Q:What is best: using technical analysis or fundamental analysis to formulate a trade plan?A: Technical analysis focuses exclusively on the study of market action while fundamental analysis focuses on the underlying economic forces of supply and demand that cause prices to move up or down or stay the same. Fundamental analysis focuses on understanding the underlying enterprise – which involves analysing a company’s financial statements, management competence, market share, competitors…etc – and then valuing its shares based on an estimate of the discounted future cashflows it could generate. i.e. Fundamental analysis uses historical and current data to estimate future stock returns and takes into consideration economic data releases, events such as political elections as well as individual company announcements. Technical analysis on the other hand assumes that all of this information is already included into a stock’s price, so all a trader has to do is find out trends in share price movements and volumes to make speculative decisions. Technical analysis studies prices and volume by utilising charts whereas fundamental analysis is more concerned about whether the company is a sound enterprise to invest in.
The reality is that both technical analysis and fundamental analysis are important and can be used together when formulating a trading strategy. Momentum and sentiment matter far more over brief periods than fundamental factors like valuation. However, this isn’t the same as saying that fundamental factors can be disregarded entirely. Technical analysis and charting is actually interesting as theoretically the graph should depict the underlying fundamentals, they are intrinsically linked; as market price tends to lead the known fundamentals. The general principle of technical analysis is that prices tend to fall to points of support, settle and move back up or fall further and rise until they hit resistance and often fall back before continuing their upward journey. Another key advantage of technical analysis is that it applies to all markets so you don’t need to an expert in any one market; for instance a moving average crossover will give the same signal irrespective if you’re looking at crude oil, a forex pair or a stock.
Although fundamental analysis is important, it is worth keeping in mind that company fundamentals are always evolving. Focusing too heavily on historical fundamentals is a bit like driving a car while looking in the rear view mirror. One problem with fundamental analysis is that it doesn’t give you the exact levels entry/exit levels, neither does it tell you when it would be best to open a hedging position to protect against a fluctuating market. So entering an equity cfd trade basing yourself on fundamentals only is not practical as yield and Price/Earnings ratios can remain unchanged for months (if not years). In these cases the fundamentals may change only due to corporate actions such as the company announcing a trading update or a director disposing of shares – however trading equity contracts for difference on such announcements is a risky strategy as market sentiment can be stronger than the fundamentals of the corporate newsflow. So it is usually a safer strategy to combine both technicals and fundamental analysis. For instance results released when a stock is in an positive trend can signal a great opportunity to go long as the uptrend implies that the fundamental update would be greeted by the market. On the other hand, bearish data released released into negative sentiment, as would be the case if the stock were in a downtrend or had just broken support can provide an ideal indication of a possible short.
Thus, combining technical and fundamental analysis is often a better strategy. You can for instance use fundamentals to decide whether to go long or short on an equity cfd trade and technical analysis to determine entry and exit points and the level at which to place a stop loss. In other words, technial analysis gives you the ‘length’ of the move and helps to quantify risk by identifying entry and exit points. Do keep in mind, however that technicals are usually more important for shorter holding periods while fundamentals are more important when considering longer timeframes. This is because fundamentals can persist for quite a long time but technicals can change completely if key levels of support or resistance are breached.
Once I heard an experienced trader say that it matters little whether one finds a stock using fundamentals or technical analysis (although it would be wise to use both), so long as one always checks the other side before taking the trade/investing. I think he was spot-on. You can’t fight a downtrend so why try…better to wait for the downtrend to end. Equally, no point in heaving into a share which is blatantly on the verge of breaking some covenant or other. Earlier this year, having used fundamentals to build a good watchlist, all I had to do was take the trades as they came up on my technical analysis scans…sounds simple huh. And now I am using my technical analysis scans to exit the trades but at times I have had to reverse the exit and go back in because the pull-backs have been shallow. I have no problem with that and I shall stick to my plan because in 2008, when all around me were losing money, I was safely out of trouble.
Note: Beware that CFD providers love to push technical analysis to retail inevstors as technical analysis often means more regular trading, which is where the industry makes its money. Even if you decide to use technicals to trade, understanding the fundamentals of a share such as market’s expectations, analyst reports and the like – can give you an advantage over other market participants.
Fundamentals gets a share into your buy list, they will not get u out of a bad trade. Fundamentals are useful but remember that how a market should react and how it does react are two very, very different things. Don’t get married to a fundamental opinion if the price does not confirm it.