Two forms of analysis, head to head

Devoid of calculations, reading, or other time-intensive research, technical analysis allows a swing trader to examine any security — be it stock, commodity, currency, or something else — and make a decision on its likely short- or long-term direction (depending on whether the chart being analyzed is a short-term chart, such as a chart where each bar represents an hour or day, or a long-term chart, such as a chart where each bar represents a week or month). Swing traders relying on technical analysis don’t care about what a company does, how it makes its money, or whether the CEO graduated at the top or bottom of her class — they care for nothing but the ticker tape (the running list of trades of a security, similar to what you may see on financial news networks at the bottom of the screen). After all, swing traders earn profits based on a security’s price, not how many widgets a company sells or the academic pedigree of its board of directors.

Technical analysis is particularly important for swing traders with an extremely short time horizon (that is, a couple of days). The shorter your time horizon, the more prominently technical analysis should figure in your trading plan because short-term price movements are driven by supply and demand for shares and not a company’s fundamentals.

The swing trader who relies on fundamental analysis is a different breed. This trader wants to know what line of business a company is in, whether that industry is on the rocks or gaining momentum, when a company reports its earnings, and what those earnings expectations are. The swing trader using fundamental analysis isn’t interested in every detail of a company’s balance sheet. After all, if you’re looking at trading stocks of ten companies in the coming week, you don’t have the time to read those companies’ annual reports cover to cover. Instead, a high-level overview is enough. Intricate modeling in Excel, though useful, isn’t practical for a swing trader who buys and sells stocks over a period of days.

Swing traders relying on fundamentals may be categorized as event-driven traders. Event-driven traders wait for specific events and then trade a security based on their expectation of how this event will drive a security’s price.

For example, assume that Apple unexpectedly announces that the sales of its latest iPhone are above expectations. An event-driven trader might look at which companies will benefit from Apple’s success — perhaps a supplier of Apple products. Or perhaps a major retailer announces disappointing earnings due to competition from e-commerce. An event-driven trader might buy shares of e-commerce companies in anticipation of a strong earnings report that will send their shares higher.

Newcomers to swing trading are typically attracted to technical analysis, for a couple reasons:

• Technical analysis, because it relies more on charts and indicators, involves less subjectivity than fundamental analysis. If you put a chart in front of ten different swing traders, they likely won’t differ a lot on the strength or weakness of the chart. However, investors often have wide differences of opinions regarding the value of a company. In technical analysis, there are just two inputs: price and volume. In fundamental analysis, there are dozens.
• Technical analysis doesn’t require nearly as much work as fundamental analysis. A fundamental analyst has more variables to deal with and more calculations to compute. To analyze a firm, a fundamental analyst must understand the dynamics of the firm’s industry, its competitors, its cost structure, its management team, and other factors.
• Except for event-driven trading, decisions based on fundamental analysis take more time to play out than those based on technical analysis. A company may be deeply undervalued relative to the market and its industry, but being undervalued doesn’t necessarily mean shares will rise tomorrow or the day after. Some companies’ shares stay undervalued for weeks, months, or even years. That’s why long-term investors rely so heavily on fundamental analysis — they can afford to be patient.

Despite the major advantages of technical analysis, my goal is to convince you to use both strategies in your swing trading plan — you tend to get the best investment results when a security’s fundamentals line up perfectly with the technicals. Neither fundamental analysis nor technical analysis is perfect, and neither is superior to the other. In fact, many top swing traders use fundamental analysis to trade short term. Why? Because as a swing trader, you need to understand what drives price movements in the securities you trade. Fundamental analysis helps you understand how news impacts the market and the shares you’re trading. After all, what drives oil stocks higher is quite different from what drives technology stocks higher. Moves out of such securities can be powerful and longer lasting than securities that pop or fall due solely to technical considerations.

You can integrate technical analysis and fundamental analysis without much difficulty, but don’t integrate them for the sake of integration. If you feel more comfortable with one type of analysis, then use that method. If you’re attracted to using fundamental analysis and event-driven trading to the exclusion of technical analysis, then excel at it. You can be a successful swing trader by using one type of analysis alone — as long as you use a strict risk management system (see Chapter 10).

There is no one right answer. Some successful traders use one or both forms of analysis. What’s important is that you know which method you enjoy using and which method plays to your strengths.

Scope approach: Top down or bottom up?

Regardless of which approach you take, you should also think about whether you want to be a top-down swing trader or a bottom-up swing trader. A top-down trader finds securities by beginning at a macro level and drilling down to an industry and then to a particular company. A bottom-up trader finds securities by beginning at the bottom (that is, with individual companies) and then selecting the company that has the best industry group and macro-level fundamentals.

