Saturday, December 6, 2008

Using Fundamental and Technical Analysis for Successful Stock Trading and Equity Investing Strategy

Short-Term Traders
Some common characteristics of short-term traders are that they:
 hold positions for short periods of time — maybe hours or days — rarely beyond a few weeks.
 place less emphasis on the fundamentals
 employ less money in their endeavours
 use derivatives in order to achieve greater leverage from their funds
 analyse the market and their positions daily—they are generally highly technical people.

Long-Term Investors
Some of the common characteristics of long-term traders/investors are that they generally:
 take a long-term view
 combine technical and fundamental analysis, with generally a greater emphasis on fundamentals
 diversify their interests — they may invest in both super and ‘free’ money accounts
 have more money at their disposal
 check their positions less often than their trader counterparts.

Combining Fundamental and Technical Analysis

Combining these two methods of analysis enables traders to take advantage of both disciplines' strengths. Fundamental analysts use balance sheet analysis and profit and loss fundamentals to determine a company's strength. Dividend yield, earnings growth, price/earnings (P/E) ratio, net asset value and other criteria are examined to determine the company's relative health. All are important measures and give the researcher vital information, but if you were to
trade based on any one of these criteria alone it's likely you would lose your money. Based on my own analysis, if you backtest each indicator over the last five years you would probably find a success rate of less than 30 per cent. Not many private traders can survive on a system that produces this level of success. However, if you were to group a number of these criteria together and conduct the same backtest it's likely the success rate would be closer to 50 per cent. This success rate coupled with sound money management could increase the chances of a trader making a lot of money.

The analyst/trader would reason that if certain criteria worked historically then the probability is that they will work in the next time frame — in real time. The analyst is working with probabilities and is not predicting the future. An example of grouping fundamental criteria is to look for shares with a P/E ratio of less than 25 per cent, a dividend yield greater than 4 per cent and earnings per share (EPS) growth greater than 8 per cent.

Technical analysts use chart patterns and technical indicators as their criteria for selecting stocks. Technical indicators are mathematical formulas that use price and volume relationships to help traders determine the probable direction of a security's price. There are a number of good indicators available, but each one traded individually, would probably lose money. Backtest each indicator and you are likely to achieve a success rate of less than 40 per cent.
Group the chart patterns and indicators together and your success rate should increase to 60 per cent and higher. I refer to this grouping of fundamental criteria and technical indicators as weight of evidence. It ensures that I will never take a trade without gathering considerable evidence and calculating that a trade has a high probability of success. If a particular group of chart patterns and indicators worked in the past, then the probability is that they will work in real time. As with fundamental analysis, technical analysis does not involve predicting the future, but rather it involves working with probabilities.

Fundamental analysis presents two main problems. The first is the large number of shares recommended. Top research analysts have a success rate of around 50 per cent (based on my analysis). With good money management and a profit/loss ratio of 2:1 or higher, a trader could make money following a research analyst's advice. Most private traders have limited funds to invest and there are usually too many shares recommended to purchase them all. This means an elimination process begins in an attempt to reduce the number of shares to a more manageable level. Without discipline, this process can turn into guesswork. A research analyst can have a good success rate of 50 per cent, be quick to cut losses, let profits run and trade successfully. In contrast, the undisciplined trader, may struggle with this elimination process and could be left holding a large number of underperforming shares the research analyst was quick to cut from his or her portfolio.

The second problem with fundamental analysis is timing. This is a subject that fundamentalists do not like to talk about too much. ‘Timing? Let's look at it in three to five years’ Fundamentalists' favourite recommendation is not to buy but to accumulate. This means purchase some now but be prepared for the shares to fall — this will allow you to accumulate more later. This is a calculated attempt to turn a negative — timing — into a positive by averaging down. In reality this actually adds the greater negative of buying in a falling market.

Technical analysis can help traders with both of these problems. A disciplined, mechanical trading system using chart patterns and technical indicators will assist traders in choosing which shares should be considered for their portfolios. Technical analysis' greatest strength lies in timing. Fundamental analysis plays an important part in helping the investor choose what to buy, while technical analysis can be instrumental in assisting investors decide which shares to buy and when to buy them. Combining the strengths of these two disciplines is a common-sense approach to investing.

Fundamental Analysis

Fundamental analysis involves analysing the underlying forces that affect the wellbeing of the economy, industry groups and companies. Top-down analysis starts with an analysis of global and local economic conditions that could have an impact on corporate performance.

Economic factors that may affect a company's success include interest rates, exchange rates, employment levels, inflation and the rate of economic growth.
Top-down analysis then trickles down from industry sectors to specific companies.

Depending on the projections for the economy, certain sectors are likely to benefit more than others. An investor can narrow the field to those sectors that are best suited to benefit from the current or future economic environment. An individual company is important but its industry group often exerts just as much, if not more, influence on its stock price. When stocks move, they usually move in groups.

