Should I use technical analysis or fundamental analysis?
To make profits from movements in the financial markets you need to position yourself as a trader or an investor and base most of your financial positions on technical or fundamental analysis.
Before you start making profits on the financial markets, you should choose how you will make it – as a trader or as an investor as there are some significant differences. As an investor, you would try to make money by investing in assets and securities for a more extended period. On the contrary, as a trader, you will execute short term trades (even as short as a couple of minutes) to earn profits when prices increase and decrease. Hence, investors can be referred to as buy-to-hold while traders are thought of as buy-to-sell.
Investors aim at a steady increase in their wealth while traders look for swift profitable opportunities, entering and exiting trading positions more frequently. As a trader, you can enter a buy transaction where you anticipate a price increase or a short selling transaction where you expect the price to decline.
Both traders and investors have the same basic types of analysis available for developing their strategies, and these are the technical analysis and fundamental analysis. Even though both of them can be used simultaneously, nevertheless, traders rely more on technical analysis, whereas investors are inclined toward fundamental analysis.
What is technical analysis?
Technical analysis is based on charts and indicators with which the trader aims to identify potential trend direction and determine profitable entry and exit points. The analysis considers the information about past prices and examines the momentum, volatility, trend and volume. When using technical analysis, you read different types of charts and graphics to find patterns and schemes in the past behaviour of the asset price. The technical analysis is based on the premise that what happened in the past will repeat in the future and that in an efficient market, all relevant factors are already incorporated in the price.
You can develop a trading strategy and plot different indicators and charts for a variety of periods. You might look for patterns in minutes charts, hourly, daily, weekly charts, and so on. Select your time length in accordance with the type of trading strategy you plan to use. If you are a position trader, use longer periods, but as a swing trader, you are interested in a medium time length, while with scalping strategy, you will set up short time frames.
Pros of technical analysis
- You can execute the analysis in less time compared to fundamental analysis;
- Since it incorporates the application of different indicators, you can easily use them in your trading activities;
- All relevant information you need is readily available for the majority of assets types and securities;
- A rather inexpensive way to develop a trading strategy because most of the indicators are immediately available on your charting platform.
Cons of technical analysis
- It is based on past data, which means that it doesn't consider factors that could affect the price movements (news, announcements, changes in economic conditions, etc).
- You can always incorrectly predict the market behaviour and loss can occur due to false signals;
- If you trade multiple assets, you must define a new set up for the specific asset. Different assets exhibit different price behaviour. For instance, setting up a combination of indicators may give you the correct signals for the GBP/USD currency pair, but the same set up may result in false signals for EUR/USD currency pair. Consequently, if you plan to trade both currency pairs, you will have to define two separate setups.
What is the fundamental analysis?
Fundamental analysis focuses on estimating the true value of a stock based on multiple factors that could have a direct or indirect effect. When using this type of analysis, you will basically look into the economic indicators, overall market and industry conditions, and company-specific factors such as earnings, liabilities, expenses, assets, financial ratios, managing team.
In general, this type of analysis is commonly used by long-term investors with a higher level of resources that aim to make higher profits over a prolonged period. Nonetheless, any investor and trader can perform at least a basic fundamental analysis as long as they have the necessary knowledge.
Advantages of fundamental analysis
- Your assessment is based on an in-depth analysis by considering a plethora of factors that could influence the stock value;
- You don’t rely solely on the past performance of the underlying asset;
- Following the economic calendars, you can get into the basic conditions of the economy and you will know what to expect;
- You don't have to constantly open and close positions, because you make long-term investments.
Disadvantages of fundamental analysis
- It is time-consuming because you have to keep track of a variety of information and analyse the collected information.
- Some information may not be easily found or you may not be able to gather all relevant data;
- It can be a more expensive type of analysis compared to the technical analysis;
- You should have an understanding of other areas such as economics, finance, industry-related knowledge. For instance, do you know how to read the financial statements? Are you acquainted with different types of financial ratios used for analysing a company’s performance? Do you know how changes in interest rates affect the price of a specific asset?
Which type to choose?
Most probably, you will ask – which type of analysis you should use. Well, the short answer is to use the one that makes you profit. The long answer would be that as a trader, you use technical analyses and as an investor, you use fundamental analysis. Nonetheless, there is no right or wrong decision when it comes to the type of analysis you will use, but if possible, a combination of both may give the highest benefits.
The best way to select your preferred analysis is to go through your personal preferences, your level of knowledge, available time, and the desired trading strategy. Decide whether you will take short-term or long-term positions in the financial market. Moreover, if you are a newbie investor with no technical background, you can start with a practice account using technical analysis, while educating yourself about the functioning of financial markets.
Comparison of technical and fundamental analysis
- Mostly used by: Long-term investors
- Type of information used: Economic indicators, industry data, company data, financial ratios, news
- Looking for: The intrinsic value of a stock
- Profits: Potential to earn higher profits in the long run
- Objective: To predict future asset performance using internal and external factors
- Buy/sell positions: When the stock is undervalued/overvalued
- Mostly used by: Short-term traders
- Type of information used: Past data
- Looking for: Patterns in price behaviour
- Profits: Potential to earn small profits over and over again
- Objective: To predict future movements based on patterns because it assumes that historical movements repeat.
- Buy/sell positions: When the trader determines and confirms a buy or sell signal.
FURTHER READING: How to read trading charts
FURTHER READING: Should I become a full-time or a part-time trader?