Fundamental and technical analysis are essential components of forex trading. They both involve research and forecasting future trends in currency pairs but they cover two different functions.
Fundamental analysis considers the fundamentals of the market, meaning the bigger picture. This is the health of the overall economy of a country and industry conditions as well as the financial health of countries (in terms of forex) and companies (in terms of stocks).
In this in-depth guide you’ll learn:
- How does fundamental analysis work for the forex market?
- How does technical analysis work for the forex market?
- What are the technical charts?
- Top 5 most popular trading strategies for technical analysis
And lots more…
Let’s dive right in…
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Technical analysis only considers the price of currency pairs, the volume that it’s being traded at and the direction in prices are moving. Technical analysis is the framework forex traders use to study patterns and trends in price movement and trading conditions of underlying assets such as foreign currency.
The theory of technical analysis is historical price movements and current forex trading conditions are rooted in the fundamentals. Basically, technical analysis works on the adage that “history tends to repeat itself”. Forex traders, to some extent, can anticipate price movements on currency pairs by correlating current patterns and trends with historical data.
How does fundamental analysis work for the forex market?
👉 Fundamental analysis involves analysing economic, social and political events and macro-environment forces that affect the supply and demand of an underlying asset. If a country goes to war, the event will affect how much demand there is for that nation’s currency. In turn, that affects the value of the country’s exchange rate.
👉 Basically, investors are more likely to invest in a country with a healthy and stable economy. More investment in a country increases the demand for the country’s currency. A politically unstable country with a terminally-ill economy is not attractive to investors and this reduces demand on the forex market for its currency.
Example of fundamental analysis: Moody’s downgrade of South Africa’s sovereign credit to junk
👉 Let’s take the example of the recent downgrading of South Africa’s sovereign credit to junk status. The action will result in South Africa’s expulsion from the World Government Bond Index (WGBI). Quoting CCNAfrica, “As a consequence, those funds tracking this index as a benchmark will become forced sellers.”
👉 Analysts have warned that the magnitude of this forced selling could be as high as US$ 8 billion, approximately R146 billion (at 1.1825 exchange rate).
👉 CNN Africa reported that the key driver behind the rating downgrade to Ba1 is the continuing deterioration in fiscal strength and structurally very weak growth in South Africa. Moody’s stated it does not expect current policy settings to be addressed effectively by South Africa. Both outcomes speak to weaker economic and fiscal policy effectiveness than Moody’s previously assumed.
👉 How did Moody’s downgrade to junk status affect South Africa’s exchange rate?
👉 Well, the effect was felt immediately. When markets opened on Monday after the announcement, the Rand fell to a record low. It weakened beyond 18 per dollar for the first time, before paring its losses.
👉 The government’s local-currency debt and Eurobonds, as well as banking stocks, also dropped. The Rand weakened 0.1% to 17.93 against the dollar by 06h45 in Johannesburg the next day. This extended Rand’s decline for the year to 22%. This is a fundamental analysis.
👉 Not all political, economic and social events in a country have such a seismic impact on a nation’s currency but it certainly did for South Africa in early 2020.
👉 The next question is, how does the forex market react to such a momentous economic event?
👉 With the downgrade to junk status, South Africa will pay more to borrow money in global markets. This will harm the equity market because investors will deem the sovereign asset to be too risky.
👉 Sovereign assets are assets held on reserve by a country’s central bank in foreign currency. They are used to back liabilities and influence monetary policy.
👉 However, despite the doom and gloom, analysts say South Africa is highly geared to changes in risk appetite and offers investors a ‘deep and liquid financial market that they can easily trade in and out of on local assets’.
👉 The Rand remains one of the most widely-traded currencies among major emerging markets, As the BusinessDay author noted, most foreign investors are in it for the yield and not the quality of the sovereign credit rating.
👉 A downgrade such as the one South Africa experienced in early 2020 can cause extreme volatility. However, it’s assumed the downgrade is unlikely to fundamentally change borrowing costs or the bandwidth of the exchange rate.
👉 Ultimately, the effect of Moody’s downgrade on Rand’s performance depends on the global appetite for risk. A country often benefits from a seismic economic event like a downgrade, despite deteriorating fundamentals for the simple reason that international investors often switch large-scale investments to high-yielding emerging markets.
👉 Now you know what fundamental analysis involves and how it is likely to affect market sentiment.
Quantitative versus qualitative fundamental analysis
👉 The basics of fundamental analysis are trying to determine whether an underlying asset is correctly valued within the broader market. In other words, the fundamental analysis considers the macro-environment rather than the micro-environment, and its effect on currency price movements.
👉 Fundamental analysis looks at the overall state of the economy of a country and the strength of its industries. It uses public data and news to assess the value of an underlying asset to arrive at a fair market value for the currency or stock.
