As a fundamental investor, it's easy to eschew charts in favor of real, rock-hard numbers. But that's a big mistake. Taking a look at a chart can add a huge edge to your investment gains when used in conjunction with solid fundamentals. Here's what you need to know to become chart smart.
An Investor Necessity
Don't write off technical analysis – while using patterns to make investment decisions might sound dubious, it's hard to argue with the fact that skilled technicians can turn their diagrams into dollars up to 90% of the time. And while the rift between fundamental and technical analysis might seem enormous, it's actually far from it. (For more, check out our Technical Analysis Tutorial.)
At its core, technical analysis is really a way to look at qualitative factors – like investor psychology – from a quantitative standpoint. Behind every pattern you'll see in a stock chart, there's a fundamental justification.
Technical analysis fills a necessary gap in the fundamental investing toolbox as well. While fundamental analysis can point out a potentially undervalued investment, the old quote from John Maynard Keynes still rings true: "The market can stay irrational longer than you can stay solvent." With technical analysis, an adaptable investor can read the market's rationality to know when to get into a fundamentally sound play.
It's not easy for fundamental investors to accept technical analysis at first. But when you consider the mechanics of technical analysis it quickly becomes clear that, contrary to popular belief, technicals and fundamentals aren't mutually exclusive – they're actually quite complementary. While I can't go over every element of technical analysis here, this article serves as a primer on blending your fundamental investing approach with charting. Let's take a look at some of the precepts of technical analysis from a fundamental point of view.
Taking on Trend
Trend is perhaps the most basic concept for any burgeoning market technician. Trend is just the general direction of a stock's price movement. If a stock is trending up, that's a bullish signal, whereas a downtrending stock is generally showing a bearish signal.
|Figure 1: Upward trend|
As a fundamental investor, you might not want to put your money in an uptrending stock out of concern that you'd already missed the boat on a price movement, but that could be a very bad move. That's because a stock is far more likely to move in the direction of its overall trend on any given day.
One of the best ways to confirm a trend is with volume. As volume increases, the chances that a trend will continue to hold are far greater.
From a psychological standpoint, trends make quite a bit of sense. As a rising stock begins to catch investors' eyes, it's only natural for the share price to increase as more and more investors – and traders – try to repeat others' success (pushing volume higher in the process). While some suggest that technical analysis can be a self-fulfilling prophecy, technicians argue that it doesn't matter why a technical phenomenon occurs, only that it occurs in a predictable manner.
Two important concepts related to trend are support – the price level that a stock has trouble falling below – and resistance – the price level that a stock has trouble rising above. Both of these come into play when we talk about reversals.
Watch the Reversals
It's clear that no trend lasts forever, which is why reversal patterns are so important. Reversal patterns are signals to technical analysts that a trend is about to end, and that it's time to either get out of a stock or take the opposite position on the play. Reversals also make quite a bit of sense from a fundamental perspective.
|Figure 2: Reversal|
When a stock rallies up to its resistance line (the $51 mark shown in Figure 2), investors will often sell off to take profits. That sell-off creates quite a bit of downward pressure that makes reaching new highs a challenge.
Likewise, when a stock falls down to its support line, some investors may see a bargain again and begin to purchase shares, raising the stock's share price and halting the downward tumble. Knowing where the support and resistance levels are can help fundamental traders choose entry and exit points in their positions.
And just as it's plain to see how a support or resistance line can hold a stock in a range, there are a number of reversal patterns – including the head-and-shoulders and the double top/bottom – that investors can look for in order to predict the end of a trend (For more on reversal patterns, see Price Patterns.)
Going Further: Moving Averages and Oscillators
Beyond patterns there are other indicators that market technicians use to gauge where a stock is headed. Among the most popular are moving averages, which chart a stock's average price over a trailing number of periods, and oscillators, which help measure a stock's momentum. (To learn more about oscillators and indicators, see our Exploring Oscillators and Indicators Tutorial.)
While fundamental and technical analysis don't seem to mesh at first glance, combining these two investing schools has its advantages and can help avoid some of the most painful losses. Fundamentals can tell you which stocks to play, but adding a bit of technical know-how can help you decide when to play them.
For related reading, take a look at Blending Technical And Fundamental Analysis.