August 14, 2003
Technical or Fundamental?
It seems like one of the most common questions we get, especially from those new to trading (or investing, for that matter), is something along the lines of "Which is better? Technical analysis or fundamental analysis?" There's no perfect answer to that question, just like there is no perfect technical system, nor perfect fundamental criteria. In fact, the best answer may simply be "It depends on what works for your style of trading". Today we'll take a look at how you can combine the two techniques, and have the best of both worlds.
To establish the framework, let's explain the basic philosophies of the two schools of thought. To make money in stocks, you want to buy low and sell high. Technical analysis is designed to spot price change patterns that can point out possible highs and possible lows. Fundamental analysts also want to buy low and sell high, but they look for stocks that will likely move higher due to improved earnings, revenues, and profitability. Simple enough?
Traditionally, an investor would define himself or herself as either a fundamental or technical trader, and trade accordingly. But that may be a mistake in today's investing environment, since both methods have unique drawbacks. Fortunately, those drawbacks of one method can be largely cancelled out by the other. Let's explain.
A purely technical trader looks for price breakouts, then takes a position in the same direction as the trend. By the very nature of his method, though, the reason for the breakout is not considered. Does that matter? Certainly. Stocks only move higher when the demand for those shares increases. But if demand for shares can increase without reason, then demand can also drop without reason. That, of course, pulls share price down and the technical trader may end up giving back his or her profits. A technical trader who realized that a price move occurred without any reason may have also foreseen that the price move was not sustainable.
On the other hand, strong fundamentals don't guarantee a return of any size to a shareholder. Remember, you only make money on a stock if the per-share price increases, and prices are set by the supply and demand of the market - not the company's performance. In that case, the technical trader would have an edge by only getting into stocks that were actually headed higher.
But what if you applied both techniques? A trader who finally saw share prices break above key resistance after a company posted improved earnings would know two important things. First, share prices are actually moving higher, and second, the improved fundamentals will attract other investors, making that rally sustainable.
The point is, while many people have always been told that the two methods are at odds with each other, they're really not - both are tools used in our goal of buying low and selling high. When used in conjunction, they actually enhance the effectiveness of each other. For you technical traders, before your next trade, ask yourself if the company's fundamentals will attract buyers who aren't watching the same technical chart you are. For you fundamental investors, before your next trade, take a look at a chart and see if the shares are actually going to go higher. While you may have to search a little longer to find stocks with strong technicals as well as strong fundamentals, you'll have a definite edge.
For more information about effectively combining technical and fundamental analysis, I recommend Bill O'Neil's book How To Make Money In Stocks. |
