Forex Analysis Guide

Chapter 1: What is Forex?

“Forex” or foreign exchange is by definition a currency trading market. It is regarded as the world’s largest market with a daily turnover of roughly 3 trillion U.S dollars. Instead of goods being traded in the forex market, currencies of the world are being traded instead. Another difference between the forex market and traditional markets of physical goods is the simultaneous nature of dual transactions. This means when you are buying a currency, you are effectively selling another currency at the same time. For example, when you are buying Euros, you might be exchanging U.S dollars for Euros. 

The players in the forex market include Central Banks, commercial banks, corporations, hedge funds and retail traders. Over the last decade facilitated by the development of fast and efficient online trading platforms, forex trading has gained a huge following among the small time retail traders. Apart from the advancement in internet technology facilitating the growth of the online forex trading industry, another key factor is the ability to “leverage” one’s investment capital. 

Leveraging

Operating on the same principle as “margin trading” in the equity markets, leveraging in forex lets a forex trader increase his investments many fold with just a limited amount of capital. For example, with a leverage ratio of 1:100, each dollar invested can be used to purchase 100 dollars worth of forex contracts. So if a trader decides to invest $1000, his invested contract value can be equivalent to $100,000. 

Profiting From Forex Trading

To profit from forex trading, one obviously needs to buy a currency at a low rate and sell the currency back to the market at a higher rate. This means a trader has to be quick to spot the price differentials in the exchange rate from the fluctuations happening in the forex market. To help the trader in spotting the profitable opportunities arising from the price fluctuations in the market, he can rely on the art and science of fundamental analysis and technical analysis.

Chapter 2: Fundamental Analysis

As we have said earlier, for a trader to profit from the price fluctuations in the forex market, he needs to be able to predict the movements in the market. One of the ways that he can analyze the market to help him make his prediction is through the art and science of “fundamental analysis”. 

Fundamental analysis is known as a science because it is based on the social science of economics. It is also known as an art among the practitioners of fundamental analysis because of the skill required to apply the theories of economic to real world scenarios effectively. 

A cornerstone of investing in forex, fundamental analysis involves studying the economic health of different countries and analyzes how that can affect the exchange rates of different currencies. It is primarily concerned with information such as figures and statements made in speeches by politicians and economists which can impact currency movements. 

Some of these important figures include: 

• Interest Rates

Higher interest rate – this will attract more investments into country and as such means more demand for the country’s currency. This in turn will push the exchange rate upwards.

• Unemployment Rates

Higher unemployment means a weaker economy. To help stimulate economic growth, central banks normally will lower the interest rate to attract investments.

• GDP Figures

Likewise, a lower GDP growth rate will indicate a weaker economy and hence the expectation of lower interest rates.

• Trade Balances Figures

A high trade deficit is normally indicative of a weaker currency as a country needs to sell off its currency to pay for its imports.

• Public Expenditure Budget

Depending on the context, a higher public expenditure could mean a lower currency due to the need for the government to raise funds to finance the increased expenditure. 

Other important information that a fundamentalist practitioner needs to take account into include statements made by key leading figures in the political and economic establishments such as the treasury, central bank and the head of state like the president or prime minister. 

Economic Calendar

To help analysts and traders get a head start in their market analysis, they usually resort to the use of an economic calendar. The economic calendar is created by economists and major financial institutions to help those who use the calendar to track upcoming economic events. They contain information such as past figures, analysts’ forecasts, the time and date of when new figures will be announced the relevant agencies tasked with collecting the market data. 

Trading the Forex Market with Fundamental Analysis

In order for a trader to use fundamental analysis effectively in his analysis of the forex market, he must base his analysis on the medium or long-term time frames. This is because fundamental factors in the economy and market require a certain period of time for the factors to play out. 

Hence by focusing on the fundamental macroeconomic factors such as those mentioned above, he can predict with a degree of certainty how a currency pair will react in the medium and long term. 

