What is the difference between Fundamental and Technical Analysis?

What Is fundamental analysis?

Fundamental analysis is the study of the data that underlies the markets.

Whether that’s macroeconomic data on the economy or the key numbers and ratios behind individual equities.

Fundamentals are the building blocks of the markets:

They are individual data points that, when combined, mean that traders and analysts can compare current and historic valuations, and make forecasts about future price movements and market trends.

Fundamental analysis allows for direct comparisons between stocks or other instruments, helping traders assess which has better prospects. This approach also evaluates whether these prospects are fully reflected in the current price. If an asset is deemed undervalued, a trader might buy it. Conversely, if it's overvalued, they might sell or wait for the price to align more closely with its true value.

Analysing a stock's earnings, dividend history, and other metrics provides traders with insights into market preferences and valuations. This process can reveal stocks that may be overvalued or undervalued relative to their industry sector or index

What Is technical analysis?

Technical Analysis is the study of price movements and market sentiment. Technical analysts focus on 'price action,' which includes the price history and trading volume of a security, alongside key data points such as high, low, open, and closing prices within specific time frames.

Whether examining short-term data over 15 minutes or long-term trends spanning months, Technical Analysis is often the first form of market analysis introduced to traders due to its straightforward techniques.

Analysts use various price charts, enhanced with indicators and tools, to visualise performance. While these charts were once hand-drawn, modern traders rely on specialist charting software

The primary tools of fundamental analysis

The primary tools of fundamental analysis are data, ratios, and comparisons. When valuing a stock, it’s customary to examine metrics such as revenues, earnings, costs, debt levels, cash flow, and dividend history. With this data, key ratios like the Price-to-Earnings (PE) and Price-to-Sales ratios can be calculated.

These metrics allow traders to compare stocks against their peers and sector averages, identifying outliers. Spreadsheets facilitate simultaneous analysis of large stock groups, enabling filters to screen for specific characteristics, such as stocks trading on a PE ratio below twenty.

The pros and cons of fundamental and technical analysis

Both disciplines can be highly valuable for traders. Technical analysis offers a more immediate perspective, allowing for short-term market analysis in ways that fundamental analysis may not be able to provide.

Pros of fundamental analysis

Fundamental analysis uses a set of common ratios, terms and valuation metrics which, at a top down level, are easy to understand and implement.

Fundamental analysis allows for a direct comparison between stocks, other financial instruments, or even the relative performance of whole economies.

Using fundamental analysis it is possible to build models that can calculate valuations, and predict future earnings, revenues and other items.

Cons of fundamental analysis

Many inputs in fundamental analysis are based on historical data, which may only be updated a few times a year, such as quarterly corporate earnings data. Alternatively, future forecasts can be used, but the further out the forecast, the less reliable it tends to be. As you delve deeper into fundamental analysis, it becomes increasingly complex, especially when examining items like balance sheets and cash flow statements.

Pros of technical analysis

Technical analysis can be performed in real-time, tracking price movements as they occur. Indicators like moving averages can be applied to charts to provide a comprehensive view of price action and trader sentiment towards a particular stock or instrument.

Basic technical analysis techniques are easy for beginners to grasp and implement, offering a way to understand market dynamics. Proponents believe that a price chart encapsulates all necessary information for trading, summarising trader sentiment, order flow, support and resistance levels, and highlighting breakouts and failure points.

Cons of technical analysis

Technical analysis is often considered more of an art than a science. While there are established rules and well-documented chart patterns, much of the practice involves personal interpretation. This means that the conclusions drawn can vary depending on the analyst’s perspective, especially when predicting future market movements.

Critics argue that while technical analysis is useful for understanding past trends, it’s less reliable for forecasting future events.

How can quantitative analysis strategies be incorporated into Fundamental and Technical Analysis?

Quantitative Analysis bridges the gap between fundamental and technical analysis, utilising mathematical and statistical methods to identify market trends, patterns, and price anomalies. Quantitative analysts, or 'quants,' often work in banks and hedge funds, using their expertise in maths and data science to create a trading edge.

However, individual traders can also incorporate quantitative techniques into their analyses, especially with the rise of generative AI and specialised software. Programming languages like Python and Pine are commonly used to enhance market studies and trade execution.

Fundamental and Technical Analysis in risk management

Effective risk management is crucial for a positive trading experience, allowing traders to stay in the market longer and access more opportunities. Technical analysis can aid risk management by signalling when to close trades, such as when prices move past key moving averages or experience a price cascade.

Fundamentals also play a role; traders might reduce trade sizes if an index's PE ratio exceeds a preset level or use tighter stop losses during periods of heightened volatility, which measures sharp price swings in the market.

Using technical indicators to confirm fundamental analysis

It's possible to combine technical and fundamental analysis, using technical analysis of price charts to confirm trading ideas or signals generated through fundamental analysis. For instance, after identifying 'underperforming' stocks through fundamental analysis, traders can apply technical analysis to these stocks' charts to spot key levels, such as those trading just below moving averages or trend lines.

Traders may wait for a price to move through these levels, perhaps in combination with an indicator signal, before entering a trade. Technical analysis also helps identify trend changes and assess trend strength, informing entry and exit points for trades.

Integrating macroeconomic factors with technical analysis

Applying technical analysis techniques to economic factors and charts is often frowned upon by purists. However, technical analysis is effective at highlighting trends and identifying changes in momentum within time series data, such as daily price data or weekly US jobless claims.

Adding trend lines or horizontal support/resistance levels to economic indicator charts provides an immediate sense of the indicator's direction and momentum. Calculating and plotting moving averages for economic data can further enhance this analysis. However, misinterpreting technical signals can lead to costly trading errors.

Using Technical and Fundamental analysis to trade CFDs

The first step in using fundamental and technical analysis to trade CFDs is to gain a thorough understanding of these disciplines. Numerous online resources, including educational articles from Pepperstone, can aid in this.

Once you've familiarised yourself with these concepts, the next step is to open a trading account. However, there's no need to dive straight into live trading. You can start with a demo account, which simulates a real trading environment without the risk of losing actual money. This allows you to practise and refine your strategies, become comfortable with the trading platforms, and observe how markets move.

After gaining confidence, choose an asset class to trade, such as indices, stocks, commodities, or FX. It’s crucial to then consider position sizing and your risk appetite. This involves deciding how much of your trading account balance to risk on each trade, determining the number of open trades at once, setting stop losses, and evaluating risk-reward ratios.

When ready, place your trade and monitor it in real-time on your desktop, laptop, or mobile device. On Pepperstone’s platforms, CFD trading is the available option, which allows you to go long (buy) or short (sell). For example, analysing a two-year candle chart of Meta Platforms shows that its share price is near its all-time high and close to horizontal resistance after an uptrend since November 2022. There are two potential outcomes: the price could break above the all-time high of $542

Source: Barchart.com

CFD traders can set alerts for Meta in case of a break above its all-time high or a rejection at this level. If the price breaks cleanly above the high, momentum may drive it higher.

Conversely, if the price fails to break through, sellers may gain control. CFDs allow traders to capitalise on either scenario: going long if the price breaks above the high, or opening a short position if the price fails and subsequently breaks down.