Fundamental vs. Technical Analysis and Why I Use Technical Analysis
The very first step in the journey of a trader is to decide whether to use technical analysis, fundamental analysis, or both when evaluating trading ideas.
There is no prerequisite. The best traders have their own way of trading. Some use technical analysis alone while some others prefer combining the two ways.
Fundamental vs. Technical Analysis
Both fundamental and technical analysis have for goal to determine what should be the price of an instrument and in which direction the instrument is most likely to go. They differentiate when it comes to the location where the information is taken.
In short, the information used in technical analysis comes from the graph.
The most important part is that you decide on something based on the advantages and disadvantages of both fundamental and technical analysis.
What is Fundamental Analysis?
Fundamental analysis is a way of looking at a specific instrument (i.e. stock, currency pair, etc.) using financial reports, conference calls, economic data, and more to evaluate the price of that instrument. The goal is to draw a conclusion concerning where the price is likely to go given the state of the economy.
For instance, a fundamental trader may notice that the Federal Reserve (USA) increased interest rate. That was the case toward the end of 2015. Higher interest rates tend to attract foreign investors because of the higher return they can get on their money. This will have for effect to increase the value of the USD. As a result, a fundamental trader could enter a Short position (selling) on the EUR/USD given that the European interest didn’t change. I other words, when USD goes up, EUR/USD goes down.
What is Technical Analysis?
Technical analysis is at the other end of fundamental analysis. It uses the relation between the supply and demand reflected on a price chart to determine who is in control and where the market is most likely to go.
Technical analysts acknowledge the fact that all information coming from economic data or news events will be reflected on the chart of a currency pair or stock. That means the news do not matter but the news’ reaction does.
Why I Use Technical Analysis
Fundamental analysis leads to information overload
How many piece of fundamental data do you need to enter a trade?
That’s a hard question to answer, isn’t it? Well, in fact, you might not feel comfortable to enter a trade based only on interest rates because there are so many other factors out there that can influence the direction in which a currency pair will go. What about employment? Imports vs. exports? Trade inventories? Inflation? Gross domestic product (GDP)?
A lot of fundamental piece of information can influence the price of a currency pair and knowing which one(s) to use is a real pain.
In a study explained in the book The Little Guide To Behavioural Investing (James Montier), bookmakers were asked to rank the factors that could helped them predict the winner of a horse race in order or priority. Then, they were given data from the 45 previous races and had to predict who would be the winner of each of those past races based on the the list of factors they previously made by increment of 5.
For instance, bookmakers were first given 5 indicators to predict the winner, then 10, then 15, and so on.
The interesting part is: the more factors bookmakers used to predict the winner of a race, the more confident they felt. The problem is: their predictions’ success rate didn’t change. Whether 5 or 40 factors were used, the success rate in predicting the race winner was the same.
This shows that, as a fundamentalist, more information will not lead to better results. You may feel more confident to enter a trade with a lot of data but you won’t be more successful. In fact, chances are that you’ll be overloaded by information.
The Benefits Of Technical Analysis
Disciplined trading and exits
A trade based on technical analysis will have precise criteria at which the trader will be able to close it. For instance, one may say that his trade on the GBP/USD will be closed once price hits the next resistance zone.
This cannot be done when considering fundamental analysis since new data is released at certain (sometimes long) time intervals. It is very hard to tell when would be the right time to exit a trade taken off fundamental data. Fundamental traders may miss big moves or exit too late.
However, once you identify what’s going on the chart and what happened in the past, you can set precise exit points. That’s the first advantage of technical analysis.
Ability to establish entry points
When should you enter a trade based on fundamentals? Has the effect of a news event already been taken into account in the price you see on your trading platform? If not, when can you confirm that the price will react as predicted?
There is a lot of ambiguity here and traders can hardly be comfortable entering their trades based on economic events.
Trading the actual reaction instead of what should happen
Theoretically, a news event or the release of economic data should impact the price in a specific way. For instance, an increase in employment in the United States should have a positive impact on the USD. As a result, the EUR/USD should go down. A fundamental trader would most likely enter a Short EUR/USD.
This happens in theory ONLY!
In reality, things are far from being perfect. A positive news in the United States could actually cause an increase in EUR/USD.
The best example of that can be explained in stocks…
On April 28th 2015, Apple was at an all-time high ($134.54). The best revenues and profits were published in their financial report and 7 days later, Apple’s price decreased 9% from that all-time high. This is a perfect example demonstrating that the reaction is not always what we think should happen.
While a fundamentalist will trade the expected news result, the technical trader will trade the reaction (i.e. what he sees on the chart). Whether the reaction is bearish or bullish, the technical trader will be able to enter a trade. This will lead in a far better result and more certainty.
So, should I drop fundamental analysis…
Trading isn’t about using only one type of analysis. It’s about combining things that will lead to a high likelihood of success. I recommend not relying solely on fundamental analysis for the reasons detailed above. However, I do not say you should drop it completely. Fundamental analysis can bring you a hedge if you know how to use it.
I prefer to rely more heavily on technical analysis because I see the relation between the buyers and the sellers. It demonstrates what is truly happening and who has the control.
What you end up using is totally up to you.
Are you a fundamental or technical trader? What motivates this decision?