Technical Analysis Trading
Technical Analysis Trading vs Fundamental Analysis Trading/Investing
Technical Analysis (TA) is the study of charts and reoccurring patterns within charts to identify and trade with market trends. Fundamental Analysis is the study of companies and market’s fundamental values and trading or investing in these shares or markets based upon your valuation model.
The problem with fundamental analysis of markets is that markets are irrational, reasonable valuations can become completely meaningless when greed and fear start to drive a market. All assets are valued on what someone will pay for them, this price is a by product of supply and demand. Demand can be based on a true need for a product, but as is often the case with the markets, demand is simply one trader or investor believing that the asset or market will go higher than the current value. This artificial demand can drive prices to extraordinary heights, not necessarily inline with a ‘true’ value. This inefficient pricing is the main reason why fundamental analysis is inherently flawed. The below graph highlights the phases of a market and the emotions that drive the market at that point.
This graph highlights the phases of an emotional market – the bottom of the market, the start of an uptrend, a blow off top and finally a falling market. Note the emotions associated with each phase of the trend. These emotions are what drive markets day in and day out.
Technical analysis (TA) is the process of trading markets based upon identify these constantly reoccurring emotional patterns – primarily greed and fear. The objective is to identify the prevailing trend and trade with that trend. Hype and fads can be a powerful force, often driving prices well beyond a ‘true’ value. Identifying these trends and trading with the rising tide is the key to Technical Analysis. Once people start to realise that the market is in fact over priced, and selling pressure becomes the driving force, they will start to bail out on mass, accelerating the sell off – fear will have taken over. Short selling offers some very rapid trading opportunities, again identifying the capitulation phase of a market can be very profitable.
I have watched these patterns play out thousands of times of a variety of time frames, across a variety of markets – stocks, currency, commodities, indexes. I used to be a firm believer in the fundamental pricing model, but time and experience have taught me that this is a fools way of playing the markets, the only thing that drives markets is people irrationality both positive and negative. A stock that rationally and reasonably can be valued at $1 could very easily become hyped, this leads to greed fueled trading could drive the price to $20, this doesn’t change the fact that the stock is still reasonably worth $1, simply the ‘demand’ has become increasingly strong. Conversely this same stock could be driven down by fear fueled traders to 10c, again the stock is still reasonably worth $1, now the ‘demand’ is incredibly weak. Fundamental value generally does has a link to the rough pricing range of a market, however emotional trading will always push and pull markets well outside there true fundamental worth. Therefore the key to successfully playing the markets is the ability to read these patterns and ride the tide.
The other key to successful trading is not being stubborn in your opinion, often your analysis will be wrong – have an exit plan. Ensure that you ALWAYS set stop loss limits, these are your lifeline in the world of trading. I personally have more trading losses than wins, but i limit my losses with tight stops, while letting my correct trades run, moving my stop up behind them to ensure any gains are locked it. A good understanding of technical analysis and a disciplined trading plan will ensure your trading path is a successful one.