in-depth analysis which includes several approaches.
Before the fund makes an investment it must identify the fundamentals of the asset, trends inside the sector, and competition if there is any, and determine if that is a short or long-term investment opportunity.
Some of the commonly used strategies include:
- Global macro: Funds exploit macroeconomic trends that can make a wider impact on a specific market or a sector.
- Trend following: The cornerstone of this strategy is to identify the direction of the market and to follow it.
- Special situations: Managers who follow this approach identify corporate events that can be used to make gains. Those include mergers, acquisitions, spin-offs, and bankruptcies.
- Long/short equity: Asset managers take both long and short positions aiming to profit from both ends of the market. If the company is on the losing side, the fund takes a short position, while a winning company is kept for the long term.v
Making gains in a volatile market with numerous variables is a difficult task. To accomplish this hedge fund managers use a variety of analyses including fundamental, macroeconomic, risk, quantitative, and technical analysis.
The goal of these analyses is to identify the right investment option and assess the timing when the investment will make the best impact on the portfolio.
Defining Technical Analysis
Hedge funds and their use of technical analysis refers to the use of price charts and statistical indicators to assess market trends. Through analyzing historical price movements and trading volumes attempting to predict future price fluctuation.
The analysis is focused on patterns, market sentiment, and trends rather than on fundamental factors that include economic indicators. Technical analysis is primarily used to define entry and exit points and to manage risk. Hedge funds also use technical analysis to capitalize on short-term market fluctuations.
The Role Of Technical Analysis In Hedge Fund Operations
Core principles of technical analysis include focusing on the stock price as a source of information, following market trends, and recognizing historical patterns that are repeating themselves.
Hedge fund managers who prefer using technical analysis believe that all relevant information about the stock is already included in its price. By analyzing its historical data and variation they trust that they can identify a pattern in price movement.
Identifying trends in price movement, no matter the direction (up, down, or sideways) is crucial for the success of a technical analysis. By identifying the trends, traders can make better-timed and informed investment decisions.
By looking over batches of data regarding price fluctuations and trade volumes it is possible to gain insights into potential price ranges in the future.
In reality making investment decisions is a combination of several approaches including technical, fundamental analysis
Tools
To successfully conduct technical analysis managers use tools like charts (line and candlestick charts), and indicators (moving averages, relative strength index (RSI), Bollinger bands, and moving average convergence divergence (MACD)).
Line charts are used to present price movement through time, while candlestick charts provide more information including different prices (open, high, low, and close) which provide a better foundation for price analysis.
With moving averages, it is possible to identify trends with ease by smoothing out the price data. RSI measures the tempo of price changes pointing out under and over-bought security.
Bollinger bands are used to identify volatility and potential price reversals based on creating bands around the moving average. On the other hand, MACD is used in trend-following strategies which shows relationships between moving averages.
Strategies That Involve The Use Of Technical Analysis
The technical analysis found its place in strategies that rely on identifying historical price patterns, market data, and statistical indicators aiming to predict future movements in the financial markets. Short-term strategies that regularly use technical analysis are:
- Trend following: The aim of the strategy is to make long-term gains by using indicators like moving averages, trend lines, and momentum oscillators to detect the direction of the price movement.
- Momentum trading: When hedge fund traders identify assets with a strong price move in a certain direction they employ momentum trading. Based on the historical price strength they enter the position expecting the trend to continue.
- Mean reversion: With the help of technical indicators, institutional traders identify overbought or oversold assets. Then they take opposite positions while expecting the price to return to its mean.
- Statistical arbitrage: The quantitative analysis combined with its technical counterpart is a good mix when you need to identify price discrepancies. The usual hedge fund approach includes taking positions in pairs of correlated assets betting that the prices will return to their historical price relationship.
- High-frequency trading: HFT trading would lose much of its edge without the technical analysis. Since they use algorithmic trading models fed by technical analysis indicators, they need data like price patterns and trading volume to conduct ultra-short-term trades.
- Pattern recognition: With the help of technical analysis hedge funds identify chart patterns like head and shoulders, flags, triangles, and cup and handle formations. They are betting that the prices will act in the same way as in the past.
Limitations Of Technical Analysis
The technical analysis did provide institutional traders with tools to exploit historical patterns, but with those, it brought its set of unique setbacks and limitations.
The biggest downside of technical analysis is that it is based on predicting future price movements based on the data from the past. Every period has its unique characteristics that mark it. Hoping that it can be replicated in the future is an outright bet that can go wrong for so many different reasons.
Also, when creating a model too specific to a unique set of data can lead to overfitting. When a model is created to fit a specific set of predetermined indicators it can be almost impossible to implement it in live trading conditions.
The overuse of technical and similar quantitative techniques pushes markets to become more efficient. This way the alpha generated with the help of technical analysis is diminished, and the analysis becomes less efficient.
Final Thoughts
Hedge funds are complex investment vehicles, and knowing all the ins and outs of their operations is not easy. One of the crucial segments of their operations is making investment decisions. Managers use different analyses to make an informed decision that could bring the highest gains combined with the lowest risk.
Technical analysis is just one of the tools that funds use, often together with fundamental analysis to better assess the market and the asset. While it found frequent use in short-term strategies it is also highly usable in some segments of the long-term approaches.
In short-term strategies using technical analysis helps with identifying investment targets, and also has wide use in momentum trading, day trading, and HFT trading. In long-term strategies, it is mostly used to identify entry and exit timings and to identify market sentiment and behavioral signs.