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What Is Technical Analysis?
Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume.
Unlike fundamental analysis, which attempts to evaluate a security’s value based on business results such as sales and earnings, technical analysis focuses on the study or price and volume. Technical analysis tools are used to scrutinize the ways supply and demand for a security will affect changes in price, volume and implied volatility. Technical analysis is often used to generate short-term trading signals from various charting tools, but can also help improve the evaluation of a security’s strength or weakness relative to the broader market or one of its sectors. This information helps analysts improve there overall valuation estimate.
Technical analysis can be used on any security with historical trading data. This includes stocks, futures, commodities, fixed-income, currencies, and other securities. In this tutorial, we’ll usually analyze stocks in our examples, but keep in mind that these concepts can be applied to any type of security. In fact, technical analysis is far more prevalent in commodities and forex markets where traders focus on short-term price movements.
- Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities in price trends and patterns seen on charts.
- Technical analysts believe past trading activity and price changes of a security can be valuable indicators of the security’s future price movements.
- Technical analysis may be contrasted with fundamental analysis, which focuses on a company’s financials rather than historical price patterns or stock trends.
Understanding Fundamental Vs. Technical Analysis
The Basics Of Technical Analysis
Technical analysis as we know it today was first introduced by Charles Dow and the Dow Theory in the late 1800s. Several noteworthy researchers including William P. Hamilton, Robert Rhea, Edson Gould, and John Magee further contributed to Dow Theory concepts helping to form its basis. In modern day, technical analysis has evolved to included hundreds of patterns and signals developed through years of research.
Technical analysis operates from the assumption that past trading activity and price changes of a security can be valuable indicators of the security’s future price movements when paired with appropriate investing or trading rules. Professional analysts often use technical analysis in conjunction with other forms of research. Retail traders may make decisions based solely on the price charts of a security and similar statistics, but practicing equity analysts rarely limit their research to fundamental or technical analysis alone.
Among professional analysts, the CMT Association supports the largest collection of chartered or certified analysts using technical analysis professionally around the world. The association’s Chartered Market Technician (CMT) designation can be obtained after three levels of exams that cover both a broad and deep look at technical analysis tools. Nearly one third of CMT charter holders are also Certified Financial Analyst (CFA) charter holders. This demonstrates how well the two disciplines reinforce each other.
The Underlying Assumptions of Technical Analysis
There are two primary methods used to analyze securities and make investment decisions: fundamental analysis and technical analysis. Fundamental analysis involves analyzing a company’s financial statements to determine the fair value of the business, while technical analysis assumes that a security’s price already reflects all publicly-available information and instead focuses on the statistical analysis of price movements. Technical analysis attempts to understand the market sentiment behind price trends by looking for patterns and trends rather than analyzing a security’s fundamental attributes.
Charles Dow released a series of editorials discussing technical analysis theory. His writings included two basic assumptions that have continued to form the framework for technical analysis trading.
- Markets are efficient with values representing factors that influence a security’s price, but
- Even random market price movements appear to move in identifiable patterns and trends that tend to repeat over time.
Today the field of technical analysis builds on Dow’s work. Professional analysts typically accept three general assumptions for the discipline:
1: The market discounts everything
Technical analysts believe that everything from a company’s fundamentals to broad market factors to market psychology are already priced into the stock. This point of view is congruent with the Efficient Markets Hypothesis (EMH) which assumes a similar conclusion about prices. The only thing remaining is the analysis of price movements, which technical analysts view as the product of supply and demand for a particular stock in the market.
2: Price moves in trends
Technical analysts expect that prices, even in random market movements, will exhibit trends regardless of the time frame being observed. In other words, a stock price is more likely to continue a past trend than move erratically. Most technical trading strategies are based on this assumption.
3: History tends to repeat itself
Technical analysts believe that history tends to repeat itself. The repetitive nature of price movements is often attributed to market psychology, which tends to be very predictable based on emotions like fear or excitement. Technical analysis uses chart patterns to analyze these emotions and subsequent market movements to understand trends. While many forms of technical analysis have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.
