In this article, we shall understand the difference between fundamental and technical analysis.
Fundamental analysis: Goal of fundamental analysis is to discover intrinsic value of a particular instrument and then deciding whether the instrument is undervalued or overvalued by comparing it with current market price. However calculation of intrinsic value differs between individual markets. For example in stock market, there are different valuation methods and indicators of company's financial health. Assessing the “right” valuation of a currency is more tricky, since there are lot of variables determining the exchange rate. Macroeconomic indicators like growth of gross domestic product, interest rates, inflation or unemployment have major impact on currencies. Traders have to be aware of announcements of these key indicators, because they can often result in short-term price movement, especially if the announced indicator is substantially different from the prediction. For illustration, in the year 2007, non-farm payroll (NFP) indicator that is showing new job opportunities in non-farm sector, did produce on average 69 pips move on EUR/USD currency pair in just 20 minutes after the announcement. That is why even purely technical traders should monitor these key macroeconomic reports as they can pose a threat to traders actively trading during these announcements.
Psychological analysis: Human psychology is always present when trading and it can have significant impact on decision making of trader. Emotions like fear and greed are associated with the desire of making profit and can cause irrational behaviour. Contrary to fundamental and technical analysis that study the intrinsic value of the instrument or how the price should change based on historical behaviour, psychological analysis does not study the instrument itself. Instead, it focuses on the trader or investor and studies how he behaves in financial markets. Crowd psychology is used to explain how traders or investors behave in financial markets, where they are surrounded by different market participants.
Technical analysis: This type of analysis is one of the oldest and most popular way of analyzing markets. Technicians do not care about the reason why does certain instrument move or whether it is undervalued or overvalued, as is the case in fundamental analysis. It also is much less demanding in terms of analysis of various statistical, sector or macroeconomic data. That is why it has become very popular, especially for individual traders and investors.
Primary objective of technical analysis is timing of entries near the start of a trend and then holding onto the trend till it reverses. Technicians believe that by studying historical price action, they can predict future price movement. That is why technicians do not look for the reason of a price movement, but rather when and in which direction will the price movement occur. Primary tool of technical traders is a price chart, that contains information about historical price movement and volume traded. There are different types of price charts, which will be discussed later. Using price charts, traders look for certain patterns that had occurred in the past and expect similar outcome from these patterns in the future. By analyzing and backtesting historical price behaviour, traders create trading strategies that they execute in real time. Needless to say, even the best strategies do not work all the time and traders must think in term of probabilities.
The basis of technical analysis can be summed up to three main principles:
All published information relevant to certain instrument is absorbed in price of the instrument. Market participants do not have the same access to published information and do not react to the information at the same pace. Because of this, information is absorbed into price of the instrument gradually. This causes development of trend, which technical traders attempt to capitalize on.
Price tends to move in trends and patterns that can offer good trading opportunities, if recognized by trader in real time. That is why technicians study historical patterns that result in certain price movement.
Prices of financial instruments are determined by supply and demand, which is affected by behaviour of market participants. These participants are likely to react to certain situations in market similarly, regardless of their investment horizon. Because of this, market patterns are likely to repeat, since they are formed by changes in supply and demand, which is affected by human behaviour that is relatively stable regardless of time.