Fundamental Investing and Technical Trading
Spread betting might sound akin to gambling but there are a wide range of tools available to help increase your chances of making a profit. If you wish to reduce the risk of incurring a loss and turn a tidy profit then you will have to learn how to analyse the markets so that you can predict potential buy and sell signals as accurately as possible.
There are two main categories of analysis that you can use to predict price movements, namely fundamental and technical analysis. Depending on whom you ask, there are those who swear by technical analysis while others feel that fundamental analysis is key. Then, there are the more conservative traders who prefer to combine both styles of analysis and they will only trade when both their fundamental and technical indicators line up.
You may have heard about “fundamental investing”, and you may even consider yourself to be a fundamental investor. You may have seen “traders” poring over charts looking for recognisable price patterns. On both counts, you might not have the faintest clue what I am talking about.
So what is fundamental investing, as distinct from technical trading, and do you really need to choose between the two?
Fundamental Investing: Understanding Fundamental Analysis
Fundamental anaylsis is the practice of studying the fundamentals of a business to determine if it is a good investment. It is a way of evaluating the value of a share on the basis of the underlying value of the business. This can involve evaluating key ratios such as P/E (Price Earnings), EPS (Earnings Per Share), looking at the amount of cash on the companies balance sheet and using this to calculate a cash value per share, looking at the companies revenues, profits and growth rates.
Fundamental analysis is a type of market analysis that derives a financial instrument’s value based on market fundamentals, which in the case of a company would be based in its financial and operational performance. For example, you would analyse the company’s cash flow, their operation and management style, their balance sheet to determine their debts and assets and more.
Fundamental investing as such is about assessing a company’s true long-term value as measured by recognised “fundamental” ratios such as the Price-Earnings (P/E) ratio. A fundamental investor hopes that the true value of the company’s stock, though currently not reflected by the share price, will be reflected in the share price over time. Some fundamental investors may not be investing for capital growth at all, but rather for a steady stream of dividend income as indicated by the “fundamental” ratio known as the dividend yield.
Some of the more common indicators investors use when analyzing the performance of a company include:
- Price-to-Earnings ratio (P/E) and Earnings per share (EPS) – this is used to determine the value of a company’s shares for every £1 of profit it makes. The higher the P/E ratio, the more valuable a company’s shares are and the lower the ratio, the less you will pay for the shares.
- Sales figures are vital for companies in sales-driven industries, such as retailers, and many traders base their decisions on forecasted sales figures.
- The Net Asset Value (NAV) per share is often used by traders to determine the minimum amount investors would pay per share of a company and then look for companies that are trading below their NAV per share.
If you were trading currencies, then you would analyse the economies of the currencies you are trading. So, if you are trading the USD against the GBP, then you would want to analyse a number of economic reports from both countries, including the GDP, consumer confidence, employment numbers and more.
A “fundamental” approach to trading commodities might involve assessing the prospective future supply and demand characteristics of the particular commodity that might cause the price to rise or fall.
In all cases, the fundamental investor or trader distinguishes price from value. Just because a stock, commodity, index or other financial instrument is “cheap” in the sense of its price being much lower than it used to be, this doesn’t mean that it is “good value”. As an analogy: the steak that is half price in the supermarket today may be cheap, but it not necessarily good value if it can only get cheaper because the sell-by date is fast approaching.
In general those who invest in shares based on fundamentals are taking a longer term view to their investments. They realise that perhaps the market is currently undervaluing a share based on their understanding of the fundamentals of the company and are hoping that overtime the market will realise this and the share price will correct itself.
From a spread betting perspective you can use fundamental anaylsis to find out if a stock is currently undervalued and therefore go long (or buy) the share in question. You could also use fundamental analysis to find out if a share is currently overvalued, which may lead you to short the stock on the basis that when the company’s share price re-adjusts this will result in it falling.
Technical Analysis of shares is the complete opposite of fundamental analysis in so far as it completely ignores all data relating to the underlying value of the company in question. Instead technical analysis attempts to predict the future movement or direction of a share based on its past performance. Technical analysts are sometimes referred to as chartists.
What is Technical Analysis? Technical analysis involves the study of statistical data such as historical prices and trading volumes to attempt to forecast future movements of prices. Many traders believe that price can be predicted according to the historical performance of a financial instrument.
This is a form of analysis that simply takes into consideration price charts and overlooks any fundamentals. It relies on using patterns and mathematical formulas to attempt to identify patterns. The most important tool of a technical analyst is the chart, where the price of a financial instrument is plotted over a period of time. The trader can use the chart to identify patterns and trends which will help him predict a possible future movement in price.
Technical traders believe that everything is reflected in the price, and that ultimately something is only worth what someone else is willing to pay for it today. While this implies that prediction based on an assessment of a company’s true value is futile, it doesn’t mean that price movements – which are a prerequisite for making money – cannot be predicted.
For technical traders, the prediction of future price movements is based on observation of past price movements. Technical traders believe that human psychology and even computer algorithm psychology (if we can imagine such a thing) is such that historic price patterns will likely repeat themselves. If a price has rebounded upwards from a particular support price or has rebounded downwards from a particular resistance price then it will likely do so again. If the price is rising now then it will likely continue rising, and if it is falling now then it will likely continue falling.
Technical traders base their trading decisions on price charts and chart patterns.
Over the years the concept of technical analysis has spurned great debate amongst professional traders with some (generally those from the fundamental analysis school of thought) saying it is for the birds, is up there with astrology and basically has no bearing on what a share’s price might do in the future.
Others however believe strongly in it the concept of technical analysis and many studies, statistical analysis, computer programs written, etc over the years to try determine whether or not it is an impact on share price movements. Whatever your thoughts on it there is no doubt that it plays a huge part in modern day trading and you would be amiss to ignore it completely. Certainly having a grasp of the basics such as moving averages, areas of support and resistance, trend lines and trading volumes is important if you are to become a successful spread trader. I’ll cover many of the key concepts of technical analysis on my blog over the coming weeks and months.
As an aside, this particular spread trader started live very much in the fundamental analysis school, but as time went on and I gained more and more experience trading I have slowly but surely moved towards more of a technical trader. My general approach these days is to try combine the two, I look for stocks which I believe are fundamentally undervalued by the market, and then use technical analysis tools to time my entry into any trade.
Although fundamental investing and technical trading are often portrayed as mutually exclusive, I don’t see it that way. In a position trading strategy it is perfectly possible to make a trading decision based on the short-term price behaviour of a stock that has long-term fundamental potential.
Even though there are advocates for fundamental analysis and for technical analysis, the fact is that neither system is infallible. Spread betting is a matter of probability and the key is to find a system that has a higher level of probability of being right and generating profits, which usually means combining both styles of analysis to generate better results.
In his book How I Made $2 Million in the Stock Market, legendary dancer-turned-speculator Nicolas Darvas recounts the story of how he migrated from being a fundamental investor to being a technical trader, ultimately to settle on the hybrid style of a techno-fundamentalist.
Note that if you’re day trading, and possibly if you’re swing trading too, you will likely be a technical trader who cares little or nothing for the “fundamental” attractions of the markets you are trading.