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Everyone knows that the key to successful investing is buy low, sell high. The only
problem is that it is a lot easier said than done. Sure, in bull markets most people can
make money as prices go up and up, but what about when markets go down? What
about when prices stay the same?
Analysis in the form of both fundamental and technical seeks to provide answers to
these questions.
This special report serves as a primer to help you understand what exactly fundamental
and technical analysis is, what are each of their strengths and shortcomings, and how
they can help you become an investor with the ability to make money regardless of
what the market is doing.
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stock eventually rises to its true value (and, hence, to a higher stock price). Conversely,
if a stock is presumed to be currently overvalued, they can sell the stock short hoping
they will be able to capture the downside profits by selling the stock high and buying it
back at a lower price. In either case, by using fundamental analysis, investors seek to
invest before the rest of the market discovers these potentially profitable opportunities.
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The above process creates a shrinking funnel, in which only the most promising companies fall out as investment candidates in the end.
Fundamental analysis is also very beneficial for those investors who are investing for the long-term. Over the long-term, when the fluctuations of daily or
weekly price swings are smoothed out, the most fundamentally sound companies are the ones that are most likely to produce and sustain rising price levels.
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Those benefits notwithstanding, fundamental analysis does possess some shortcomings that make it difficult for investors to rely on this approach alone. Specifically:
Despite the fact that it provides invaluable business and investing intelligence,
fundamental analysis is extremely time consuming. While this is true even for
national economic analysis, it is particularly the case for fundamental analyses of specific industry sectors and individual companies, each of which often
require customized research and analytical protocols. The enormous time
requirements demanded by fundamental analysis (1) severely limits the breadth
of research that can be performed and the number of companies that can be
covered, (2) makes it difficult to deploy the analysis on a real-time basis, and (3)
makes it impractical to update the analysis on a frequent basis.
Fundamental analysis is highly subjective. Not only do the criteria employed to
conduct fundamental analysis differ from analyst to analyst, but the definitions
of these criteria within a given analysis can be imprecise. Moreover, many of
those who conduct fundamental analysis for a living (such as professional stock
analysts) either have a vested interest in providing bullish reports on the companies that they cover or else rely too heavily on internal company information,
either of which tends to bias their findings.
Finally, while assessing company strength is clearly valuable, the idea that
fundamental analysis can routinely identify undervalued or overvalued stocks
must be regarded with a large dose of suspicion. The premise of this assertion
is that a single analyst can somehow unearth hidden value (or lack thereof) in
a company that has escaped the notice of millions of market participants and
thousands of financial journalists. While this might happen on occasion, it is not
reasonable to expect that it will take place very often.
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Its value and insights notwithstanding, fundamental analysis can consume a great
deal of time, with often hours or even days required to evaluate a single stock.
The optimal methods for fundamental analysis typically vary from industry sector to industry sectorsometimes even from company to companyimposing
a very steep and changing learning curve.
Because so much of the information used for fundamental analysis differs from
company to company, a great deal of subjectivity is involved in the practice,
making it hard to compare conclusions across companies, industry sectors, or
analysts.
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Technical analysis suffers from none of these problems. While far from simple, technical
analysis is based on a limited range of principles that can be learned within an equally
limited period of time. Stock pricesthe key parameter of technical analysisare
objective measures, easily and openly available, and immediately comparable across
companies and industries. As such, stock prices are not subject to interpretation, hidden variables, or analyst bias and so serve as a reliable and accurate basis for valuing a
given stock.
Technical analysis takes place after the summation. As noted, technicians rely on price as the primary unit of analysis. But price is nothing more
than the summation of all investors opinions as reflected in the markets aggregate supply and demand. In other words, technical analysis begins with the
summationeliminating most of the imprecision and guesswork of fundamental analysisand giving you uniform, quantitative benchmarks against which to
assess your predictions.
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On the other hand, if a football team that normally wins 50% of its games loses five
games in a row, will that trend of losses affect the outcome of its next game? Almost
certainly. Depending on the team, either the players will become so dispirited they will
start to give up, or they will be so angry they will be energized to victory. In either case,
what happened before will affect what happens in the future. There is no guarantee
of the direction in which the effect will operatefor its impact will be influenced by a
variety of factorsbut only the assurance that there will be an effect.
The patterns of stock supply and demand are similar to the patterns of a sports teams
wins and losses because both patterns are the sum of individual attitudes and expectationsof investors in one case and of athletes in the other. Trendswhether up, down,
or sidewaysare the result of the accumulation of these influences. Sometimes trends
strengthen as they go on, and sometimes they weaken or reverse. The primary goal of
technical analysis is to understand, based on what has happened in the past, how a
current situation is likely to resolve itself.
Your first task, of course, is to identify the patterns taking place in stock prices. But
your second task is equally important: to understand what the human emotions are
behind these patterns and how they are likely to evolve as trends strengthen or wane.
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other direction. In addition, sideways or trendless trends can suddenly begin to move
up or down.
It is with regard to the stock price trends and patterns that the principle of buy low, sell
high comes into play. If you can reliably predict that a down-trending stock is going to
stop declining in price and begin ascending, you can buy at the point of inflection and
sell when the up trend is about to endmaking it a theoretically simple matter for you
to earn a profit. Likewise, if you can reliably predict that an up trend is about to end and
a stock is about to decline, you can profit by selling short.
Technical analysis gives you these capabilities. While technical analysis is far from perfect, a skilled technical analyst can make reliable predictions with regard to future stock
price movements that, more often than not, will actually transpireand will appear
almost like magic to the untrained eye. It is being able to identify and forecast these
changes in trends that the roots of profitable technical investing lie.
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All trading in the stock and/or options market involves risks. Any decisions to place trades are personal decisions that should be made after thorough research, including a personal risk and financial
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of the ODD are available from your broker, at http://cboe.com/Resources/Intro.aspx, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606.]
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