How to Use Fundamental and Technical Indicators in Stock Trading - ecobiztalk

 

How to Use Fundamental and Technical Indicators in Stock Trading

Stock trading is the activity of buying and selling shares of companies or other financial instruments in the stock market. Stock traders aim to profit from the fluctuations in the prices of these securities, which are influenced by various factors such as supply and demand, news and events, economic conditions, and investor sentiment.

To analyze the stock market and make informed trading decisions, stock traders use two main approaches: fundamental analysis and technical analysis. Fundamental analysis evaluates the intrinsic value of a security based on its financial performance, competitive advantage, growth potential, and other qualitative and quantitative factors. Technical analysis focuses on the price movements and trading volume of a security, using mathematical tools and charts to identify patterns, trends, and signals.

Both fundamental and technical analysis have their strengths and limitations, and they can complement each other in providing a holistic view of the market and the securities. In this article, we will discuss some of the important fundamental and technical indicators that stock traders can use to build a trading toolkit and how to combine them effectively.

Fundamental Indicators

Fundamental indicators are metrics that reflect the financial health, profitability, and growth prospects of a company or a sector. They are derived from the financial statements, such as the income statement, the balance sheet, and the cash flow statement, as well as from external sources, such as economic indicators, interest rates, and news and events.

Some of the common fundamental indicators that stock traders use are:

• Earnings per share (EPS): This is the amount of profit that a company earns for each share of its common stock. It is calculated by dividing the net income by the number of outstanding shares. EPS is a measure of the profitability and growth potential of a company. A higher EPS indicates that the company is generating more earnings for its shareholders, which can lead to a higher stock price.
• Price-to-earnings ratio (P/E): This is the ratio of the current stock price to the EPS. It is a measure of the valuation and the expectations of the market for a company. A higher P/E indicates that the market is willing to pay more for each unit of earnings, which implies that the company has strong growth prospects or a competitive edge. However, a very high P/E can also indicate that the stock is overvalued or overhyped, which can increase the risk of a price correction.
• Dividend yield: This is the ratio of the annual dividend paid by a company to its current stock price. It is a measure of the income and the stability of a company. A higher dividend yield indicates that the company is paying out a larger portion of its earnings to its shareholders, which can attract income-oriented investors. However, a very high dividend yield can also indicate that the company is facing financial difficulties or that the stock price has declined significantly, which can reduce the attractiveness of the stock.
• Return on equity (ROE): This is the ratio of the net income to the shareholders’ equity. It is a measure of the efficiency and the performance of a company. A higher ROE indicates that the company is generating more income for each unit of equity, which means that the company is using its resources effectively and creating value for its shareholders.
• Market capitalization: This is the total value of all the shares of a company in the market. It is calculated by multiplying the current stock price by the number of outstanding shares. Market capitalization is a measure of the size and the influence of a company in the market. A larger market capitalization indicates that the company has a dominant position or a strong reputation in its industry, which can affect its stock price and its ability to raise capital.

Technical Indicators

Technical indicators are mathematical calculations that use the historical price and volume data of a security to generate signals and forecasts. They are displayed on charts, such as line charts, bar charts, candlestick charts, and point-and-figure charts, to help traders visualize the price movements and identify patterns and trends.

Some of the common technical indicators that stock traders use are:

