LONG ANSWER
Short term traders & long term investors
Generally speaking, traders look to make profits in the short term, i.e. ranging from a day or two (and sometimes intra-day) to weeks. They are as happy to trade ‘short’ as they are to trade ‘long’. In other words, they are as happy to sell an instrument expecting to profit from a price fall, as they are to buy an instrument expecting to profit from a price rise. On the other hand, investors look to make profits in the longer term, i.e. over many months or years. It’s relatively rare for them to hold any short positions, largely because a by-product of economic growth is that markets tend to rise over the long term. Whether or not the sort of economic growth enjoyed by the world over the last thirty to forty years is sustainable over the next thirty to forty years - is open to debate. If the doom and gloom forecasts of the climate change lobby are anything to go by, then a traditional long term buy and hold (LTBH) policy is likely to be an investment trend of the past.
Conflicting ideologies
Historically, traders and investors, with their reliance on TA and FA respectively, have often been at loggerheads with one another. For the most part, this stems from the view held by many investors that it’s wrong to speculate and profit from an asset losing value - e.g. a stock - as this exerts downward pressure on the share price. This could then affect the dividends paid to investors and, possibly, affect staff salaries and jobs. In reality, in the medium to long term, such a negative impact is highly unlikely. Indeed, there is no precedence of a
profitable and well managed company being brought to its knees as a result of a bear raid by traders selling the stock short.
A common goal
These days, speculating on the markets has become more and more sophisticated, and each camp looks to the other for help in fine tuning their trading and investing decisions. Both groups are united by having (relatively) small amounts of cash at their disposal, fairly basic kit in the way of computers and internet connections etc. and, for the most part, by working alone. By contrast, professional proprietary traders (known as ‘prop traders’) who work for city institutions such as banks and hedge funds aren’t bound by such restrictions. Their uniquely deep pockets, state of the art kit and collective intellectual might, enable them to operate pretty much as they please. Much debate exists on forums like T2W about the extent to which this elite group relies upon TA and FA in order to make their trading decisions. That question won’t be addressed here though, as it’s probable that you wouldn’t be reading this if you are one of them! For the purposes of this FAQ, it’s assumed that you’re a typical T2W member: a retail trader working from home.
Alternative approaches
Before getting into the crux of what TA and FA are, there is another question worth considering first. Namely, are there any other methods available to retail traders for making trading decisions that fall outside conventional TA or FA? The answer is yes, indeed there are, but the methods tend to be highly specialised or rather esoteric. An example of the former would be a breed of day trader known as a ‘scalper’ who bases their decisions exclusively on the Depth of Market (DoM) price ladder. (See graphic, below). Traders who become proficient at doing this can make very large sums of money. To do it, you’ll need a well funded account (upwards of USD $25,000), top notch hardware and connection speeds, a professional trading platform, very fast reactions and shed loads of skill. It only appeals to a select few and, surprise, surprise, it’s not at all easy to master! Without the benefit of experience with a city institution or tuition from a seasoned practitioner, learning to trade this way often proves to be a tough row to hoe for those that attempt it.
Moon gazing and coin tosses
On the face of it, the esoteric methods for trade selection range from the comic to the bizarre. The natural world often plays a big part, e.g. trading according to the phases of the moon or going long if it’s a sunny day or short if it’s a rainy one! However, one shouldn’t scoff, as there are traders who swear by the efficacy of moon gazing; just as there are traders who swear by the efficacy of Fibonacci retracements or Elliott Waves etc. (see Useful Links - post #3). The beauty about trading is that the proof lies in the bottom line: no one can argue with that! Even the sunshine or rain method may not be quite as daft as it sounds, not least because there is a school of thought that insists it’s entirely possible to make money by entering trades at random or at the flip of a coin. In both cases, the basic premise is that it matters not whether the trader is long or short the market. What matters, is how they manage the trade once they’re in it. One thing is certain; it’s simply not possible to make consistent profits over the long haul without implementing sound risk and money management principles.
Technical Analysis (TA)
All the information available to users of TA is derived exclusively from past transactions of the instrument(s) being analysed. The two key components of this are the price and the time that the instrument traded at that price, both of which are a matter of historical fact. Supplementary data is also known, such as the volume of shares or contracts traded and whether they were traded at the bid or ask. No other factors are taken into account. Price, time and volume - based on past transactions - comprise the complete toolset that enables TA practitioners to decide at what price and in which direction to trade.
Fundamental Analysis (FA)
Practitioners of FA focus on everything else – literally! This ranges from things like company reports through to news announcements – usually key economic data. Company reports contain financial statements which detail such things as turnover, profit before tax, earnings per share (EPS), return on capital employed and net debt etc. Additionally, reports contain statements by the company Chairperson, which tend to put an overly positive spin on the results – no matter how good or bad they are – along with the future prospects for the company. Nonetheless, it is possible to interpret the language they use to your advantage, as Robbie Burns explains in his bestselling book: ‘The Naked Trader’. Referring to the Chairperson’s statement, he writes:
“I have one key method of working out whether the company I’m holding should be sold, or certainly not bought! This method simply involves looking for one key word: ‘challenging’. In my opinion, this word means one thing: the company is probably in some kind of trouble! Two other words to look out for are ‘difficult’ and ‘volatile’. My simple method works rather well”.