👉 Fundamental analysis for forex involves creating a model to determine the estimated value of a currency pair or stock based on publicly-available data. In short, the price value is an estimate taking into account the analyst’s educated opinion based on what has happened historically in similar circumstances.
👉 Therefore, fundamental analysis involves both quantitative and qualitative research.
➡️️ Quantitative research: data that can be measured or expressed in numerical terms (hard numbers)
➡️️ Qualitative research: estimates based on qualified analysis of events that will affect (intangible)
👉 If an analyst estimates that a currency value should be significantly higher than its current value or will likely increase in value, the trader may open a position to buy the currency or stock. Traders who ‘copycat’ these fundamental analysts will follow their lead.
👉 If an analyst estimates that a currency value should be significantly higher or will likely decrease in value, the trader may open a position to sell the underlying asset. The assumption is that, in favourable trading conditions, the underlying value will increase in value and traders will profit from the upwards price movement.
👉 This form of analysis is opposite to technical analysis which forecasts the direction of price movement by analysing historical market data such as price and volume. Basically, fundamental analysis involves finding the intrinsic value of a currency, stock or commodity.
What is the intrinsic value of a currency?
👉 The intrinsic value of a currency in forex trading is the perceived or hypothetical true value. The intrinsic value differs from the current value because the currency could be over-or under-valued. Intrinsic value is an important component of fundamental analysis.
👉 In other words, the intrinsic value of an underlying asset is the subjective value that is arrived at through an objective calculation or complex financial model.
How does technical analysis work for the forex market?
👉 Technical analysis is all about getting technical over the detail. It involves scrutinising the tiniest price movements, mainly using charts. Technical analysis is based on the assumption that historical price movements can determine the current trading conditions and potential price movement.
👉 Traders use charts to look for patterns and trends that formed in the past and they base their forex trading decisions on the price of the underlying asset behaving in the same way as it did before. For example, if a price level held as a key support or resistance point in the past, traders assume it will come around to this historical price level again.
Using charts for technical analysis
👉 Technical analysis is based almost entirely on charts. Advanced charting features are available on popular trading platforms such as MetaTrader 4 and MetaTrader 5. A large part of a forex trading course revolves around teaching beginner traders how to set up and read charts for technical analysis.
👉 Technical charts are the easiest way to graphically depict historical data and for forex traders to visualise price movements. Charts that map past day trades help you identify spot trends and price patterns which alert you to trading opportunities.
👉 While the technical analysis may sound very technical, it is in fact very subjective. Two traders can analyse the same technical chart and come to two different conclusions. The easiest way to get around analysing charts is to adopt one of the popular trading strategies that have proven to be successful.
What are the technical charts?
👉 A technical chart used for forex trading is a visual representation of a currency pair’s price movement over a set period of time. It uses historical price data to identify trading opportunities.
➡️️ The y-axis (vertical axis) on a technical chart represents the price scale.
➡️️ The x-axis (horizontal axis) represents the time scale.
👉 Prices are plotted from left to right across the x-axis. The most recent price is plotted furthest to the right.
Types of charts used for technical trading on the forex market
👉 There are three types of charts that forex traders use to analyse price movements on currency pairs over time. These charts allow traders to view historic data to make predictions on future trading opportunities. Each chart allows a trader to set time frames ranging from tick data to weekly, monthly and even yearly data.
👉 Tick data refers to any market data which shows the price and volume of every point. Tick data usually includes historic information about every change to the best bid and ask. Tick data is also known as high-frequency data.
👉 Long-term data will show price movements from anything to a few weeks and months or year-by-year periods. They are favoured by traders taking a longer-term approach to a forex trade position and are not playing the spread or are not trading intraday (day traders).
Line chart
👉 Simple line charts draw a line from one closing price to the next closing price. It helps a forex trader to quickly determine the trend on current prices.
👉 When the closing prices are mapped along a line, a trader can see the general price movement of a currency pair over a period of time. A trader sets the timeframe so closing prices can be reviewed in anything from seconds to minutes, hours, days or weeks.
👉 The reason line charts are popular on trading platforms like MetaTrader 4 is because many traders regard the closing prices to be more important than the opening prices. Price fluctuations within a trading session are reduced online charts.
Bar chart
👉 Bar charts make use of bars where each bar has a high (top) and a low (bottom) with a line on either side. The right side represents the opening price and the left side represents the closing price for a selected period of time.
👉 Traders can set their bars using different colours to identify a price that closes higher or lower than it opened.
For example:
➡️️ Green lines below bars are called bull or Up bars and they represent prices that closed higher than the open price.
➡️️ Red liens are called bear or Down bars and they represent prices that closed lower than the open price.
