Technical Analysis vs Fundamental Analysis
Technical analysis vs fundamental analysis has always been a debate in the investment and trading community for years.
Some of the most successful traders in the world use both these two methods to analyze securities and the markets to make accurate trading decisions for better market timing.
A good idea is to incorporate both in a trading system but it is not necessary. We find that the best use for fundamental analysis is when we make our long-term predictions and trade decisions and use technical analysis for short-term predictions and trade decisions.
How To Use Fundamental Analysis
What is meant by fundamental analysis is that this type of analysis focuses on a business’s financial statements. Usually, the fundamental analyst looks to analyze the business’s earnings, assets, liabilities and other financial parameters.
The analyst value of the company to its current price to forecast a future valuation and price. A trade decision is made from the forecast of the analysis, the fundamental analyst buys or sells if the company is undervalued or overvalued.
When a fundamental analysis is applied to other securities than stocks, example forex or futures, it focuses on the overall state of the economy. Parameters considered include among others interest rates, production, earnings, employment, GDP, housing, and manufacturing.
A good measure when you should use fundamental analysis is when your investment period is three months or longer.
Now how does fundamental analysis differ from technical analysis…
How To Use Technical Analysis
Charles H. Dow, founder of the American newspaper The Wall Street Journal was the first to observe (1884) that the markets repeat themselves continuously, creating price patterns.
These price patterns include support and resistance at price levels, different trends and momentum changes. Price action can also be divided into fractals meaning that price pattern repeats themselves in shorter and longer time period i.e. technical works on all time frames, monthly to one minute.
The technical analyst study price charts to make forecasts and trade decisions form.
Some technical analysts say that all information is reflected in the price of a security and that investors emotional responses to price movements create price patterns since the investors have different information and knowledge used to their advantage.
Historical price patterns repeat itself because of the trading between buyers and sellers (demand and supply). Because of the importance of supply and demand, you must master this concept to become a successful technical trader is support and resistance.
Some technical analysts also use technical indicators. A technical indicator is a mathematical formula calculated on the price of the security. Today there are hundreds of technical indicators used to help traders make buy and sell decisions.
Technical analysis is the best analysis to use when swing and day trading securities. Since most securities price moves in waves – a technical analyst uses strategies to find the best opportunities to profit from these moves.
Technical Analysis vs Fundamental Analysis
So which is better of technical analysis vs fundamental analysis, the best analysis method is the one that suits you best and gives you to confidence to be consistent trading your trading plan.
Both technical and fundamental analysis can be used to forecasts a price development – fundamental is often best for long-term forecasts and technical for a short-term forecast.
Note that it is never possible to predict a securities future price with certainty.
A good idea is to incorporate both fundamental and technical analysis in a trading system to improve your trading performance.
Better Fundamental And Technical Analysis Basics
If you want to become better at fundamental or technical analysis and get better results, market timing (using correct orders) and implementing risk management basics will have an important factor.
Market timing is about having patience and not chasing the market.
So to become a better fundamental and technical trader you need to use correct orders.
A variety of orders is available when buying and selling securities, some guarantee execution, other guarantee prices.
The following four are the most common types of orders used when trading securities you need to know about:
- Market order
- Limit order
- Stop order
- Stop limit order
A market order is one that guarantees execution at the current market for the order given its priority in the trading queue. The market order is the most common order used to purchase securities.
A limit order is one that guarantees a price but not execution. If you want to buy and place a limit order it will be treated as a market order if your limit is at or above current market ask price. If you place the order below current market ask there is a chance that you don’t get filled but you have a better cheaper entry if you get filled (the order get executed).
A stop order (also refers as a stop-loss order) is your risk management order. This is a stop order you use to exit your position at the point where you think your trade is not valid anymore.
A stop limit order is a joint order of the stop order and the limit order. A stop-limit order will be executed at a specified price after the given stop price has been reached. The great thing about the stop-limit order is that it can be executed at a better price if for example the security traded is a stock that gaps away from the specified price. The reason for this is because once the specified price is reached the stop-limit order becomes a limit order at that price or better if there is an order that can fill your order.
If you want to become better at both fundamental and technical analysis – use limit orders and stop limit orders when trading. Make it a trading rule to only use orders that prevent you from chasing price and helps you buy where it is cheap and sell where it is expensive.
Simple Risk Management Strategy
Risk management is “the holy grail” in trading, a good risk management strategy can increase your profits more than any trading strategy can.
But what is risk management?
It is when you decide the risk (potential loss) in a trade and then take the appropriate action given your risk tolerance. You have to have a risk management strategy, else, you will end up digging yourself into a hole.
How to decide how many contracts you should buy or sell when you have a setup? It depends on how much you are willing to risk and where you are going to place your stop.
How much should you risk?
We recommend that you never risk more than two percent on trades, one percent is optimal, but only you can decide how much you should risk. Higher risk gives you a higher reward when you have winning trades but also larger drawdowns when you have losing trades.
Keep your risk low, in general, just think what a 50 % drawdown would do to your account. You may think that a 50 % win is going to take you back to break even, oh no, take a look at the example below.
Example: Your initial account capital is $100.000. You invest everything and suffer a 50 % loss, account decrease to $50.000 (=$100.000*0,5). You invest everything again and get a 50 % gain, account capital increase to $75.000 (=$50.000*1,5), but that’s $25.000 short of what you initially had. You need a 100 % gain after a 50 % loss to recover up to break even.
It is time to calculate how many contracts you should trade with depending on how much of your account in percent you are willing to risk per trade, say you only want to risk one percent. You can then calculate your risk per trade in $. With your $1.000.000 account:
One percent (0,01) * $1.000.000 = $10.000 risk per trade
Your risk for one trade is $10.000. Now you calculate the risk for each contract depending on where your entry and stop-loss is. For this example, you want to buy and placed a limit order at $40 and your stop-loss at $37. The risk per contract is then:
$40 – $37 = $3 risk per contract
When you now have risk per trade and risk per contract, you can calculate the number of contracts you can buy for the security, taking your risk per trade divided by your risk per contract, you will get the number of contracts you should buy.
$10.000 / $3 = 3.333 contracts
You can now enter your trade with 3.333 contracts and if your stop loss is hit you will know that you only lost one percent of your account and you will live to trade another day! This is an essential trading strategy you have to understand and apply to your trading if you want to achieve trading success and to avoid blow up your account, like so many traders do every day.
To Your Success,