• Moving averages (MA): These are the average prices of a security over a specified period of time, such as 10 days, 50 days, or 200 days. They are used to smooth out the price fluctuations and show the direction and the strength of the trend. A rising MA indicates an uptrend, while a falling MA indicates a downtrend. A shorter MA is more sensitive to the price changes, while a longer MA is more stable and reliable. Traders use different types of MAs, such as simple, exponential, weighted, and adaptive, depending on their preferences and objectives.
• Moving average convergence divergence (MACD): This is a momentum indicator that shows the relationship between two MAs of different lengths, such as 12 days and 26 days. It is calculated by subtracting the longer MA from the shorter MA, and it is plotted as a line or a histogram. The MACD is used to identify the changes in the trend and the momentum. A positive MACD indicates a bullish momentum, while a negative MACD indicates a bearish momentum. A crossover of the MACD and the signal line, which is a 9-day MA of the MACD, is a common signal for buying or selling a security.
• Relative strength index (RSI): This is a momentum indicator that measures the speed and the magnitude of the price movements of a security. It is calculated by comparing the average gains and the average losses over a specified period of time, such as 14 days. The RSI ranges from 0 to 100, and it is used to identify the overbought and the oversold conditions of a security. A high RSI, above 70, indicates that the security is overbought and may be due for a pullback or a reversal. A low RSI, below 30, indicates that the security is oversold and may be due for a bounce or a recovery.
• Stochastic oscillator: This is a momentum indicator that compares the closing price of a security to its price range over a specified period of time, such as 14 days. It is calculated by subtracting the lowest price from the closing price and dividing it by the difference between the highest and the lowest prices. The stochastic oscillator ranges from 0 to 100, and it is used to identify the overbought and the oversold conditions of a security. A high stochastic, above 80, indicates that the security is overbought and may be due for a pullback or a reversal. A low stochastic, below 20, indicates that the security is oversold and may be due for a bounce or a recovery.
• Bollinger Bands: These are volatility indicators that consist of three lines: a middle line, which is a 20-day MA of the price, and two outer lines, which are two standard deviations above and below the middle line. They are used to measure the volatility and the deviation of the price from the mean. A wider band indicates a higher volatility, while a narrower band indicates a lower volatility. The bands also act as dynamic support and resistance levels for the price. The price tends to revert to the middle line when it reaches the upper or the lower band, which can signal a reversal or a continuation of the trend.

How to Combine Fundamental and Technical Analysis

Fundamental and technical analysis can be combined to provide a more comprehensive and balanced view of the market and the securities. Traders can use fundamental analysis to identify the securities that have strong fundamentals and attractive valuations, and then use technical analysis to determine the optimal entry and exit points for their trades. Alternatively, traders can use technical analysis to screen for the securities that have favorable price movements and trends, and then use fundamental analysis to confirm their quality and potential.

For example, a trader who is interested in buying a stock can use the following steps to combine fundamental and technical analysis:

• First, the trader can use fundamental indicators, such as EPS, P/E, dividend yield, ROE, and market capitalization, to filter out the stocks that have high earnings growth, reasonable valuations, stable dividends, efficient performance, and large market size. These indicators can help the trader narrow down the list of potential candidates and select the ones that have strong fundamentals and competitive advantages.
• Second, the trader can use technical indicators, such as MA, MACD, RSI, stochastic oscillator, and Bollinger Bands, to analyze the price and volume patterns of the selected stocks. These indicators can help the trader identify the direction and the strength of the trend, the changes in the momentum, the overbought and the oversold conditions, and the support and resistance levels. The trader can use these indicators to determine the best time to buy or sell the stocks, based on the signals and the forecasts generated by the indicators.
• Third, the trader can use a combination of fundamental and technical indicators to monitor and evaluate the performance of the stocks. The trader can use the fundamental indicators to track the changes in the financial results, the growth prospects, and the market conditions of the stocks. The trader can use the technical indicators to adjust the stop-loss and the take-profit levels, and to exit the trades when the indicators show a reversal or a divergence in the trend or the momentum.

By combining fundamental and technical analysis, the trader can have a more complete and objective picture of the market and the securities, and can make more informed and rational trading decisions.

Conclusion

Fundamental and technical analysis are two different but complementary approaches to analyze the stock market and make trading decisions. Fundamental analysis evaluates the intrinsic value of a security based on its financial performance, competitive advantage, growth potential, and other qualitative and quantitative factors. Technical analysis focuses on the price movements and trading volume of a security, using mathematical tools and charts to identify patterns, trends, and signals.

Both fundamental and technical analysis have their strengths and limitations, and they can be used together to provide a more comprehensive and balanced view of the market and the securities.