Accountancy Resources
Fundamental Analysis examines the trends a company has reported to pick a logical and reliable investment or the selection of companies based on financial strength and performance.
The alternative — technical analysis — is described. Fundamental analysis relies on the most recent history of financial statements and the trends these reveal to pick companies. The technician analyzes price patterns and signs to pick a stock. These two approaches — picking a company based on history or picking a stock based on price patterns — are quite different.
However, both fundamental and technical indicators can be used together.
The value of using fundamental and technical indicators together is that this provides you with twice the information. Both sources are worth studying, and neither is exclusively ‘right’ or ‘wrong’ for everyone.
Traders are understandably concerned with improving the timing of their trades. So they seek entry and exit signals in order to improve their timing. These involve a wide range of indicators that work together or, of equal value, contradict one another. Contradictory indicators should warn a trader away from making a decision merely because there is no clear or strong signal. Traders need reliable and consistent signs.
When you find a company that appears strong in all of the fundamental tests, the technical indicators can be used as confirmation, an independent and separate method for verifying the strength of a company as well as assuring yourself that your timing is good. The same confirmation action can work in the opposite direction, with fundamental strength confirming the strength of a stock and timing that technical tests reveal.
Investment Risks examined a series of risks from a fundamental perspective. Technical Knowledge and Experience Risk takes another look at the risk issue, but from a technical point of view.
Technical indicators are not only separate methods for timing entry and exit, but are also valuable as confirming signals for fundamentally based investment decisions.
The first distinction that has to be made between fundamental and technical analysis is that of risks. An investor is most likely to purchase shares of stock as part of a buy-and-hold strategy. This may last years or, for some, only a few months. The selection is based on the company rather than on the price trend in the stock. In comparison, a trader is more likely to focus on the price movement and trend in the stock and is much less interested in the fundamental strength of the company.
So investors focus on financial history and traders focus on the current price.
In summary, that is the most likely distinction between investors and traders; however, you can combine fundamental and technical analysis to round out your opinions of companies and their stocks, time your entry and exit, and diversify your portfolio. This also diversifies your risks, because the types and degrees of risk for investors and traders are not identical. They are quite different.
The basic difference between fundamental and technical is in focus, either on historical financial results, or on anticipating price movement.
Market risk is going to be found in all kinds of markets, even those in which price trends are uncertain. Traders are keenly aware of this and tend to develop strategies to maximize profits in bull markets (characterized by a trend of rising prices) as well as in bear markets (markets where prices are on the decline). Traders believe that by using the right strategies and positioning themselves correctly it is possible to make profits in both kinds of markets. In comparison, those who believe profits are only possible when stock prices are rising (bull markets) by definition have to stay out of the market when they think prices are declining; and that is half the time.
Market risk was explained in the Investment Risks and from a fundamental perspective. A fundamental investor (likely as well to be conservative) has to be aware of price volatility even though the selection criteria include mostly or exclusively a range of fundamental indicators. Most fundamental investors seek stocks of companies with exceptional capital and market strength that are likely to rise in value traders rely on technical indicators (and are more likely to be drawn toward speculation rather than a buy-and-hold strategy), and they understand that price volatility defines risk. So market risk from a fundamental point of view can be clarified and called volatility risk for the technical trader. Traders are likely to recognize the potential for profit in either bull or bear markets, and also are likely to use a range of different strategies that work in both situations.
Volatility risk is specifically related to the breadth of the trading range. This is simply the point spread between the most recent high and low price levels at which a stock has traded. Breadth is relative, however. In a $10 stock, a breadth of two points is considerable; in a $100 stock, it is less volatile simply because the stock’s price is higher. So breadth defines volatility, and the degree of breadth is the price movement in comparison to the price level of the stock.
The trading range can be thought of as a reflection of supply and demand, just as it works in any other market. In real estate, if houses within one neighborhood usually sell for between $135,000 and $150,000, the ‘trading range’ of housing is defined between those high and low prices; and the ‘breadth’ is $15,000. This could also be called a 10 percent breadth because the price difference between high and low is 10 percent of the high.
