There are two primary analytical approaches to know when investing in the stock market. They are fundamental analysis and technical analysis. Generally speaking, technical analysis deals with analyzing the price movements and price charts to predict next market moves, while fundamental analysis focuses more on the underlying makeup of a company such as the financials, the current sales, the leadership, and future vision.
Using Fundamental Analysis
When using fundamental analysis to make investing decisions, in most cases you are most likely planning on buying and holding that investment for the long term. Why? Because the underlying pieces of information that are analyzed are factors that indicate longer-term values.
Among the many pieces of information analyzed when using fundamental analysis on a company are:
- Revenues: How healthy are the current reported revenues for the company as compared to others in that industry? How do their current revenues compare to previously reported revenues? Are they improving and growing?
- Earnings Per Share (EPS): EPS is the company earnings per share of stock after dividends have been paid. In other words, the net income for the company divided by the total number of outstanding shares of stock equals the company earnings per share. How does the company EPS compare to its previous historic returns? How does this compare to the industry standard? What does the future look like for their forecasted EPS?
- Price to Earnings Ratio (P/E ratio): The price to earnings ratio compares the company current stock price to the EPS. If a company stock price is $100, and they have an EPS of $10 per share, then their P/E ratio would be 10 ($100 share price / $10 EPS = 10). This means that investors are willing to pay $10 for every $1 the company earns. How does this compare to their historic returns and the industry standard for the respective company?
- Profit Margins: A company’s profit margin is the difference between the operating costs of providing their product or service and the price at which they sell that product or service to the public. If you are a grocery store, it may cost you $1 for each gallon of milk you buy, but you sell that gallon of milk for $3 to the public. Your profit margins would then be $2 ($3 sell price – $1 wholesale cost = $2 profit margin). The higher the profit margins of a company, the more likely investors will be attracted to that investment.
When all is said and done, investors want to know what the earnings of the company are. Fundamental analysis ratios like those stated above are ways to take the company earnings and compare it to different aspects of the business. The higher the earnings, the better the potential investment.
Using Technical Analysis
Technical analysis, on the other hand, focuses on current stock price patterns. It can be thought of as understanding the psychology of market movements. Using statistics, recognizing price patterns and using past price movements to determine future price movements can be used to make profitable trades. Some of the main pieces of information used with technical analysis are:
- Price patterns
- Market trends
- Support/resistance price levels
These are just the basics to get started, as this list could be nearly endless.
Unlike fundamental analysis, technical analysis studies the movement of the market based on current price movements. Many patterns have been identified that technical analysts look for that indicate the price of a stock will move a certain direction. Patterns are searched for on price charts of a company over time. Some common price patterns used are:
- Double-top & double-bottom: This pattern indicates a potential reversal in the direction of the current price trend. If the price has been trending up, and its price has risen to the same level twice but never past that level over a given time, this indicates that a potential decline in price is approaching.
- Head & shoulders: This is similar to the double top and double bottom price pattern, and also indicates a potential price trend reversal is approaching. When the price chart of a stock forms what looks like a head and shoulders, this indicates an upcoming reversal.
- Triangle Formations: When you see a stock price chart forming triangles like the image below, this indicates that the price will soon break the pattern in the direction of the current trend.
Watching for common price patterns gives traders an edge on potential price movements, giving them the ability to enter the market at the right time and make a profit relatively quickly.
A market trend is when the price of a stock is moving in a predictable direction due to increased awareness and popularity. If a market is trending up, it means that the overall movement of the stock price is rising. If a market trend is down, it means that the overall movement of that stock price is falling.
This doesn’t mean that the stock cannot drop in value ever, it means that the overall movement of the stock price is rising. See the chart below for an example:
Support & Resistance Levels
As a vital piece of fundamental analysis and technical analysis, identifying support and resistance levels in the market allows traders to identify price points that the market is holding strong to. A support or resistance level is a price point at which the stock market has reacted to multiple times.
For example, a stock price may be reacting to the price of $80 per share. It may rise to that price then drop back below that price multiple times, giving investors a reason to believe that as the price approaches $80 again, it will likely react similarly, giving investors an edge to make a trade for a profit.
Support and resistance levels can also start out as a support level then turn into a resistance level in a down market. A price may be dropping to $60 per share multiple times bouncing back each time it approaches that price. Then it may break that $60 price mark and drop to $50. It then may rise back to $60 per share but never past bouncing below that price as a resistance level.
(Note that the support level at $60 was broken from day 7 to day 8, and then became a resistance level)