Beginners Guide to Forex
Module 7: Types of Trading
Many traders sit up nights trying to decide if they should be fundamental analysts or whether they should be chartists, or technical analysts. Well, whether you know it or not, if you are a trader you probably use both technical and fundamental analysis to make your trading decisions.
As weird as it seems, it is one of the most hotly debated questions when it comes to the forex market. Everyone has their own opinion and will vehemently defend their view but in reality you need to consider both in your daily trading.
The Fun in Fundamental
Chartists will point to example after example of why technical analysis is the one you should use however if you have ever watched what happens to the markets on Non Farm Payroll Friday then you cannot deny the power of fundamental data. Imagine for a moment that you are trading on the first Thursday of the month. Your chosen currency pair is in an uptrend and all your indicators say buy. You probably feel pretty good about being long in this situation. You may even be considering staying in your trade over the weekend and into the next week. Then along comes the US employment situation, this is the grand-daddy of all the fundamental news announcements and tends to shake the forex market up in ways that no other announcement does regularly.
So you are sitting on a long trade that you think is a winner, but like all major economic releases the US employment situation triggers significant price volatility. If the announcement is a shock to the consensus then you could expect to see the currency price gap significantly which makes you a rock star if you are right and lower than a snakes belly if you are wrong. Even your stop loss order isn’t going to save you in this scenario since all orders turn into Market Orders, which mean you will be filled at the prevailing price.
Fundamental analysis for the forex market examines the macroeconomic indicators, asset markets and political considerations of one nation’s currency as opposed to another. Macroeconomic indicators include things such as growth rates (Gross Domestic Product), interest rates, inflation, unemployment, money supply, foreign exchange reserves and productivity. Other macroeconomic indicators include the CPI – a measurement of the cost of living, and the PPI – a measurement of the cost of producing goods. Asset markets are made up of stocks, bonds and real estate. Political considerations influence the level of confidence in a nation’s government, the climate of stability and level of certainty.
How it Works?
There is a basic rule of thumb that says a currency can become more valuable in two main ways: when the amount of currency available in the world market place is reduced (for example, when the US Fed increases the interest rates and causes a reduction in spending), or when there is an increase in the demand for that particular currency. There are also many little influences that can nudge the currency’s value.
An interesting number to watch when you are checking out the macroeconomics of a country is the official interest rate. Be careful not to jump to any premature decisions however, interest rates work like a split-personality and can have both a strengthening and a weakening effect on your currency. On the negative side, investors will often sell off their holdings as interest rates increase because they believe that higher borrowing costs will adversely affect stock rates. This can cause a downturn in the stock market as well as in the national economy. However, high interest rates tend to attract foreign investments which can strengthen the local currency.
Another thing to keep your eye on is the International Trade Balance. A trade balance which shows a deficit (more imports than exports) is usually a bad sign. Deficits mean that money is flowing out of the country to purchase foreign made goods and this can have a devaluing effect on the currency. It is important to remember that the market will generally dictate whether a trade deficit is bad news or not. If the country routinely operates with a deficit it has probably already been factored into the currency price. Trade deficits will generally only affect a currency when they are reported higher than the market consensus.
The official definition from the International Federation of Technical Analysts (IFTA) is that technical analysis is the systematic method of analysing financial instruments, including securities, futures and interest rate products, with only market-delivered information such as price, volume, volatility and open interest. The tools of technical analysis are measurements and derivatives of price, for example on-balance volume, price oscillators, momentum measurements and pattern recognition. A Technical Analyst applies such tools for forecasting and timing the trading and investing in financial instruments. Technical Analysis is a universal discipline.
The basis of modern-day technical analysis can be traced to the Dow Theory, developed around 1900 by Charles Dow. It includes principles such as the trending nature of prices, confirmation and divergence, and support / resistance. Technical analysts, or chartists, use a number of tools to help them identify potential trades.
How Does it Work?
Think of technical analysis like weather forecasting. The weatherman (weatherperson) will look at the weather patterns that are currently emerging and compare them to similar weather patterns that have happened in the past. If 8 of the last 10 instances of this particular weather pattern resulted in rain, the weatherperson will likely predict rain. However, when trading it is important to remember that, much like the weather, the market is ultimately going to do whatever it wants to do and may often go against historical patterns.
Technical analysis can also be tied to human behaviour. People can often behave in predictable ways and tend to repeat their behaviour under similar circumstances.
Technical analysis is the art/science of attempting to identify crowd behaviour in order to join the crowd and take advantage of its momentum. This is where the oft over used phrase, “control your emotions” comes into play. You will want to be sensitive to what the market is doing without succumbing to crowd mentality. Technical traders work hard to avoid political and analyst chatter because they believe that all the information they need to know is already embedded in the price.
Remember not to over analyse however, every action causes a reaction (though not necessarily equal or opposite, that is physics not trading). There are millions of traders analysing the same charts as you are and that leads to a cat-and-mouse sort of game playing that can be incredibly complex, riddled with bluffing, cheating feints and double-crosses. Traders can be a crafty bunch.
Wrapping It Up
So rather than the question Technical or Fundamental, you may be better off figuring out how to incorporate both into your trading. Limiting yourself to one style of analysis can be a big mistake. The more information you can gather regarding your currency pair the better equipped you will be to trade in this highly volatile market.
One last little nugget of advice is, investors expectations change over time. That means you will have to be on your toes, watching for changes and emerging trends. Technical analysis shouldn’t be scary, but be mindful that you need to have the knowledge and background in order to do it successfully. Once you understand the basics, you will realise there is a lot of information to be learned from your charts and it is all free for the taking.
Forex trading is one of the riskiest forms of investment available in the financial markets and suitable for sophisticated individuals and institutions. The possibility exists that you could sustain a substantial loss of funds and therefore you should not invest money that you cannot afford to lose.
Download Raghee's eBook!
Raghee's “crash course” into the many lesson’s she's learned within the FX market, including previous Daily Trading Edge entries with her own trading strategies.