In the previous part of this Beginner’s Guide series, I addressed 3 common (and also costly) mistakes when it comes to trading. There, I also alluded to analyses which help you to make an informed decision on your trade. Knowing this would help to answer a fundamental question:
“How do you know when would be a good time to buy/sell a stock?”
Finally, after all these rounds of appetizers, we arrive at the main course. The meat, if you would, where we can delve much deeper into: Fundamental Analysis (FA) and Technical Analysis (TA).
Essentially, these are the two schools of thought when it comes to trading and investing.
If you want to take active charge of your finances, you have to know this.
An exception would be that you’re adopting a long-term dollar cost averaging (DCA) approach, which does not call for discernment as to timing or entry into the position.
I would think that if you’re reading this, you would not fall under the latter category that is into DCA, right?
This article is meant to serve as an overview into FA and TA, for I am sure that this topic would be entirely foreign to some of you. Once you get the basic moves, we can get swimming towards the deeper end of the pool. And then, head out to the open sea and attempt to swim with the whales.
You can be sure that there is much to be discovered, enjoyed, and gained.
1. Fundamental Analysis (FA)
Recall that the goal of any analysis would be to answer the question: “How do you know when would be a good time to buy/sell a stock?”
In the case of FA, this is answered by deriving the dollar-value of the stock. This dollar-value is also known as the intrinsic value of the stock.
For example, Apple’s stock price is currently $148.64. However, after conducting FA, the intrinsic value is determined to be $115.23.
Comparing the current price with the intrinsic value, you would be able to know whether the stock is currently undervalued (stock price lower than intrinsic value) or overvalued (stock price higher than intrinsic value).
Those who adopt FA hold the view that over time, the stock would eventually move towards its intrinsic value. So if you buy an undervalued stock, you would be looking for it to correct upwards towards its intrinsic value, and eventually profit.
How do we know what the intrinsic value is?
Your next question will then be – how is FA being conducted? How did we arrive at this sum? Why are there different scenarios in the example above?
To be clear, there is no one magic formula which everyone uses when it comes to deriving the intrinsic value of the stock. (Can you imagine if there was indeed a magic formula… Wouldn’t everyone be attempting to buy and sell at the same prices?)
Nonetheless, here’s a broad list of factors that are being analyzed in FA. These factors all influence the business to varying extents:
- Overall economy
- Industry conditions
- Changes in consumer behaviour
- Company’s financial strength (i.e. balance sheet, income statement, cash flow statement)
- Company’s management
It is also noteworthy that Wall Street analysts seem to widely adopt FA.
Depending on the number of factors you are taking into consideration, conducting FA might take a long time. However, because both macro and micro factors do not change frequently, this analysis is typically updated on a quarterly basis when the company provides a financial update.
Therefore, you could also view FA as a method which holds a longer timeframe, and has less action as compared to TA.
For further investigation into this topic, here are some commonly used methods for your learning pleasure, each serving different purposes:
- Price-to-earnings ratio (P/E ratio)
- Forward P/E ratio
- Price/earnings-to-growth (PEG) ratio
- Price-to-sales ratio
- Price-to-book (P/B ratio)
- Discounted cash flow
For even further practice, here’s an example of how FA can be conducted on AAPL.
On that note, there are also “intrinsic value calculators” which tend to be proprietary in nature. These typically shortcut the work for you at a cost, seeing that there are multiple data points that have to be pulled out, with specific formulaic calculations being applied.
Sounds interesting? Here comes TA with its different set of features.
2. Technical Analysis (TA)
Let’s come back to the question: “How do you know when would be a good time to buy/sell a stock?”
TA answers this by looking at the statistical trends, typically in the stock’s price and volume, to identify patterns. By analyzing the pattern which the stock displays, one can gather its characteristics and make an educated guess about where it might be headed in the near term.
Unlike FA which attempts to derive the intrinsic value of a stock, TA posits that all known factors have already been taken into consideration in the price action. Thus, TA looks at price charts to gather clues on patterns and trends.
Although one can study the stock charts to identify candlestick and chart patterns, there are other simple and powerful studies which can be utilized as well.
What tools can we utilize in TA?
There is no lack of studies available in TA, and it is not uncommon that these give off contradictory signals when used in combination. Nonetheless, all it takes is to find combinations which work. Remember, simple doesn’t mean ineffective. In fact, it could be precisely because these are widely used that gives them some amount of credibility.
