There are many different methods traders can use to attempt to predict how the forex market is going to behave. Although all markets are, to some degree, unpredictable, there are tried and tested ways that have, time and again, proved themselves to be worthy of consideration. Methods of analysing the forex market, or any market, for that matter, can be split into two categories.
These are technical analysis, and fundamental analysis and, to give yourself the best chance of turning a tidy profit from forex trading, you’ll want to familiarise yourself with both and use them in accordance with one another. When put into practice, you’ll no doubt find that technical and fundamental methods of analysis are intrinsically linked and, as such, to heed one while ignoring the other would be a major mistake.
This guide will first explain the two terms in some detail and then go on to compare the two and, with any luck, you’ll go away a better, more informed forex trader. So, let’s begin by explaining what we mean when we talk about technical analysis and providing examples which you can put to good use during your exploits as newly-qualified forex traders.
What is technical analysis?
Technical analysis involves examining the data and corresponding graphs surrounding a currency’s or currency pair’s recent and historical performance. In short, it’s a numbers game which, rather than concerning itself with things like news, local economics, and global politics, instead asks traders to focus on cold, hard statistics.
Now, fortunately, technical analysis doesn’t require traders to rely on the naked eye alone when attempting to decipher and interpret the complex behaviours of a wide range of currencies and currency pairs; instead, traders will often utilise things called forex indicators to help them get the very most out of the data at hand.
Forex indicators are basically mathematical formula and algorithms which, when applied to forex pricing data, among other things, can give traders an idea of how a currency will likely perform in the future, and what has caused a currency to behave way it has done in the past; they can both explain and predict the behaviour/performance of a currency or currency pair and, as such, help traders determine when’s a good time to buy/sell/margin/leverage.
Popular forex indicators and trustee tools of the technical analyst include things like the MACD, which is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA, the RSI, which is a momentum indicator used by forex traders to identify when a currency pair has been overbought or oversold, and Bollinger Bands, which consist of three lines, one which sits above the currency price, one which sits below, and one which reflects the 21-day simple moving average.
For more information on technical analysis, please see our Top three forex indicators article.
What is fundamental analysis?
Fundamental analysis instead focuses less on mathematics and statistics and more on real world occurrences which could affect forex trading. News, local economics, and global politics are at the heart of fundamental analysis so, as you’d expect, fundamental analysis can often be used to explain some of the patterns/trends identified during technical analysis.
Probably the most important of all variables in the world of fundamental analysis, in the context of forex trading, is global interest rates. National/zonal interest rate changes, rumours, and announcements, will always affect a country/zone’s native currency and, as such, smart forex traders always keep a close eye on the financial news because they know the power such news can have on the forex market.
If a country’s economy is doing well, interest rates tend to go up, and if a country’s economy is doing poorly, interest rates tend to go down. So, if there’s news of a couple of hundred thousand new jobs popping up over the course of the next couple of months due to businesses expanding their operations etc., then it is likely that the feds (federal reserve, in the case of the US, at least) will seriously consider raising rates.
Obviously, there’s more to it than this but, by keeping a close eye on the news, many traders are able to successfully pre-empt interest rate hikes and get in early or, conversely, sense a lull coming and sell accordingly.
Which is a more effective Forex indicator?
As you’ve probably guessed, there’s no right answer here; or rather, it’s a trick question. Neither technical analysis nor fundamental analysis is a more effective forex indicator because, to have the best chance of succeeding in the forex market, a trader must recognise and observe both.
Indeed, when used in conjunction, the two methods complement each other perfectly and give traders the best possible chance of making the right predictions and generating a profit from forex trading. Numbers and graphs are fantastic for identifying reoccurring patterns and trends and things of that nature.
But, when it comes to the big news, you’ll want to have your thumb pressed firmly on the pulse of the world economy, so to speak, ready to react to any bit of news relative to forex trading, big or small.
To summarise, you’d be a fool to favour one of the described methods of analysis over the other because, only by observing all factors and paying attention to all trends and patterns can you attempt to gain a full understanding of the forex market.
One affects the other and so to ignore one would be like trying to drive a car with one eye covered; you’d be putting yourself at a dangerous disadvantage and would likely pay for it so, when forex trading, remember to employ both technical and fundamental analytical tactics.
Thanks, and, as always, happy trading!