Solid analysis is key to making the best decisions in both forex and stock trading. There exists two main methods of analysis in the discipline and these are called fundamental and technical analysis. In general terms, fundamental analysis seeks to understand values and trends by focusing on the financial records or statements of a company or business entity in order to come up with a fair estimate of their value. On the other hand, technical analysis thrives on the assumption that a business entities value is reflected in the information that is available to the public thereby focusing on analyzing parameters related to price fluctuations on the market.
Technical analysis is often thought of by most traders as a cumbersome process needing a sophisticated aliens mind, but it really comes down to understanding the supply and demand on the market and using the insight to know how the price is going to behave in the future. This article will look at the core principles of technical analysis and it how it compares with fundamental analysis.
What is technical analysis and what assumptions underlie its existence?
Technical analysis is essentially an approach to evaluating securities, currencies and other financial assets that uses statistical analysis of the activity on the market. The excessive use of forex charts and market data especially in forex circles has also earned it other colloquial terms such ‘forex chart analysis’ and ‘forex market analysis’. Additionally, forex trading based on fundamental analysis as a primary method of analysis is also known as fundamental analysis forex. The most common traded assets are currencies (as in forex) and company’s securities. Technical analysts seek to establish a solid foundation for investment decisions through the use of charts and other statistical tools.
Like most scientific approaches to evaluate information, technical analysis thrives on three main assumptions.
1. The Price Is An Accurate Reflection Of A Companies Or Securities Value
Technical analysis embraces what is known as the Efficient Market Hypothesis which stipulates that the price of the stock on the market is a reflection of its value. The intrinsic belief in this hypothesis is that everything that concerns a company, that is, the fundamental factors, broader factors and the psychology relating to the market is measured in the stock price. This eliminates the need for detailed analysis of other factors and directs the focus to the stock price thus the technical analyst’s fascination with stock or currency prices on the market.
2. Prices Take Definite Trends
Another assumption engrained in technical analysis is that prices take particular trends that can be short, medium or long term. To put it in simple terms, technical analysts believe that stock or forex prices have a high chance that they will carry on in a particular trend rather than moving in an indefinite pattern.
3. Patterns Tend To Repeat Themselves
Technical analysts have embraced the belief that price trends repeat themselves over a course of time. This is often recognized in the nature of price movements which usually repeat themselves over certain periods and this behavior is often related to emotions such as fear and excitement. Technical analysis combines an understanding of these emotions and related market trends to understand the movements on a broader scale. Most forms of technical analysis have thrived for decades due to the approach’s efficiency in understanding and predicting future market trends.
Technical And Fundamental Analysis: A Comparison
Having considered the basic assumptions underlying technical analysis, let’s have a deeper look at how the method compares and differs with the fundamentalists approach.
The different points of focus relating to these two approaches means a different set of tools used to evaluate the market trends. Technical analysis mainly utilizes charts whereas fundamental analysis employs financial statements. Fundamental analysis seeks to have an idea of the company’s value by analyzing financial records such as balance sheets, income statement and cash flows. The process aims to establish the value of the company by using the projected cash flow and the present net value by discounting the former to the latter. The resulting value is considered the company’s intrinsic value. When it comes to the market, a great investment opportunity means having a stock price that is less than the intrinsic value.
In sharp contrast to fundamental analysis, technical analysts do not take the company’s financial records into consideration, the object of focus is the stock price on the market as the general belief is that the stock price provides an accurate reflection of the company's value.
The time factor
Fundamental analysis is essentially a technique that takes a long term method when considered against technical analysis. The stock charts can provide data over varying periods of time ranging from a few minutes to weeks whereas fundamental analysis uses data that’s been collected over an extended period of time which can range from a quarter to a number of years. This makes fundamentalists to take a long time before they produce a company’s value. This method has the advantage that it may evade some of the factors that can result in the pricing of the company in a short period as the price may be corrected over a period of time.
From what we've considered, it’s safe to conclude that these two schools of thought pursue different goals. Technical analysts set out to find a lot of trades on a short and medium basis which can be retraced later on whereas fundamentalists aim to have investments that go a long way down the years.
Which Method Is The Best?
Well, this question will take you to varying responses from critics if you take it to the web for consultation. You are sure to come across strong views which favor either one of them or a combination. All in all, the best method to use comes down to the goals the investor has in mind. Those who are more focused on long term investments tend to go for fundamental analysis as a primary method whereas those who are more into making several trades in short terms tend to favor the technical methods. Some investors tend to avoid extremes and try to come up with a process that combines the two to increase the likelihood of success by minimizing the negative effects that come with overcommitting.
Combining Technical And Fundamental Analysis: Is It Worth It?
Fundamental and technical analysis seem to be two methods that are based on different and opposing values with each having a set of advantages and disadvantages. Some investors have adopted a more out-of-the-box approach by coming up with a sort of hybrid approach combining the two, to reap the good fruits of each approach. This has proved an effective method overtime as there are a lot of investments which have evidently benefited from the approach. An investor may use fundamental analysis tools to support a particular tool that is traditionally used in technical analysis, For instance, there are investors who combine the two, by first using fundamental analysis to find a stock which is undervalued and then employ technical analysis methods to identify the specific entry or exit points into the trade.
Technical analysis and fundamental analysis remain major players in the forex trading world despite the shortfalls attached to each method. The question of whether to select one or both rests in the trader’s goals and the available resources to fully exploit the analysis process. However, it is essential that every trader makes sure they have at least a basic understanding of each method of analysis in order to make informed decisions.