For example, if the U.S economy has been facing an increase in its unemployment rate, this means on the whole that the economy is weak and ultimately a weak dollar. To profit from such a scenario, a trader will purchase Euros in the hope that the euro will increase in value relative to the U.S dollar. 

On the other hand, if the signs are indicating that the U.S economy is experiencing growth, this will prompt investors to invest more in U.S financial instruments such as equities and treasury bonds. Consequently, this will result in a stronger dollar. To profit from this kind of scenario, a trader will need to sell the euro against the dollar in the expectation that the U.S dollar will rise relative to the euro. 

While fundamental analysis is useful in helping traders predict the movement of currency for the medium and long-term, it is insufficient on its own, as it does not provide specific entry and exit points for a trader to act upon. Because of this, it is difficult for a trader to manage his trading risk especially when he is relying heavily on leverage. In order to help him determine the best entry and exit point for his trade he need to rely on something more technical such as technical analysis.

Chapter 3: Technical Analysis

While technical analysis can initially be mentally challenging for the uninitiated, it is actually the most frequently used method by forex traders to help them identify suitable entry and exit points for their trades. Essentially, it is a methodology which comprises of an array of technical observations that can be utilized for predicting price movements as well as generating buy and sell signals. 

One confusing aspect of technical analysis is the fact that the technical analyst is faced with so many ways of analyzing the market. This leads to the danger of misinterpreting the information on hand and thus resulting in the wrong conclusion. 

On the other hand, since almost everyone is relying on technical analysis to identify their buy and sell signals, it results in a self-fulfilling prophecy. Since everyone is observing the same technical indicator, this will invariably result in the market moving in the direction as predicted by the indicator. 

Trading the Forex Market with Technical Analysis

A key tool used by traders in technical analysis is price charts especially candlesticks charts. Candlesticks charts are used for the identification of price trends once they developed in the market. For forex traders, this is crucial since movements in the forex market comprises mainly of trends. Once the trader is able to identify the trend, this will allow him to capitalize on its movement until the trend changes direction.

Resistance & Support

To help traders indentify changes in the trend, one of the key concepts used by technical analysts is the concept of resistance and support. The resistance level is the level where prices have peaked and are having difficulties rising further. 

On the opposite end is the support level. The support level is the level prices are at their lowest and is unlikely to fall any further. While the determination of these levels is subjective, they do help traders in determining the ideal entry and exit point as the areas around these levels are normally where price reversals will occur.

Exponential Moving Averages (EMAs)

Another frequently relied upon tool by technical analysts is Exponential Moving Averages or EMAs. EMAs are a trend-following or lagging indicator which filters out market noises resulting from random price fluctuations as well as to smoothing out the price actions so the trends are more discernible. The difference between a simple moving average and EMAs is the fact that the latter gives more weight to the more recent prices. 

To help traders spot changes in the trend with EMAs, they look for crossover between the short period EMA and the longer period EMA. Once the crossover has occurred, this is indicative of a change in the trend.

Oscillators

Apart from the tools mentioned above, technical analysts also use a variety of oscillators to determine the conditions in the market. One of these frequently used oscillators is the Relative Strength Index (RSI). 

The RSI

An innovation of J. Welles Wilder, the RSI is defined as a momentum indicator that contrast the quantum of recent losses to recent gains over a period of time to determine if the market is overbought (overvalued) or oversold (undervalued). It provide traders with a better perspective since it gives more weight to the more recent data and is less sensitive to sharp fluctuations. Traders determine the conditions of the market by looking at the reading of the RSI which is on a scale of 0 to 100. If RSI reading is below 30, this meant that the market is oversold. On the other hand if the RSI reading is above 70, this meant that the market is overbought. 

Another Way of Using the RSI

In addition to determining if the market is overbought or oversold, the RSI can also be used to indicate divergence in the market. This is a situation where prices are reaching new highs but is not indicated as such by the RSI readings. In such a scenario, this means a price reversal is likely to occur very soon. 