At a company level, fundamental analysis may involve the examination of financial data, management, business concept and competition. Most often the aim of company analysis is to derive a stock's current fair value and forecast its future value. If the fair value is not equal to the current stock price, fundamental analysts believe that the stock is either overvalued or undervalued and that the market price will ultimately gravitate towards the stock's
fair value.

Most private investors focus on a company's financial data and ratio analysis. A company's vital statistics and financial performance can also be used to determine the financial health of a company and to then compare it with other companies.Some of the more popular ratios are found by dividing the stock price by a key value driver. The following is a list of potential inputs that can be used to analyse a company's financial situation:
 market capitalisation
 sector
 sub-industry sector
 net profit margin
 PEG ratio (P/E ratio divided by EPS growth)
 earnings per share
 earnings per share growth
 net tangible assets
 cash flow
 return on equity
 return on assets
 price earnings ratio
 dividend yield.

This financial information could help an investor determine whether or not a company is healthy and a low risk and how it compares with other companies. As part of the analysis process, it is important to remember that all information is relative. Usually companies are compared with other companies in the same sector.

Fundamental information is important but finding it is very time consuming, particularly on a stock by stock search. Ninemsn's website has some fundamental research tools that could save investors a lot of time in finding healthy, low-risk companies. See my article on creating watchlists for more information on this subject.

Fundamental analysis can be a valuable tool but it should be approached with caution. Remember that research written by an analyst who is selling advice is merely expressing an opinion and often has some sort of bias. As investors, we are putting our faith in company accountants and auditors to present accurate figures reflecting the true state of a company's financial position. It is important to keep in mind that corporate statements and press releases
offer valuable information but they are delivered with the intention of presenting the company in a favourable light.

As with every other analysis tool, investors need to take the good aspects of fundamental analysis and combine them with the strengths of other types of analysis to assist in making commonsense investment decisions. With this in mind, my objective is to find fundamentally healthy, low-risk companies and profit from future price movements by using technical analysis to time entry and exit levels.

Technical Analysis

Technical analysis is often described as the study of price and volume for the purpose of predicting future price action. This is a myth. It is not possible to predict the future and new investors could start at a disadvantage if they waste valuable time trying to develop a trading system that can predict the future.

Technical analysis is about probabilities and weight of evidence. Here's an example. Let's say you read about a chart pattern and you believe that it could be profitably traded. You scroll through hundreds of charts, checking two years' worth of history and determine that the pattern has a 25 per cent success rate. While you are doing this backtesting you discover another chart pattern that raises the success rate to 35 per cent when both are present. After studying and testing technical indicators you find one that fits the two chart patterns and results in a success rate of 45 per cent. Trading only healthy, low-risk companies that meet specific fundamental criteria raises the success rate to 55 per cent.

Further to this trading only shares in a rising trend may increase the success rate to 65 per cent. This is trading with weight of evidence. Trade any one of these criteria alone and it's likely you would lose your money. Group them together and you have weight of evidence with positive historical results.
Test the group in real time to determine its level of success, then develop a complete trading plan. When you commence trading your system you are not attempting to predict a future increase in price. You are trading based on probabilities and reacting to price changes.

If your system worked with historical and real-time testing then the probability is it will work in the future. With disciplined risk management rules and a 2:1 profit/loss ratio, a system with a 50 per cent success rate should make a lot of money. A 2:1 profit/loss ratio means that for every $1 you lose on bad trades you make $2 on the good trades. I separate technical analysis into two parts — charting and technical indicators.

Charting is old school analysis. Its practice goes back hundreds of years, long before computers introduced charting and technical indicators to the masses. Charting provides us with a historical perspective — a picture of price action. Studying price action can help investors judge the strength of buyers and sellers, identify and time attractive trades, and assist with entry and exit levels. Many mechanical system traders shun charting because of its subjective nature — people often see what they want to see in a chart. Charting tools are a small but important part of my weight of evidence analysis. The charting tools that I use are trend lines, support/ resistance levels and reversal patterns.The subjectivity of charting means there are many different ways to use, view and analyse the various charts and charting tools. There is no right or wrong — right is what works. I do not suggest that my way is the right way, only that it is right for me.

Technical Indicators
Technical indicators are mathematical formulas that incorporate price and volume in their calculations. Gauging the probable direction of the next price movement is done by grouping indicators together and testing them over previous price action. Computers have played a major role in contemporary analysis where some investors develop purely mechanical trading systems with technical indicators.A chart shows previous price activity. At the end of the day, information on the stock's open, high, low, close and volume is added to the chart. Over the
course of time, the chart becomes a picture that can be analysed. The same information that is visible on the chart, and the way each component relates to each other, is used in technical indicators to measure the internal strength of that specific market. The result is another picture that can be analysed and compared with the original. Similarities and differences give the analyst clues as to the next probable direction of prices.Analysts are attempting to shift the odds in their favour by studying the market and trading a security that has a high probability of moving in a specific direction based on historical and real-time testing.

For more Information:
Stock Trading, Shares and Equity Investment Guide
Stock Market Investment Planning. Investment Advice for Money Managers. Stock Market Investment Tools. Investment, Trading. Investment Tips & Stock Market Advice.



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