16.Technical vs. Fundamental Analysis
For those who want to become a trader, one of the first things that should be taken care of is the building (and following) of a comprehensive trading strategy.
This strategy should be based on your trading style, risk aversion, trading capital, and financial goals.
As well as the above, the method by which you’re going to analyse the market should be an essential component.
Types of market analysis
There are three major types of market analyses that will help you decide when and how to trade:
- Fundamental analysis
- Technical analysis
- Sentiment analysis
Fundamental analysts base their analyses on the study of economic, social, as well as political forces that affect the supply and demand of a financial asset and the risks that influence its price.
Technical analysts use technical trading strategies to analyse the price movement of an asset with market charts in order to determine profitable entry and exit points.
Sentiment analysis relies more on the assessment and understanding of how investors think, and how their moods and expectations impact the markets. After all, people are the ones creating a market by either buying or selling an asset.
It’s logical to suppose that analysing their way of thinking and reacting will help making better trading decisions.
We will, however, only talk about the features of fundamental and technical analyses in this article, as sentiment analysis can be considered a part of technical analysis and fundamental analysis, which we will explain later.
Which is the best market analysis?
Most beginner traders often wonder which type of analysis is the most profitable and effective way to invest, but is it really possible to answer?
Who can say that one method is better than another one?
After all, they all look at the market in a different way.
Some traders would say that you can’t use fundamental analysis without also relying on technical analysis. Others would say that you’re either a fundamental analysts or technical analyst.
As you continue trading, you will likely come to realise that you often need to combine aspects from all types of analyses to create a profitable trading approach.
How to apply fundamental analysis on currency pairs?
Because fundamental analysts believe that information isn’t necessarily reflected in the price of an asset, they assume that prices and values are different.
Thus, this type of analysis looks at the forces that affect the supply and demand of an asset to know where the price of this asset is heading.
Once fundamental analysts have determined the intrinsic value of an asset, they can compare it with the current asset’s price to know if the asset is over – or undervalued.
If the price of an asset is undervalued, then a fundamental trader would probably decide to buy the asset, as they believe the price should go up. Conversely, if it is overvalued, they should sell the asset, because its price could go down.
This is how fundamental traders spot potential profitable trading opportunities.
What is the impact of changes in the supply and demand relationship on currencies?
Fundamental analysis in Forex is all about determining what economic factors can affect supply and demand of a country’s currency.
To put it simply, if there is increasing demand, or a reduction in supply, then the price of a currency will certainly rise. Conversely, if there is a reduction in demand, or an increase in supply, then the value of a currency will surely fall.
So, the best way to control systematic risk in the Forex market is to follow an economic calendar. This calendar will help you understand the impact of the weakness/strength of a country’s economic stance on its currency.
Usually, when a country’s economic outlook is positive, its currency strengthens against its counterparts, as more foreign investors are looking for investment opportunities in this country – and vice-versa.
#1 Fundamental strategy: News trading
One of the most well known examples of a fundamental Forex trading strategy is news trading.
With this strategy, traders open positions based on live economic news being released – either before or after depending if they have a directional bias.
The statistics with the highest impact on the forex market are usually the ones that are the most important for the Central Banks, as they are the most influential players in this market.
Growth, inflation and employment figures are usually the stats that can trigger the highest volatility, especially the GDP (Gross Domestic Product), the PCE (Personal Consumption Expenditures) and the CPI (Consumer Price Index), and the unemployment rate as well as the number of jobs created.
With these figures, news traders can take advantage of higher price volatility by determining if the outlook for a country’s currency is good or bad, which will impact the demand of a given currency.
#2 Fundamental strategy: Currency carry trading
Remember that when trading the currency market, you do not invest in currencies, but in currency pairs. You’re buying one currency, and selling another one simultaneously.
The currency carry trade method relies on the differential rate between the two currencies – the one you’ll pay and the one you’ll receive. The idea is to borrow money from a currency with a low interest rate to buy another currency with a higher interest rate, making profit from the difference.
This technique is likened to an “interest arbitrage”, whereby traders care less about the direction of the currency pair and more towards the profit or cost associated with holding a specific currency pair.
How to use technical trading?
With technical analysis, traders rely on the historical prices of an asset to determine where this asset is going next.
Charts are the best way to visualise past prices and recognise trading patterns, which can give hints about future price movements if the situation repeats itself.
As well as using charts to study market prices, technical traders also use technical indicators, such as Moving Averages, Relative Strength Index (RSI), and Momentum, to develop their technical trading tactics. We will cover technical indicators below.
Technical analysis is based on 3 key assumptions:
- Prices discount all available information
- Price moves in trends
- History repeats itself
Studying historical price and volume is relevant for technical traders, as they assume that all available information is displayed in the price, which impacts the associated trading volume as soon as new available information is incorporated by market participants.
Consequently, studying the price action of an asset is enough to understand what’s going on, and predict which direction the asset is going to take.
Because prices are believed to follow a certain pattern, technical analysis is based on a major concept – market trends.
When prices are trending, then the next price movement is likely to be in the direction of the trend (or in opposite direction in case of price reversals), rather than being random.
When trading, technical analysts make money by analysing trends to guess where the asset might be heading, and when will be the best timing to enter/exit the market, as they believe that prices always follow one of the three types of trend:
- Key Chart Levels to Identify on a Forex Chart (And How to Trade Them?)
- Revealed: All Support and Resistance Levels You Need to Use
- Easy to Understand Price Action Trading
What is a trend?
