The use of the fundamental approach in trading has long been an object of argument between its followers and those who mercilessly deride the method's usefulness. We will not take sides in this eternal argument, but we will try to find out how the average trader can benefit from fundamental analysis. Read on to discover the strengths and weaknesses of fundamental analysis as a traders' tool. (For more insight, see What Can Traders Learn From Investors.)
The fundamental approach is based on an in-depth and all-around study of the underlying forces of the economy, conducted to provide data that can be used to forecast future prices and market developments. Fundamental analysis can be composed of many different aspects: the analysis of the economy as the whole, the analysis of an industry or that of an individual company. A combination of the data is used to establish the true current value of stocks, to determine whether they are over- or under-valued and to predict the future value of the stocks based on this information. (To learn more, see Introduction To Fundamental Analysis.)
Methodology-wise, different approaches can be taken. For example, industry groups can be compared with other industry groups, while specific companies within those groups are compared against each other.
Role in Trading
The expediency of applying fundamental analysis to trading depends on several criteria. The first factor that should be taken into consideration is the potential profit sources you are targeting. A stock exchange is no factory and it does not produce any kind of material value. If you are really after a profit you need to know whose loss can be turned into your profit. Moreover, to trade profitably, you need to know the reasons for which somebody else's money can become yours.
There are three profit sources:
1. Your fellow traders, specifically those who are less knowledgeable, less experienced or simply too slow on the draw, can be a source of profit for you.Of course, the traders are out to make money, but many them will also lose money. Here you can profit by applying better trading skills and better quality trading systems.
2. Initial public offerings and companies issuing additional stock can provide you with an opportunity to cash in on the discrepancy between the IPO price of the stocks and the prices at which they will eventually settle. As a trader, your earnings will be well-deserved compensation for the risk you take on, but this level of risk can be reduced by using technical analysis. (To learn more, see the IPO Basics tutorial and The Murky Waters Of The IPO Market.)
3. Established companies, mutual funds and other large financial organizations make big moves in the financial markets, and can act as portfolio builders for investors and traders. In this case, a trader's profit will act as compensation for the risks taken. In fact, the trader insures major investors against fluctuations in the cost of the stocks by buying the related risks and trying to use them.
Therefore, technical analysis can be considered a means of profiting from less experienced traders, whereas one of the ways fundamental analysis can be used is as a tool for making money on a major market player (a major corporation or government).
As far as short-term trading is concerned, fundamental analysis cannot be used as a "tactical", short-term decision-making method. Technical analysis enables traders to gain a vision of the market and make the right move at the right time, while fundamental analysis should be applied strategically, over longer periods of time. It helps an investor obtain information about the overall state of the market, attractiveness and state of a specific security as compared to other securities, However, when and how to react to the information, derived through fundamental analysis, is determined using technical analysis. (For more insight, see The Basics Of Technical Analysis.)
Regardless of your trading role and attitude to fundamental analysis (and the amount of trust you put in it), you have to be knowledgeable about a number of things to use this approach. The underlying principles of fundamental analysis are based on a number of factors that affect the economy. Year in year out, these factors are becoming increasingly volatile and harder to predict. For a person who isn't educated in the required related fields, trying to find the key morsel of fundamental information in that motley hodge-podge of economic, political and other data and correctly interpreting it can become a wild goose chase.
Short-term traders are less able to benefit from fundamental analysis, but what about long-term investors?
Even if you are an expert who spends 24 hours a day keeping an eye on all the fundamental developments that can influence the market, the reliability of your forecasts will still be relative. Fundamental analysis will probably work most of the time, but there will hardly ever be the possibility of predicting when it's going to fail. As a result, it is most effective when used over a longer time frame, allowing it to provide a more balanced picture of a company.
The fundamental approach is often used by long-term investors, but it can also be combined with technical analysis to help traders gain insight into the overall state of the market and the attractiveness of a particular security.