While the tools to use also differ on your trading strategy, here are some common ones to use:
Simple moving averages
These track the price movement over a period of time to average out the stock’s price. The direction and slope of the moving averages show you the trend of the stock. The steeper the slope, the stronger the trend. Adding moving average lines of different parameters (i.e. a different time-frame) would assist in identifying changes in the trend as well.
For instance, in swing trading, you could use the 20-day and 40-day moving average to show you how the trend is performing. If the 20-day moving average crosses below the 40-day moving average, this would signify a change to the downtrend in the short-term.
Depending on your timeframe and strategy, moving averages provide a simple yet powerful analysis of the stock’s movement.
Support and resistance
Think of the support as the floor, and resistance as the ceiling. These are horizontal lines which can be interpreted without the use of specific tools. All you need to do is connect the highs and lows of the price points.
There is a rationale behind these support and resistance areas.
The support is where bulls are stronger than bears, as they buy into the stock and prevent further dips in price. Conversely, the resistance is where bears are stronger than the bulls, as they sell the stock and prevent further surges in price.
So if the resistance is broken, it means that the bulls are charging upwards. Likewise, if the support gets broken, bears and leading the price downwards.
For a little more insight into the psychology of support and resistance (memories, pain and regret), check this quick read out.
Similar to the support and resistance, trend lines are horizontal lines drawn by connecting the highs and lows of the price points. These would be useful when the stock is trending up or down, as it offers insight as to where the prices might land next to form new highs or new lows.
There are also a variety of indicators (trend, momentum, volatility, volume), which I will go into greater detail in subsequent articles. For now, this would suffice as an introduction.
If you are already raring to go, TradingView is a widely-used platform where you can discover a variety of tools available for TA.
3. Which is better – FA or TA?
Now that we’ve had a better understanding of what FA and TA are, here comes the million-dollar question: Which is better?
To which, my immediate response would be: For whom, and what purpose?
The question of “who” is, again, meant to be a personal one. Only you would have the answer to that.
This is because you have your own preferred style of doing things. The same applies with trading – surely you would have your preferred methods. (If you don’t know yet, you’ll figure it out as you experiment. Ideally with paper trading first, please, before using live capital.)
As for the purpose, you should be able to see that using FA typically involves an investor’s mentality, which has a longer time horizon in mind. On the other hand, TA is used commonly for trading as the time horizon is shorter. Should you not know the difference between the investing and trading, do check this quick differentiator out.
Nonetheless, this is not to say that the two cannot be combined.
Regardless of the method, let’s face it – we only have one common goal in this. Which is to make our monies work hard for us.
So instead of strictly sticking by either one, wouldn’t you agree that it always helps to stack the odds in our favour?
4. Combining both FA and TA
Assuming a FA-first approach, meaning that you have already derived the intrinsic value of the stock, you could use TA to help time your entry and exit. This can be done by using oscillators (more on that in a subsequent article) to identify overbought and oversold regions. By entering in an oversold region, the chances of the stock rallying are higher. Similarly, by entering in an overbought region, the chances of the stock correcting are higher as well.
Alternatively, assuming a TA-first approach, you could use FA to identify stocks with good fundamentals. This would give you the conviction that the stock would climb higher. Conversely, if the fundamentals reflect less strength, you would be more cautious in entering the position, or perhaps even choose to go with a counter with stronger fundamentals instead.
The first time I was learning about FA and TA, I honestly thought to myself – this is hard! Then I remembered the saying…
That nothing worthwhile is ever easy.
Rather than haphazardly getting into stocks, which is like blindly throwing money into the stock market, it made sense to grind through the learning and get practice.
After all, mastery comes with experience. The more I expose myself to it, surely it would sink in and eventually make sense.
Again, the key is not to master everything, but to have a system that works for you. Be it FA or TA, or combining both, it’s about what is comfortable for you in the long-run.
If I compare this to all the other life-skills that I’ve learnt, then I’ve got to be patient and continue working at it.
There’s more fun to come, which in this case will eventually lead to more funds too. Focus on the process, and the result will take care of itself.
Can anybody start trading and investing on their own? If you’ve read up to this point, the answer is a resounding yes. Stay tuned to the next parts of the series as we adopt a systematic approach in generating a step-by-step beginner’s guide.
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