Candlestick chart
👉 This is the most popular type of chart for technical analysis and is used most often on trading platforms like MetaTrader 4.
👉 Candlestick charts add dimension and colour to a Bar chart by illustrating the area of the bar between the open and close price in a two-dimensional form.
👉 Candlesticks visually represent the difference between the open and close prices.
➡️️ An Up candlestick follows when the close price is higher than the open price.
➡️️ A Down candlestick follows when the close price is lower than the open price.
👉 Up candlesticks are green and Down sticks are red.
👉 If the close price is equal to the open price, you will not see a Candlestick; only a line. This type of candlestick is called a ‘Doji’.
👉 The thin lines that extend between one candlestick and another are called Wicks.
➡️️ A Wick above the candlestick is the high level.
➡️️ A Wick between the candlestick is the low level for a selected period of time.
➡️️ A large Wick (relative to the Candlestick) indicates to traders a potential turning point in the support and resistance levels.
Top 5 most popular trading strategies for technical analysis
👉 There are many popular forex trading strategies in circulation; ranging from simple to highly complex. Some of these trading strategies rely solely on technical charts and some rely on a combination of fundamental and technical analysis.
👉 Here are the Top 5 forex trading strategies to look at if you are new to forex trading.
Support and resistance trading strategy
👉 Traders are taught to look for spot support and resistance levels on the charts, regardless of the asset they are trading. Support and resistance levels act like bookends that prevent the price from moving either higher or lower.
👉 The support and resistance trading strategy is one of the most effective ways to predict future price movements in the forex market. Support and resistance levels show traders the sentiment of the market as a whole as well as highlight where a trader should not open a position.
Trend trading strategy
👉 As the name indicates, the trend trading strategy involves identifying currency pairs that are trending either up or down. The trader can identify in which direction they are likely to move if the trend holds.
👉 The next step in the process to find forex trading opportunities on positions. Traders use trending indicators for this such as the RSI (Relative Strength Index) which tracks the strength of a currency pair’s movement.
Fibonacci trading strategy
👉 The Fibonacci trading strategy is one of the most popular and most well-known technical trading strategies for the forex market. It was named after a famous Italian mathematician and is considered as a medium- to long-term trading strategy.
👉 The Fibonacci technical analysis tool is used to follow repeating support and resistance levels. It works on the basis that markets historically move in trends and the trading strategy is used to decide whether to go long (buy) when the market is trending up or to go short (sell) when the market is trending down.
Scalping trading strategy
👉 Scalping is probably the oldest and most useful technique available on the forex market, particularly for beginner traders who should adopt a low-risk forex trading strategy.
👉 The scalping trading strategy involves taking profits on small price changes soon after a trade position has been opened and becomes profitable. Charts used for scalping help a trader to gain on the number of small winning trades by making a sacrifice on the size of the win.
Candlestick trading strategy
👉 Candlestick charts are the most common chart types used by forex traders. They can be set up on the MetaTrader 4 trading platform. Candlestick charts are better than all the other charts available because they reveal so much more about past price action.
👉 Candlesticks accurately reflect the price movement for a certain period of time, set in timeframes from one minute and up to one month. They’re the most effective charts for indicating trading opportunities for buy and sell positions.
👉 Candlesticks are very effective in volatile trading conditions but are not as effective in less volatile times. They are often used with one or more of the popular forex trading indicators.
Which is better for forex trading? Fundamental or technical analysis
👉 In forex trading, there are strong supporters for both types of analysis. In truth, one is not better than the other. It all depends on how traders look at the forex market and what suits their trading strategy. Traders typically choose the type of forex market analysis that suits their trading style and is the most profitable.
👉 Fundamental analysis looks at the big picture and technical analysis looks at the small details on currency price movements using charts. On top of that, you get sentiment analysis which involves looking for bull and bear indicators for current and future trading opportunities.
👉 Fundamental analysis is said to shape sentiment where traders use educated opinion regarding why the market is behaving in a certain way and which direction it is likely to take. Technical analysis, on the other hand, uses charts to corroborate market sentiment.
👉 Fundamental analysis is used more often to determine the quality of long-term positions while technical analysis is typically used to assess short-term positions on active currency pairs.
👉 At the end of the day, fundamental and technical as well as sentiment analysis should be used together as a package deal to get to grips with the bigger picture, the technical detail and market sentiment.
Forex Trading Africa Disclaimer
Trading forex is associated with high risks and can lead to investors and traders losing a significant amount of money. The information in this article should only be used to educate yourself on how forex trading works and the pros and cons of trading on the forex and stock markets.
Pay due caution to the risks involved in day trading and take the necessary precautions to avoid losing capital on forex positions.