Fibonacci Retracements Ratios

More of a series of ratios rather than a technical indicator, the fibonacci ratios are a series of numbers that describe a state of natural progression in terms of proportions. They are used by traders as an indication of possible levels of resistance and support. These levels are normally plotted on a chart with the following ratios: 

• 23.6%
• 38.2%
• 50%
• 61.8% 
• 100%

The idea of Fibonacci retracements is to predict to which level the prices will retrace to. This information will in turn help the trader decide if he should go long or short. 

Chapter 4: Fundamental Analysis vs. Technical Analysis

As we have learnt, fundamental analysis is more suited for the analysis of the market in the medium and long term. Technical analysis, on the other hand, is more suited to situations where traders want to trade on the short term price movements. It ignores the fundamental factors and concentrates solely on the price data on hand. Hence, to say outright that fundamental analysis or technical analysis is better than the other is like saying an orange taste better than an apple. This is because traders normally use fundamental analysis when it comes to investing in the market. 

When it comes to speculating in the market, they tend to rely more on technical analysis. In short, the importance of each type of analysis weighs heavily on the trader’s motive for trading whether it is for investments or reaping a quick profit through speculations. 

For Investments Purposes

When it comes to investments, a trader will normally look to the qualitative and quantitative factors surrounding the investment. This is why the analysis is geared toward the fundamentals of the market sector and the interrelated sectors. It is always about looking at the bigger picture such as whether the economy is in a recession, a boom or in transition. 

For Speculation Purposes

The short-term trader is normally more concerned about the profits that can be earned from the short-term price movements in the market. Hence, his focus is normally on the price trends in the market and the volume traded. 

So Which Is Better?

Traditionally, fundamental analysis has been the only accepted method of analyzing the markets. However, with the advancement of computer technologies and online trading platforms, analysis of the markets has become more technical and uses software algorithms to help traders make their trading decisions. In fact, computerized trading forms the bulk of the transactions that are occurring in the forex market. In short, the market has changed and to be able to stay in the game one must be able to adapt to the changing circumstances. In other words, the best way to beat the market is to use a combination of both fundamental analysis and technical analysis. Use fundamental analysis to choose the currency pair to trade in and use technical analysis to determine the best time to buy or sell. 

Chapter 5: Summary

The chapters that we have covered above only represent a brief overview of the analysis methodologies used by forex traders. It is recommended that before you start to trade in the forex market, you should seek more in depth knowledge about the skills that are needed for a good assessment of the market that you are going to trade in. Once you have a good understanding of the market, you need to develop a trading strategy based on what you know and stick to it regardless. A trader is only as good as his attitude. 

Trading Attitude

While a person might be able to come up with the best possible trading strategy, the strategy is only as good as the mental state of the person acting on it. If the person is too fearful, greedy or inflexible, there is very little hope that the trading strategy will get to be implemented as the way it was designed for. One must always remember that the market is always fluid and circumstances changes every minute of the trading day. While some circumstances can be predicted, there are some which cannot be foreseen. How a trader will react under those circumstances will ultimately determine if he will be a successful trader or not. 

Suggested Trading Tips

The focus of fundamental analysis is on the macro economic factors that can the exchange rate of a currency and technical analysis uses historical price data to help traders predict future possible price movements. With a combination of both approaches, you should be able to arrive at a single conclusion regarding the price movements in the market. 

We mentioned earlier that technical analysis is flexible enough for a trader to use to find out different trading conditions in the market. To avoid any misinterpretation, understand the different uses of each tool and always use an alternative method of confirming your analysis before you make your trading decision. This way you can avoid acting on false signals generated by the ‘noise’ in the market. Finally, remember trading forex is a high-risk endeavour. As such, always trade with money that you can afford to lose to avoid being pressured mentally by extraneous factors.