Recognizing that you can use technical analysis or fundamental analysis with the top-down or bottom-up approach is important. For example, you can select undervalued securities using fundamental screens (a bottom-up approach, as explained in Chapter 8) and then vet those securities for strong or weak chart patterns. Alternatively, you can identify strong or weak stocks using industry chart patterns (a top-down approach, also covered in Chapter 8) and then investigate those securities to find the candidates that are most compelling to buy.

Styles of trading: Discretionary versus Quantitative

Discretionary swing traders evaluate potential trades based on their trading plan. They use either fundamental or technical analysis to determine whether each trade meets their requirements. Although the discretionary trader’s rules are written down, he or she may pass on or take trades based on experience or gut. The discretionary swing trader doesn’t follow a program such as, “If A, then B.” Instead, he or she synthesizes all available info, weighs items, and then makes a call.

Quantitative swing traders are very different. They map out trading strategies that a computer can execute. The quantitative system can be based on technical inputs (like price, indicators, and so on) or fundamental ones (such as earnings surprises, sales growth rates, and other corporate events). The strategies are programmed into a computer software program that tests them on historical market data. The quantitative swing trader analyzes those results to determine whether the strategy is worth pursuing — if it produces higher profits than the overall market, for example.

As you may’ve guessed, the two approaches both have advantages and disadvantages:

• Discretionary trading allows for a fresh look at each situation and the ability to pass on trades when external data that may not be easily captured in a computer program indicates decreased chances of success. The future isn’t always similar to the past, and discretionary traders can understand how markets change over time and incorporate such changes into their trading plan.

  This approach does have its drawbacks: Discretionary traders must make a decision on each buy or sell, and they’re more prone to falling in love with trades, becoming emotionally attached or failing to follow the trading plan.

• Quantitative trading largely takes the human out of the equation. A computer program executes the trades as programmed. Of course, the swing trader executing this program developed the program based on the historical success of applying certain rules (for example, buy a stock when it makes a new high for the first time in 20 days). After the program is set, the swing trader isn’t making a decision on each trade. The quantitative trader can step back and watch the computer work its magic.

  But quantitative trading systems also have their drawbacks. Can a system be designed to capture all contingencies or possibilities that may arise? Of course not. Moreover, even though a certain strategy worked in the past, there’s no guarantee it will continue working in the future. When losses occur, the quantitative swing trader must determine whether the setback is a temporary part of the system or whether it represents a change in the market environment, requiring development of a new quantitative model.

This text is geared toward discretionary traders. Although hard data on the proportion of swing traders who are discretionary or quantitative is hard to come by, my experience and anecdotal evidence point to discretionary trading as the more common approach. Most swing traders feel more in control when they evaluate each trade instead of relying on a computer to execute transactions.

That doesn’t mean discretionary trading is superior to quantitative trading. Only that each approach requires a different skill set. I’m a discretionary trader because I believe my experience in the markets can’t be easily programmed, I enjoy using discretionary trading, and I have developed a system over time. But if you incline to quantitative trading methods and are experienced in programming or want to find out more, I recommend accessing other resources focused solely on quantitative trading methods.

Understanding how and why technical analysis works

So why does technical analysis work? How can examining past price history possibly provide insight into future price movements?

• Market participants, acting alone, react similarly to major news. Technical analysis is partly based on the psychology of crowds. Even though all investors may not be congregated in a single room, they’re all human — even quantitative systems have humans behind them. Hence, they’re susceptible to the same emotions all humans share: greed, fear, hope, and the like. Security prices would be very difficult to analyze if everyone trading were Spock-like — perfectly logical with no emotions getting in the way.

• Market participants have memory. Traders, investors, and other market participants have reference points when they buy or sell securities. The price they pay when they buy a security affects when they’re likely to sell that security (even though it should have no bearing on that decision). They remember their purchase price and, naturally, want to either make a profit or break even. If the security price swoons after they purchase shares, they’re likely to feel pain. And if the price recovers to their original purchase price, many will be happy to sell to break even. What these traders and investors often don’t realize is that hundreds, if not thousands, of others are experiencing these same emotions. This fact is why certain price levels are more significant than others. Securities tend to find support (a level at which security prices stop falling and begin to rise) and resistance (a level at which security prices stop rising and begin to fall) at round numbers.

