It is fair to say that the foreign exchange market is very news driven. For example, a central bank governor says something unexpected and there can be a significant impact on currency prices in a short period of time. Even something as simple as a different word used from the previous month, to describe market conditions can send a ripple through the markets.
When central banks change monetary policy and change the official cash rate, that countries’ currency may also move very quickly.
There are also numerous regular reports which provide an insight into how well an economy is performing or not. These can lead to assumptions on what central banks decide to do in order to stimulate an economy or keep in inflation in check, which then has a direct impact on currency prices.
Having said all of that, there are two main approaches when it comes to the analysis of currencies - they are fundamental analysis and technical analysis.
Fundamental analysis involves an assessment of the country’s economy and the difference in interest rates between two countries, as this will have a direct impact on the price of a currency pair. Fundamental analysis has always been seen as a more traditional approach as logically, an accurate assessment should provide an accurate forecast.
Technical analysis doesn’t need much of an introduction and is more widely used by private traders. Technical analysis principally involves the study of a currency pair’s actual price, to form an opinion on the likely future direction in which the price will move.
When major economic releases are not being published, price action in currency pairs can be quite technical and therefore technical analysis can be very effective.
Basis of Technical Analysis
Despite what people may tell you, there are only two things that move prices. They are supply and demand — nothing more and nothing less.
When demand for something is greater than supply, prices rise. Conversely, if supply is greater than demand, prices fall. This is true in the foreign exchange market.
The cause of supply and demand in the foreign exchange market could be discussed for hours. Is it interest rate differences? Is it yield curves? Inflation data? Employment reports? The interesting thing is that no-one can be absolutely sure at any point why people may be buying and selling currencies. Herein lies the beauty of technical analysis.
At no time does technical analysis attempt to determine why there might be supply and demand, only that there are certain levels of supply and demand. By studying actual movements in a price, we can determine, to a great extent, what the present levels of supply and demand for a currency are, what market participants may be thinking and can therefore analyse the currency pair as a trade.
The strength of technical analysis is that you are buying and selling on the basis of the actual price, rather than relying on hypotheses about future value based on central bank statements, yield curves etc.
Technical analysts assume that all fundamental and economic influences on a currency price are already taken into consideration in the market, so they simply monitor the price action. Many technical analysts go as far as suggesting that fundamentals are not important and are not worth considering at all. In other words, the price tells you everything you need to know.
At any point in time, the price reflects the consensus between buyers and sellers – it is the point where they are prepared to engage and do business with each other.
Does Technical Analysis work? If yes, why?
Well, despite the passage of time, human nature and behaviour over the years remain constant. All market participants are driven by similar emotions and will often react to situations in the same way. Technical analysts develop an understanding of the way crowds of people will react to certain situations.
Moreover, there is always a continual flow of new participants into the market and they are generally ignorant of the way the market has behaved in the past. For this reason, the same mistakes and behavioural patterns are often repeated by each new group of market participants. These mistakes and patterns lead to decisions which are either demand or supply for something, which of course determines the price.
For this reason, I believe that technical analysis is less about trading and more about the study of mass psychology. We study the way people react in certain situations in the market. We are able to monitor price patterns and determine what is most likely to happen. Furthermore, the beauty of technical analysis is that it is equally effective in markets around the world, as human nature is the same around the world.
Technical analysis is not perfect, however it can greatly assist us in identifying high probability trading opportunities.
Why Not Fundamentals?
I am the first to concede that fundamentals has its place in market analysis, even though I prefer not to use it. One of the biggest differences between fundamentals and technical is often the time before any accurate analysis may come to fruition.
In fact, the time it will take for an accurate prediction of currency price movement based on fundamental analysis to come to fruition is uncertain. It is very difficult to judge exactly when price movements are likely to happen. One thing is known, though, and that is that anticipated movements are seldom immediate and can take several months if not years to occur.
Fundamental analysts assume that all fundamental information is reflected in the price of a currency pair. In an ideal and effective market, that is exactly what should happen; however, it is not always what does happen. Determining where a price should be is an incredibly difficult proposition.
Analysts will often attempt to determine whether a currency is undervalued, overvalued or about par. Then a decision can be made on whether to buy, sell or do nothing.
Fundamental analysis has several weaknesses, with one being the likelihood the market will agree with you. An individual is assuming that what she or he perceives to be solid analysis regarding a currency’s future outlook is an opinion that will be shared by most other market participants.
At the end of the day, your opinion matters for nothing in the market. What we think about a currency is not important – it is what everyone else thinks, that is important.
Fundamental analysis has been used for a long time and is the traditional means by which many investors, stockbrokers and financial industry participants analyse the markets. There is a lot of merit in fundamental analysis, and what it tries to achieve.
Unfortunately, one of the things underpinning its effectiveness is that all market participants act in a rational manner. I say unfortunately as many market participants can be gripped by fear and greed and act in a manner that is anything but rational.
Herein lies the advantage of technical analysis – you are studying the way in which people behave in the market, whether it is logical, makes any sense or not.
One final word on technical analysis and its effectiveness. There is a well known saying in trading which says, “trade what you see, not what you think”. The chart will tell you everything you need to know, and unfortunately in this environment, what we think and believe counts for nothing. No one else in the market cares what we think.
So, remain objective and let the chart tell you precisely what is happening.
The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.