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A Review of Fundamental and Technical Stock Analysis Techniques

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DOI: 10.4172/2168-9458.1000163

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ISSN: 2168-9458

Review Article Open Access

A Review of Fundamental and Technical Stock Analysis Techniques

Veliota Drakopoulou*
Ashford University, San Diego, California, USA

Abstract
“Never fall in love with a stock, because it will never love you back.” The objective of this technical paper is to
present the leading fundamental analysis and stock valuation techniques used by daily equity traders in the selection
of stocks in actively traded equity portfolios. Daily equities traders use mostly technical charts and other instruments to
recognize patterns that can advocate perspective activity without measuring a stock’s intrinsic value to make trading
decisions. Chart analysis is devised to detect trades with highly expected probability outcomes by setting exact price
targets. The purpose of this technical paper is to advocate the importance of fundamental analysis in the investment
decisions of daily traders. Fundamental analysis is based on the critical comparisons of a stock’s intrinsic value to
the prevailing market price. If the stock’s intrinsic value exceeds the marker price, it makes sense for a fundamental
investor/trader to buy the stock. This paper supports the idea that utilization of both investment techniques would lead
into more successful investing decisions for equities traders.

Keywords: Stock analysis; Stock valuation; Marker price; Traders uncertainly such as accounting frauds, the threat of war in the Middle
East, economic crisis, and political scandals can force the market down.
Fundamental Stock Analysis Also, the Standard & Poor 500 stock index is one of the U.S. Commerce
Fundamental analysis is the cornerstone of investing. The biggest department’s leading indicators of the U.S. economy that would assist
part of fundamental analysis involves delving into the financial policy advisors to make better judgements about monetary and fiscal
statements and performing a quantitative analysis, this involves looking policy since the stock market responds in precedence to a recession or
at revenue, expenses, assets, liabilities and all the other financial aspects economic growth [4].
of a company to gain insight on a company’s future performance. Industry analysis provides pivotal conclusions about which
When talking about stocks, fundamental analysis is a technique that industries will survive the anticipated economic situation. Porter
attempts to determine a security’s value by focusing on underlying suggested the competitive strategy analysis framework a standard
factors that affect a company’s actual business and its future prospects. approach to industry analysis. His five components of industry
On a broader scope, fundamental analysis can be performed on structure pertain (1) “the threat of new entrants”, (2) “the rivalry among
industries or the economy as a whole. One of the primary assumptions existing competitors”, and (3) “the substantial threat of substitutes “,
of fundamental analysis is that the price on the stock market does not (4) “ the buyer’s bargaining power and supplier’s bargaining power. A
fully reflect a stock’s “real” value but in the long run, the stock market financial analyst by considering each one of the five-aforementioned
will reflect the fundamentals. The biggest criticisms of fundamental elements can appraise more efficiently the industries responses to the
analysis come primarily from two groups the proponents of technical prospective economic environment. After deciding which industries
analysis and believers of the “efficient market hypothesis” [1]. currently appear appealing, the subsequent act is proposing specific
Fundamental valuation firms within the industry.
Fundamental analysts support that the individual equity securities Quantitative analysis
and the stock market in its entirety have a fundamental “intrinsic value”
that is concluded by analyzing present and prospective “earnings, cash In the United States, companies publicly offering securities for
flows, interest rates and risk variables” [2]. A company’s fundamental investment dollars need to file with the Securities and Exchange
Commission (SEC) the following documents: (1) The 10-K annual
analysis determines a stock’s intrinsic value, the stock’s actual value
report, which includes the audited financial statements, management
contrary to the price it is traded in the stock market. Fundamental
discussion and analysis (MD&A) and schedules filed with the SEC
analysts buy overvalued stocks with an “intrinsic value” higher than
within 90 days of fiscal year end, (2) The 10-Q quarterly report, which
the trading market value, cause fundamental analysis shows that the
pertains the unaudited financial statement and MD&A filed with the
stock is valued higher than its traded price making it more pragmatic to
SEC within 45 days of fiscal quarter, (3) The 14A proxy statement
buy the stock. Granted that there are various methods of pronouncing
which includes the proposed actions taken to a shareholder vote,
the intrinsic value, the supposition of all these methods relies on
company ownership, executive compensation and performance
the belief that “a company is worth the sum of its discounted cash
versus peers (4) Registration statements for newly-offered securities,
flows meaning that a company is worth all of its future profits added
together”. Furthermore, these perspective gains must be discounted
to account for the time value of money, that is, that present value of
money available now is more worthwhile than the same amount in the
future, due to its probable earning capability [3] *Corresponding author: Veliota Drakopoulou, Ashford University, San Diego,
California, USA, E-mail: [email protected]
Qualitative Analysis -EIC Analysis Received October 05, 2015; Accepted November 04, 2015; Published November
09, 2015
EIC analysis is an established approach to decide on which stocks
to buy and it is the abbreviation for “economic, industry, and company Citation: Drakopoulou V (2015) A Review of Fundamental and Technical Stock
Analysis Techniques. J Stock Forex Trad 5: 163. doi:10.4172/2168-9458.1000163
analysis”. Complementing the economic analysis, all common stocks
issued are subject to market uncertainty risks. Stock prices respond Copyright: © 2015 Drakopoulou V. This is an open-access article distributed under
the terms of the Creative Commons Attribution License, which permits unrestricted
favorably to earnings growth, low inflation, increasing gross domestic use, distribution, and reproduction in any medium, provided the original author and
products (GDP), and a less volatile market. Also, major sources of source are credited.