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How Technical Analysis Is Used
Technical analysis attempts to forecast the price movement of virtually any tradable instrument that is generally subject to forces of supply and demand, including stocks, bonds, futures and currency pairs. In fact, some view technical analysis as simply the study of supply and demand forces as reflected in the market price movements of a security. Technical analysis most commonly applies to price changes, but some analysts track numbers other than just price, such as trading volume or open interest figures.
Across the industry there are hundreds of patterns and signals that have been developed by researchers to support technical analysis trading. Technical analysts have also developed numerous types of trading systems to help them forecast and trade on price movements. Some indicators are focused primarily on identifying the current market trend, including support and resistance areas, while others are focused on determining the strength of a trend and the likelihood of its continuation. Commonly used technical indicators and charting patterns include trendlines, channels, moving averages and momentum indicators.
In general, technical analysts look at the following broad types of indicators:
- Price trends
- Chart patterns
- Volume and momentum indicators
- Moving averages
- Support and resistance levels
The Difference Between Technical Analysis And Fundamental Analysis
Fundamental analysis and technical analysis, the major schools of thought when it comes to approaching the markets, are at opposite ends of the spectrum. Both methods are used for researching and forecasting future trends in stock prices, and like any investment strategy or philosophy, both have their advocates and adversaries.
Fundamental analysis is a method of evaluating securities by attempting to measure the intrinsic value of a stock. Fundamental analysts study everything from the overall economy and industry conditions to the financial condition and management of companies. Earnings, expenses, assets and liabilities are all important characteristics to fundamental analysts.
Technical analysis differs from fundamental analysis in that the stock’s price and volume are the only inputs. The core assumption is that all known fundamentals are factored into price; thus, there is no need to pay close attention to them. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use stock charts to identify patterns and trends that suggest what a stock will do in the future.
Limitations Of Technical Analysis
Some analysts and academic researchers expect that the EMH demonstrates why they shouldn’t expect any actionable information to be contained in historical price and volume data. However, by the same reasoning, neither should business fundamentals provide any actionable information. These points of view are known as the weak form and semi-strong form of the EMH.
Another criticism of technical analysis is that history does not repeat itself exactly, so price pattern study is of dubious importance and can be ignored. Prices seem to be better modeled by assuming a random walk.
A third criticism of technical analysis is that it works in some cases but only because it constitutes a self-fulfilling prophesy. For example, many technical traders will place a stop-loss order below the 200-day moving average of a certain company. If a large number of traders have done so and the stock reaches this price, there will be a large number of sell orders, which will push the stock down, confirming the movement traders anticipated.
Then, other traders will see the price decrease and also sell their positions, reinforcing the strength of the trend. This short-term selling pressure can be considered self-fulfilling, but it will have little bearing on where the asset’s price will be weeks or months from now. In sum, if enough people use the same signals, they could cause the movement foretold by the signal, but over the long run this sole group of traders cannot drive price.
How You Can Use Fundamental Analysis And Technical Analysis Together
Enjoy the best of both worlds.
When it comes to stock analysis, fundamental analysis and technical analysis are two main schools of thought used when researching for the right stock to invest in.
Fundamental analysis involves looking at the actual value of a stock. Fundamental analysts mainly study overall economic conditions, to the financial data, and management of a company when making investment decisions. Hence, historical returns, working capital, and dividend history of a company will be of interest.
Technical analysts on the other hand, formulates their investment decisions mostly on patterns and charts. They predict future movement of prices with the help of technical indicators.
In this article, we will not get into details of how they both differ, but instead on how investors can combine both when making investment decisions.
Examples of confirming fundamental trends with technical indicators:
#1 Volatility relationships
The reported revenues and earnings are unpredictable with scenarios such as these:
- Earnings are positive for the first year, followed by net operating losses the next
- Many one-time adjustments appearing
- Non-core profits from selling assets (this distort earnings per share)
- Management cannot control expense
In these situations, fundamental volatility makes growth forecasting difficult. Price volatility will occur.
#2 Revenue/earnings change seen in price trends
As revenues and earnings rise, so will stock price. The same is true in the other direction; as revenues and earnings decline, stock prices are likely to fall as well.
#3 Market changes seen in financial results and in price breakouts
The market for an industry changes due to various economic reasons. This leads to price breakouts for companies within the industry.
For example, if a tech company is awaiting approval of a new patent, the stock price may anticipate that approval (or a denial). Prices will likely break out of predicted trading ranges.
