There are two major ways to analyze financial markets: fundamental analysis and technical analysis.
Fundamental analysis is based on underlying economic conditions, while, technical analysis uses historical prices in an effort to predict future movements.
Ever since technical analysis first surfaced, there has been an ongoing debate as to which methodology is more successful. Short-term traders prefer to use technical analysis, focusing their strategies primarily on price action, while medium-term traders tend to use fundamental analysis to determine a currency's proper valuation, as well as its probable, future valuation.
Before implementing successful trading strategies, it is important to understand what drives the movements of currencies in the foreign exchange market. The best strategies tend to be the ones that combine both fundamental and technical analysis. Too often perfect technical formations have failed because of major fundamental events. The same occurs with fundamentals; there may be sharp gyrations in price action one day on the back of no economic news released, which suggests that the price action is random or based on nothing more than pattern formations. Therefore, it is very important for technical traders to be aware of the key economic data or events that are scheduled for release and, in turn, for fundamental traders to be aware of important technical levels on which the general market may be focusing.
Fundamental analysis focuses on the economic, social, and political forces that drive supply and demand. Those using fundamental analysis as a trading tool look at various macroeconomic indicators such as growth rates, interest rates, inflation, and unemployment. Fundamental analysts will combine all of this information to assess current and future performance. This requires a great deal of work and thorough analysis, as there is no single set of beliefs that guides fundamental analysis. Traders employing fundamental analysis need to continually keep abreast of news and announcements that can indicate potential changes to the economic, social, and political environment. All traders should have some awareness of the broad economic conditions before placing trades. This is especially important for day traders who are trying to make trading decisions based on news events because even though Federal Reserve monetary policy decisions are always important, if the rate move is already completely priced into the market, then the actual reaction in the EUR/USD, say, could be nominal.
Taking a step back, currency prices move primarily based on supply and demand. That is, on the most fundamental level, a currency rallies because there is demand for that currency. Regardless of whether the demand is for hedging, speculative, or conversion purposes, true movements are based on the need for the currency. Currency values decrease when there is excess supply. Supply and demand should be the real determinants for predicting future movements. However, how to predict supply and demand is not as simple as many of you would think. There are many factors that contribute to the net supply and demand for a currency, such as capital flows, trade flows, speculative needs, and hedging needs. And so we clear, supply and demand and support and resistance are not the same thing.
For day and swing traders, a tip for keeping on top of the broader economic picture is to figure out how economic data for a particular country stacks up.
Prior to the mid-1980s, the FX market was primarily dominated by fundamental traders. However, with the rising popularity of technical analysis and the advent of new technologies, the influence of technical trading on the FX market has increased significantly. The availability of high leverage has led to an increased number of momentum or model funds, which have become important participants in the FX market with the ability to influence currency prices.
Technical analysis focuses on the study of price movements. Technical analysis use historical currency data to forecast the direction of future prices. The premise of technical analysis is that all current market information is already reflected in the price of each currency; therefore, studying price action is all that is required to make informed trading decisions. In addition, technical analysis works under the assumption that history tends to repeat itself.
Technical analysis is a very popular tool for short-term to medium-term traders. It works especially well in the currency markets because short-term currency price fluctuations are primarily driven by human emotions or market perceptions, The primary tool in technical analysis is charts. Charts are used to identify trends and patterns in order to find profit opportunities. The most basic concept of technical analysis is that markets have a tendency to trend. Being able to identify trends in their earliest stage of development is the key to technical analysis. Technical analysis integrates price action and momentum to construct a pictorial representation of past currency price action to predict future performance. Technical analysis tools such as Fibonacci retracement levels, moving averages, oscillators, candlestick charts, and Bollinger bands provide further information on the value of emotional extremes of buyers and sellers to direct traders to levels where greed and fear are the strongest. There are basically two types of markets, trending and range-bound; in my latest book 'I Will Teach You How To trade In 20-Hours', I attempt to identify rules that would help traders determine what type of market they are currently trading in and what sort of trading opportunities they should be looking for.
Is Technical Analysis or Fundamental Analysis Better?
Technical versus fundamental analysis is a longtime battle, and after many years there is still no winner or loser. Most traders abide by technical analysis because it does not require as many hours of study. Technical analysts can follow many currencies at one time. Fundamental analysis, in contrast, tend to specialize due to the overwhelming amount of data in the market. Technical analysis works well because the currency market tends to develop strong trends. Once technical analysis is mastered, it can be applied with equal ease to any time frame or currency traded.
However, it is important to take into consideration both strategies, as fundamentals can trigger technical movements such as breakouts or trend reversals, while technical analysis can explain moves that fundamentals cannot, especially in quiet markets, such as resistance in trends.
What Moves the Currency Market in the Short Term?
For any type of trader, fundamental or technical, the importance of economic data cannot be underestimated. Having worked in the FX markets for many years, I have learned that even though there are many traders who claim to be pure technicians and do not factor fundamentals into their trailing strategies, these same traders have also frequently stayed out of the markets ahead of key economic releases. In fact, many system traders turn their systems off ahead of big releases such as the U.S. nonfarm payrolls reports. On the other side of the spectrum, there are also technicians who do factor fundamentals into their trading strategies and wait only for key economic releases to put on breakout trades. As a result, it is important for any type of active market trader to know what the most important economic releases are for the U.S. dollar.
And this is exactly what I trade and teach - technical structure with fundamental conviction. Price and volume pays, opinions don't.