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Technical analysis basics |
Technical Analysis Basics
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Generally, when investors are deciding which options
or stocks to buy, they will need to analyze the
stocks to see whether they're worth buying. There
are 2 methods of analyzing stocks, technical analysis
and fundamental analysis (following hot tips from
your neighbor doesn't count, unless your neighbor
happens to be a Mr. Buffett).
Fundamental
analysis involves researching to
see if the market in general, as well as the
stock in particular, is currently undervalued
or overpriced. The fundamental analyst does
so by comparing the current stock price with
what they think is the fair value.
To gauge a stock's fair value, the fundamental
analyst will look at the "basics"
of a company. He will check the company's
management practice, cash flow, total assets,
earnings and revenue, debt, paid-up capital
and so forth, to determine exactly how much
the company's stock should be worth.
Once he has that value, he will compare it
with the current stock price. If the stock
price is cheaper than his estimation of its
fair value, he will conclude that the stock
is undervalued and worth buying.
That's fundamental analysis in a nutshell.
For a more complete description, you can read
TheStreet.com's
article.
On the other hand, Technical Analysis
involves trying to predict a stock's price
movement by looking at how it has previously
performed, and how people might act in the
future. To a Technical Analyst, a stock price's
past movement tells a lot about how it will
move in the future.
A Technical Analyst doesn't care what a stock
is really worth. Instead, he cares whether
the public will buy the stock or not. He will
use various charts and indicators (which we
will discuss in the following pages) to monitor
the trend and momentum of a stock as well
as investors' behavior.
If a stock is on a roll and investors appear
greedy, the technical analyst will probably
decide that the price will continue to rise,
and will invest in the stock. On the other
hand, if the stock is losing steam, the technical
analyst will probably conclude that investors
are starting to lose interest in the stock,
and he will avoid buying it since the price
trend might reverse.
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Fundamental
Analysis attempts to uncover undervalued
or overpriced stocks. Technical
Analysis attempts to read the trend
and momentum of a stock to determine if
the trend will continue or reverse.
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So
which method is better? There are pros and
cons to both methods, and both are utilized
in the market. However, when we're dealing
with options, the preferred method is Technical
Analysis.
Fundamental Analysis tends to deal with annual
reports and quarterly forecasts, and to predict
the steady growth of a stock. When we're working
with stock options, "annual" and
"quarterly" timeframes are just
too long.
In option trading, the options we buy or sell
usually have timeframes measured in weeks
or months, and we do not have the luxury of
waiting for a company's next annual report
to confirm our move.
On the other hand, since Technical Analysis
works to predict trends and momentum in stock
prices, it is better suited to analyze short-term
movement in stock prices. These momentum indicators
can be used to show short-term trends, even
to the extent of 5-minute intervals.
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Technical
Analysis is better able to
predict short-term price movement,
and is therefore more suitable for
option-trading, where timeframes
are measured in weeks, rather
than years.
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However, be warned that neither method (Fundamental
or Technical) is 100% accurate in predicting
a stock's movement, long-term or short-term.
Stock and market levels are easily affected
by external forces such as global terrorism,
oil prices, inflation and political change,
as well as news that is directly related to
the stock in question.
Therefore, caution must always be used when
trying to predict a stock's movement, whichever
method you choose to utilize.
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