Fundamental analysis (FA) is aimed at capturing both systematic risk and idiosyncratic risk associated with a given security. While the market risk encompasses the macroeconomic factors – like monetary policy, economic cycle or unemployment rate, the residual risk includes company-specific factors – like financial ratios, management style or market share. Technical analysis (TA) is a method of evaluating securities by analyzing statistics generated by market activity, such as price and volume. It does not measure the intrinsic value, but instead it uses charts to identify patterns that can predict future price activity. Knowing how to perform both fundamental and technical due diligence is essential for successful investors and traders.
The criticism concerning TA is derived from the Efficient Market Theory (EMT), which states that the market price is fair and that past information is already discounted into the price. TA is based on the premise that the patterns in market prices are assumed to recur in the future, and thus, these patterns can be used for predictive purposes. However, since the stock market can move in an irrational manner, charts will not accurately represent the company’s fair value. The common denominator between technical and fundamental analysis is the study of trends. While TA is the study of trends in price and volume, FA concerns itself with economic and corporate growth trends and the projection of performance based on trends of relevant factors.
TA involves the study of trading patterns through the use of charts, trend lines, support and resistance levels, and other mathematical tools, in order to predict future movements in price. While the lagging TA indicators trail the price action of the instrument they are tracking, the leading TA indicators seek to predict the time and price where a security is most likely to change direction (i.e., RSI, Bollinger Band). The underlying premise of technical analysis is that price movements are not random, and that patterns in price movements tend to repeat themselves. Similarly, fundamental analysis requires a forecast of the fundamental data itself before conclusions are drawn. FA requires a close examination of the financial statements to determine firm’s current financial strength, future growth and profitability prospects, in order to estimate whether the stock’s price is undervalued or overvalued. Numerous ratios, derived from balance sheet and income statement data, are used in fundamental analysis including Working Capital Ratio, Debt-Equity Ratio, Return on Equity (ROE) Ratio or Earnings per Share (EPS). The general consensus is that, over time:
• industry behavior accounts for 15 to 20% of the price fluctuations
• the economy accounts for 30 to 35% of the price fluctuations
• company specific information accounts for 30 to 35% of the price fluctuations
• other factors make up the remaining 15 to 20%
While FA may be the preferred method to longer term investors, day traders use TA because of the fact that trades are entered into and exited within a very short time frame.
And another important aspect in short-term trading: the tape. When you have the skill of reading the tape the chart starts to be a bit of a lagging indicator, hence eliminating the use of oscillators.
From my experience, reading the tape is a double-edge sword. Watch out on that!
Toni,
very interasting point. Can you elaborate more on it?
Ovidiu,
When reading the tape you develop a strong skill in feeling the direction of the markets within the next 30 seconds or so. However, in both NYSE and NASD, you cannot see the so-called “masked” orders, even though you might have access to level-two prices or specialist’s book.
Toni,
Indeed, but then you look at the prints. Of course, with these HFTs now in the market the noise is at a high level.
HTF is part of the problem…but not the only one.
from my experience, die hard supporters of TA have little or no concerns about its theoretical fundaments. some regard TA as solid science simply because “it works” (when it doesn’t work, it’s the trader’s fault for not having read the correct pattern), and if it works it’s right, why bother ask anything further. not to mention that it uses a lot of “sophisticated” math and funny terms, so it’s gotta be true science. as you said, TA is merely based on assumptions. math is just an extension of logic, so the question remains – what is the logic? of course TA cannot be ruled out, particularly for the very short term and in the absence of big news, however I guess its strength comes from the fact that many active market participants believe in (or just “respect”) the same popular TA measures, making whatever they predict self fulfilling, or maybe these TA measures somehow capture some of the psychological biases of short term punters given a certain price action, like “it went up enough for now, let’s take some profit”. however I can’t see how this can be of any use beyond the very short term. all it takes is one piece of big and unexpected news to make all past data and possible TA measures based on it irrelevant.
It makes sense what you say. Definitely, TA is about short-term horizon. If everyone looks at the same metrics, it becomes self-fulfilling.
am o intrebare si as dori un raspuns clar si direct:
am marea rugaminte sa-mi spuneti titlurile a doua carti bune de ananliza tehnica si fundamentala dupa care ma pot pregatii si aprofunda aceste tehnici deoarece doresc sa am o idee cat mai clara a pietelor .
George,
I will get back to you this weekend. By the way, welcome to my blog and next time try to use names on the addressee line.
Toni,
I will be interested in that too …
Interested in what? Once we made things crystal clear what is your question now?
Toni,
2 books on FA and 2 on TA like George was referring to
sir yes sir
I got some course notes from bloomberg on candlestick and ichimoku analysis… anybody wants them, I can send you a pdf file. use them at your own risk
I myself don’t like them at all, too much magic form my taste.
If the other 2 guys want, you guys could share e-mail addresses and take it from there.
Borat,
I would appreciate if you could help me with that material … if you could upload them somewhere (better for everybody) or send them to bogdanbmm “at” yahoo.com would be great either way
thank you,
BMM
Borat,
Could you help Bogdan, please?
>y pleasure sir, will send the gentleman an email tomorrow
You are the man.