I am a day trader, and yet people sometimes ask me questions about the market that go beyond my area of expertise. They assume that since I am successful at one aspect of the market, I should have insight into questions of national and international economics, particularly as it relates to large scale political events. The fact is that day trading does not require any specialized insight into these issues. But since many people often assume that success in one economic arena implies knowledge of any and all other economics topics, it is important to distinguish the difference between a day trader’s expertise as an analyst and that of other economists. When you do, you will also understand that there are different ways to interpret and act on the market, and I would like to explain why I find my own area of expertise particularly useful.
To put it briefly, there are two kinds of financial analysts: a fundamental analyst and a technical analyst. The main difference between them is that a fundamental analyst determines whether or not the market accurately reflects true value while a technical analyst determines whether or not a financial instrument is profitable based on current market conditions.
Let me explain these differences in more detail. The fundamental analyst looks at micro- and macro-economic data to determine whether the price of a financial instrument is overvalued or undervalued. For example, he might look at the following data when analyzing a stock:
1. Financial statements for the company.
2. The current financial strength.
3. Future growth and profitability prospects.
4. Current management skills.
5. Patents and research and development projects.
6. Annual and quarterly earnings reports.
7. The economic, political and competitive environment facing the company.
8. Any current news items or rumors relating to the company’s operations.
In other words, fundamental analysis is the study of basic, underlying factors that affect the supply and demand of the financial instruments being traded. Fundamental analysis looks at the cause of market movement and tries to determine how accurately market value reflects real value.
On the other hand, a technical analyst assumes that the current price of a financial instrument such as stocks or commodities already discounts all the above information. He is not concerned with how a stock should be valued, but how it is valued by the current market, and, more importantly, how that stock’s value trends.
There are three main points that a technical analyst applies:
1. The market action discounts everything. Regardless of what the fundamentals are saying, the price you see is the price you get.
2. The price of a given security moves in trends.
3. The historical trading patterns of a security will tend to repeat.
I am a technical analyst, and I believe in its principles for a few important reasons. First, the markets are driven by greed and fear, not by supply and demand. An economic report itself is meaningless; it is traders’ reactions to the report that moves the market. Second, price data is more “objective.” You can interpret financial data and economic reports any way you want, but support levels are support levels, and a weekly high is a weekly high. It is easier to interpret hard facts more than financial statements because many times these statements might be misleading.
To see this difference, consider the following examples. If IBM announces that it will meet its projected sales targets, the shares would probably drop sharply because traders hoped that IBM would exceed its goals. In another situation, however, DELL might announce that they will meet their targets, and the shares jump up because traders doubted that that DELL would make it due to the “difficult economic environment.” The insights of a fundamental analysis actually suggest an outcome opposite from what actually occurs.
The final reason that I prefer technical analysis is that it is easier, and therefore faster, to learn. You can acquire the basics from a mere handful of books, whereas you need to study micro- and macro-economics to master fundamental analysis. And even then, you might be fooled by the market, as the above example showed.
Now, I do not want to say that technical analysis is better than fundamental analysis. They are each “better” for different purposes. For some people, it is easier to conduct research on fundamentals, and there are many traders out there who achieve their trading goals by using fundamental analysis. For other traders it is easier to read charts instead of financial statements, and they are more successful doing this. I encourage you to at least try both methods and then decide which one is better for you. And figuring that out is incredibly easy: it’s the one that ends up being more profitable.
