Technical & Fundamental Analysis

Technical analysis and fundamental analysis are two different methods for forecasting the potential future direction the price of an asset might take. The two approaches are dramatically different and most traders follow one method or the other in their trading, although it is possible to combine both and realize the benefits of each. As you continue reading this article you might have some ideas about how to combine fundamental analysis and technical analysis in your own trading style.

What is fundamental analysis?

Fundamental analysis is used to determine the intrinsic value of an asset. Typically, it is used with stocks, but it can be used for other asset classes too. Traders using fundamental analysis look at everything from the big picture of global economic growth and development to the smallest details of the financial strength of a company and its management team. Through fundamental analysis the trader hopes to find the strength of supply and demand, and the financial strength of the company or market being analysed.

What is technical analysis?

Technical analysis differs greatly from fundamental analysis because it is concerned with using statistical trends in price to forecast future price of any asset. This is done by studying the price history and trading volumes of the asset under investigation. The assumption made by technical analysts is that all fundamental data is already known and baked into the price of the asset. Because of this, they believe fundamentals don't need any attention. Technical analysis looks for patterns in the price history of an asset to try and predict what the future price of that asset will be. These patterns can provide predictive value based on the past movement of the asset price, or as an indication of the market psychology behind the asset.

Their difference and combination

Technical and fundamental analysis differs in what factors are examined to predict the future price of an asset. Fundamental analysis is concerned with all the external factors that might influence the price of an asset, how they influence the asset and what the true value of the asset is based on all these factors.

By comparison, the technical analyst is only concerned with price history and price action. They look at the historical patterns in an assets' price to determine the future course of price. Technical analysis is also concerned with trader psychology since price action is an extension of market psychology. Technical analysts only concern themselves with price and volume data.

Examples (RSI, Bollinger Bands, ADX)

Fundamental analysis uses all the available data about a stock or asset to create a model for determining the true value of that asset. This is a very broad-based approach that can take days or weeks to complete properly.

Technical analysis uses price action and statistical tools in analysing the price action of an asset and predicting the future direction of price. These tools include models such as oscillators. An oscillator is a technical analysis tool that constructs high and low bands between two extreme values and then builds a trend indicator that fluctuates within these bounds. Traders use the trend indicator to discover short-term overbought or oversold conditions. Some common oscillators are the stochastic oscillator, relative strength (RSI), rate of change (ROC), and money flow (MFI).

Benefits and Risks

The benefit of fundamental analysis is that it focuses on the true value of an asset without considering the current price. It's been proven as a solid method for long-term investing. It is good for managing risk and also assists in asset allocation decisions. Over the long term, it's been shown that fundamental analysis is most likely to be correct in predicting the future price of an asset.

The benefit of technical analysis is that assets can be analysed rapidly and since it focuses on price action it is effective in setting price targets. It is quite useful for short-term traders who are attempting to forecast short-term price moves. Market sentiment, market psychology and supply and demand can be seen by looking at a price chart.

When looking at risks, one of the downfalls to fundamental analysis is the time required to do it properly. Fundamental analysis also risks the trader being unable to gain an edge since all the information used in fundamental analysis is available to all traders. Short-term traders who use fundamental analysis risk being right on the direction of price, but at the wrong time.

Technical analysis is quite subjective, which puts traders at risk when they are unskilled at conducting technical analysis. There is also the risk of a trader becoming paralyzed when doing analysis if they begin using too many technical analysis tools.