J Stock Forex Trad Volume 5 • Issue 1 • 1000163

ISSN: 2168-9458 JSFT, an open access journal
Citation: Drakopoulou V (2015) A Review of Fundamental and Technical Stock Analysis Techniques. J Stock Forex Trad 5: 163. doi:10.4172/2168-
9458.1000163

Page 2 of 8

(5) Documents concerning tender offers (a tender offer is an offer to the (a) “the investor’s required rate of return on the stock because this
buy a large number of shares of a corporation, usually at a premium rate becomes the discount rate or is a major component of the discount
above the current market price) and (6) Filings related to mergers and rate”, (b) “all valuation approaches are affected by the estimated growth
acquisitions. rate of the variable used in the valuation technique such as dividends,
earnings, cash flows, or sales and based on the efficient market
The average 10-K annual report is overfed with numerous
hypothesis these variables must be estimated forcing analysts to derive
footnotes, disclosures and adjusted numbers offered as alternatives to
to different stock valuations because they have different estimates for
the recognized numbers contained in the body of the income statement
these critical variable inputs”.
and balance sheet requiring a really sophisticated reader to interpret
them. Harper [5] in his article emphasized on the red flags aimed to These two approaches of equity valuation should be used as
isolate the fundamental operating performance of the business when appreciative, not competitive since they both depict “the present values
analyzing financial statements. He affirmed the reader to remove of expected cash flows”. The main diversity among the referenced
two types of gains that may not be sustained. One type of gains not techniques is how they measure the cash flow used. The easier measure
sustained include the non-recurring gains - these include gains due to of cash flow is dividends since these are evidently cash flows paid
the sale of a business, one-time gains due to acquisitions, gains due to directly to the investor signifying that “the cost of equity should be
liquidation of older inventory (that is, liquidation of the LIFO layer), used as the discount rate”. The dividend technique is useful when
and temporary gains due to harvesting old fixed assets, where lack of considering valuation for a stable, mature business entity with an
new investment saves depreciation expense. expected constant long-term growth. On the contrary, the dividend
technique is laborious to execute to corporations that do not remit
The other type not sustained is gains due to financing - these are
dividends throughout times of elevated growth, or that presently
important because, while they are real gains, they are often random
reward very limited dividends because they have high rate of return
variables that depend on market conditions and they may be reversed
investments preferences attainable.
in future years. The sources of financing gains include special one-
time dividends or returns on investments, early retirement of debt, An alternative description of cash flow is the “operating free cash
hedge or derivative investments, abnormally high pension plan returns flow”, which are cash flows after direct costs such as cost of goods sold,
(including an upward revision to expected return on plan assets, which general and administrative expenses, working capital disbursements
automatically reduces pension cost) and increases to earnings or EPS and capital expenditures needed for perspective growth. Since we are
simply due to a change in the capital structure, for example, an increase discussing the cash flows available for all capital provisions, the discount
in EPS due to an equity-for-debt swap. rate employed is the firms weighted average cost of capital (WACC), a
remarkably effective model when comparing firms with diverse capital
In regard to Harper’s green flags, the key principle as far as
structures because WACCs’ formula arrives at the firm’s equity value
financial statements are concerned is that it is important to see
conservative reporting practices. In regard to the two most popular after subtracting the value of the firm’s debt obligations from the value
financial statements, the following implies conservatism: In the Income of the total firm. The third cash flow measure is free cash flow available
Statement: Conservative revenue recognition is shown by things like to equity owners, which is similar to the operating free cash flow but
no barter arrangements, no front-loaded recognition for long-term after payments to debt holders. Therefore, the appropriate discount
contracts, a sufficient allowance for doubtful accounts (that is, it is rate is the firm’s cost of equity. A possible challenge of these cash flow
growing with sales), the choice of LIFO rather than FIFO inventory techniques is that they are very reliant on the significant inputs, which
costing method and the expensing of rather than capitalizing of R&D are (a) “the growth rates of cash flows” and (b) “the estimate of the
expenditures. discount rate”. A trivial modification in either of these values can have
consequential effect on the appraised value [6].
In the Balance Sheet conservative reporting practices include
sufficient cash balances; modest use of derivative instruments that are The Growth Approach to Investing
deployed only to hedge specific risks such as interest rate or foreign
Growth stocks are not necessarily shares in growth companies.
currency exchange; a capital structure that is clean and understandable
Growth stocks are stocks envisioned to transpire a higher rate of
so those analyzing the statements don’t have to sort through multiple
return than other stocks in the market with indistinguishable risk
layers of common stock, preferred stock and several complex debt
characteristics. The higher rate of return of growth stocks results
instruments; and a debt burden that is manageable in size, not overly
because at some point in time the market undervalued it in correlation
exposed to interest rate changes, and not overly burdened with
to other stocks. Although, the stock market corresponds to stock prices
covenants that jeopardize the common shareholders.
quickly to depict latest information, attainable information is not
The Value Approach to Investing always perfect or precise. Accordingly, the use of faulty or incomplete
information by most analysts may cause a given stock to be undervalued
There is a plethora of valuation techniques that fall into two general or overvalued at a point in time.
approaches reflecting the complexity and importance of valuing stocks,
(1) “the discounted cash flow valuation techniques, where the value of If a stock is undervalued when the accurate information becomes
the stock is estimated based upon the present value of some measure of attainable, its price subsequently should increase to portray its true
cash flow, including dividends, operating cash flow, and free cash flow”; fundamental value. During the price adjustment period, the stock will
and (2) “the relative valuation techniques, where the value of a stock is be considered a growth stock since its realized return will surpass the
estimated based upon its current price relative to variables considered required rate of return. A future growth stock can be the stock of any
to be significant valuation, such as earnings, cash flow, book value, or type of company, and not necessarily limited to growth companies
sales”. Both of these approaches have several common factors such as since the stock need solely to be undervalued by the market.
If investors identify a growth company and discount its future
1
For the definitions of mixing and martingale, see Chapter 3 of White. earnings or cash flows correctly, the current market price of the growth

