The Importance of Analysis in the FX Market
FX market analysis comes in two distinct forms; technical and fundamental analysis. Discussions have raged since the birth of trading as to which analysis is best, or whether traders should employ a combination of both disciplines, in order to make more informed trading decisions. The efficacy of both technical and fundamental analysis is also disputed by what is referred to as the "efficient-market hypothesis", which states that market prices are essentially unpredictable.
Whilst discussions have been ongoing for decades as to which form of analysis is best, one issue all trading experts and analysts will agree on is that both forms have features and benefits that can assist traders. Analysts would also agree that it can take a lifetime of practice and application to become proficient at either, or both forms of analysis. The first noted use of technical analysis was back in the 1700's by Dutch merchants and traders, whilst candlestick analysis allegedly began in China in the eighteenth century, courtesy a method developed by Homma Munehisa, to determine demand for basic commodities such as rice.
Many fundamental analysts will dismiss technical analysis, suggesting that the majority of technical indicators cannot and do not work, because indicators are "self fulfilling and lagging". They may doubt the efficiency and value of the most commonly used indicators such as the: MACD, RSI, stochastics, DMI, PSAR (parabolic stop and reverse), Bollinger bands etc. However, there's many traders who employ technical analysis in their trading plan, who will categorically state that using indicators, to enter and the exit their trades, actually works. Not every time, but in terms of probability and average performance, their technical analysis works well enough over time to ensure they have developed a credible trading plan and strategy, "an edge" as traders often refer to it.
However, it is ironic that nearly all fundamental analyst-traders will still use forms of technical analysis, even on a relatively vanilla, indicator free chart. They will perhaps decide what method of price display they prefer: candlestick, Heikin-Ashi, line, pin-bars, etc. Or they will use a fairly basic strategy to trade including: higher lows, lower highs, moving averages, head and shoulders' patterns, fractals, pivot points, Fibonacci retracement and drawing trend lines etc. Once some of these formulas are placed on a chart, the chart can look as busy as a chart containing many of the afore-mentioned indicators. And are not calculations as to where to place stops and take profit limit orders also forms of technical analysis?
So even dedicated fundamental analysis traders still have to use technical analysis, they will just prefer to concentrate on news, events and data releases to make, or to confirm their decisions. And they will stay abreast of all releases, perhaps by using Twitter, or paying the extra expense of using what is referred to as "a squawk", in an attempt to be on top of the market and their trading decisions.
However, this section of our site is not here to discuss the relative merits of fundamental and technical analysis, we are developing an FX school in which we will do that at length, we are just going to provide a brief overview of the key differences between the two distinct areas of analysis.
What is FX technical analysis?
Technical analysis (often referred to as TA) is the forecasting of future financial price movements based on an examination of past price movements. Technical analysis can help traders anticipate what is likely to happen to prices over time. Technical analysis uses a wide variety of indicators and charts that display price movements over a selected time period. By analysing statistics gathered from trading activity, such as price movement and volume, traders hope to make a decision regarding which direction price may take.
Many technical analysis-traders pay little attention to news. They take the view that eventually the detail and perhaps the drama of an economic news release, will eventually reveal itself on a chart. Indeed, price on a chart can often react before traders have even seen data released, or had a chance to read the news and then make an informed decision. This can be as a consequence of algorithmic/high frequency traders being able to front run the news in lightning speed before many mortal traders can react.
What is FX fundamental analysis?
Fundamental analysts examine the intrinsic value of an investment, in forex this requires the close examination of the economic conditions affecting the valuation of a nation's currency. There are many major fundamental factors that play a role in a currency's movement, many of which are contained in what is termed "economic indicators".
Economic indicators are reports and data released by a country's government, or a private entity such as Markit, that details a country's economic performance. Economic reports are the means by which a country's economic health is generally measured. Released at scheduled times the data provides the market with an indication of a nation's economic situation; has it improved or declined? In FX trading, any deviation from the median, the previous data, or from what is been predicted, can cause large price and volume movements.
Here are four major reports which can (on release) effect currency price.
Gross Domestic Product (GDP)
GDP is the widest measure of a country's economy; the total market value of all goods and services produced in a country during a defined period. GDP figures lag, therefore traders often focus on two reports issued before the final GDP figures; advanced report and the preliminary report. Revisions between these reports can cause considerable volatility.
Retail sales' reports measure receipts of all retail stores in a specific country. The report is a useful indicator of overall consumer spending patterns, adjusted for seasonal variables. It can be used to predict the performance of more important lagging indicators and to assess the immediate direction of an economy.
Changes in the production of: factories, mines and utilities within a nation's economy can indicate the overall health of the economy. It also reports their capacity; the degree to which each factory's capacity or utility is being used. Ideally a nation needs to experience a production increase, whilst being near its maximum capacity.
Traders using this data often monitor utility production, which can be volatile as the demand for energy, is affected by weather changes. Significant revisions between reports can be caused by weather changes, which can cause volatility in the national currency.
Consumer Price Index (CPI)
The CPI measures the inflation change in the prices of consumer goods across approx. two hundred different categories. This report can be used to see if a country is making or losing money on its products and services. It can also be used to determine whether or not a central bank or government will raise or reduce base interest rates, to either cool or stimulate the economy.