By Brenda Kelly, Chief Market Strategist.
While trading financial markets was once seen as the preserve of City professionals, over the last decade or so, trading has become increasingly democratised. Events such as the financial crisis of 2008, have catapulted coverage of financial markets out of the business pages and into mainstream news bulletins. The increase in media coverage and the decoding of industry jargon has enabled more of us to form a clearer understanding of how markets work and has led to greater interest in how we can trade in these markets ourselves. Advances in technology, in particular in data processing power, have also led to two very different approaches to trading, the technical and the fundamental. Here Brenda Kelly, chief market strategist at brokers IG, explains the differences between the two camps.
Technical analysis is essentially trading using algorithms and charting tools to identify market trends. Technical analysts seek to discover patterns that can provide insight into how buyers and sellers are behaving. Since certain behaviour patterns have been seen repeatedly in the past, it’s possible to identify them as they emerge in the present- something that helps with predicting the likely future trend for the market stock. For example, Marty Schwartz, an expert technical trader, identified potential investments by looking for positive divergences in price action over the broad market.
A technical analyst, therefore, would advocate buying a given stock when it hits the average, if patterns show it usually goes up after.Alternatively, if there were a sharp sell-off in a given stock, a technical analyst would only be concerned with asking how this price movement fits into the on-going trading pattern being tracked. In comparison, a fundamental analyst would look for reasons as to why the company’s share price has fallen.
Fundamental analysis represents the more traditional approach to trading, in which the financial soundness of a company is scrutinised. Fundamental analysts try to discern the true value of a stock. By calculating if that stock is over or under-priced in the market, they are able to make decisions about when to trade. When the analyst gets it right, the price in the market converges with the true-value estimate over time. Warren Buffet, one of the most successful fundamental analysts ever, for example achieved a compounded annual gain of approximately 19% since 1965, compared to 9% for the S&P 500.
Fundamental analysts must therefore assess whether the price of the stock is fair in comparison to the company’s future profits and the future dividends they will receive as a shareholder. In order to estimate this, fundamental analysts will take a relatively long-term approach, considering everything from financial statements and revenue forecasts to quality of management and projected growth.
When deciding where to invest, fundamental analysts look at:
- Earnings per share – whether margins and share prices are rising alongside sales
- Company revenues – the amount of sales taken over a set period of time
- Industry fundamentals – wider industry trends that may impact a company’s performance
- The bigger picture – an overview of the wider macroeconomic climate
Which is best?
Whether to use technical or fundamental analysis remains a continuing debate within the industry. There are clear arguments to be made on each side. Fundamentalists claim that unforeseen events can cause technical chart models to fail. In comparison, technical analysts argue that forecasting based on fundamental analysis is too subjective.
While in the past, the fundamental approach held the most sway amongst both professional and private traders, the emergence of easily available charting tools and the ability to trade using other people’s algorithms, (rather than developing them yourself) has made the technical approach far more accessible. Ultimately, understanding the strengths of each method may provide the best opportunities for profit. Fundamental analysis is often used to choose healthy stocks, while technical analysis is used to decide when to trade. As trading grows in appeal and attracts a wider audience it is important to understand that there really is no right or wrong approach; it’s down to you to develop the individual strategy that suits best.