The analysis of common stocks for the purpose of buying and selling the “right stock at the right price” has been going on for almost 200 years. During that time, two very different types of analysis have developed — fundamental and technical.
Fundamental Analysis
Basically, fundamental analysis depends upon statistics. The fundamentalist studies a company’s profit-and-loss statements, quarterly balance sheets, auditors’ reports, dividend records, sales data, management ability, products, the competition, etc.
After all of this, he compares this data with the data on other companies and the market, and decides what the stock is worth. If the current price is under his evaluation he buys, and if it’s over it he sells.
Technical Analysis
Technical analysis is the “study of the action of the market itself,” which depends upon the accurate recording of mounds of data, transferring it to chart form, and then deducing from the pictured history the probable future trend of the stock.
The technician argues that there is no such thing as an “intrinsic value” of a stock, and that the price is determined solely by supply and demand.
The price may be influenced by fundamental factors, but there are other factors that are more complex. They include the emotions of hope and fear, and the irrational and rational actions of thousands, perhaps even millions, of buyers and sellers. And it includes their needs and resources — factors beyond the ability of the most powerful computers to precisely assign a value.
The technician would say that there is but one true value of a stock, and that is the price most recently recorded, because it takes into account all of the factors mentioned and is determined in the free marketplace by buyers and sellers.
And since prices move in “trends,” the technician studies those trends for patterns that have historically either terminated a trend or established a new trend. Chart patterns and formations, and support and resistance levels are studied, and the result is the prediction of probable new patterns and price objectives.
Technicians identify certain patterns, such as head and shoulders, pennants, triangles, rectangles, support and resistance zones, the gold cross, cup-and-handle, etc. Each has its own degree of probability, but not one is even close to being 100% accurate all of the time; hence, technical analysis is more of an art than a science.
Modern Technical Analysis
In the last 40 years, and especially since the introduction of the personal computer, technicians have relied upon data that in the past was too difficult to collect and evaluate.
I rely not only on chart patterns, but also on the “market indicators” like Moving Average Convergence/Divergence (MACD), stochastic, momentum, the Relative Strength Index (RSI), Bollinger bands, and my own invention (which is a derivation of Bollinger bands) — the Collins-Bollinger Reversal (CBR).
In addition, I study the “sentiment indicators” such as the American Association of Individual Investors (AAII) Sentiment Survey, the CBOE Volatility Index (VIX) and other sources, in order to determine investor attitudes toward the market by quantifying the levels of optimism and pessimism among various groups of investors.
I am especially interested in groups that in the past have, by the strength of their opinion, accurately pointed me to a future market direction.
For example, the AAII Sentiment Survey tells me that when its members are very bullish, I should hesitate to buy stocks since their optimism is usually highest at market tops. And the reverse is also true; when the poll shows most investors are bearish, that is the time for me to be bullish.
This is some of the theory behind the practical application of the art of technical analysis.
For further explanation and study, I suggest “The Technical Analysis of Stock Trends” by Edwards and Magee and OptionsZone.com’s Technical Analysis 101 section.
And be sure to check out my Trade of the Day on OptionsZone.com, where I provide a daily stock pick complete with a chart and supporting technical commentary, outlining where it’s been, where it’s heading and why it’s worth a second look.
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