How do you pick which stocks or currencies to buy, hold or sell?
The answer to that question, of course, can make or lose a fortune and if I knew the definitive answers I wouldn’t be here hunched over my desk writing about it – I’d be cruising the Caribbean, fielding calls from new best pals, Warren Buffett and Hugh Hefner.
While there are no certainties in investing, other than those that flow from insider trading or having your bush block rezoned for coalmining (despite the possible subsequent risks), there are ways of making your chances of success better. They fall into two main camps: fundamental analysis and technical analysis, also known as charting.
For the benefit of those relatively new to the area, fundamental analysis of a share involves evaluating everything that may impact on its future value, including the state of the economy, the political climate, industry conditions and, of course, the financial standing of the company itself. It takes into account factors including the business’s cash flow, profit and loss history and projections, its product line, its competition and, importantly, the calibre of its management.
All of these will affect a share’s price but, apart from what you can glean from the media, annual reports, balance sheets and company statements to the stock exchange, much of the information you could benefit from will be difficult to access.
Nonetheless, fundamental analysis is an attempt to rationally evaluate a company’s investment prospects based on as much relevant information as you can muster – and if you have the right analysis and access to the right information, it can serve you well. For many individual investors, that may be too big an ask.
The role of technical analysis
Enter technical analysis. It deals with these conundrums by ignoring them. Technical analysis looks at a wide range of graphs and charts – hence the term “charting” – derived from a company’s share price over a period, including right up to the present, seeking to detect trends that indicate where the price is likely to go.
Why the price is likely to head in a certain direction (the domain of fundamental analysis) is not relevant. All that’s relevant is where the charts indicate it is heading.
A key feature of technical analysis is that it assumes the market price reflects all that is (fundamentally) known about a stock by the market and doesn’t try to add to that underlying quantum of fundamental information.
It just looks at market behaviour (be it rational or irrational) and makes a call on where the market is likely to head next, based on where it’s been trending or on discernible patterns of activity in recent times.
You can make your trading decisions based on that analysis alone if you wish.
It’s an approach that doesn’t ask questions or offer explanations. It just says this is the way the market is behaving (for whatever reason) so make your investment decisions accordingly.
Choosing the right analysis
When trading shares or currencies, do many people rely on technical analysis alone, or is a mix of technical and fundamental analysis a better approach?
Technical analyst Regina Meani says: “It comes down to individual preference, but I would suggest there would need to be years of experience behind a decision to rely on any trading tool in isolation. It’s said that the best opportunities lie where the fundamentals and the technicals come together.
“I believe that, in some instances, day traders rely solely on technical analysis and it does come into its own in the currency markets, where it performs to a high level of accuracy. However, I don’t believe that there is a reliable measure for which avenue performs better.”
Chris Weston, head of research at IG and a keen user of charts, also believes using a mix of technical and fundamental analysis produces the best results. The term he uses for this approach is “technimentals” – where “I take a fundamental strategy that I think works, and apply the technicals to it. In most cases, using the two together works best for me.”
Weston tempers this by saying that share trading and currency trading are not the same – different dynamics and ways of reading the likely direction of a trade apply. He says that with shares, using fundamental analysis alone may produce good results, because there may be plenty of information about a particular share, enabling a reasonable judgement to be made about its future trading direction.
It’s a different story with currencies
As Weston points out, there’s a massive amount of activity going on, including traders hedging portfolios, companies hedging profits and the biggest players of all, central banks, carrying out their normal business operations. On top of this are speculators trying to make a dollar.
“To try to have an understanding of how all this works on any given day, it’s just huge. Without looking at the market’s price action – the domain of charts – which blends all this trading activity together into one picture, it would be very hard to get your trading right.
“Currency markets are very, very difficult. They are fascinating beasts when you get to understand them, but that takes time – years – and trading practice. With currency trading, that’s why you need to start small and get to understand what the tools of technical analysis indicate, how they work and how they can help you.”
Trading platforms offered by all serious trading houses provide charting tools and on many you can set up a trial trading account to get a feel for how technical analysis functions.
Both Weston and Meani stress education is vital to trading successfully, and encourage traders to take courses and read widely. Meani regards Technical Analysis of Stock Trends by Robert Edwards and John Magee as the “bible” of charting, while her soon-to-be-published Technical Analysis – The Charting Way promises to be useful.
She recommends the technical analysis course run by Kaplan Professional. She says the Australian Professional Technical Analysts organisation (www.apta.org.au) is open to both professionals and non-professionals.