Trading trends is everything in technical analysis, as every tool (chart pattern, or mathematical indicator) has the capability to be used to determine the trend, and where the asset is within this trend.
A trend represents the general direction of an asset. Charles Dow, considered the father of technical analysis, established that the market has three trends: upward, downward, and sideways (or flat).
Dow also believed that a trend has three parts:
- Secondary (or intermediate)
The primary trend is measured in months or years and represents the general direction.
The secondary trend, on the other hand, usually represents a correction within the primary trend and lasts between three weeks and three months.
The minor trend, which represents fluctuations in the secondary trend, usually last less than three weeks.
Technical analysts believe that by studying past price movements, they can predict future price actions.
When they recognise a price pattern that is comparable to what was formed in the past, they know that they should buy/sell the asset hoping that the price will evolve in a similar way.
Because market participants keep reacting in the same way, there is a self fulfilling prophecy aspect in technical analysis.
Trend lines, support and resistance levels
Spotting the trend of an asset is the principal objective of technical analysis, and trend lines are levels that can help determine potential areas where the trend might be reversing.
A trend line connects significant higher lows if the price is following an uptrend – this is an ascending support trend line. Trend lines connect significant lower highs if the price is following a downtrend – a descending resistance trend line.
To be valid, a trend line must be touched by the price at least three times.
It’s also important that there is a psychological reaction when the price touches the trend line with the price going back up, or down. The steepness of the line should also be “normal” – not too flat, neither too steep.
What is price pattern recognition?
Price pattern recognition is a very powerful tool when analysing price action in order to predict the future direction of an asset.
Of course, this doesn’t mean that the price is going to react in a certain way – it’s more like an indication.
There are a few things you need to take into consideration when using price patterns to make your trading decisions:
- Prices should be following an established trend: upward or downward – price patterns appearing in sideways trends are usually not valid
- Volatility, the height, and the width of the pattern in relation to the trend are very important. The bigger the pattern is compared to the previous one and the trend, the more valid the potential outcome would be
- Do not enter/exit the market before a pattern is confirmed. Wait for validation, like a breakout for instance
Here, it’s all about market participant psychological changes that usually materialise themselves in recognisable price patterns. Because traders know about them, they’re able to forecast possible outcomes and where the price might be heading.
What are chart patterns?
There are usually three kinds of patterns:
Continuation patterns describe situations where the price trend is likely to follow the current direction. Among the most common continuation patterns are triangles, flags, pennants, as well as the cup and handle.
Reversal pattern signals that there is a potential change in the current trend of an asset. The most common reversal patterns are the reverse head and shoulder, double or triple top/bottom, wedges, and the rounding top/bottom.
Indecision patterns occur when neither buyers or sellers are in control. Usually, indecision patterns can be spotted thanks to candlestick charts with doji and spinning top being the most common of this kind of pattern. These patterns reveal the body of their candles have almost the same opening and closing price.
What are technical indicators?
In addition to support and resistance levels, trend lines, channels, and price patterns, technical analysts also use mathematical indicators, or technical indicators, in their Forex trading strategies.
A technical indicator is usually displayed below a chart, or next to the price chart to provide additional information about the trend, support and resistance levels, volatility and momentum.
Technical analysts will mainly use indicators either as an alert, or a confirmation, that the current trend might be changing, or accelerating in the existing direction.
Lagging vs. leading indicators
Trend indicators determine the dynamics and direction of a market like moving averages. These indicators are often referred to as lagging indicators.
As a beginner trader, it would be wise to start with these, as they will help you confirm the trend after it has been established, allowing you to trade with the trend. Among the most well known lagging indicators are the Moving Average Divergence Convergence (MACD), Parabolic SAR, and Bollinger Bands.
Leading indicators can then be used to spot enter/exit points, as they provide early signals about a trend reversal or continuation. Oscillators such as the Stochastic and the Relative Strength Index (RSI) are the best kind of leading indicator, to help traders spot overbought and oversold situations.
If you want to receive confirmation before investing, you can also use strength indicators that will show how strong and powerful a trend is, such as the Directional Movement Index (DMI).
Fundamental Analysis vs. Technical Analysis
In summary, fundamental analysis is more of a long-term approach, while technical analysis helps in determining more accurate entry and exit points over the short-term.
Some would say that their goals are different, as fundamental analysis is closer to investing, while technical analysis is more about trading.
That said, even though both types of analyses are seen as opposing styles, it’s better for you to know both trading methods. It will enable you to create a more efficient and profitable trading strategy: a technical understanding of the market, and a fundamental knowledge of which forces drive it.
If you aren’t sure about the level of your knowledge in both areas, you should consider taking an online financial trading course to improve your knowledge and skills.
CHAPTER QUICK LINKS
- 2.Why is Forex Popular?
- 3.Why Forex is (or isn’t) for You
- 4.How Does Forex Work?
- 5.Popular Traded Currencies
- 6.History of Forex Market
- 7.FX cash, CFD or Spread Bet?
- 8.How Margin Trading Works
- 9.Best Time of Day to Trade
- 10.Forex Regulation And Protection
- 11.Forex Trading Examples
- 12.Making a Living Trading Forex
- 13.Mind, Money, Method
- 14.Forex Risk Management Strategies
- 15.Winning Forex Strategies
- 17.New Forex Trader Mistakes
- 18.Dangers of Forex Trading
- 19.Next steps