J Stock Forex Trad Volume 5 • Issue 1 • 1000163

ISSN: 2168-9458 JSFT, an open access journal
Citation: Drakopoulou V (2015) A Review of Fundamental and Technical Stock Analysis Techniques. J Stock Forex Trad 5: 163. doi:10.4172/2168-
9458.1000163

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company’s stock will reflect its future earnings or cash flows. Investors good investment by most GARP investors. While a 1 or less is desired,
who purchase a growth company’s stock at this correct market price companies with a PEG ratio of around 0.5 are considered better as they
will gain a rate of return coherent with the risk of the stock, even when have good growth potential but, are also slightly undervalued - Growth
the superior earnings growth is achieved. In several occasions, investors at a Reasonable Price” [7].
overvalue the estimated growth rate of earnings or mislead the growth
period for the growth company and as a result over appraising the Income Investing
intrinsic value of a growth company’s stock. Investors who pay the Income investing is likely one of the simplest stock-picking accesses
inflated stock price for a growth company will earn a rate of return as it primarily centers on companies that give a fixed income. When
subordinate to the risk-adjusted required rate of return, despite the investors think of fixed income they prevalently think of fixed-income
fact that the growth company experiences above-average growth of securities such as bonds and, stocks of substantiated firms, which
sales and earnings. An analyst can adapt the Greenspan model for use have attained an assured magnitude and are no longer competent to
with individual equity securities. The Greenspan stock value computes extend higher levels of expansion. These companies usually no longer
the ratio of a company’s estimated earnings per share for the next 12 are in rapidly ontogeny industries and so as a recourse of reinvesting
months to the current yield on a 1-uear Treasury security. If this ratio is retained earnings, mature firms cultivate to pay out retained earnings
less than the current stock price, the security is overvalued. If it is more, as dividends as a way to supply an income to their shareholders.
the stock is undervalued.
According to Doan [8] preferred stocks are appointed as fixed
Growth at a reasonable price (GARP) investing income securities. Fixed income preferred stocks pay out fixed yearly
Growth at Reasonable Price (GARP) is precisely a compound quotas as dividends in quarterly, monthly or semi-annual outflows and
stock investment strategy that emphasizes the assortment of these fixed settlements generally do not deviate over the life-span of
undervalued investments with anticipated continuous income growth the securities. Preferred stocks reward an exact fixed amount that is
in the forthcoming years. GARP investors integrate value metrics and clarified in the Prospectus consented to the inaugural buyers in the
individual judgment to decide on stock choices. GARP Investors chase security’s original public offering (IPO) when the security was first
stocks of companies with estimated profits or income in the 10-20% offered to investors. The perennial amount of the preferred dividend
range. Furthermore, Growth and GARP investors analyze the financial is characteristically declared as a percentage (the coupon rate) of the
of corporations with predictable imminent-term growth and accord liquidation preference, which in general matches the initial price to
concentration to growth forecasts of corporations inside the same line the public. The formula for preferred dividend premiums is that the
of business. yearly dividend payment is uniform to the coupon rate multiplied by
the liquidation preference amount. For example, “a preferred with
GARP investors given that they are concerned about growth, apply a $25.00 liquidation preference per share and an 8.25% coupon rate
the “P/E ratio valuation metric” as it allocates how income correlates will pay $2.0625 per share per year ($25.00 times 8.25 divided by 100
to stock share prices. The P/E ratio can be assessed by “dividing the equals $2.0625). If the dividend is paid quarterly, the preferred will pay
current share price by the earnings per share (EPS) price (P/E Ratio = $2.0625 divided by four or $0.515625 per quarter per share. If you own
Current Share Price / Earnings per Share)”. A “P/E ratio in the 10-20% 100 shares of the preferred, you will receive a quarterly dividend of
range provides more unbiased information for a GARP investor as it is $0.515625 multiplied by 100 shares or $51.5625 per quarter; or $2.0625
less pricey and, less riskier than a stock with a P/E ratio of 25 or above multiplied by 100 shares or $206.25 per year”.
which indicates an overvalued stock”. Chasing stocks with lesser P/E
ratios is also a stratagem of value investors. On the contrary, Growth A good income investment on preferred stocks pertains familiarity
investors choose stocks with higher P/E ratios because there are high with (a)” Credit Ratings, a factor to be considered when buying income
anticipations the company will feature momentous growth. securities is the Moody’s and S&P credit ratings of the firm”, (b) “Call
Dates, an income investor should select securities with call dates that
GARP and growth investors also are concerned for corporations are three to five years in the future”, (c) “Distribution Dates, select
with a lower price to book (P/B) ratio. “The P/B ratio is used to gauge securities that pay on distribution dates that fit the income investor’s
how much value the market actually places on the book value of the schedule”, (e) “Current Yield, only when potential income investments
business in question and it is computed by dividing the current share meet the above criteria should the income investor select income
price by the book value per share (P/B Ratio = Current Share Price securities for the highest available current yield”, and (f)”The IPO
/ Book Value per Share), where Book Value per Share = Book Value Prospectus, the prospectus, issued at the initial public offering (IPO),
(Assets - Liabilities) / Outstanding Shares”. GARP investors look for a is essentially the legal contract between the investor and the issuer of
lower P/B ratio as it is inclined to reveal larger values. GARP investors the security. The prospectuses are online at the SEC EDGAR website”.
specifically purse corporations with a P/B ratio that is lesser than the
standard for the industry since it designates a greater prospective for CAN SLIM Investing
profit when the market rectifies itself and values the stock correctly.
CANSLIM is a philosophy of screening, purchasing and selling
While the P/B ratio is used to gauge the respective value of a common stock developed by William O’Neil, the co-founder of
corporation and assist conclude if its stock is under or overvalued the Investor’s Business Daily. CAN SLIM is Investor Business Daily’s
PEG ratio is another favorite valuation metric used by GARP investors (IBD) acronym for the seven common characteristics all great
to assess growth potential in relation to the value of the company. “It is performing stocks have before they make their biggest gains. As
calculated by dividing the P/E ratio by the projected growth in earnings described in Investors.com, each letter represented in the CAN SLIM
of the company (PEG Ratio = P/E ratio / Projected Growth in Earnings). acronym includes: “C = Current earnings per share should be up 25%
For the GARP investor, a PEG ratio of 1 or less is a good indicator or more and in many cases accelerating in recent quarters. Quarterly
that the company warrants additional examination. For example, a sales should also be up 25% or more or accelerating over prior quarters,
company with a P/E ratio of 15 and a projected growth in earnings A = Annual earnings should be up 25% or more in each of the last
of 25%, or 15/25 equals a PEG ratio of 0.6 and, would be considered a three years. Annual return on equity should be 17% or more, N = A