The technical side may also contradict fundamental trends. There is a strong correlation between financial developments and market price. However, there is a time lag or even a predictive change on either side.
Here are some examples:
Seemingly predictable financials, but very volatile price trends
Fundamentals can appear stable, yet the have very volatile prices at the same time. This is usually driven by the undercurrents and news about a company. The news can suggest the change in the fundamentals, even though it will take time before they appear.
Price movement is usually supported by a valid reason. These reasons do not always appear in the fundamentals first, but the high price volatility may imply a trend that contradicts what the fundamentals are showing.
Highly volatile fundamental trends, but low price volatility.
A company can experience high fundamental volatility without a correspondingly volatile technical trend. A company may be expanding its product base, or even changing management. These factors cause fundamental volatility for up to three years.
When prices remain stable during such a period, it is likely the company is perceived as a strong long-term hold.
High earnings predictions but declining market price.
Sometimes a company predicts high earnings, but the price drops anyway. For experienced fundamental analysts, it signals more in-depth analysis of the financial report. When market price for a stock falls, demand for shares is dropping, meaning investors are losing faith in the company.
It also means that investors think the earnings predictions are overvalued. This contradiction should be carefully considered.
No obvious financial change, but sudden run-up or decline in stock price.
Market sentiment do not appear in financial reports. Also, the latest financial results are out of date if you want to make a decision today. So even when there are no news on the company and yet prices change drastically, it signals possible news or data to be revealed.
Under such situation, relying on historical financial information will be useless.
Review current news about the company. Find out why prices are changing (regardless of whether prices are moving up or down). Match technical changes to fundamentals. The causes will likely be published in the next financial report. But the technical signs will tell you that the change is already known. You only need to look for it.
Using Both Schools Of Thought
It is impractical to base every investment on one school of thought.
You can make good use of both fundamental and technical indicators. Market risk involves price and volatility. While some measurements are often inaccurate, they make an important point that fundamental investors cannot ignore volatility and stock price trends.
You may consider a range of both fundamental and technical indicators to follow. Picking a series of indicators shortlists stocks for you. It also isolates specific risk levels and growth candidates from the many companies in an industry.
While you are likely to select your favorite fundamental and technical indicators, consider the following list. These are straightforward, easy-to-follow trends. Also the information is easy to find on company websites, annual reports, financial statements, and brokerage sites:
- Trend in revenues over many years
- Gross profit margin
- Net margin (based on core earnings)
- Dividend yield (and consistency in increasing dividends annually)
- Current ratio
- Debt ratio
- P/E ratio (based on core earnings per share)
- P/S ratio (if company profits are inconsistent, or losses have been reported)
- Trading range trends over the long term
- Price high/low analysis and volatility (adjusted for spikes)
While these are by no means applicable to every situation, they can cover most of the concerns that investors normally have about risk on various levels.
How Investors Can Prosper With Technical Analysis
Even the most basic knowledge of stock charts can help you make better investing decisions
By Michael Kahn, Contributing Writer
February 6, 2020
Many investment advisors and money managers have a little secret. They will proudly tell you that they rely heavily on fundamental analysis, carefully weighing earnings, market share, competitive environment and demographic trends to select the best stocks for their clients. What they do not tell you is that they check their stock charts before they make any moves.
Why? Because technical analysis of the market – using charts – still is the best way to know whether their other analyses are validated in the real world.
Let’s say a company creates a new product that they project will sell millions of units at a handsome margin. They even get favorable reviews by critics at their industry trade show. Investors armed with this intelligence buy up all the shares they can – then watch them drop sharply in value.
How can that be?
What those investors did not know was that the stock was already up 50% on the year, and that sellers were starting to trade with more urgency. So even though the company is sound and will make a lot of money, the stock’s value already reflected that knowledge.
SEE ALSO: 20 Top Stock Picks the Analysts Love for 2020
That information is in the charts.
Technical analysis gets a bad rap in the investment world. Don’t blame the analysis. Blame the practitioners. Even I, as a 30-year veteran in the discipline, cringe when I hear a TV interview with a technician forecasting the market because two lines on a chart crossed each other.
The stock does not move because the lines crossed. The lines crossed because the stock is telling us something. And it is telling us whether the odds for buying or for selling are better.
