There are 2 primary methods of analyzing markets: technical analysis and fundamental analysis.
Technical analysis uses the historical price chart of a market to predict future price moves. Fundamental analysis looks at underlying characteristics of a market like news, balance sheets, and other financial reports.
Which one should you use? Or should you use both?
Let's get into the details of each type of analysis, the benefits and downsides of each, and how to figure out what you should be using.
Technical analysis is basically the study of patterns on price charts.
The core belief behind technical analysis is that the behaviors of all of participants in a trading market can be seen in the price charts.
There are many types of technical analysis, but here are two of the most common methods.
Technical Analysis Examples
Support and Resistance
There are many types of technical analysis, but one of the most frequently used techniques is support and resistance.
Support and resistance are levels where price changed direction in the past, and could be an area where price reacts in the future.
Support is a “floor” where price could turn and start heading back up.
Here's an example of a support level where price bounced off the support several times, before heading higher.
Obviously, the price will not always bounce off the support level. If the support level doesn't hold, then price is likely to go lower.
In this example, price initially bounced off the support level, but the level was broken and price headed lower.
The concept also works for resistance, which is a level above the current price action where price is likely to bounce and head down.
Here's an example of resistance on the GBPJPY chart.
Price headed down every time it hit the level.
Again, this won't always happen. But if price reacted to the level before, it's likely that it will react to it again in the future.
Although these support and resistance levels have been drawn as lines, they are more like zones. They exist between a range of prices, not at one specific price.
Here's what it looks like on a chart.
I find it easier to draw a line, but keep in mind that price won't turn exactly at a line.
The best support and resistance levels are areas on a chart where there was a strong move away from the zone.
So you'll see big wicks on candles, or big filled candles.
To learn more about how to draw support and resistance levels correctly, read this tutorial.
Another technical analysis method is to use indicators.
These are graphs that are overlayed on a chart and are created by performing mathematical calculations on price and/or trading volume.
One of the most popular indicators is a moving average.
My favorite moving average is the exponential moving average.
Moving averages help traders visualize trends better and show how current price action relates to price action that happened in the past.
A popular moving average is the 200 simple moving average (SMA).
Here's an example of the 200 SMA on the GBPUSD chart.
As you can see, this currency pair is in a strong downtrend because it's way below the moving average.
This information is useful because it gives traders a clue as to where price could head next.
Generally speaking, when price is below the 200 SMA, it's weak, so it's more likely to go down. If it's above the 200 SMA, it's more likely to go up.
Obviously, price cannot go up or down forever.
But eventually, price will reverse or slow down enough so that the moving average will catch up to it and price will start closing above the moving average.
That can signal that the downtrend is over and there is now a bias to the long side.
Benefits of Technical Analysis
Traders like technical analysis because they can focus on the chart and not have to worry about how much to weigh fundamental factors in their trading decisions.
Let's look at trading cocoa commodity futures as an example.
If you're using fundamental analysis, you might analyze the cocoa market by looking at:
- The weather in cocoa producing countries
- How much each country produces
- How much each country has planted
- The cost to ship cocoa
- Taxes on cocoa
- How much cocoa companies are buying
- And more
So with all of the fundamental factors that can potentially affect the price of cocoa, which ones do you focus on?
Is the weather most important?
Should you focus more on cocoa production?
It's tough to know.
But if you use technical analysis alone, you just have to look at the chart and follow your technical trading strategy.
For example, some traders use the Golden/Death Cross trading method.
The trading method is simple.
Place a trade every time the moving averages cross over.
No fundamental analysis necessary.
Other traders like using the RSI indicator.
There are many different technical trading strategies out there.
Find one that meets your risk/reward criteria and backtest it to be sure it works.
That's another huge benefit to technical analysis. You can backtest trading strategies to see how they would have performed in the past.
Downsides of Technical Analysis
The biggest downside of technical analysis is that it doesn't take fundamental factors into account when making trading decisions.
So there can be situations where the technical analysis alone can look good, but the fundamental analysis would rule out the trade entirely.
For example, there are companies that are losing a ton of money every year, but have a good looking chart.
If you only used technical analysis to make a trading decision, you would only see half of the picture.
You might buy the stock based soley on the technicals.
But if you studied the fundamentals, it would have been obvious that it was not a good buy, or it should have been a very short-term trade.