  I’m amazed at how often traders place buy-limit or sell-limit orders at round price figures. Don’t they realize that many other traders may be doing the exact same thing, and that their actions may prevent the price from ever reaching that level? Quite simply, a sell limit of $100 isn’t too bright, because other traders or investors likely placed orders at that same round number. And their orders may prevent yours from ever getting executed (the overwhelming supply of shares at that level will force the stock to retreat before reaching $100). On the other hand, a sell limit of $98.71 is smart, because it’s unlikely that other traders placed an order at that specific price, and you have a much better chance of your order getting executed.

• Smart investors’ actions show up on the chart. Smart money often refers to investment money made by institutional investors who have greater resources than individual investors (for instance, access to research, staff, and so on). Institutional investors invest their money with specialized managers who can visit a company’s headquarters and pay for expensive research. Smart money also constitutes insiders at a firm who have an information advantage over other market participants and may trade on that information.

  Dumb money, on the other hand, refers to investment money made by amateurs who buy or sell securities for the thrill of investment or without proper diligence. Dumb money doesn’t necessarily mean individual traders; it can include retirement plans or corporate plans that divest securities that no longer meet the plans’ criteria. This selling pressure pushes prices down for no good reason. Dumb money can also include institutional investors who buy or sell stocks because they fall in love with their investments. Believe it or not, institutional investors are subject to the same whims and emotional swings experienced by all traders.

• Folks with knowledge of a company’s prospects can only take advantage of that knowledge by trading on the open market. Their trading shows up on the ticker tape (it’s the law). So if you know that Amazon is going to have a blowout quarter (by legal means, of course, and not through illegal insider sources), you can’t profit from that knowledge except by buying shares. And your buying is going to show up as volume on a price chart. Others who may not know about the blowout quarter can, nonetheless, infer that something is up when they see Amazon’s shares rising on heavy volume.

Sizing up the technical advantages and disadvantages

Because the price chart shows all available public and private information, technical analysis can really shine bright when prices diverge from their fundamentals. Opportunity is greatest when you’re in the minority, but right. If everyone, including you, expects shares of Twitter to do well, you won’t make much money because others have already come to the same conclusion and positioned themselves according to that expectation. However, if you think Twitter will surprise investors to the upside and everyone else is on the other side, you stand to make a large profit if you’re right and the crowd has to correct its collective opinion by buying shares.

For example, shares of Enron were tumbling in late 2000 despite what appeared to be stellar fundamentals. Price drops were met by upgrades and buy recommendations by Wall Street analysts who, using all available public data, determined that shares represented significant value.

But prices kept falling. A swing trader using technical analysis would conclude that something wasn’t right. If everything was peachy, why were shares falling? Something must be up. And sure enough, something was up — something mischievous indeed. Investors using fundamental analysis, on the other hand, are often alerted of underlying cracks in a company’s financial position after it’s too late.

Despite the advantage technical analysis has of signaling information that you may not know, this strategy isn’t a cure-all for your trading woes. Reading a chart isn’t a pure science, and sometimes whipsaws or indications can give you one signal, only to reverse a short while later. Moreover, a major event outside of everyone’s control can occur that no one could have foreseen. For these reasons, you’ll never know with certainty that a particular chart pattern or indicator will yield a profitable signal. Swing traders (indeed, all traders) have to learn to live with this uncertainty, which also exists in fundamental analysis. Some swing traders are actually wrong the majority of the time, but still extremely successful. Why? Because the many losers are small, whereas the few winners are large.

Technical analysis can also be useful for new markets. For example, what is the appropriate price for Bitcoin? I have no idea; it’s simply too new to understand this asset class. But technical analysis can assist you in determining when (or if) to buy and sell a cryptocurrency. Some of the major advantages of technical analysis are that it

• Applies consistently across time and markets
• Can be used on a single security in a short period of time
• Incorporates the psychology of the crowd, whether rational or irrational
• Allows for support and resistance levels for exits and entries
• Involves low levels of subjectivity in the analysis of charts

But technical analysis also has some glaring weaknesses. For example, it

• Ignores a security’s fundamentals
• Allows traders to be on the side of irrationality
• Assumes the market is always right
• Contains a degree of subjectivity (not as subjective as fundamental analysis, but charts are open to some interpretation)

The two main approaches of technical analysis

This book covers the two major aspects of technical analysis: charting and using technical indicators. Reading charts and using indicators are of equal importance to the swing trader who uses technical analysis, so you should be adept at both. (Keep in mind that technical indicators are largely unhelpful if you don’t understand basic chart pattern interpretation.)