In the stock market, breadth and trading range are what define volatility risk. The greater the breadth, the greater the risk. For traders, who are most likely to focus on short-term price movement, higher volatility means greater profit potential in a short period of time. It also means greater volatility risk. For most traders, the most realistic approach is to focus on the stocks with moderate volatility, thus accepting moderate volatility risk in exchange for potential profits. If volatility is too high based on a self-defined risk tolerance, the stock is not appropriate. If volatility is too low, then traders will be equally disinterested because in exchange for low risks, profits are also unlikely.
The trading range is the entire framework for technical analysis, and for identifying varying levels of price volatility. Virtually all technical indicators rely on observations of price movement in relation to the trading range.
Trading range, or the price difference between high and low trading in recent sessions, is the most important technical concept to remember. Without identifying a trading range, you cannot interpret current price movement or identify risk levels.
In technical analysis, two terms are essential, as they frame the trading range and give meaning to the current supply and demand for shares of a particular company. These are support and resistance. Support is the lowest price in the trading range, or the lowest level at which sellers and buyers can strike an agreement to exchange shares. Resistance is the highest point in the trading range, or the highest level where price agreement is possible under prevailing conditions.
The concepts of support and resistance define the majority of technical indicators, and traders rely on the structure provided by the trading range (defined as the price breadth existing between support and resistance) to identify strength or weakness of price movement. Most technical indicators involve price ‘tests’ of support or resistance. A breakout below support or above resistance has significance, whether it represents creation of a revised trading range, or fails and price then retreats back to the established trading range. Many indicators involve failed tests of these borders, often preceding price movement in the opposite direction.
The borders of the trading range — support and resistance — are the ‘lines in the sand’ that identify success or failure of all short-term price movement.
The trading range, its breadth, and the action between price and the borders of support and resistance are the entire structure of technical analysis. Trading relies on the interpretation of price patterns and, specifically, on how price moves within (or breaks out of) the support and resistance borders.
Traders also face the endless challenge of how to make the best use of capital, based on their risk tolerance and willingness to use borrowed funds. Investors have to contend with this as well. Do they limit investments to available cash or use margin accounts to virtually double their potential positions? The more leveraged a position, the more profit potential and the greater the risk of loss.
For traders, leverage is just as much of an issue. However, because traders tend (generally) to be willing to assume higher levels of risk than investors, their leverage risk may be greater as well.
With more potential for loss, leverage may mean much greater dollar value to loss as well as dollar value to potential profit. This is a reality for traders, and as a consequence, many will limit their use of basic tools such as margin accounts simply to keep risks low even in trading strategies demanding greater risk levels. So the overall risk should be part of the equation for traders; greater risks associated with short-term trading can be made even greater by also maximizing the use of a margin account, for example.
Leverage is a great way to double or triple your profits; it is also an efficient way to expand your losses just as quickly.
To keep this in perspective, ask yourself: Would you max out a homeowners’ equity line of credit (HELOC) to free up funds to trade stocks? Most people would reject this as too high-risk and also as an action likely to threaten the security of their home. However, the same people who would deem using home equity too risky might use a margin account to double up their positions in stocks. If the stocks lose market value, the money borrowed in a margin account has to be repaid.
For example, assume you have $20,000 in cash. Under the margin rules, you have to maintain 50 percent in cash and securities, meaning you can borrow $20,000 in your margin account and create stock positions of up to $40,000. If the prices of stocks go up 20 percent, the $40,000 placed into shares of stock increases in value to $48,000. The $8,000 profit is great, and is twice what you would have profited using only cash. However, what happens if the positions lose 20 percent? Now the account is valued at only $32,000. Because you have to maintain that 50 percent value in your margin account, you would get a margin call from your broker, and would be required to either come up with another $8,000 or sell some of your holdings. The $8,000 would restore value to $40,000 and satisfy the 50 percent margin requirement. If you do not meet the margin call, your broker then sells $8,000 of your holdings. This reduces your account value to $24,000 and also reduces your margin to $12,000.
Leverage risk for traders based on maximum margin can be described as the risk of losing twice as much in exchange for the potential of gaining twice as much. Before creating maximum margin positions, it is important to understand this risk and to be willing to accept it or, if not, to avoid margin trading altogether.
Margin-based investing is simply getting access to the potential for doubling profits . . . or losses.
