Thursday, February 18, 2010

Fundamental and Technical Analysis

What are the differences between Fundamental and Technical analysis?

So you’re all ready to start trading. You have decided that you have some money that you would like to put to use in the stock market. You have opened your brokerage account and your funds have already been transferred so you’re all ready to start buying and selling stocks and rake in all the profits that the stock market offers.

Now you ask yourself the big question. How am I going to know what to buy and what to sell? What strategy am I going to use to ensure that all (or realistically, most) of my trades or investments end up as winners and give me the profits that I am after?

Fundamental Analysis:
One of the things that you can do is follow a similar approach to the one you take when you buy a car, a house or any other asset. You analyse what you are buying, look at exactly what it is that you are buying and if you believe that you are getting good value compared to the price you would pay (in this case the price that the stock is trading at) then you buy it and hold it for as long as the original reason why you bought it is still valid. In a way, you are betting either that the market is not valuing your stock properly (i.e. it is undervaluing it and will eventually value it properly, leaving you with a profit) or that you can see something about a specific company, its sector or the economy in general that the market is perceiving incorrectly.

The reasons why you might think that a company is undervalued or that its intrinsic value should be higher than it’s trading at are as varied as there are investors and traders in the market. Perhaps you want to buy the stock of a company that pays out a quarterly dividend or maybe you want a company that is experiencing a very rapid rate of growth or one with a low P/E ratio. All that matters is that the reasons that you are buying the stock are all related to the fundamental characteristics of the specific company, its sector, or the economy in general and not related to what the market is currently pricing its stock at. Price is only important insofar as it allows you to determine whether the company’s shares are currently overvalued or undervalued according to your analysis. This is called fundamental analyisis and any trading or investing related to it is usually called trading or investing based on fundamentals.

It is important to point out that if you trade or invest according to fundamental analysis, day to day fluctuations in the price of a stock should be of little consequence to you. The moment at which the price of the stock is considered fair or overvalued (or simply that the risk of holding it outweighs its potential reward) would be a signal to sell out of it.

Technical Analysis
Technical analysis on the other hand, assumes that there is no advantage to be gained from analysing the fundamentals of a company, its sector or the economy since all information is known by all market participants and therefore factored into its stock price. On top of this, fundamentals can always be to a certain extent subjective and a matter of opinion but there are two things that are objectively accurate and backed by real money from market participants: Price and Volume.

Technical analysis relies on the premise that stock prices move in trends and if a trend (or lack thereof) is correctly identified, then market participants can benefit from it. From a technical point of view, a stock price can be trending or range-bound. When a stock is trending one would buy or sell in the direction of the trend and when a stock is range-bound, one would use counter-trend techniques to buy low (at the lower limit of the range) and sell high (at the upper limit of the range).

Technicians use concepts such as chart patterns, fibonacci analysis, candlestick analysis, technical indicators , tape reading techniques and support/resistance analysis all of which are in the end derivatives from price and volume. Technical analyis looks at all of these tools as ways of gauging the reaction of traders to market events and so in a way they reflect the psychology of the aggregate of all market participants. Since in the very short term markets are driven by the two opposing emotions of fear and greed, technicians look for repeatable patterns in their behavior and ways to profit from it. Some people even claim that trading based on technical analysis is in a way a self-fulfilling prophecy because all traders are looking at the same price charts, volume, indicators, etc. so some of their actions will be trying to anticipate certain well-known past patterns and in so doing contribute to their actual formation.

Trading using solely technical analysis would mean that you could trade a symbol, not knowing which company it belongs to and be able to buy and sell according to the techniques that you use in your trading strategy.

In conclusion:
Fundamental and technical analysis are not mutually exclusive and in fact many traders and investors actively utilize both of them to make investing and trading decisions. In general, one could very loosely argue that the shorter the time-frame the likelier it is for a trader to rely on technical analysis whereas for longer holding periods fundamental analysis is favored. This, of course is a very simplistic way of looking at it but a good rule of thumb nonetheless.

Another way people combine both fundamental and technical analysis (which is the one I use) is to use fundamental analysis to determine what to invest in or trade and then use technical analysis to determine when to actually buy or sell thereby increasing the probabilities of a profitable investment or trade.

Although we have focused mainly on stocks, fundamental and technical analysis are used with any financial instrument such as stocks, bonds, options, futures and foreign exchange. The only difference would be of course that the fundamental factors would be different. For example when looking at corporate bonds for example one would need to analyse not only the fundamental factors related to the company but also consider interest rates, inflation, etc. When looking at foreign exchange for example the fundamental analysis would need to be done on the whole country or region and not on an individual company. Technical analysis principles on the other hand are used for the most part the same way to analyse all financial instruments.