How To Combine Fundamental And Technical Analysis

Fundamental and technical analyses are the most common approaches investors use to evaluate investment opportunities. Many investors view these methods as competing philosophies. But, for smart investors, combining these approaches can lead to superior insights and improved returns.

This article will explain how to integrate fundamental and technical analysis into a holistic methodology.

1. Start with Fundamental Analysis

Review the company's financial statements in depth. Analyze revenue growth over the past five years. Is revenue growing consistently year-over-year? Or is growth stagnating? Look at profit margins like gross margin, operating margin, and net margin. Are margins stable or increasing over time? Declining margins may indicate problems.

Also, examine the company's balance sheet. What is the debt/equity ratio? Is the company taking on excessive debt that could be dangerous? Make sure debt levels are sustainable.

Calculate return on equity (ROE) over time as well. ROE shows how efficiently the company generates profits from shareholders' equity. Look for stable or increasing ROE.

Researching the background and track record of top executives is important. Do they have the right expertise to lead the company? Make sure management's incentives are aligned with shareholders.

You'll also want to understand the company's competitive advantages or economic moats. Does it have patent protection, a strong brand, cost advantages from scale, or network effects that competitors can't replicate? These moats protect profitability.

Look at the company's historical earnings growth. Have earnings grown steadily over the past decade? Erratic earnings may signal problems generating consistent profits.

Consider the stock's valuation multiples like the P/E ratio and PEG ratio. Is the stock undervalued relative to historical averages and industry peers? Don't overpay for growth.

Weigh qualitative factors as well, like industry trends, market opportunity, and disruption risks that could impact future growth.

After a thorough fundamental analysis, you'll understand the stock's underlying business health and value. Technical analysis comes later.

2. Use Technical Analysis to Identify Entry Points

After screening for fundamentally sound stocks, study their price charts and technical indicators to determine opportune buy points. Look for chart patterns that typically precede an upside breakout, such as double bottoms, bull flags, ascending triangles, or breakouts above resistance levels.

The double bottom pattern involves two distinct low points followed by a rise, signalling a potential trend reversal. Bull flag patterns occur during uptrends when brief downward movements are followed by continuations higher.

Ascending triangle patterns involve horizontal resistance and rising support levels that converge, often resulting in an eventual break above resistance.

Analyse moving averages to see if shorter-term averages are on the cusp of crossing above longer-term averages, creating a "golden cross" buy signal. Monitor momentum indicators like the Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD) for oversold conditions that often mark bottoming points.

3. Let Winners Ride Using Technical Analysis

After entering a trade based on favourable fundamentals and technicals, continue using technical analysis tools to follow the trend. Identify support and resistance levels that define the trend channel.

Ride winners and give profitable positions room to run higher within the channel. Avoid prematurely selling winners before they hit your target price.

Only consider closing out trades when you get a clear technical sell signal like a break below channel support, bearish chart pattern, moving average crossover, or bearish momentum divergence.

For further information, read this article: Trading in a Bear vs. Bull Market - Strategies and Tips

4. Cut Losses Short Using Technical Tools

No investment strategy works perfectly 100% of the time. When a trade moves against you, use technical analysis to define logical stop-loss levels where you will exit the position and cut losses short. Place stop losses below key support levels or under essential moving averages.

Employing disciplined stop losses and risk management is critical for long-term trading success. Technical analysis helps implement this by taking emotion out of sell decisions.

5. Verify Breakouts and Breakdowns

Technical chart patterns will sometimes generate false signals. Before acting, verify upside breakouts and breakdowns using technical and fundamental filters. Check that volume is expanding on the breakout bar or breakdown bar.

Make sure the fundamental news aligns with the technical signal. For example, positive earnings reports or analyst upgrades should accompany a bullish breakout. Use both types of analysis to improve the odds of accurate signals.

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6. Focus on Longer Timeframes

When conducting technical analysis, concentrate primarily on the daily, weekly, and monthly charts to discern the major trend.

The long-term timeframe carries the heaviest weight. Utilize 60-minute and 5-minute charts to identify entry and exit points within that larger trend.

Remember, the most reliable profits come from trading in the direction of the prevailing long-term trend based on the stock's fundamentals.

7. Let Fundamentals Override Contrary Technicals

Technical indicators are helpful but imperfect tools and may occasionally generate signals that conflict with the fundamental analysis.

For instance, a stock might break below a critical support level or moving average despite solid earnings growth and increasing profits.

In cases where the technicals diverge from improving fundamentals, maintain a long-term perspective and stick with fundamentally superior stocks. Let the fundamentals override the contrary technical signals.

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In Summary

Combining fundamental and technical analysis insights allows investors to make more informed trading decisions. Fundamental analysis provides the cornerstone for identifying quality stocks and maintaining a long-term perspective. Technical analysis provides the tools to maximize timing, entry points, risk management, and profit-taking.

These two approaches can help investors skillfully select stocks with growth potential, time entries, and exits, set intelligent stop losses, and improve overall trading performance.

While neither method is perfect, integrating the best principles of fundamental and technical analysis can give investors an advantage in the markets.

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“When considering “CFDs” for trading and price predictions, remember that trading CFDs involves a significant risk and could result in capital loss. Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be considered investment advice.”