J Stock Forex Trad Volume 5 • Issue 1 • 1000163

ISSN: 2168-9458 JSFT, an open access journal
Citation: Drakopoulou V (2015) A Review of Fundamental and Technical Stock Analysis Techniques. J Stock Forex Trad 5: 163. doi:10.4172/2168-
9458.1000163

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company should have a new product or service that’s fueling earnings analysis is based on the three suppositions: (1) “the market discounts
growth. The stock should be emerging from a proper chart pattern and everything,” (2) “stock prices move in trends,” and (3) “history of
about to make a new high in price, S = supply and demand. Shares stocks tends to repeat itself” [11,12]
outstanding can be large or small, but trading volume should be big as
the stock price increases, L = Leader or laggard? Buy the leading stock Moving Averages
in a leading industry. A stock’s Relative Price Strength Rating should be Moving averages are primarily the most recognized technical
80 or higher, I = Institutional sponsorship should be increasing. Invest indicators used to decide the direction of trading stocks. Every moving
in stocks showing increasing ownership by mutual funds in recent average model is the consequence of a statistical computation of
quarters, M = The market indexes, the Dow, S&P 500 and Nasdaq, an averaging number of preceding information plotted into a chart
should be in a confirmed up trend since three out of four stocks follow enabling traders to watch at smoothed data rather than focusing on daily
the market’s overall trend” [9]. price movements inherited in all financial markets. The employment
CANSLIM’s affluent investment strategy derives from its of moving averages is to recognize trends and reversals, measure the
concentration to tangibles such as gains, as well as intangibles like a durability of a stock’s momentum and distinguish varied time periods
corporation’s comprehensive determination and ideas. O’Neil accents to observe momentum, substantiate a stock’s possible support and
the significance of selecting stocks whose earnings per share (EPS) in resistance levels and determine beneficial stop-losses settings [13].
the latest quarter have increased on an annual basis. A corporation’s Moving averages as lagging indicators
EPS indicates a questionable percentage growth, but the CANSLIM
system proposes no less than 18-20% growth recommending that Moving averages they do not foresee new trends but as lagging
fundamentally all of the high performance stocks indicate remarkable indicators validate trends once they have been recognized. A stock’s
quarterly increases. Although, the 18-20% growth is a common price can only be trending up, trending down and trading in a range.
practice, the genuinely staggering corporations generally exhibit A stock is up trending when the price is above a moving average and
growth of 50% or more. The “CANSLIM system robustly emphasizes the average is slopping upwards. Conversely, a down trending stock
to investors to recognize low-quality earnings figures that are not is portending with a down slopping average. Frequently, traders hold
precise representations of company performance since companies a long position (buy) when the price of a stock is trading above the
are enticed to manipulate earnings and immediate superficial moving average and a short position (sell) when the stock price trades
numbers as earnings figures”. O’Neil claims that, once you verify below the moving average [14].
that a company’s earnings are of moderately good quality, it’s wise
for an investor to compare them with other companies’ earnings in
Momentum trading with moving averages
the same industry. Stable earnings growth in the industry supports The momentum trading strategy responds to the short-term
the industry is prospering and the company is prepared to breakout. stock price fluctuations rather than the fundamental information of
Dogs of the Dow a company. Momentum traders’ quest advancements in stock prices,
earnings, or revenues and they take a long or short position ardent
The Dogs of the Dow is an investment strategy concerning weak that a stock’s momentum will protract an upward or downward trend
stocks or low-priced stocks called the “dogs”. This strategy does not when the stock is moving notably in one direction on high volume.
necessitate technical analysis of former stock prices and volume of The momentum indicator is the accumulated net change of a stock’s
trading or fundamental analysis of financial statements, valuation closing prices over a specified period creating a momentum line
of cash flows, and assessment of prospective growth rates for the plotted to the price chart, and it parades an axis of zero, with positive
assortment of securities. prices manifesting a continuous upward stock movement and negative
The Dogs of the Dow strategy obliges the investor to classify from prices designating a continuous downward movement. That upward
the highest to the lowest the dividend yields (dividends divided by or downward momentum indicator generally instantly represents a
the price of the stock) of the thirty stocks comprising the Dow Jones breakout, which is a price movement through a recognized level of
Industrial Average. The investor invests in the ten stocks with the support or resistance usually accompanied by heavy volume and raised
highest dividend yields alternatively acquires the five lowest-priced volatility for the stock, implying that even a period or two of prolonged
“small dogs” of the ten highest-yielding dividend stocks. After one year, momentum will force that stock in the direction of the breakout.
the 30 Dow stocks are rated anew, and the stocks with the ten highest Concomitantly, the technical trader watches the momentum chart and
dividend yields are retained. If a stock is no longer among the ten, it the Level 2 screen to look for verification of a breakout to execute a
is sold and superseded by a new Dow dog that is one of the ten stocks market order [15].
with the highest dividend yield [10]. Murphy describes how to evaluate momentum by watching at
moving averages of stock prices with several time periods. Moving
Technical Stock Analysis
averages of twenty days or less can gauge short-term momentum, while
Technical analysis appraises equity securities by evaluating the twenty to one hundred days moving averages are considered as a good
statistics of preceding stock prices and volume caused by market standard of short-term momentum and conclusively 100 days moving
activity. Technical analysts do not measure a stock’s intrinsic value but averages or more can be used to rate long-term momentum. The
alternatively use charts and other instruments to recognize patterns author also proposes that one of the optimal approaches to determine
that can advocate perspective activity. Exactly, as there are many the durability and direction of a stock’s momentum is to position three
investment techniques on the fundamental analysis, there are as well moving averages onto a chart and watch for upward or downward
many various types of technical traders. Technicians can depend momentums. A robust upward momentum can be identified when
on chart patterns, technical indicators and oscillators. Moreover, the shorter-term averages are preceding longer-term averages on the
technical analysts’ exclusive use of historical price and volume data is chart and the two averages are diverging providing a buy signal. On the
what separates them from fundamental analysts. The field of technical contrary, when the shorter-term averages are located below the longer-

