There are two main schools of thought when it comes to analyzing trading: fundamental analysis and technical analysis. Now, there are also other types of analysis, such as quantitative, but many traders focus on technical and fundamental analysis.
Investors and traders use fundamentals in an attempt to find the “true” value of the stock. However, the market doesn’t always agree with the fundamentals. While these metrics are useful, they can sometimes be misleading.
Experienced traders use both fundamental and technical analysis to evaluate stocks and options and plan their next moves. If you want to get an inside look behind the millionaire trader mindset, check out this free guide that could teach you how to multiply your money.
What Is Fundamental Analysis?
If you’re wondering how to do fundamental analysis, you’ve come to the right place. This strategy involves an evaluation of the financial health of a business to decide how or whether to invest in its stock. When conducting fundamental analysis, some of the most important factors to review include a company’s earnings as well as:
- Stock price to earnings ratio (P/E)
- Earnings per share, found by dividing a company’s net income less dividends by its outstanding shares
- Stock price to sales ratio (revenue) (P/S)
- Dividend payout ratio, which compares shareholder dividends to the entire net income of the firm
- Price to book ratio (P/B), which compares the market price of a stock to its book value as indicated by the company’s financial reports
- Return on equity, found by dividing the shareholder equity into the net income of the firm
What Is Technical Analysis?
Technical analysis goes beyond the financial indicators of a company’s stock to glean knowledge from historical and current trading charts. Traders who become adept at technical analysis learn to read common trade signals, chart patterns, and other forms of analysis to make market decisions. This strategy relies on the idea that stock prices tend to follow specific trends and patterns, and that looking at these motifs provides valuable information when used to predict the future action of a specific stock.
When To Avoid Fundamental Analysis
Fundamentals can be useful in some cases, but it’s general, not wise to use it with “disruptive” companies. For example, take a look at Amazon.com Inc. (AMZN). If you just looked at the fundamentals, you may be compelled to short the stock.
Typically, when you’re using fundamental ratios, such as price-to-earnings ratio (P/E) or price to cash flow ratio (P/CF), you would compare it to the industry average. At a quick glance, AMZN’s fundamental ratios are extremely high compared to its index, creating a potential argument for a short sale.
However, that wouldn’t be wise. Based on AMZN’s price performance over the years, that short would’ve been a disaster. You see, it’s hard to actually find the “true value” of a stock like AMZN. The market may be pricing in other factors, such as growth potential and potential changes in the industry. On the other hand, these ratios may be useful for more stable companies that have been around for decades like Caterpillar (CAT) or General Electric (GE).
That said, you have to pick and choose your spots when deciding between fundamentals and technicals. Now, if you want to see how one trader – who turned just over $15K to more than $5M in a few short years – uses fundamentals and technicals to schedule his paychecks take a look here.
Fundamental vs. Technical Analysis
Some traders say fundamentals trump technicals, while others will say the exact opposite. If you’re looking for an answer to the question, “Which type of analysis is better?” you won’t find consensus on this controversial subject. In fact, many successful traders multiply their money by combining both techniques to their advantage.
Fundamentals can often help you find the factors that make the stock price move. For example, if there’s a shift in the fundamentals of the industry, fundamentals would be useful. Now, technical analysis can help with determining the price action. In other words, if you use technical analysis, you might be able to spot a pattern that could signal a stock is poised to run higher.
If you want to learn how to use chart patterns and potentially generate high returns, check out how this former school teacher turned into a trading millionaire using three simple patterns.
That said, you have to figure out which works best for you. Maybe you don’t like fundamentals and focus more on chart patterns. Either way, you have to be comfortable when you’re trading or you won’t make a significant profit.