Now that we know what the Forex market is and who participates in it, it is time for us to learn some of the types of strategies there are for trading. Cold analysis – and not intuition or excitement – should be the basis of any single trading decision. Analysis is the objective and logical conclusion about the possible future behavior of the instrument we are interested in trading.
There are broadly two types of analysis – fundamental analysis (FA) and technical analysis (TA). Their difference is simple: fundamental analysis studies causes and the technical analysis studies consequences. Fundamental analysis asks a question: “Why did the quotation go in X direction at N moment?” whilst technical analysis says: “If the quotation went in X direction at N moment, now it may go in Y direction”.
Both methods are legitimate and either of them can be used effectively. You should clearly understand the methodology of both types of analysis to be able to choose the one you are more comfortable with. It may also be that like many traders you will prefer to use a combination of the two.
Everything in this life has its foundation, a basis. For your house it is a thick layer of concrete that won’t let the building sink into the ground. For your intellect it is your education and upbringing and the books you have read including this one. For a healthy sportsman’s body it is the everyday routine of exhausting exercises and the consumption of wholesome food. For a developed economy it consists of efficient governmental mechanisms, and a strong manufacturing and export infrastructure. The Forex market is no exclusion to this rule. It too has its own foundation and this is what fundamental analysis describes.
You may have already guessed what creates the basis of this interesting market. The answer can be summarized in one word – events. It is the various events of different economic importance occurring in the different spheres of business and life that form the basis of the Forex market. Without events quotations tend to freeze up, but when something serious happens quotations tend to jump like a flea. For example, after World War II the German currency devaluation so much that prices in ordinary shops changed two times a day and the sum needed to pay for a purchase was weighed on scales in order not to waste hours individual bills of money. Could you predict such a move of the rate? You bet! Though this example is not a typical one (as we have mentioned above, the Forex market is more stable than the equities’ markets) it is very illustrative for us to see how the basis of a currency may collapse.
Unfortunately it is much harder for a trader in the present time to carry out fundamental analysis in comparison with 60 years ago. There are no
Fundamental analysis accounts for the dependence of quotations on supply and demand
world wars anymore but there is a bewildering array of many different economic events. This is mainly because of globalization.
So, fundamental analysis (FA) accounts for the dependence of quotations on supply and demand, which is naturally dependent on fundamental economic factors. There are plenty of factors that affect currencies, but all of them are well known and one can easily trace their influence upon the quotations. FA is more effective when applied to big periods of time as the data metrics for many fundamental factors appear once a week, a month, a quarter, or a year. The only kind of FA for short-term predictions is called “bulletin trading”. It is when a trader reads important economic news in realtime and makes his trading decisions based on it, but the main feature of this method is the possibility to predict the supply and demand dynamics without “market noise” (short-term market fluctuations).
Technical analysis (FA’s competitor, and we will discuss it in more detail later) is based on the idea that it is useless to look for the reasons for changes in prices as it is impossible to find the cause of the change before this cause has already affected the quotation, therefore it is enough to study the behavior of quotations themselves. TA is effective when working with short periods of time – from minutes to weeks.
The main disadvantage of FA as we have already mentioned is the complexity of the world’s global economy nowadays. If you are good enough in mathematics and logical thinking it wouldn’t be that hard for you to link up 15-25 different parameters and trace their interconnections in relation to one fundamental indicator (FI), but unfortunately it’s hardly enough for an accurate prediction. There are about 40 different fundamental indicators for each country participating in the Forex market. So, in order to compose more or less realistic predictions of currency fluctuations you should have either a genius mind, amazing persistence, a decrease in the accuracy of calculations or funds to maintain your own analytical research centre.
There is one more serious problem with FA. A large amount of capital is required to trade with when making medium-term predictions because there is a good chance the market will go against you initially, incurring high losses and leading to margin calls etc. Even if your analysis was correct and the expected quotations materialize your profit potential is limited because you can only trade with a small part of your deposit.
That’s why Fundamental Analysis is ignored by 9 traders out of 10 and why “every tenth” trader in his turn is familiar with FA – almost comparable with the number of people who are able to speak Latin.
Whilst we recognize the complexities involved in employing FA, our conclusion is that it is a necessary aspect of Forex trading strategy. Few people consistently profit from Forex, which means that a significant number of traders may be missing an opportunity for using FA, and their methods can be improved for more successful trading. So, let us be different.
As we have described, the basis of fundamental analysis is the concept that one can predict the behavior of a market or its parts by individual macroeconomic (fundamental) indicators (factors). Not only is the market influenced by the underlying processes displayed by those indicators, the publishing of updates of the values of these indicators at regular intervals has its influence too. The initial influence on the Forex market occurs as a result of some economic processes; then secondarily the market is affected by indicator information published in the mass media. The initial influence forms the basis of the market, the world economic background, whilst the secondary influence, i.e. the release of that background indicator reading, leads to long-term fluctuations of rates during trading sessions – and indicators start working as a single factor in the market.