J Stock Forex Trad Volume 5 • Issue 1 • 1000163

ISSN: 2168-9458 JSFT, an open access journal
Citation: Drakopoulou V (2015) A Review of Fundamental and Technical Stock Analysis Techniques. J Stock Forex Trad 5: 163. doi:10.4172/2168-
9458.1000163

Page 5 of 8

term averages on the chart, the momentum is in a downward trend and averages are analogous because they are expounded equivalently and
that’s a good sell signal. used by technical traders to smooth out price fluctuations. Since EMAs
stance a stronger weighting on recent data than on older data, they are
Support and Resistance levels with moving averages more responsive to the newest price changes than SMAs are, which
Charting is a technical trading precept of visualizing the movement causes the effects from EMAs timelier and illustrates why the EMA is
of a stock price between momentous support and resistance levels. A the favored average among many traders.
support level is a price level that a stock impedes to go below and is the Investors’ trading technique and investing choices are the
price level were bull traders use to enter a trade. Likewise, resistance determinants of which moving average to utilize. Daily traders appoint
is price levels above which a stock has difficulty ascending and the to benefit from the exponential moving average’s ability to apprehend
buyers’ sell their long positions take profits and enter short positions. short-term price fluctuations essential to their trading needs. Long term
Characteristically, a stock’s price will range between the support and investors and swing traders elect to use the simple moving averages
resistance levels until it “breaks out” or “breaks down” [16]. to enchant long-term changes. The EMA is ordinarily more reactive
Another common application of moving averages is setting up to price changes than the SMA and initiates more signals resulting in
intended price supports. Trading practice with moving average reveals prospective more wrong signals and whipsaws. The SMA normally has
that dropping stock prices “will often stop and reverse directions” a slower motion and originates fewer signs that could attest to be more
at a support level, which is nothing more than a moving average. credible but concomitant to remissness profits.
Commonly, traders will use the 100-day or 200-day moving average
Variable moving average
as a support level to verify anticipated movements of stock prices. On
the adverse, technical traders use the 200-day moving average as a A variable moving average is an exponential moving average
resistance level to prognosticate stock prices falling below a significant that based on the volatility of the data automatically modifies the
support level. Traders use the resistance level as a signal to obtain smoothing constant. The smoothing constant used in the moving
profits or to exit from any open long positions and also use this average average calculation is larger when the date is more volatile giving
as an entry point of a short position because the price often bounces off more weight to the current data. Alternatively, the variable moving
the resistance and downtrends. average uses a smoothing constant for less volatile data. Trader’s
belief that high volatility associates with strongly trending markets is
Simple and exponential moving averages erroneous. Strong trending markets are generally less volatile due to
The mathematical average of a stock price over a defined period of the uniformity of daily price fluctuations. Volatility intensifications
time forms a simple moving average. For instance, to calculate a 15-day appear in up-trending, down-trending, or sideways markets where
moving average the open, close, low or high prices of the stock can be stock prices follow unstable daily movements (“i.e., down a lot, up a
used to determine a moving average by adding the referenced stock little, up a little, up a lot, up a little, down a little, etc.”).
prices for the last 15 days and then divide the result by 15. The resulting Standard moving averages are not tolerant to changes in volatility
average integrates the past 15 data points to provide the trader a virtual suffering to predict correct trends during high volatile markets. On
of how the stock is priced the past 15 days [17,18]. the contrary, variable moving averages by automatically adjusting the
Murphy interestingly remarks in his article that stock traders smoothing constant perform better in both high and low volatility
markets. The formula to compute the variable moving average is “VMA
name this tool a moving average and not a typical mean considering
= (0.78*(volatility index) * stock’s closing price) + (1-0.078 * volatility
that the most recent stock prices are superseded by the new prices as
index)*yesterday’s VMA,” where the absolute value of a “9-period
they become attainable imposing the data set to successively moving to
Chande Momentum Oscillator” is used for the volatility index. The
account for the new available stock prices warranting the superiority of
higher the volatility index the more volatile the market is, increasing
present prices. Once the values of the MA have been calculated, they
the sensitivity of the moving average (Paritech, 2004).
are mapped onto the charts used by technical traders and then joined
to formulate a moving average line. Parabolic SAR
Technical traders according to Murphy commit to the use The parabolic SAR is a technical indicator illustrated on a stock
exponential moving averages to diminish the impediment in simple chart as a series of dots placed either above or below the stock price
moving averages by exerting more weight to the latest stock prices pivoting on the price momentum representing a shape of curve that
comparative to the older prices deeming on the specific period of resembles a parabola. The parabolic SAR is a functional indicator in
the moving average. The shorter the EMA’s period, the more weight trending periods and when the trend of the stock is upward a small
will be addressed to the most recent price. Murphy states that the dot is placed below the price while a dot is placed above the price when
exponential moving average is more responsive to latest information the trend is downward. Eminently, Parabolic stands for a curve that
since it delivers more weight to recent prices. The formula to evaluate has the shape of a parabola and SAR is the abbreviation for “Stop-and-
the EMA equation is: “EMA= (P *a) + (Previous EMA * (1-a)), where Reverse,” meaning that the position is reversed when the protective
P=Current Price, A=Smoothing Factor = 2/ (1+N) and N= Number of stop is hit and it was first introduced by Wells Wilder in 1978 in his
Time Periods”. honored book the “New Concepts in Technical Trading Systems.”