Understanding how and why fundamental analysis works

Understanding how fundamental analysis works is a bit easier than understanding how technical analysis works. Here’s why this strategy is effective:

• The higher the earnings of a company, the more others will pay for a piece of that company. If you own a condo that produces $1,000 in income each month, how much would you value that cash flow? Different people would value the condo differently, depending on their risk tolerance levels and the certainty of that cash flow continuing. But obviously, if the condo were producing income of $2,000 per month, it would be worth double what it was worth when it was producing $1,000 per month (holding all else equal).

  Fundamental analysis isn’t that different, except that instead of producing rental income of $1,000 per month, companies produce earnings and report them quarterly. Of course, shareholders don’t usually receive a firm’s entire income because much of it is reinvested in the business and little, if any, profit is distributed (such as in the form of dividends). But the point is, fundamental analysis works because it measures a company’s value based on its expected future earnings.

• Arbitrageurs keep prices in check. Another important reason fundamental analysis works is that arbitrageurs are looking for riskless profits. For example, suppose a security is trading at $25 per share, and the company is valued at $1 billion. If the firm had $2 billion in cash on its books and no debt, an arbitrageur would step in to take advantage of the mispricing. The arbitrageur could buy the company for $1 billion and then pay for the purchase using the cash the company has on its books. So fundamental analysis works because firms, governments, and individuals are constantly looking for riskless profits.

Okay, you’re convinced that fundamental analysis has merit, but can you benefit from it in your swing trading? The answer is yes. But you should be aware of its limitations and how you can address them:

• Unlike technical analysis, you can’t uniformly apply fundamental analysis to securities. A swing trader who understands how to interpret chart patterns and technical indicators goes through the same process whether he or she is trading corn, cotton, gold, oil, stocks, exchange traded funds or cryptocurrencies. The chart analysis is the same, and resistance and support both apply because market participants behave in similar ways regardless of what they’re trading.

  Master the fundamental analysis of cotton, however, and you aren’t much better off when you come to trading oil. Master the fundamental analysis of real estate companies, and you’ll face a new ballgame when it comes to technology companies. Differences persist between market fundamentals and how you analyze them. For this reason, swing traders who rely on fundamental analysis often must specialize in a few markets.

• Fundamentals change less often than chart prices. A company reports its earnings and sales figures once every three months (in some international markets, companies report once every six months, but the general rule is companies report each quarter). Swing trading based on a report that’s two months old can be hazardous because whatever value the report contained was likely incorporated in the company’s share price during the first few days after the report was released. This fact doesn’t mean you should ignore news of a company that isn’t recent. But it does mean that you don’t want to buy a security based on a news report issued two months ago that sales are raging. The reason for the purchase has to be a recent catalyst or the convergence of good technicals (a chart) and good fundamentals.

Surveying the fundamental advantages and disadvantages

Fundamental analysis has its pluses and minuses. Some aspects, such as its emphasis on industry dynamics and competition, make it well suited for the swing trader; other aspects, such as its focus on value realization over the long term, make it a poor swing trading tool.

The advantages of fundamentals are centered on the focus on value — what a firm is actually worth. Fundamental analysis

• Estimates a firm’s intrinsic value regardless of where the market trades
• Incorporates industry and market effects, which can drive security prices in tandem
• Wins out over the long term — fundamentals drive the prices of securities
• Assumes the market is wrong at times
• Drives trends in the near term in response to unexpected events

Of course, fundamental analysis also has its shortcomings because it

• Can be incorrect in the short term when you most need it
• Is more subjective than technical analysis
• Relies heavily on your skill to interpret relevant market information
• Doesn’t provide reference points on exits should your assumptions be incorrect

I don’t recommend exiting based on a company’s fundamentals unless it’s driven by an event (for example, an earnings report, the announcement of a merger, the announcement of tariffs, and so on). But exiting a security simply because it’s expensive is unlikely to lead to excess profits because securities routinely overshoot on the up and downside. As a swing trader, you’re better off basing exits on the strength or weakness in the price chart. Stock prices fall faster than they rise, and commodities tend to rise faster than they fall. Therefore, if you own a stock, you may want to exit quickly given that stocks can fall faster than they rise. Fundamentals change too slowly to react in a timely manner on an exit (again, except for event driven situations). Use stop-loss orders to protect your downside.

Looking at catalysts and the great growth/value divide

Fundamental analysis is principally concerned with a company’s value (or perhaps more accurately, what a company’s value appears to be). But even a company that is undervalued may stay undervalued unless some catalyst occurs to cause other investors to revalue shares higher.