Now in all fairness, you could still make money by looking at the chart alone.
However, when you don't know the fundamentals behind price movements, it can also be harder to stay in a trade because you don't know if there is a long or short bias.
You can also be caught off guard by a change in the underlying characteristics of a company, commodity or cryptocurrency project.
The other type of market analysis is fundamental analysis.
This is when traders examine reports, statistics and factors outside of the price chart to make trading decisions.
Analysis of these data points can give traders clues as to where price will go next.
Benefits of Fundamental Analysis
Fundamental analysis helps you understand what's going on behind the scenes at a company, project, or in a particular market.
Traders utilizing fundamental analysis will examine things like:
- Balance sheets
- Imports and exports
- Interest rates
- Commitment of Traders Report
- Team members on a project
- And more
When you know a lot of detailed information about a company or market, you're more likely to stay in a winning trade longer and cut your losses short because you know the underlying events that can affect the price.
Fundamental analysis can also help you find good deals because there can be stocks or cryptocurrency projects that are undervalued.
The only way to figure out that they are undervalued is to understand the company or project, relative to others the in that niche.
Downsides of Fundamental Analysis
The hardest part about using fundamental analysis is getting the timing right.
For example, if you're trading stocks, a company could have negative earnings for months before the price of the stock starts to go down.
Or a company could have an amazing product that's selling well, but the stock price doesn't go up.
This happens because there are 2 different market forces at play in trading/investing:
- The trading market for the shares
- The supply/demand for the product itself
The product the company makes could be selling well, but if people trading the shares do not see value in it, then the value of the stock will not go up.
On the flip side, traders could feel that a company better than it really is and buy the stock, causing the price to go up.
We see this a lot when groups promote a stock heavily and cause the price of the stock to go up a lot, even though the underlying fundamentals of the company do not warrant the increase in price.
As I mentioned before, it can be difficult to figure out which fundamental factors will actually affect the price of the asset.
Therefore, fundamental analysis is much more of and art than a science, compared to technical analysis.
The same concepts apply to any trading market.
Which is Better, Technical or Fundamental Analysis?
Overall, one analysis method is not better than the other.
You have to figure out which method, or combination of methods, is best for you.
Trading is shades of gray.
Many new traders believe that there are a handful of trading methods that are guaranteed to make money for anyone who follows the method.
In reality, every trader has to find the trading method that works with his or her personality, and the market they are trading.
Some traders are better at following strict technical trading strategies.
Others are better at using only fundamental analysis.
Many traders use a combination of both analysis methods.
We all have a natural inclination to seeing the world in different ways.
It's like how some people are good at sports and others are good at music.
We will each be able to spot opportunities based our our natural talents and educational backgrounds.
So if anyone tells you that one is better than the other, remember that they are speaking from their personal experience.
It's an opinion.
Find out what works for you.
Can You Use Both at the Same Time?
Although there are some traders who only use one analysis method or the other, there are many others that use a combination of both methods.
For example, when analyzing a stock, you could use technical analysis to find opportunities to buy or sell, based on the stock's chart.
At the same time, you could examine fundamental factors like the balance sheet of the company, sales projections and the company's competition.
Many traders use fundamental analysis to identify good companies to buy, then wait for favorable technical analysis to place a trade.
Or they might identify weak companies that are overvalued and look to short the stock.
Some markets are more conducive to blending technical and fundamental analysis, while others are better analyzed with one or the other.
The bottom line is that you have to find out what works best for you and the market you're trading.
This can only be discovered through doing your research, backtesting and learning from successful traders.
What Kind of Analysis is More Useful for Day Traders?
Generally speaking, technical analysis is more useful for day traders.
The reason is that fundamental factors have less of an effect on short-term price moves.
That said, there are few fundamental factors that can affect day traders.
For example, news announcements can move the markets dramatically, in a short period of time.
Many day traders will stay out of the markets before major news announcements, because of the volatility during these times.
But some of them will trade immediately after the announcement, based on what was expected before the announcement.
So that's the difference between fundamental and technical analysis.
One analysis method is not necessarily better than the other. It really depends on your personality and the market you're trading.
First, find the method that makes the most sense to you and matches your trading personality. You might want to use a mix of both.
Next, figure out which markets can be trading profitably with that analysis method.
Finally, always test your theories to see if they actually give you an advantage.