Technical analysis is the use of a collection of methods that look for patterns in the chart that may predict future behavior. Technical analysis assumes that all the information related to a currency pair available is already priced in. Therefore, the theory is that if a particular pattern is repeated in the past, recognizing that pattern can help the trader predict the immediate future.
Pros and Cons
The biggest advantage of using technical analysis for Forex trading, is that the trader doesn’t need to conduct research on economic climate and predict future policy decisions. As the FX market is fluctuating according to patterns, it becomes far easier to automate the trading strategy. Finally, as more and more FX traders start to trade according to technical analysis theories, the higher probability exists that it becomes a self-fulfilling prophecy.
On the flip side, if the trader ignores the economic and policy climate affecting the FX market, it can be very easy to enter losing positions (especially on the long term) even when the signs of trouble are clear.
Tools and Techniques
Even a beginner trader can start using these tools without understanding the technical calculations as the popular platforms will have ready made tools which can be inserted into the chart. The following looks at some of the basic tools of technical analysis.
Support & Resistance
One of the most fundamental patterns seen in price movements in Forex markets is the chart moving up and down in cycles. The turning points of these cycle patterns make up the support and resistance levels of a chart.
In very basic terms, the support line is the temporary limit where the price can’t break through to reverse the overall trend. In the example above, the blue boxes are supporting the overall downward trend and not letting the price reverse into an upward trend.
The resistance is the opposite of support. In the example, they’re shown in orange. If the overall trend was going up, the support for an upward trend would be the bottom troughs and the resistance would be the ceilings.
A very basic trading strategy when the price is trending down is to buy the currency at resistance and sell at support levels, (if the price is on uptrend, buy at support and sell at resistance). Although this can work in theory, in the real world its almost impossible to accurately predict the price trend and the support/resistance levels without using other tools.
One of the basic tools to identify whether the overall price is trending up or down, is to use a moving average (MA). This indicator takes the last X number of closing prices and averages the price for the current periods moving average. The larger the X, the stronger the MA trend.
The diagram indicates the 30-point MA in Orange, 10-point MA in black and 5-point MA in blue. As evident, the blue line follows the oscillations of the market far closer than the orange line. Therefore, the orange line shows a much stronger trend line. Nevertheless, as a large spike in the past can affect a MA line unnecessarily, traders tend to use exponential moving averages (EMA) that give more weight to more recent price points.
In the above example, the blue line represents the 30 EMA vs. the orange 30 MA line. The 30 EMA is more sensitive to recent price changes while still considering 30 past closing prices. Therefore, it’s more accurate to use EMA trend lines to discern the overall price movements.
Assuming the trader has identified the overall trend, how can he still be confident that the trend won’t reverse as soon as he commits to a trade? This is where oscillators come in.
Some of the most common oscillators are Stochastic Oscillator & Relative strength index (RSI). Without going into the technical details of how they work, lets look at how to interpret the signals.
The stochastic oscillator and RSI look similar when plotted in the charting software.
Here, the bottom chart is the RSI and the next one is the stochastic oscillator. The blue line on the candlestick chart is the 30 EMA. The most important factor to identify here is that both the oscillators break out of their darkened zones before the actual trend reversal takes place. Therefore, by studying the breakout of the oscillators, the trader can be confident that a trend reversal is about to take place.
Other Tools and Notes
There are many more tools such as Fibonacci’s retracement, Bollinger bands and MACD which can indicate possible future trends, support and resistance levels. The most important thing to realize is that none of these tools can predict the FX market 100% accurately. Still, a trader can improve his or her odds by adding the use of these tools to their arsenal. As a beginner, when the options seem overwhelming, start with the basics. This goes for tweaking the parameters of the tools mentioned earlier as well. By using the default settings of the tools above, (as most other traders will also use the same parameters) the market can behave in a self-fulfilling manner.
Fundamental analysis is when the FX trader considers underlying economic or policy reasons for a currency’s price fluctuations. The main idea behind the analysis is if the currency’s underlying economy is predicted to do better compared to other countries, the price of that currency will go up and vice versa.