He goes on to explain how he uses a traffic light system to highlight key words or phrases such as ‘challenging’ in red, ‘in line with expectations’ in yellow and ‘exceeding expectations’ in green. He then tallies up each colour, using any bias towards red or green as a trigger to either sell or buy the company shares. Company reports usually cover three months or more, so using them as a means to day trade is uncommon. Typically, they’re used by longer term traders or investors.
News
News announcements also come under the FA umbrella and tend to be of greater interest to traders, especially day traders. However, please note that predicting the news and positioning oneself appropriately in the market ahead of its release is very difficult and is not recommended to new or inexperienced traders. A better tactic is to trade the reaction to the news once it’s been released. For this reason, many day traders make a point of being ‘flat’ (i.e. out of the market) ahead of a news release such as Non-farm Payroll figures or BoE interest rate announcements etc.
Volatility & liquidity: Viagra for traders
Individual company announcements can result in large intra-day – and sometimes multi-day - price moves, accompanied by a lot of volume. This perfect combination of volatility and liquidity offers the potential not only for profit, but also the ability to get in and out of trades at the desired price trading ‘size’ i.e. a lot of shares - without the risk of bad fills and slippage. The daily chart below is of Pfizer (PFE), the U.S. pharmaceutical giant. The first blue arrow indicates the day that PFE gained approval from the Food & Drug Administration (FDA) for Viagra. At the time, Viagra was marketed as a medical treatment for male erectile dysfunction syndrome. As can be seen on the chart - initially - the market was far from engorged with excitement by the news. However, a few weeks later, stories emerged in the press that many thousands of prescriptions were being written for the drug as it could be used by anyone as a sexual stimulant, and not just by those suffering from the medical condition that it was designed to treat. The effect this news had on the share price mirrored the effect that the drug was having on those that used it, shooting up from a swing low of $32.10 to a swing high of $40.60. Many day and swing traders who profited from this 25% rise in just four days will have used TA to enter and exit their trades, but they were alerted to the initial opportunity by news, i.e. pure FA at its most basic.
Markets and logic, like oil and water?
The reason why most traders use TA and/or FA is that both methods are based on logic and their principles are fairly simple to access, understand and apply. However, using either approach to make money consistently over the long term is a much harder task. As the old saying goes, ‘trading is simple, but it isn’t easy’. Generally speaking, it’s true to say that TA appeals mostly to traders, while FA appeals mostly to investors. This is because fundamental data tends to change gradually over time. For example, suppose that you spot a company with a great product, excellent management team, full order book, no debt and making money hand over fist. It’s probable that it was doing these things last week and last month. Going forward, it’s also probable that it’ll continue to do these things next week and next month. Therefore, based on this information alone, its share price is unlikely to do anything dramatic intra-day or, even, over several days. However, assuming the fundamental picture doesn’t change, over many months or years, its share price
should rise. ‘Should’ is in italics because, as many investors will point out, prices don’t always move in the way that sound logic indicates that they will! TA appeals to traders as it is ideally suited to analysing probable price movements over very short time periods, right down to a few minutes, or less in some cases. It’s able to do this as it highlights the engine behind short term price movements: an imbalance in supply and demand. This is discussed in greater depth in the
Essentials Of First Steps Sticky, where you will also find a simple example of how a trader might use FA and TA respectively.
The long and the short of it
In summary then, TA focuses on historical prices that enable traders to find patterns that may repeat themselves in the future. Practitioners believe that all the fundamental information known about an instrument is already factored into the price. Additionally, they tend to believe that markets are not efficient and that price can become temporarily oversold due to a lack of demand and too much supply or, overbought, due to a lack of supply and too much demand. This presents traders with buying and selling opportunities respectively. Such imbalances arise because markets are driven by people, and people are emotive beings who are greedy to make money and fearful of losing it. In the short term, it’s their collective sentiment that moves the markets and accounts for the constant flux in the demand / supply dynamic. Skilful practitioners of TA are able to get in tune with that sentiment and profit from it, regardless of whether it’s bullish or bearish.
Like TA, FA also uses historical facts to find trading and investing opportunities, as well as emerging news stories and broker upgrades and downgrades etc. The chart of PFE illustrates how FA can be of use to traders. It also illustrates that the initial excitement and interest in PFE could not be sustained. By the end of May that year, price had retraced back down to the $34.00 level. This is likely to be the result of traders cashing in their profits, allowing LTBH investors to step in and accumulate more stock at a better price. Just as cream rises to the top and an incoming tide floats all boats, the logic of FA is that the share price of profitable and well managed companies should rise over time. The foibles and unpredictable nature of human behaviour which causes short term price movements will be ironed out in the long run, allowing the fundamental strengths of the company to drive up the value of its shares. It appeals to LTBH investors especially, who understand market cycles and are prepared to ride out (relatively) short lived bear markets. They accept that prices may fall during periods of economic decline but, as soon as the good times return, their stock will soar and make them money.
Bear markets also provide the perfect opportunity to buy good companies at discount prices. It’s an approach which has worked pretty well for Warren Buffett over the years, making him one of the world’s wealthiest men. He writes,
“For some reason, people take their cues from price action rather than from values. Price is what you pay. Value is what you get”. He’s also one of those investors mentioned earlier who are rather disparaging of those of us who trade in the short term, evidenced by this witty remark,
“According the name ‘investors’ to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a romantic”. In spite of his disapproval, increasingly, exponents of both disciplines are looking to one another for help and inspiration. After all, their ultimate goal is the same; to do whatever they can in their respective timeframes to make a consistent profit.