That’s it. It does not tell us exactly what will happen, but it does give us a good idea of what we should do.
There’s plenty of jargon and high-level math for the experts to ponder, but I’d like to take you through a few simple aspects of technical analysis that any investor can use. Once you’re armed with this, you’ll be well on your way toward assembling a winning portfolio.
What Is Technical Analysis?
There are several popular definitions, but I boil it down to this: Technical analysis is just the study of data generated from the market and from the actions of people in the market.
Such data include price levels that served as turning points in the past, the number of shares of stock bought and sold each day (volume), and how fast price movements occur (momentum) over a given period of time.
Let’s say that a stock price of $50 brought out the sellers on one or two occasions in the past. This price level is now called “resistance” (more on this later) because it tends to resist price advances over time. Why? Likely because that level is considered expensive, and therefore when the stock gets near that price, investors step up their selling activities, increasing the supply of stock relative to the demand. Economics 101 suggests the stock will stop going up and may actually start to decline.
Technical analysis, or charting, also attempts to measure how investors feel about the market at any given time. This is important because when everyone thinks the same way, the market tends to do the opposite.
It’s the fear-and-greed pendulum. When everyone is convinced the market is going to keep moving higher, as it did at the peak of the housing bubble or the peak of the bitcoin bubble, then theoretically everyone has already bought. There is nobody left to buy, so any negative news, either actual or perceived, will cause a stampede to the exits.
Remember back in March 2009 at the end of the bear market? Investor sentiment was as negative as it ever was … and in hindsight, it was one of the best buying opportunities in history.
Technical analysis presents the opinion of the market itself through the unchangeable facts of stock price and volume movements.
How It Works
The basic idea is that the collective actions of all market players leave clues in the charts for us to find. Let’s say that after a nice run-up, both bulls and bears become a bit more uncertain. Bulls tend to take their profits a bit earlier, and bears don’t press their short positions (bets against stocks) – essentially the same thing in reverse.
SEE ALSO: The 19 Best ETFs for a Prosperous 2020
On the charts, we see lower price highs and higher price lows. They form a shrinking trading range that looks like a triangle. In fact, that’s what this pattern is called.
Whenever such a pattern forms in a stock, we know that stock is resting before making a move. Whether that move is to march higher or head lower is yet to be determined. However, most of the time, when price action breaks out of the shrinking trading range, it tends to continue in that direction for a while.
The triangle pattern does not forecast what will happen. However, when the market breaks out from the pattern, we get a good idea what we should do about it.
But even when a stock breaks out from a pattern, chartists do not know for sure that the stock will go up, and they do not know how long it might take. They simply know that the probability of making money by owning the stock is good.
If they are wrong? A failed breakout is possible, but the beauty of the pattern is that it tells us when we are wrong sooner, rather than later, to minimize losses.
There is an old joke where a fundamental analyst and a technical analyst are eating dinner together and someone knocks a knife off the table. It lands firmly in the fundamental analyst’s shoe.
The technician asks, “Why didn’t you move your foot?”
The fundamentalist replies, “I thought it would go back up.”
The knife falling is the same as a downside breakout from a triangle. When that happens, it is best to get out of the way.
How to Use It
You can get as complex as you want, but most investors can benefit from knowing just a few things about the market or the stock they want to buy.
- Is the trend rising or falling?
- What support and resistance levels are nearby?
- For a stock, how does it look compared to its sector and to the market as a whole?
A trend is simply a directional move over time. If prices on the chart seem to move from the lower left corner to the upper right corner, then the trend is rising. (And if it moves from the upper left to the lower right, the trend is falling.)
SEE ALSO: 20 Expert Market Outlooks for 2020
We can measure how powerful the trend is with momentum and many other indicators. But the bottom line is that a stock or a market making higher highs and higher lows over time is in a rising trend.
As in physics, a body in motion tends to stay in motion unless acted upon by an outside force. Some of these forces come from within the market, such as waning performance or lack of interest (shown by falling volume). There also are price levels.
Support is a price level at which a stock or market tends to stop falling. Resistance is a price level at which it tends to stop rising. Support often represents a cheap price, while resistance often represents an expensive price.
