The Story goes like this ...

Once upon a time in the Opportunity-Land, there live two fellows by the name of Arul and Ah Chong. Arul is a fundamental investor while Ah Chong is a technical analyst. One day they are tasked to decide on which of the three listed lemonade company to put their money in so that they can generate the greatest return.

The first thing that Arul does is to gather the financial statements of all three lemonade companies. He will access a few key aspects such as revenue and profit of the past five to ten years, net profit margin, debt to equity ratio, current ratio and cash ratio etc. He then derives the intrinsic value of these three companies and compares with their current share price.

Arul most likely will invest his money in the most undervalued lemonade company, which is the company that is the most under priced when compared its current share price with its intrinsic value. Arul believes that in the long run, the share price will increase towards its intrinsic value and hence Arul’s investments will grow together in value. If Arul has more time, he will also visit the three lemonade shops to “touch the brick”, meaning to see for himself how does these three companies run their business.

Arul does not analyze the price charts of the companies’ shares other than looking at what is the current price. Short term price fluctuations will not bother Arul as he believes that in the long run his investments will grow to reflect its true value.

As for Ah Chong, being a technical analyst in stocks, he will study the price charts of all three lemonade companies with the purpose of predicting their next share price movements based on historical trends. Ah Chong aims to find the company where its share price will present an upward trend in the near future.

With Ah Chong’s technical analysis knowledge and methods, he will purchase the share that he has chosen now at a lower price and sell it at a higher price after the uptrend happens, hence earning the difference. Ah Chong neither analyses the companies’ financial results, nor visit the shops to access their businesses, all Ah Chong does is analyzing the price charts and make the trade. Short term price fluctuations mean a lot to Ah Chong as this will affect his profit.

Both Arul and Ah Chong may end up choosing the same lemonade company, but their approach of choosing them is totally different. With the above analogy, we can outline further the difference between fundamental analysis and technical analysis.

Financial Statements vs. Price and Volume Charts

Fundamental Analysis (FA) relies on analysing the company’s financial statements such as balance sheets, cash flow statement and income statements, in order to determine its intrinsic value. With the intrinsic value, a fundamental investor will know whether the company is currently undervalued, fair valued or over valued as compare to its current share price.

The objective is to invest in undervalued companies and let the money grow as its share price slowly reflects its true value in future.

On the other hand, Technical Analysis (TA) relies on price charts such as simple price line charts, candle stick charts, OHLC charts and etc. The objective is to study the price behaviour of a share based on its price movements in the past, then purchase the share where its price has the highest probability of moving upwards in short term, hence earning the difference by buying low and selling high.

Traditional TA’s indicators usually found in software packages such as MetaStock, Tradestation and StockCharts.com have many popular indicators like SMA, MACD, RSI, CCI, OBV, etc. These traditional TA indicators required trader's interpretation and proper knowledge in interpreting the buy or sell signals generated by these indicators and are widely used by amateur traders. Traditional TA indicators are derived from price and volume and hence are generally lagging. For example, the first point of the SMA20 line can only be drawn on the 21st day, namely 20 days later from the price & volume indicators.

On the other hand, professional traders and investors worldwide use price and volume as it is based on law of supply and demand as well as always trend leading versus traditional TA indicators. Price and volume chart reading provides professional traders and investors with the 3-Dimensional view into the buying and selling activities as well as providing an early warning of a change in investor sentiment and breakdown or reversal from the expected outcome.

As such, Price and Volume is a more superior study based on technical analysis. Better known as Volume Spread Analysis, it focuses on price and volume make popular by founder, Tom Williams in 1970-1980s. It takes the approach to analyse the market prices and volume with relation to the spread or range of the price bar and volume bar. This method worked primarily on the Law of Supply and Demand. Richard D. Wyckoff is a very famous 1930s trader and observer of syndicate traders. He made observations on the professional activity termed as Composite Operator or better known as Smart Money nowadays.

It has been observed by Richard D. Wyckoff that the Smart Money move the market based on law of supply and demand. More demand means prices will move higher and vice-versa. The activity of these professional operators or Smart money will be shown via Volume Spread Analysis and more importantly, their true intentions are clearly shown on a price chart if the trader knows how to analyse them. Volume is the major indicator for the Smart Money or professional trader.

Time Horizon

As seen from the analogy, FA approach require a longer time horizon, approximately six months to a year or even longer, in order for the share price to move towards its true value.

In the contrary, TA approach is mainly short term as the uptrend of shares seldom last more than half a month due to market forces. Hence TA approach will move its capital from one share to another within weeks to capitalise on any upward moving share.

Value Investing vs. Trading

FA approach is often regarded as value investing as they believe that the true value of the company will be reflected by its share price. Hence FA approach is to find companies with high intrinsic value but currently it is still not reflected by its share price.

On the other hand, TA approach is often regarded as trading as it is similar to running a trading business whereby the goal is to buy something at a lower price and sell it at a higher price to earn the difference.

Can both Co-Exist?

Although some traders and investors considered both school of thoughts as oil and water of investing that these 2 approaches can’t be possibly mixed, there are actually successful investors and traders who found ways to combine both techniques and put them in great use.

For example, fundamental analyst may use FA to select the companies to invest (using FA to determine WHAT) and TA, namely chart reading techniques to determine when is a good entry point to buy and sell the stock (using TA to determine WHEN). This could prevent them from paying a premium and achieve greater yield in future.

Technical analyst may use FA methods to strengthen their decision in making a particular trade. They can access the company’s financial performance to make sure the shares that they are trading belongs to companies with sound fundamentals, hence double ensuring that the stock price has a great likelihood of moving upwards.

One aspect of Value Investing is also focusing on dividend paying company which has worked well for the last several years for many investors as illustrated in the bestselling book "Dividends Don’t Lie" by local authors and professional fund managers, B. Wermine and Martin Wong in Malaysia. The authors have successfully demonstrated with the proven track records that that they have been able to beat the stock market with above average returns consistently by focusing on selecting good quality dividend stocks (using FA to determine WHAT) and timing their entry/exit via Volume Spread Analysis (using TA to determine WHEN).

Watch out for next article in this series of education articles brought to you by iVSAChart: “Introduction of Volume Spread Analysis and its relation to Technical Analysis”.

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This article only serves as reference information and does not constitute a buy or sell call. Conduct your own research and assessment before deciding to buy or sell any stock. If you decide to buy or sell any stock, you are responsible for your own decision and associated risks.