The difference between EMA and SMA The Parabolic SAR is a “time/price reversal system” used in trending
markets to enable traders to follow the upward or downward trend of
The divergence between the EMA and SMA is the susceptibility the dots to appraise when to reverse a position and enter a trade in
each one displays to changes in the data used in its computation. the opposed direction. The Parabolic SAR system responds highly in
Precisely, the exponential moving average (EMA) gives a higher markets with a dominant trend and fails despondently in sideways or
weighting to current prices than the simple moving average (SMA) non-trending markets. Wilder created an acceleration element into the
does, while the SMA accords the same weighting to all prices. The two system. Every day the stop motions in the direction of the latest trend.

J Stock Forex Trad Volume 5 • Issue 1 • 1000163

ISSN: 2168-9458 JSFT, an open access journal
Citation: Drakopoulou V (2015) A Review of Fundamental and Technical Stock Analysis Techniques. J Stock Forex Trad 5: 163. doi:10.4172/2168-
9458.1000163

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Initially, the repositioning of the stop is correspondingly slow to enable advancement and the security is still in a downtrend and falls below a
the trend time to substantiate. As the acceleration factor rises, the SAR lower stock price than the last low. MACD can either form as a series
starts to move quicker, subsequently catching up to the price action. A of “higher lows” or a “second low” that is higher than the previous low.
buy signal occurs when the most recent high price of a stock has been
A Bullish Moving Average Crossover transpires when MACD
defied imposing the SAR to be positioned at the most recent low stock
migrates above its 9-day EMA, or trigger line. Bullish Moving Average
price. As the price of the stock rises, the dots will rise as well, first slowly
Crossovers are probably the most common signals and the least
and then picking up speed and accelerating with the trend. The SAR
dependable. These crossovers can lead to whipsaws and many deceitful
starts to move a little faster as the trend advances and the dots presently
indications if not used in simultaneity with other technical indicators.
catch up to the price action of the stock.
Bullish Moving Average Crossovers are used at times to validate a positive
The accelerating system of SAR is considerably profitable because divergence such as the case where a Bullish Moving Average Crossover
it allows the investor to get into a trade position after the dots move follows the second “low” or higher “low” of a positive divergence.
closer to the price action, thus verifying that the trend is established. A Bullish Centerline Crossover transpires when MACD moves above
Technical traders can apply “stop-loss orders” using the evolvement of the zero line and into positive domain. This is an evident sign that
the SAR to secure gains caught on in an upward trend and traders in a momentum has converted from negative to positive or from bearish to
bear position can use this system to decide the time to cover their short bullish. After a Positive Divergence and Bullish Centerline Crossover
positions. Also, another lead of the Parabolic SAR trading system is occur, the Bullish Centerline Crossover can act as a verification signal.
that it is radically automatic, and detaches all of the human sentiments From the three signals, moving average crossovers are probably the
from trading enabling investors to reach a better ordered and uniform second most common signals. Occasionally it is cautious to assign a
trading pattern. The drawback to this system is that most stocks do not price filter to the Bullish Moving Average Crossover to safeguard that
build uniform trends and as a result force the SAR to be moving into a it will maintain. An instance of a price filter would be to buy if MACD
spasmodic way preventing the trader to enter and exit with consistent breaks above the 9-day EMA and remains above for three days. The buy
profits [19]. signal would then originate at the end of the third day.
Moving Average Convergence Divergence (MACD) MACD bearish signals
The Moving Average Convergence/Divergence (MACD) was MACD generates bearish signals from three main sources. These
developed by Gerald Appel and is one of the simplest and most reliable signals are mirror reflections of the bullish signals: (1) “Negative
indicators available. MACD uses moving averages which are lagging Divergence”, (2) “Bearish Moving Average Crossover”, and (3) “Bearish
indicators and converts them into momentum oscillators by subtracting Centerline Crossover”, as explained by Murphy. Trading divergence
the longer-period moving average from the shorter-period moving is a popular method to use the MACD histogram but, unluckily, the
average. More specifically, the MACD uses the difference between divergence trade is not very precise since it fails more than it succeeds.
a stock’s 26-day and 12-day Exponential Moving Averages (EMA) One of the most collective settings is to locate chart points at which
closing prices converting these two lagging indicators into momentum price performs a new high stock price swing or a new low stock price
oscillators appearing in a plot that forms a line that oscillates above and swing but the MACD histogram does not, revealing a divergence among
below zero. The 12-day EMA is the faster more responsive indicator price and momentum. A negative divergence forms when the security
while the 26-day EMA is the slower indicator less prone to whipsaws. advances or moves sideways, and the MACD declines. Moreover, the
Generally, technicians also plot a 9-day EMA of MACD together with MACD histogram is an effective visual image of the difference between
the 12-day and 26-day EMAs to act as a bullish or bearish trigger line. MACD and its nine-day EMA. The histogram is positive when MACD
A bullish crossing over takes place when MACD moves above its 9-day is above its nine-day EMA forming a bullish moving average crossover
EMA, and a bearish crossing over emerges when MACD moves below and negative when MACD is below its nine-day EMA forming a
its 9-day EMA. bearish moving average crossover. If prices are rising, the histogram
expands as the rate of the price movement accelerates, and contracts
A positive MACD displays that the 12-day EMA is trading above as price movement slow down. The same principle works in reverse as
the 26-day EMA. As the MACD begins to upsurge the gap between the prices are falling.
12-day EMA and the 26-day EMA broadens indicating that the positive
One of the factors causing traders to enter bad positions with this
momentum increases, in other words, the rate-of-change of the faster
technique is they enter a trade on a signal from the MACD indicator
moving average is higher than the rate-of-change for the slower
but exit it based on the move in price. Since the MACD histogram
moving average indicating a bullish period. Alternatively, a negative is a derivative of price and not the price itself, this approach is
MACD indicates that the 12-day EMA is trading below the 26-day controversial. In other words, stock prices frequently explode up or
EMA. If MACD is negative and declining further, then the negative gap down levering stops and pressuring traders out of position just before
between the faster moving average and the slower moving average is the move practically make a prolonged turn and the trade becomes
escalating. Downward momentum is accelerating, indicating a bearish rewarding. To determine the incompatibility between entry and exit,
period of trading. MACD centerline crossovers occur when the faster a trader can use the MACD histogram for both trade entry and trade
moving average crosses the slower moving average. exit signals. To do so, the trader trading the negative divergence takes
MACD bullish signals a partial short position at the initial point of divergence, but instead of
setting the stop at the nearest swing high based on price, should stop
As explained by Murphy, the MACD generates bullish signals from the trade only if the high of the MACD histogram exceeds its previous
three main sources: (1) “Positive Divergence”, (2) “Bullish Moving swing high, indicating that momentum is actually accelerating and the
Average Crossover”, and (3) “Bullish Centerline Crossover”. A Positive trader is truly wrong on the trade. If, on the other hand, the MACD
Divergence, although, it is the least common to transpire, it is the histogram does not generate a new swing high, the trader should add
most dependable of the three signals and vanguards larger stock price to the initial position, continually achieving a higher average price for
moves. A positive divergence is reflected when the MACD instigates an the short [20].

J Stock Forex Trad Volume 5 • Issue 1 • 1000163

ISSN: 2168-9458 JSFT, an open access journal
Citation: Drakopoulou V (2015) A Review of Fundamental and Technical Stock Analysis Techniques. J Stock Forex Trad 5: 163. doi:10.4172/2168-
9458.1000163

Page 7 of 8

MACD benefits Relative Strength Index (RSI)

