1. Fundamental analysis examines the health of a company using balance sheet data, revenue projection models and just plain common sense.
A fundamental analyst might say, "I'm buying XYZ because they have little debt, great cash flow and big profit margins, and everyone around the world seems to love their widgets more and more every day."
Pros
• Most of us agree with this thinking and can gather the data fairly easily.
• It is generally a smart practice to invest in a company with sound financials that is witnessing material revenue growth.
Cons
• The problem with fundamental analysis is that you are still making predictions about the future that may not come true.
• Fundamental analysis can be a lengthy, complex process.
• Remember that even if a stock looks financially healthy and is relatively cheap compared to its peers, that doesn't mean that it will always rise in value. A stock's price is also determined by the supply and demand of its shares.
2. Technical analysis looks at a chart of a stock's price movements. Analysts look for patterns to determine future movements in the stock. There are hundreds of "indicators" that can help find buy or sell points, or price trends and momentum.
Indicators have been created by investors over the years. They take the data in the chart and apply a mathematical formula. This produces a line, dot, band or other visual cue for the analyst to interpret.
A technical analyst might say, "I'm buying XYZ because the stock price is above its 50- and 200-day moving averages and has strong momentum at the moment."
Pros
• Patterns in price and volume can help us identify trends. They can also find price levels where investors tend to buy or sell.
• This analysis goes quickly once you know and understand the indicators you want to use.
• Technical analysis can help you rationalize the price you are paying. In other words, if you researched a company and simply bought it without looking at a chart, you have no way of knowing where the stock is in relation to its past.
Would you want to buy a stock that is at an all-time high and has just risen over 40% in the past month? What if you then looked at a chart and noticed that it had done that three times in the past, and that each time it hit a new high it then sold off 20%?
Cons
• There is an overwhelming amount of different indicators out there. It is tough to find the ones that are most effective for your style of trading.
• It takes skill and experience to identify trends and patterns.
What technical indicators should you use?
There are dozens of different indicators to choose from. Some are better than others.
I suggest that you focus on some of the more commonly used ones for your strategy. I believe that basic indicators, followed by many investors, are more reliable than more obscure methods.
Such common indicators include moving averages, volume, Fibonacci levels, Bollinger Bands, trend lines, ATR, MACD and Stochastics.
Hints and Tricks
Support and resistance levels give us price ranges to enter or exit a stock. Sometimes it helps to draw a trend line (like the one in black above) to find those levels.
Average True Range (ATR) and volatility help us measure how much a stock "normally" moves and if it is behaving oddly. This indicator may be either showing you an opportunity or warning you that there might be an underlying problem.
Moving averages help identify trends. A simple technique is to make sure a stock is above its 50- and 200-day moving averages if you are going long. On the chart above, these are the orange and red lines. Once the stock price gets below the 50-day moving average, it may be time to sell.
Summary
I believe that technical analysis works mainly because so many people believe in it and use it. It almost becomes a self-fulfilling prophecy.
It has been used in some form or fashion for thousands of years, dating all the way back to Chinese rice farmers. The patterns and indicators sometimes seem unusual, but amazingly, many still manage to find their way into a stock's chart. You would be amazed at what pops up.
Use a combination of both types of analysis. You would be foolish to omit one or the other.
Remember that there is always more than one solution
Jared A. Levy
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