Stocks can be traded based on information disclosed in company financial statements or based on historical trading patterns that are graphed on charts. A third option for trading stocks is to combine the two techniques.
Trading on Fundamentals
Trading stocks based on fundamentals starts with the analysis of the financial statements that companies release regularly. This trading method seeks to determine the relative value of companies based on a variety of data points, including the growth of earnings, revenues and market share. The price/earnings ratio is one piece of fundamental information that can be used to compare company values. This ratio is calculated by dividing a company's share price by its earnings per share. A company with a share price of $45 that earns $3 per share would have a P/E ratio of 15. Another company that is priced at $90 with earnings of $3 per share would have a P/E ratio of 30. In fundamental trading, the stock priced at $45 would be considered to be the better value, as it earns as much per share as the $90 stock, but is only half the price.
Warren Buffett has used fundamental analysis to become one of the wealthiest people in the world.
Instead of using financial statements, technical trading is done by charting stock price and volume movement. Buying and selling using technical trading indicators uses historical data to reveal chart patterns that have been repeated over time. Traders use the repetition of these patterns to try to predict near and intermediate term changes in share prices. An example of a technical indicator would be an upside breakout. This occurs when a stock that has traded within a narrow price range suddenly breaks above the upper prices in the range. If similar patterns have preceded significant appreciation in the share price of that stock, a technical trader would buy shares once the breakout occurs.
The combination of fundamental and technical analysis can be used to provide separate buy signals on the same stock. For example, a stock that has a low relative P/E that has just broken through the upper end of its trading range would be giving two separate buy signals. While multiple buy signals provide no guarantee of trading success, in this example the combination of value derived from fundamental analysis and a potential move higher based on the technical trading patterns can increase the odds of making a profitable trade.
All three trading techniques can also be used to determine when stocks should be sold. For example, a stock that has a much higher P/E ratio than similar stocks could be considered as being at or near its highest expected share price, based on fundamentals. A stock that breaks through the bottom of a narrow trading range, referred to as a downside breakout, may be signaling that a stock is heading lower based on technical analysis. Using a combined approach, a stock with a high P/E ratio that has also had a downside breakout could be giving two separate sell signals.