If a stock you want to buy is approaching a price at which sellers got active in the past (resistance), you might want to reconsider that purchase. But if your stock just pushed through that resistance level, you know the market’s psyche may have changed and what was once considered to be expensive may now be considered cheap.
There’s also “relative strength analysis,” which is a comparison to peers, sectors and the broader market. Even during a bull market, some stocks perform better than others. So you may, for instance, not want to load up on lagging areas of the market no matter what the fundamentals might say.
Fundamentals and Technicals Are Partners
While they seem to be at odds, fundamental analysis and technical analysis can complement each other, even if they have different conclusions about the same stock. For example, a stock may be overvalued based on the fundamentals, but if it has a strong chart, it may have more room to run before value players really start to sell. Conversely, a stock may seem fundamentally cheap, but chartists are selling it because it is in a strong declining trend.
That’s not a problem with either method. It’s just that sometimes, the charts see things that don’t yet show up in the fundamentals.
And sometimes non-company-specific news overshadows the fundamentals. For example, a company might issue strong earnings guidance, but that same day, a peer might also release bad news that sends the entire sector lower.
When the fundamentals and technicals agree, investors can buy or sell with confidence. But even when they do not agree, simply being aware of risks from the other side will allow investors to make better decisions.
Does Technical Analysis Work? (It’s not what you think)
Last Updated on October 7, 2020
I’m sure you’ve wondered…
“Does Technical Analysis work?”
“Is trading as simple as drawing a few lines on the chart?”
“Is Technical Analysis all I need to become a profitable trader?”
- You might say Yes because everything you need to know is on a price chart
- You might say No because you need to combine fundamentals, news, etc.
So, who’s right and who’s wrong?
Well, that’s what you’ll find out in today’s post (and it’s not what you think).
Or if you prefer, you can watch this training video below…
What is Technical Analysis and how does it work?
Technical Analysis refers to using past prices (or volume) to make your trading decisions.
And this brings me to an important question…
Does Technical Analysis work?
First, how do you define whether Technical Analysis works, or not?
- I’ll backtest a trading strategy using Technical Analysis
- Benchmark the results against a buy and hold approach on the S&P 500
If the trading strategy can beat a buy and hold approach, then we can conclude that Technical Analysis work (but more on that later).
So what’s the benchmark to beat?
If you look back historically, a buy and hold approach on the S&P 500 has a return of about 10% a year with a maximum drawdown of 56%.
How do you develop a trading strategy that beats the market?
- Read research papers and find out what works in the financial markets
- Extract the trading strategy
- Develop your trading strategy
- Verify your trading strategy
1. Read research papers and find out what works in the financial markets
There’s a huge resource at www.ssrn.com (and it’s free).
If you want some ideas, look up “momentum” and “value”, these are proven strategies that offer an edge in the markets.
The most important thing is to understand WHY a trading strategy works and the concepts behind it.
Don’t focus on the exact parameter like which is the best moving average, indicator, etc.
Those are not important.
2. Extract the trading strategy
Most research papers provide the trading strategy — and the backtest work is also done for you.
This means you can “copy” a strategy and it has a high degree of success.
3. Develop your trading strategy
If you’re lazy and don’t want to make any changes to the trading strategy, then move on to the next step.
But if you want to develop your own strategy, then here are some things to consider…
If you add too many rules, you might be curve fitting your strategy (to past data) and it’ll probably fail in the live markets.
Generally, the fewer rules you have, the better your strategy will work.
4. Verify your trading strategy
Never trust the results of other traders (no matter what).
You must always verify the strategy yourself so if anything goes wrong, you take 100% responsibility.
There are 2 ways you can verify your trading strategy.
You can either backtest it or forward test it in the live markets.
A trading strategy that works?
Using the concepts I shared with you earlier, let’s backtest a momentum trading strategy and see if it can beat the markets.
Here are the rules…
Go long when a stock hits a 40-week high
10% trailing stop loss
Pick the top 20 stocks with the largest price increase over the last 40 weeks
Sometimes you’ll get too many stocks to choose from. So, a filter like this helps you select which stocks to trade.