Another way that traders use leverage is through the use of options in addition to buying and selling shares of stock. Options are intangible contracts to buy or sell lots of 100 shares of stock. They cost only a fraction of what it would cost to trade 100 shares, and that is where options are so attractive and have become popular as a trading and speculative tool.
Options are attractive not only as speculative tools, but also as a means for managing a portfolio. For long-term investors, options can provide insurance for paper profits, or create short-term profits for no added market risk. However, they are complex instruments and are more completely explained in Basic Long Option Strategies.
For the moment, it is only necessary to understand that options are excellent leverage products. However, they involve specific types of risk. Your brokerage firm will allow you to trade options only once you have established your experience in options trading and knowledge of risks. You also need to maintain a level of account value in order to trade options, which requires a margin account; and brokerage firms require minimum account value before the margin account is available.
Brokerage firms assign trading levels for options trading. Under the lowest level, you are allowed only the most basic of trading techniques. More than any other method of trading, options are complex in terms of the jargon and sheer number of possible strategies. Some are very high-risk and others are quite conservative. Remember, however, that as with all kinds of strategies, knowing the range of risk is the essential first test you need to pass before placing money into the market. This applies to options and other forms of leverage more than with the act of just buying stock.
Traders can take up two general kinds of positions in the market, whether involved with stocks, options, or exchange-traded funds (ETFs). The best known of these two is a long position. Under this approach, you buy shares of stock or an ETF (or an option contract). The sequence of events is the well-known buy-hold-sell.
Traders can also take up the opposite approach, the short position. Under this approach, you sell shares (or options) as a first step. This exposes you to substantially higher market risks.
For most traders, the long position is better known whether it involves all cash or margin (or other forms of leverage).
Traders who use short positions generally take much greater risks. So short position risk describes using the initial sale to create profits when the value of the stock falls, or involves the risk of loss if and when the value rises.
Short positions are used in a variety of different ways. Selling stock, a strategy called short selling, is a complex and potentially high-risk strategy. Under this approach, your brokerage firm borrows the shares of stock and lends them to you to sell. So you have to pay interest on the borrowed stock while also being exposed to market risk. You hope the price of stock will fall so you can close the position at a profit. If the price rises, the transaction ends up in a loss.
Most people new to trading will be likely to avoid short selling as an acceptable strategy. The risk level and cost of shorting stock are too high for most individuals; and with the use of options, it is possible to play a bear market without needing to go short.
Imagine mortgaging your house to get all the money you could, selling everything else you own, and converting all your assets into speculating on the price of a single tulip bulb.
As insane as that sounds, it happened in the 17th century, not just to one person but to a spectrum of people from all walks of life. This famous example of a market mania has been called the ‘tulip mania’ and it had a disastrous outcome. The prices of tulip bulbs exchanged as commodities ran up to unbelievable levels when speculation fever took over and thousands of people wanted to get in on the amazing profits.
The rarity of tulip bulbs was the beginning of the problem. A seed may require 5 to 10 years to produce a tulip flower and another 3 to 5 years to work itself into a bulb. Rarity is also defined by specific color markings. In 1635, the commodity trading activity began on tulips still in the ground, and the action was done via promissory notes instead of the exchange of cash. Trading even went beyond this, with sales made for tulips that had not yet been planted. This was called a windhandel (wind trade).
As irrational as the tulip mania was, it was not an isolated case of temporary insanity. Trading in all markets is always susceptible to manias of exactly the same kind.
Prices ran up very quickly, within less than one year, and one record-level sale involved the sale of 40 bulbs for 100,000 florins. To put this in perspective, a ton of butter was worth 100 florins at that time. Two years after it began, the bubble reached its peak and very quickly evaporated. Thousands of speculators, mortgaged and leveraged to the hilt, were completely destroyed practically overnight.
This puzzling event took place on a large scale and involved commodity prices running into outrageously high price levels. It relied on a true mania, a form of greed in which those on the outside think they are losing the opportunity to get rich like everyone else. They take risks they cannot really afford and get into the market, and the new demand creates even higher prices.
There are three issues that define greed buying like this. First, when profits look easy or automatic, logic is abandoned. People will pay anything just to get a position in the market as long as they are sure prices will keep rising. Second, speculators think the upward move will never end. And third, speculators do not set exit levels for themselves, where they will take their profits and get out. Oddly, when asked, speculators express the belief that they will somehow just know when prices are peaking. The truth is that as long as there is someone else willing to pay more, speculation looks like a game impossible to lose. But the day finally arrives when the new speculators run out. The ‘greater fool theory’ — the belief that there are always plenty of people who will pay more than you did — only works for a while.