One of the primary benefits of MACD according to Murphy is that The relative strength index (RSI) is an illustrious momentum
it incorporates aspects of both momentum and trend in one indicator. indicator in technical analysis showing “overbought” and “oversold”
As a trend-following indicator, it will not be wrong for very long. stock positions while momentum measures the rate of the rise or
The use of moving averages ensures that the indicator will eventually fall in stock prices. The indicator is plotted between a range of zero
follow the movements of the underlying security. By using Exponential to 100 where 100 is the highest overbought condition and zero is the
Moving Averages (EMAs), as opposed to Simple Moving Averages highest oversold condition. The RSI helps to measure the strength of a
(SMAs), some of the lag has been taken out. As a momentum indicator, security’s recent up moves compared to the strength of its recent down
MACD has the ability to foreshadow moves in the underlying security. moves. This helps to indicate whether a security has seen more buying
MACD divergences can be key factors in predicting a trend change. or selling pressure over the trading period. The standard calculation
A Negative Divergence signals that bullish momentum is waning, and uses 14 trading periods as the basis for the calculation, which can be
there could be a potential change in trend from bullish to bearish. This adjusted to meet the needs of the user. If the trading periods used are
can serve as an alert for traders to take some profits in long positions, lowered then the RSI will be more volatile and is used for shorter-term
or for aggressive traders to consider initiating a short position. trades. The following formula is used to calculate the “RSI = 100 – 100/
MACD can be applied to daily, weekly or monthly charts. MACD 1 + RS, where RS= (Sum of the closing prices of up days/n)/ (Sum of the
represents the convergence and divergence of two moving averages. closing prices of down days/n) and n=trading periods”.
The standard setting for MACD is the difference between the 12 and
26-period EMA. However, any combination of moving averages can be Like most indicators there are two general ways in which the
used. The set of moving averages used in MACD can be tailored for each indicator is used to generate signals - crossovers and divergence. In the
individual security. For weekly charts, a faster set of moving averages case of the RSI, the indicator uses crossovers of its overbought, oversold
may be appropriate. For volatile stocks, slower moving averages may and centerline. The first technique is to use overbought and sold lines
be needed to help smooth the data. Given that level of flexibility, each to generate buy-and-sell signals. In the RSI, the overbought line is
individual should adjust the MACD to suit his or her own trading style, typically set at 70 and when the RSI is above this level the security is
objectives and risk tolerance. considered overbought. The security is seen as oversold when the RSI is
below 30. These values can be adjusted to either increase or decrease the
MACD drawbacks amount of signals that are formed by the RSI. A buy signal is generated
when the RSI breaks the oversold line in an upward direction, which
One of the beneficial aspects of the MACD as explained by Murphy is
means that it goes from below the oversold line to moving above it.
also one of its drawbacks. Moving averages, be they simple, exponential
A sell signal is formed when the RSI breaks the overbought line in a
or weighted, and are lagging indicators. Even though MACD represents
downward direction crossing from above the line to below the line.
the difference between two moving averages, there can still be some lag
Setting the overbought and oversold levels at 80 and 20, respectively,
in the indicator itself. This is more likely to be the case with weekly
can use a more conservative approach.
charts than daily charts. One solution to this problem is the use of the
MACD-Histogram. The MACD-Histogram represents the difference Another crossover technique used in formulating signals is using
between the MACD and its trigger line, the 9-day EMA of MACD. The the centerline (50). This technique is exactly the same as using the
plot of this difference is presented as a histogram, making centerline overbought and oversold lines to formulate signals. This technique
