If you listen to anyone debate the fundamentals versus the technical, you quickly realize that there is a lot of passion in both schools of thought.
The fundamental investor believes in the numbers and assumes that fu- ture value can be identified by watching financial trends. In contrast, the technician is more interested in tracking a stock’s price and in trying to anticipate the price trend.
The debate between these two theories is interesting because they are so far apart in basic assumptions. It is often the case in debates that each side shares some common ground, but disagrees on the essentials. As far as analysis goes, the fundamental and technical adherents have virtually nothing in common. The whole premise by which they pick stocks, de- cide when to sell, and establish value, is completely different on each side.
The arguments against the other side may define the differences as well as any other point. Fundamental analysts proclaim that financial re- sults are the only dependable means for establishing the value of a com- pany. The price trends, in the fundamental view, are short term, chaotic, and unreliable, caused by many conflicting and inaccurate momentary fac- tors. The immediate supply and demand within the market is illogical, price movement overreacts to news and gossip, and much of the daily price movement is either random or artificial. These points are convincing.
Fundamental and technical analysis are not just two different ap- proaches to the same question. They are entirely different in nature.
Fundamentals deal with corporate financial results, while technical indicators focus on stock price trends.
Key Point
Technicians have an equally convincing argument. They point out that by the time you obtain accurate and reliable information, it is woe- fully out of date. The historical financial information published by a company has nothing to do with today’s pricing trends or with the direc- tion of price movement, the technician believes. Ultimately, it is the tim- ing of decisions that determines whether you earn a profit or suffer a loss in the market.
Which side is right? In this book a detailed examination of fundamen- tal analysis is provided with examples, definitions, and graphics. For now an objective analysis of the essential technical tools is worthwhile. Every in- vestor, even the faithful fundamentalist, should be aware of the basics of the other side. Combining the essential tools of both fun-
damental and technical analysis may prove to be the most effective methodology for anyone.
Following are the brief concepts of technical analysis. (Remember, a detailed study of the technical side will involve more in-depth analysis and study;
these are only the basics. For more study in this field, one of the best books on the topic is Getting Started in Technical Analysis by Jack D. Schwager).
1. Charts. The chart is the essential tool of technical analysis. The technician believes that prices move to establish specific pat- terns and that a study of those patterns will indicate the price movements of the imme- diate future.
The most popular and simplest type of chart is the bar chart. This is a series of vertical lines, one for each day. The line shows the range from high to low price during that day, and includes a small hori- zontal line moving to the right, showing the closing price. Some bar charts also in- clude a small horizontal line moving to the left to indicate the day’s opening price. A daily bar chart and its features are shown in Figure 2.1.
C o m p a r i s o n s b e t w e e n F u n d a m e n t a l a n d Te c h n i c a l A n a l y s i s 35
chart
the basic tool of technical analysis, used to study price movements in the belief that specific patterns signal how future prices will change.
bar chart a form of price charting in which a series of daily prices is shown side by side over time. The vertical bar shows the range of prices during the day from high to low.
A small horizontal extension to the right shows the closing price for the day and some bar charts also include a small horizontal exten- sion to the left for the day’s opening price.
The close-only chart is a more summarized price tracking tool. It does not include high and low prices, but simply shows the closing price.
Over an extended period of time, close-only charts may be augmented with a long-term moving aver- age of the price as well.
The point-and-figure chart is more complex that the more common price charts. Ignoring the time element, the point-and-figure variety is made up of a running series of Xs and Os. Although calculation of the degree of movement affects how the chart is constructed, Xs represent upward trend and price movements, and Os are down- ward trends.
The candlestick chart is the most advanced form of price tracking. In the candlestick, the range between opening and
high
closing price
opening price
low
FIGURE 2.1 Daily Bar Chart
close-only chart
a price tracking chart showing closing price only, but not the range of high and low price ranges.
closing prices (the “body”) moves vertically, and if price moved above or below the body, additional lines (called “shadows”) extend above and below. The direction of movement for the day is also indicated.
When the closer is higher than the open price, the body is white; when the closer is lower, the body is black. These distinctions are summarized in Figure 2.2.
The importance of price trends in technical analysis is crucial. The entire sys- tem is based on the idea that the most re- cent trends reveal and anticipate what is going to happen next.
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point-and- figure chart a type of chart used by techni- cians to track price but not time.
Rising prices and trends are repre- sented by a series of Xs and the stronger the movement, the more Xs appear.
Downward prices and trends are shown as a series of vertical Os.
closing price
low high
opening price closing price
low high
opening price
FIGURE 2.2 Candlestick Chart
2. Trading range. Charts are used to track prices and trends and to find specific patterns in a stock’s movement, volatility, and direction.
Technical analysis is based on a study of the pat- terns seen in charts and of the trading range they reveal. A stock’s trading range is the distance be- tween high and low prices, demonstrated over time. For example, if a stock has traded for the past three months between 28 and 34, it has a six-point trading range. This is significant be- cause, until the prices moves above or below the trading range, it establishes the current supply and demand levels for that stock.
3. Support and resistance. Trading range is a defin- ing aspect of price analysis. A stock is expected to remain within the trading range until a sig- nificant change occurs, brought on by news, events, earnings surprises, or shifting demand for shares. The lowest price in the trading range is called support, and is the lowest price that the stock is likely to trade within the established trading range. The highest price in the trading range is resistance, which is the highest price the stock is likely to trade.
4. Breakout. To the nontechnical, the whole dis- cussion of trading range, support, and resistance appears interesting but not especially revealing.
In fact, as long as the price remains within that defined range, there is not much to observe be- yond enabling you to define a stock’s level of volatility. A broad range is more volatile than a narrow one. However, trading range does be- come interesting when there is a breakout. This is a movement in price above or below the es- tablished range, usually indicating a change in the range itself, and creating a new trading pat- tern, different trading range, and perhaps a change in volatility as well.
candlestick chart
a form of chart that efficiently summarizes a day’s trading range, high and low price, and direction of movement.
price trends the tendencies of stock prices to behave in particu- lar ways over time, and to demon- strate patterns that, in the view of the technical ana- lyst, reveal how prices are going to move next.
trading range
the distance be- tween a stock’s established high and low prices over a period of time, representing the current levels of price supply and demand for the stock.
support the lowest likely price for a stock within its estab- lished trading range.
5. Trading patterns. Remember, technical ana- lysts look for specific patterns to reveal and anticipate future price movement, often as quickly as a matter of days or even hours.
These patterns have been given names.
These include gaps (patterns showing space between one day’s close and another day’s open); spikes (an unusually exaggerated price movement well above or below previously established trading levels); triangles (trading patterns establishing either a broadening of the price range over a series of days, or a nar- rowing); flags (short-term price congestion with trading range running parallel); pen- nants (short-term price congestion in which the trading lines converge); V formations (sudden price reversals, such as a new price high, followed by an immediate downward movement, or a sudden and sharp decline followed by a sharp price reversal); and head and shoulders (a popular three-part price trend in which three stages are experienced:
stage numbers one and three establish a trad- ing top or resistance level, and the middle stage sets a resistance at a higher level; a re- verse head and shoulders has the same pat- tern, but involves support levels and establishment of bottom price levels).