Analysis of financial markets is usually divided into two main disciplines, known as fundamental analysis and technical analysis. Each are different approaches to the decision making process, in the context of trading or investing in financial markets. In general terms, any market analysis is about selectionof:
- Markets and instruments in which to trade
- Timing when to open and close trades or investments
- Maximizing returns
Both approaches assume market efficiency. That is, the price of a particular stock, commodity or financial future reflects all the knowable information about that asset at any given time together with the opinions of all market participants regarding that information
Fundamental Analysis
Fundamental analysis approaches the decision-making process by determining the intrinsic value of a financial instrument. For this purpose, the following examples of available economic and financial data may be used:
- Price Earnings (P/E) Ratio
- Book values in the case of stocks
- Crop Reports
- Import/Export figures in the case of commodity futures
- Interest rates
If the price of an instrument is trading for less than its intrinsic value, its price is expected to rise. Conversely, if the price of an instrument is trading for more than its intrinsic value, then its price is expected to fall.
Fundamental analysis philosophy assumes an efficient market – in which information is disseminated perfectly and is acted on rationally. However, market observation suggests that these assumptions do not necessarily hold, particularly in the short term.
Technical Analysis
Technical analysis approaches the decision-making process by examining the market for the financial instrument itself. It is the study of price activity – more specifically, price patterns – to identify favorable trade opportunities. The data from the market are primarily:
- Price
- Volume
- Open interest (in futures markets)
Technical analysis is not concerned with the value of whatever underlies the financial instrument, but with how the forces of supply and demand are impacting upon its price. Technical analysis philosophy assumes:
- The market is not efficient
- Information and market opinion is reflected by price
- Recurring price patterns will provide clues to future price movement
Hence in analyzing historical price patterns, the technical analyst looks for price behavior that suggests the possible initiation, conclusion, or continuation of a trend.
Which Analysis Method to Use?
The question as to which method is superior is subject to great debate. According to market trader and author, Jack D. Schwager, traders holding “polar-opposite” views regarding the efficacy of fundamental versus technical analysis can each be successful. It is possible to succeed as a trader by being a pure fundamentalist, a pure technician, or a hybrid of the two. The best method depends on the individual.
The primary difference between the two approaches is that fundamental analysis is concerned with the why of market behavior, while technical analysis is concerned with the when.
References:
- “Getting Started in Technical Analysis”, Jack D. Schwager. John Wiley & Sons. NY 1999.
Harry P. Schlanger - Hello, I started out as a physicist working for research organisations. Mostly in the area of heat transfer in solids and porous media. ...