crossovers and divergences easily identifiable. A centerline crossover will often form signals after a movement in the direction they are
for the MACD-Histogram is the same as a moving average crossover predicting but are used more as a confirmation then a signal compared
for MACD. If you will recall, a moving average crossover occurs when to the other techniques. A downward trend is confirmed when the RSI
MACD moves above or below the trigger line. If the value of MACD is crosses from above 50 to below 50. An upward trend is confirmed when
larger than the value of its 9-day EMA, then the value on the MACD- the RSI crosses above 50.
Histogram will be positive. Conversely, if the value of MACD is less
Divergence can be used to form signals as well. If the RSI is moving
than its 9-day EMA, then the value on the MACD-Histogram will be
in an upward direction and the security is moving in a downward
negative. Further increases or decreases in the gap between MACD
direction it signals to technical traders that buying pressure is
and its trigger line will be reflected in the MACD-Histogram. Sharp
increasing and the downtrend may be coming to an end. Divergence
increases in the MACD-Histogram indicate that MACD is rising faster
can also be used to signal a reversal in an upward trend where the RSI
than its 9-day EMA and bullish momentum is strengthening. Sharp
is decreasing signaling increasing selling pressure in an upward trend.
declines in the MACD-Histogram indicate that MACD is falling faster
The RSI is a standard component on any basic technical chart. The
than its 9-day EMA and bearish momentum is increasing.
relative strength indicator focuses on the momentum underlying the
MACD is not particularly good for identifying overbought security and is a great secondary measure to be used by traders. It is
and oversold levels. Even though it is possible to identify levels that important to note that the RSI is often not used as the sole generation
historically represent overbought and oversold levels, MACD does of buy-and-sell signals but used in conjunction with other indicators
not have any upper or lower limits to bind its movement. MACD can and chart patterns [21].
continue to overextend beyond historical extremes. References
MACD calculates the absolute difference between two moving 1. Janssen C, McClure B (2015) Fundamental Analysis.
averages and not the percentage difference. MACD is calculated by
2. Reilly FK, Norton EA (2006) Investments (8th edn.), Mason OH, Thomson
subtracting one moving average from the other. As a security increases Higher Education.
in price, the difference (both positive and negative) between the two
3. Investopedia staff (2015) Guide to Stock-Picking Strategies.
moving averages is destined to grow. This makes it difficult to compare
MACD levels over a long period of time, especially for stocks that have 4. Strong RA (2007) Practical Investment Management. Mason OH: Thomson
Higher Education.
grown exponentially.

J Stock Forex Trad Volume 5 • Issue 1 • 1000163

ISSN: 2168-9458 JSFT, an open access journal
Citation: Drakopoulou V (2015) A Review of Fundamental and Technical Stock Analysis Techniques. J Stock Forex Trad 5: 163. doi:10.4172/2168-
9458.1000163

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5. Harper D (2014) Advanced Financial Statements Introduction. 13. Murphy C (2006) Moving Averages: How to use them.

6. Reilly FK, Brown KC (2006) Investment Analysis and Portfolio Management. 14. Murphy J (2015) Moving Averages: Simple and exponential.
Mason OH: Thomson Higher Education.
15. Bergen J (2013) Introduction to Momentum Traders.
7. Investor Guide Staff (2002) Stock Strategies: Understanding GARP Stock
Investing Strategy. 16. Kuepper J (2015) Gauging Support and Resistance With Price By Volume.

8. Doan D (1998) Income investing basics. 17. Murphy J (2015) Moving Average Convergence/Divergence (MACD).

9. Investopedia Staff (2014) Introduction to the Parabolic SAR. 18. Langager C, Murphy C (2015) Exploring Oscillators and Indicators:
Introduction.
10. Mayo HB (2008) Investments: An Introduction. Mason OH, Thomson Higher
Education. 19. Moving Averages-Variable (2004) Paritech.

11. Jansen C (2015) McClure Fundamental Analysis: Introduction. 20. Schlossberg B (2015) Trading The MACD Divergence.

12. Janssen C, Langager C, Murphy C (2015) Technical Analysis Tutorial. 21. What is CAN-SLIM? (2008) Investor’s Business Daily.

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