Every indicator for major world economies is regularly scheduled to be updated at a specific date and time. There are special economic calendars (Forex4you provides a comprehensive one here) with dates when individual indicators are is published and information about the most important events in various countries. There’s no doubt that traders’ interpretations of these indicators may vary, and depending on the interpretation a currency quotation may maintain its current path, break it or amplify it. The result, in general, is dependent on several different factors at once: general market conditions, the impartial assessment of economic conditions in countries affected, the expectations and future predictions of trend in traders’ minds and the values of the indicators themselves.
Factors influencing the currency market can be divided into several reference groups:
Monetary economic indicators are the most important ones. They reflect governmental policy concerning the current economic situation. This group consists of:
- official discount rate of the national central bank
- money supply indexes M1, M2, M3
- plans for redemption and placement of government securities
- governmental plans for volume of redemption and placement of credits (public debt dynamics)
Indicators of investment and trading capital moves enable you to assess the supply and demand of importers and exporters. These indicators include:
- balance on current accounts
- balance of capital accounts
- balance of payments
- balance of trade
Indicators of the inner financial market state of a country display how profitable the investment in national currency may be and, as a result, the potential investors’ demand for it in assets with fixed income (deposits, bonds, etc.). This group contains:
- discount (interest) rate evolution of the interbank credit market
- adjustment date and its evolution
- evolution of stock market indexes
- medium and long-term national securities profit dynamics
- supply of of US Treasury bonds, its rate and volume evolution
Summarized fundamental indicators characterize the economic situation of a country; they also display the country’s dynamics and possible manifestations of its weak points. Those indicators are:
- Gross Domestic Product (GDP)
- country budget – deficit or surplus
- volumes and intensity of budgetary funds receipts
- volumes and intensity of national expenses
- general consumption (national)
- summarized private investments (national)
- volume of citizens’ personal savings
- general export volume
- general import volume
- unemployment rate
Production and trade indicators display the volume and possible development directions of corresponding sectors of the economy. One can trace inner demand for the national currency and the level of production development and its dynamics. They also display the willingness of common people and companies to spend the national currency. This group includes the following indicators:
- effectiveness of use of production capacities
- industrial production index
- volume of industrial orders
- industrial reserves
- durable goods demand
- volume of retail sales
- volume of credits received by consumers
- mortgage volume and general volume of credits for real-estate purchases
- commercial credits volume
Productivity and labor activity indicators. On the one hand they characterize the market’s labor power, its dynamics and the level of development, on the other hand they are indirect indicators of future customer demand and expectation. This group includes:
- productivity index
- all indicators concerning employment and unemployment rates
Inflation indicators are the indicators of inflationary pressure on the economy of a country described. They display the potential fall of a national currency and the credit policy trends of a country (particularly the refinancing rate). This group includes:
- GDP deflator
- Consumer Price Index (CPI)
- Producer Price Index (PPI)
- index of export prices
- import price index
- consumer price index in the energy sector
- price dynamics of barrel of oil
- labor force price index
- hourly remuneration of labor force
Indicators of business and consumer activity and expectations (their optimism) are questionnaire indicators mostly, demonstrating the confidence level of investors, consumers and other economic subjects in their future and current affairs. One can indirectly divine the future demand for durable goods and the medium and long-term placements of funds and credits from them. Indicators of this category are leading, that is, they reflect how other market indicators might change in 3-6 months time, more seldom for a month or a year, or more. These indicators are:
- business climate index
- consumer optimism index
- indicator of business optimism in the service sector
- purchasing managers’ business optimism indicator
- delayed economic indicators
- coincident economic indicators
- leading economic indicators
Building sector indicators are analyzed to help in predicting the next step in the business cycle as housing usually leads the economy. Some of building sector indicators are:
- existing home sales
- volume of building permits
- volume of housing starts
- general building expenses
- new home sales
As a result of analyses of fundamental indicators, one of two possible decisions are taken:
- decision to make a long-term investment in the correspondent currency
- decision to start “bulletin trading”
You should take into account the following aspects while analyzing every indicator:
- Unit of measurement, mutability, source data and dynamics of an indicator during the previous periods.
- What indicator is it in relation to the economic cycle? Is it delayed, coincident or leading?
- The time of appearance and periodicity of an indicator.
- Is it possible to learn preliminary and revised versions of an indicator if it is released once per cycle?
- Absolute minimum and maximum levels of an indicator in the history and deviation amplitudes in different periods of an economic cycle.
- Its degree of influence compared to other fundamental indicators.
- Its degree of influence on the results of other fundamental indicators.