Greed trumps logic; it also trumps risk awareness and ultimately destroys a speculator’s plan to double up and get out.
The same mentality works when markets are falling. Panic is just as irrational as greed, and traders will sell out of positions to avoid bigger losses tomorrow. The result of greed and fear is that traders may buy high and sell low instead of taking the sage advice to ‘buy low and sell high.’
The greed and panic risk — or extreme reaction risk — can be expressed in another way: ‘Bulls can make money, and bears can make money. Pigs and chickens get slaughtered.’
Tulipmania was not just an oddity that happened once 400 years ago. Similar manias have occurred throughout the history of trading in stocks and commodities, even quite recently. Between 1995 and 2000, the dot.com bubble that created the new Internet sector at one time had thousands of companies selling stock, many of which produced no products and offered no services. As many inexperienced first-time entrepreneurs became millionaires overnight based on nothing but a public offering, a growing number of others jumped onto the trend. Today, many of the most successful companies are survivors of the dot.com years, but for every success story, there are hundreds of cases of people losing everything, not only in start-up offerings but also in speculation in the stock of these new companies that have nothing in the way of assets or even products.
The dot.com fad of recent history was just as illogical as any other mania. Traders invested fortunes in companies with no tangible assets and no product or service. It’s no surprise that most of the dot.com companies are no longer around.
At various times in the history of the United States, investment crazes have occurred in real estate, cotton, railroads, canals, the auto industry, time-share computers, and biotechnology, to name only a few industries. In most of these instances, the few companies that survived produced a product that had a market, but often with too many players. For example, in 1910 there were more than 200 auto manufacturers selling cars in the United States.
In Investment Risks, knowledge and experience risk for fundamental investors was analyzed and explained. This referred to the actual investing background an individual needs to have before being able to realistically understand the stock market and how it works.
Of equal importance is a variation of the same idea, or technical knowledge and experience risk. This is quite different than the fundamental risk requiring an understanding of financial statements and trends. On the technical side is the range of price and volume trends and measurements of price movement. This includes a lot of formulation and the study of how different moving averages converge or diverge; how subtle shifts in price patterns or gaps in between trading sessions change the picture and anticipate what comes next. The name ‘technical’ analysis is accurate because it is very technical and in many instances difficult to grasp.
The need for a keenly developed interpretive skill cannot be emphasized too much. Technical analysis is focused primarily on price trends or, more to the point, on anticipating price direction based on the most recent indicators. Many of these are hard to spot or can be misread; even the best-understood technical signal can also turn out to be a failed signal, meaning that an indicated direction simply does not materialize. Technicians attempt to manage or spot failed signals by confirming what appears to be going on or by waiting for a secondary change in the current trend.
The technician who relies on the study of price indicators is also called a chartist because he or she studies price charts of selected stocks in the attempt to spot entry and exit signals, and to make a move before the larger market also recognizes what is going on. A chartist who succeeds in the early detection of developing price changes is probably more experienced than the average trader, and knows how to interpret signals as well as spot a potential failed signal.
Technical analysts are different kinds of people than fundamental analysts. Technicians enjoy the fast-paced action of the moment and are probably more willing to take risks as traders. Fundamentalists take greater comfort in historical trends and the potential for sustained long-term growth, even to the extent of ignoring and completely discounting the chaos of short-term price movement.
Investors cannot simply become traders overnight. The risk tolerance is different and each discipline defines different kinds of people, with different philosophies about the markets and how to use them.