Pros and Cons
The main advantage of fundamental analysis is that the predicted price fluctuations are based on real world value. Therefore, identifying large enough influencing factors can accurately predict future price trends. Nevertheless, especially on the short term, prices can be driven much more by seemingly random trader behaviors.
Tools and Techniques
Unlike technical analysis, fundamental analysis deals less with charts and much more with research and economic indicators. The following are some of the economic indicators and how they will affect the related currencies.
GDP and Retail Sales
Gross domestic product (GDP) can be characterized as a country’s economic output. The most important factor traders look at is the GDP annualized growth rate. As a country’s GDP reporting date draws closer, traders will have varying ideas on the predicted outcome and the consensus will be priced in. As soon as the report releases, if the report indicates that the growth rate is better than expected, the currency will appreciate and vice versa.
The retail sales numbers indicate the appetite for consumer spending. If the consumer spending is on the downturn, it can mean an upcoming recessionary cycle (as GDP is largely affected by retail sales). When trading with USD currency pairs, the retail sales numbers report of the USA (released monthly) can be used as a short-term indicator compared to the GDP report (released quarterly)
CPI & Interest Rates
The consumer price index (CPI) measures the inflation of an economy (i.e. how fast the prices of goods are rising). If the rate is higher, the monetary authority will raise interest rates to bring consumer spending down. That means that more investors will be willing to buy bonds of that currency thus increasing its demand. Therefore, the price of the currency will increase. In case if inflation is lower than expectations, this can drive the price for the currency down. On the other hand, if traders sense runaway inflation (such as in the case of Venezuela) the demand for the currency can drop very fast.
Employment reports include measures of unemployment rates and wages. If the unemployment is low and wages are growing, the populace will spend more in the future thus increasing GDP and vice versa. Therefore, a positive employment report will strengthen the currency of the underlying economy.
The above indicators were relating to periodical measures released by the governing bodies. There can still be major influencing events for FX markets in the form of specific geopolitical effects. For example, the Brexit, the US election, NAFTA deal, Trade wars etc. can all influence the Forex market. The main point to look out for here is to understand how an event will affect the underlying economy and trade accordingly. Even if the other traders don’t share your sentiment, if your prediction is correct, the markets will move in your favor in the long term.
Types of Traders
As a FX trader, there are several styles of forex trading that can be followed. They can be broadly categorized by the time frame the positions are held for.
Scalp trading is the most active form of trading as the positions are only held for literal seconds or minutes. The strategy is entirely built on technical analysis as fundamentals can not affect such a small timeframe. It’s also important to select a FX broker with low commissions and fast execution times as there needs to be several hundred small trades to make a significant profit.
Like scalp trading, day traders will also use technical analysis unless a sudden geopolitical event comes to light. Day traders trade positions within the day and don’t typically hold positions overnight. They also require generally fast execution and low commissions to make profit.
Swing trading is the next natural step of the trading styles. Here, the positions are held from several days to weeks. The analysis can be a mix of technical and fundamental analysis as both can affect the pricing in this time frame. As the positions are only entered and exited once in a while, this can be a practical trading style for FX traders looking to enter the Forex market part time.
This is the trading style with the longest timeframe. Typically, the positions are held across months or even years. FX position trading is mostly driven by fundamental analysis and closely resembles traditional stock trading. Here, the most important criteria for your broker needs to be their trustworthiness and the fact that they won’t shut down for a long time to come.
Once the basics of FX trading is learnt by reading, the next step is to learn by doing. Still, a beginner needs not risk real money and can develop a trading strategy by using a demo account. The best way to utilize a demo account is to treat it as if your real money is on the line. This can also help the aspiring FX trader to gauge the broker, customer service, the platform and any analysis tools.
During this practice, as well as eventual real trading, it can be very helpful to keep a trading journal. This will help keep track of the trading strategies and tools used. With this, it becomes easier to refine the strategy to improve the outcomes.
Once Forex trading on the demo account becomes a comfortable experience, the trader can dip their toes into using real money. It’s still very important to keep learning new tools and refine existing knowledge. It can be hard to keep emotions out of FX trading therefore it becomes imperative to use automated trade entry and exit strategies such as stop and limit orders to ensure that the strategy is followed.