There are as many trading strategies as there are Forex traders. However, almost all the strategies are based on the two basic approaches: fundamental and technical analyses. If you want to understand the underlying principles of the two, here is the perfect guide for you.
Generally, participants of financial markets use fundamental and technical approaches to analyse the structures of the markets. In regard to the foreign exchange (Forex) market, the use of technical analysis is understandable but how do you explain Forex fundamental analysis? Unlike companies, countries have neither profit and loss accounts nor balance sheets.
However, fundamental analysis generally seeks to determine the intrinsic value (that is, the true worth) of an investment. Therefore, Forex traders apply it to assess the actual economic performance of a country’s currency by evaluating the economic indicators that affect its valuation. Those economic indicators are usually press releases by governments and research organisations and they include:
These indicators examine the economic health of nations and are released by their governments from time to time.
GDP, the broadest measure of a country’s economy, is an indicator of the economic productivity of a country within a year. It represents the total market value of all goods and services the company produces in that year. It is a widely used indicator of national economic growth.
However, in Forex trading, it is often considered a lagging indicator because it is a measure of yearly performance. As a result, most market participants use more of the advance and preliminary GDP releases. Usually, significant differences between the two are often responsible for high market volatility.
The retail sales indicator is a measure of the total revenue generated on retail sales within a country. The report tracks the retail industries of the country such as auto dealers, department stores, and apparel etc. It gives an indication of the spending pattern of the citizens, economic prosperity (or otherwise) of the country, and the overall direction of the economy itself in the short term.
Since it indirectly measures internal economic growth, adjustments to the indicator often have a significant volatility effect on the market. Interestingly, retail sales and GDP measures are positively correlated. That is, if retail sales are positive from month to month, there is a very high likelihood that the GDP will be strong, too. Also, growth in a crucial retail sales category such as auto dealers can suggest employment growth.
The Consumer Price Index (CPI) tracks over 200 different categories to assess change in the prices of consumer goods. It can give you hints about the true economic valuation of the goods and services the country is producing. That is, if the country is making or losing money on them.
However, attention should also be paid to import indicators as an interaction between them (and a number of other factors) eventually influences the currency. Rising imports leading to trade deficit, a situation whereby a nation imports more than it exports, for instance, can have an opposite (negative) effect on the exchange rate.
You can apply fundamental analysis to your Forex trading by using these highlighted economic indicators to measure the economic performance of a nation and the subsequent value of its currency. To be able to do this, you will have to keep tabs on their releases and also bear in mind that those factors are just some of the many factors that actually move the market.
In conducting Forex fundamental analysis, the following guidelines will help:
Primarily, technical analysis studies price behavior of financial instruments by using its historical data conveyed in charts. Using those charts, it seeks to identify the past and current demand and supply situation of currencies by recognizing different patterns and shapes in price action.
Hence, in short, technical analysis can be thought of as a framework that uses the past structures of price to make predictions about its future movement. Using specific tools, it seeks to analyse market structure by assessing the highs, lows, and flows of the market. Tools used by technical analysts include:
The working principle of technical analysis is the reasoning that all market variables are already reflected in the price behaviour on charts. Consequently, using this reasoning, technical analysts believe that publicly available information (and anything else) do not have to be analysed to be able to identify opportunities in the market. That is, in short, the price is all there is to see.
Also known as pivot points, support and resistance are certain predetermined levels at which there is expected to be a reversal in price. They represent key levels of price that can be used to identify powerful trading opportunities.
Technical analysts pay special attention to these levels as it has been observed that price tends to respect them again and again. Usually, when the price reaches a support level, traders buy. And when it gets to the resistance level, they sell.
Chart patterns are a powerful analytic tool for evaluating the sentiment of participants about the market. They also reflect, through the patterns and shapes they form, how this sentiment and other market variables contribute to the movement of price. They include channel, hammer, head and shoulder, and bullish and bearish engulfing.
Forex technical analysts use a wide range of indicators in attempting to predict price movements. Some of those indicators are the Relative Strength Index (RSI), the Stochastic, and the Moving Averages. Many technical indicators have been developed over the years and have been widely embraced by traders all over the world.
As a Forex trader, you can approach the market using two basic forms of analysis: fundamental and technical analyses. Fundamental analysis is the use of economic indicators such as Gross Domestic Product and Retail Sales reports to assess the value of a country and its currency.
Technical analysis, on the other hand, is based on price action. It seeks to identify repetitive patterns in the past movements of price and use them to predict its direction. It is a school of Forex analysis that believes that all news and economic indicators are always reflected in price behaviour.
However, you can use both. That is, you can skillfully combine fundamental and technical analyses to yield a powerful techno-fundamental approach. This strategy will not only help you identify more trading opportunities but also avoid many disastrous market movements.