The topic of risk is different from a technical point of view as well. Fundamental risk is related specifically to historical financial strength and operating trends. In comparison, technical risk is related to price volatility and trends and to related indicators (like volume, for example) that also are derived from trading action. Technical risk management requires traders to select stocks for trading that match risk tolerance, and that reflect known volatility the trader finds acceptable. This is very focused, because it involves price as a primary indicator (and for some the only indicator). Compared to fundamental risk management, this is a more concentrated form of risk management. Fundamental analysis has to test many factors including profit and loss, capital strength and working capital, dividend trends, competitive stance within a sector, and quality of management. Technicians seek indicators that anticipate changes in price movement of the stock. There is a lot involved in this process, but the focus is narrow. An observation of fundamental and technical analysis is often summarized as being the difference between hindsight and foresight, investing and trading, low risk and high risk, or conservative and speculative. These generalizations may apply, but not in every instance. An equally important difference is a reflection of market culture itself. There are significant differences in the perspectives of investors and traders that also show up as different attitudes and opinions between fundamental and technical approaches to the market. Among the many adages about the market, one applies to help make a distinction between the two groups. That is, ‘The market rewards patience.’ Fundamental investors tend to be very patient and methodical in their approach to the market, but technical traders need and want results immediately, perhaps within the trading day.
Technical strategists enjoy the excitement and fast action of the market. Fundamental investors are patient and willing to wait for many months, even years, to realize a profit.
Some people on the technical side find the fast entry and exit to be exciting and stimulating, and it is. Traders may be classified as occasional players in the market or as high-volume traders. For example, day trading is an activity in which trades tend to be entered and exited within a single trading session. So by the end of the day, no open positions remain. From a regulatory point of view, day trading presents a problem of a different kind of risk. All margin requirements are based on positions at the end of each trading day, so day traders can execute a high level of trades and use leverage to expose themselves and their brokerage firm to risk, but without incurring any margin requirements. For this reason, a requirement was put in place to identify pattern day traders and require them to maintain a minimum cash and securities value of $25,000 in their accounts. This individual is defined as anyone who executes trades in the same stock four times or more within five consecutive trading sessions. If orders reach this level, they will be banned if the trader does not have an account with the broker with at least $25,000 in cash or securities.
To learn more about the rules governing pattern day traders and margin requirements that apply, go to www.finra.org/Investors/SmartInvesting/AdvancedInvesting/DayTrading/P005906.
Day traders do not close positions the same day they are opened specifically to get around margin requirements. Many traders believe that trading trends can be identified and acted upon within very short time periods. In fact, one of the amazing facts observed by traders is that chart and price patterns occur regardless of the time duration being studied. Most people who are not day traders use daily charts as the default time duration, and technical patterns are observed on a day-to-day basis. This works for nonâ “day traders willing to hold positions open for more than a single trading session. The day trader, however, uses charts based on more frequent changes. With the Internet, it is easy to create instant charts and track live feeds for any listed stock, with increments that track on any time period desired. For day traders, five-minute charts provide valuable information about developments in price trends as they evolve.
The observed price patterns that are used to signal entry or exit work in all time durations. So whether you use a daily chart or a five-minute chart, you will find the same technical signals.
The five-minute chart patterns that develop are going to exhibit the same price and chart trends as the daily charts do. However, in a daily chart, the trend encompasses an entire day and many interim price patterns do not show up. So the day trader’s argument for more frequent increments in charts is that many entry and exit opportunities are lost in the longer-term chart. Of course, this rapid-action charting system is not for everyone. The dedicated day trader is likely to observe hour-by-hour tendencies in price patterns. A lot of study has gone into analyzing how price trends develop throughout the typical trading day. For example, some traders will tell you not to make trading decisions in the day’s first hour. Others believe it is a mistake to put in an order during the Wall Street lunch hour. And many believe that the last hour of the day is when most trends make their move.
Isolating trading activity to specific times of day adds yet another element of timing to the technical decision. Traders find methods that work for them and provide discipline to make their strategies work.
For anyone inexperienced in trading, the world of day trading is probably too risky. However, the excitement of making decisions by the hour or even by the minute is difficult to match. The more analytical, long-term fundamental approach is comparatively dry and unexciting, even if it may ultimately be more profitable. The truth is that picking high-value stocks and holding them for many months or years is usually profitable, but traders need and want that daily action to make the experience satisfying. This is the big difference in market culture. The fundamental analyst is likely to be a value investor using a buy-and-hold strategy. The trader, especially the day trader, does not want to own stock for more than the minimum time needed to generate a profit. There are merits and flaws in both systems, without any doubt. It makes the most sense to remain open-minded to both strategies, and even to combine investing and trading in your portfolio. Day and Swing Trading expands on the discussion of trading to examine day trading in more detail, and to compare various trading systems.
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