- Transaction Costs: $10 per trade
- Test universe: Russell 3000 stocks
- Execution: Monday open
- Maximum open positions: 20
- Test period: 1990 – 2020
- Positions size: 5%
Here’s an example of the trading setup…
Trading strategy results
- Number of trades: 4630
- Winning rate: 45.83%
- Profit factor: 1.5
- Annual return: 23.47%
- Maximum drawdown: 53.02%
And here’s the performance over the last 28 years…
As you can see, this trading strategy has a higher annual return and a lower drawdown (compared to a buy and hold approach).
Overall, this is a simple strategy that beats the market.
And this brings me to an important question…
Is Technical Analysis all you need to become a profitable trader?
Some of you might say “YES” based on the results I’ve shared with you earlier.
Now, not so fast my young padawan.
Yes, Technical Analysis can give you an edge in the markets.
But, it’s not enough to make you a profitable trader.
This is the ONE thing you need so your edge can play out
Earlier, the trading strategy had a maximum drawdown of 53.02% — and this is with zero leverage.
Now, if a greedy trader decides to employ 2 times leverage, he’ll suffer more than a 100% drawdown and blow up his trading account.
Here’s another example…
There are two traders, John and Sally.
John is an aggressive trader and he risks 25% of his account on each trade.
Sally is a conservative trader and she risks 1% of her account on each trade.
Both adopt a trading strategy that wins 50% of the time with an average of 1:2 risk to reward.
Over the next 8 trades, the outcomes are Lose Lose Lose Lose Lose Win Win Win Win .
Here’s the outcome for John:
-25% -25% – 25% – 25% = BLOW UP
Here’s the outcome for Sally:
-1% -1% -1% -1% +2% +2% +2% +2% = +4%
So here’s the lesson:
If you don’t have proper risk management, you’ll still end up a losing trader even though you have an edge in the markets.
Do you have what it takes?
If you look at the results below, you’ll notice there are losing streaks that can last for many months.
And sometimes, the drawdown can be as much as 20%…
Now let me ask you:
Are you prepared to handle the losing streak when it comes?
Because you can have an edge and proper risk management but, without the “strength” to endure the drawdown, it’s impossible to be a consistently profitable trader.
Clearly, your trading psychology is important (and too many traders neglect it).
If you want to improve your mental strength, then go read Trading Psychology: 6 Practical Tips to Master Your Mind and Money
Conclusion: Does Technical Analysis work?
Yes, Technical Analysis works and it can give you an edge in the markets.
However, Technical Analysis alone is not enough to become a profitable trader.
- A trading strategy with an edge
- Proper risk management
- The correct trading psychology
If you lack any one of them, then it’s impossible to find success in the markets.
Now, here’s what I like to know…
Does Technical Analysis work for you?
Leave a comment below and share your thoughts with me.
Yes but as you said I only risk one percent of my account but I need to work on overhearing and stick to the rules of entry I have made up a strategy of my own and it works well but while trading I will experiment a little with it JUST TO SEE if it works better fortunately I do this only on a demo account lol
Awesome, let me know how it works out for you. cheers
There is never any verifiable data in these type of “selling a dream” strategies. They are all about getting you to pay the person publishing the idea.
If they were successful then there would be more verifiable data.
Trading isn’t a get rich quick scheme.
Instead, it’s a get rich slow scheme.
Yes, I believe. All I have to do now is perfect my trading tools and start working, thank you very much.
To be honest, I’m not the best backtester. I see what is happening in the market, think “yes ican do that”, then chicken out because the market is giving me mixed messages. E.g. the market reaches a support level and goes through and looks like a breakout. I goto sell the market and second guess myself “should I sell now, because it might reverse back through the support, or should I wait to see if it will go through a few days and bounce back up to the now resistance level before heading back down. I have missed multiple trades this way. I seem to have too many mixed messages from the market, or just lack confidence.
Thank you for sharing, Michael.
It’s best to define your strategy first, and then backtest or forward test it.
Once you’re confident it has an edge, then it’s a matter of execution without hesitation.
actually, i am somehow new in the forex world, trying very hard to develop a strategy that works after almost blowing up my first account. i believe in technical analysis base of on what have discovered so far from my study and research tho am yet to test run my strategy. but how can one combine technical analysis and fundamental analysis at the same time, is it possible?
The only person that I know who does it is Mark Minervini.
He has written a few books and you can check it out.
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