In analyzing price action, forex traders make use of two main kinds of analysis. Those who concentrate on price action, and ignore most other factors choose to direct their efforts at perfecting their skills at technical analysis, while traders who prefer to study the economic events that cause the market action mostly focus their efforts in studying fundamental analysis. In this article we’ll take a brief look at both of these concepts, before moving onto examine them in greater detail in further lessons of our school.
Many traders combine the information provided by these two types of analysis to generate trading signals. Others concentrate on one aspect of analysis and exclude the other from their calculations, and it is fair to say that either approach can be valid depending on the circumstances. There are traders such as Martin Schwartz who acquired reputation and wealth by trading on the basis of technical analysis, along with those like Jim Rogers whose success was based on fundamental analysis almost exclusively. But while they would disagree on many subjects, both of these people would probably agree that emotional control and discipline are the most important aspects of a successful trading career, even before analytical prowess.
How Different are Fundamental and Technical Analysis?
We should note here, before going on with our discussion of the various aspects of the two analytical schools, that while the explanations of the fundamental and technical analyst on a phenomenon may differ from each other, the end result, and the trade recommendation can in many cases be the same.
To give an example of this, we may examine the classical case of a parabolic price graphic which would make both kinds of analysts cautious, but for different reasons. The technical analyst would look at his charts, notice the extreme values registered on the indicators, and would caution against joining a trend that is in danger of suffering a sharp reversal as the inevitable countertrend movement occurs. The fundamental analyst would look at the euphoria in news sources and analyst community, consider the declarations of government authorities and important personages, and would probably give the same warning. While the tools and indicators used by these two individuals are different, their actions often coincide with each other.
Fundamental and technical analysis are not exactly the same thing, and at least in the longer term, the predictive power of fundamental studies is almost certainly greater. Nonetheless, these two are akin to two different languages describing the same phenomenon, and at least on hindsight, they always show the same direction, and reach the same conclusions.
Let’s take a brief look at these two schools.
What is Fundamental Analysis
Fundamental analysis is the discipline that tries to make sense of price movements in light of economic data and news flow. In comparison to technical studies, fundamental analysis has a larger selection of indicators. While many traders choose to focus on the news releases and indicators that appear to determine the day-to-day movements in the financial markets, fundamental analysis in fact studies many other aspects of economics including politics, financial law, social attitudes, in addition to the many other aspects of human life.
Fundamental analysis aims to establish a cause and effect relationship between market movements and economic developments. In that sense, it is different from technical analysis which regards the price action as the beginning and end of trading. While technical analysts generally argue that the price action reflects all information available to the market, fundamental analysts seek to identify imbalances and “errors” in the market that may offer profit opportunities. Unlike the technical trader, the fundamental trader is always skeptical of the price action, and seeks alternative explanations to the “wisdom of the market” in evaluating price trends.
While this type of analysis has been proven to be efficient and reliable through the ages, there are a number of issues that we must keep in mind in order to avoid being too optimistic about the predictive powers of our approach. While fundamental analysis can and often does indeed warn us on possible errors in market attitudes to economic realities, there’s no indication that the correction will happen anytime soon. Similarly, bubbles and market extremes often cause analysts to rationalize the unhealthy positioning of the market, invalidating the healthy advantage of skepticism inherent in the fundamental approach.
Advantages of Fundamental Analysis
The greatest benefit derived from study of fundamental analysis is the ability to understand the causes that drive the market action. By understanding market dynamics, we can be confident in maintaining a position as long as the cause that triggered the trade exists. A thorough grasp of fundamental analysis also ensures that we do not lose our composure in the face of market volatility. Those who employ fundamental studies in gauging the price action are confident that they are on the tracks of the greatest geniuses of forex trading. All those who successfully made millions or billions in this business were users of fundamental analysis; and there is no reason to doubt that if we were to use the same methods we can achieve the similar, if not the same results with them.
What is Technical Analysis?
Unlike fundamental analysis, technical analysis is a relatively new discipline that is still being perfected by its practitioners. Still, years of continued use has made it an inseparable part of the traders arsenal: technical studies are probably the only tools used for determining entry or exit points, and in short term trading, technical analysis is probably the only analytical tool that has any predictive power.
Technical analysis is based on three important assumptions about market events. First, technical analysis posits that the prices discount all information available to the public. Secondly, it assumes that price movements are not random, and that technical tools can be used to establish the underlying currents behind the price action. Third, it claims that price trends tend to repeat themselves. In other words, past developments provide some guidance on the direction and magnitude of future price action. In consequence of these three assumptions, technical analysis regards the price action as the conscious activity of a mass of financial actors who act collectively as if they were one large sentient being with emotions and feelings. In other words, just like the case with a beehive, or an ant layer, the seemingly independent actions of individual traders are targeted toward achieving the most sensible and logical course for prices in general.
Naturally, if collective will of traders is rational and makes meaningful decisions, then the future choices of that body would depend on its past actions. And if such a logical coherence, and a train of reasoning between past and present exists, it would be possible to examine and understand the rules behind that train of reasoning, and consequently to follow it and to profit as a result.
And there lies the basis of technical analysis. Just as we deduce that a person who takes out keys from his pockets is intent on opening the door, we expect that a certain spike or collapse in prices, a period of trending activity, or consolidation must lead to their logical conclusion in the markets in breakouts, or successive highs or lows, the nature of which is determined by technical analysis.
Advantages of Technical Analysis
Technical analysis is simple and straightforward, with tools available to every one from the seasoned hedge fund manager, to the novice retail trader. In addition, technical tools are easier to interpret than fundamental indicators, the understanding of which usually requires a period of diligent study. Finally, since technical analysis focuses on the price action exclusively, the technical trader has only one needle in his compass: the price, on which any calculation about profits or losses must be based.
Technical studies have been refined and perfected over the years, and by using them we are making use of the heritage of thousands of experienced and knowledgeable traders who have contributed to the effort. By mastering the various aspects of technical trading, we can also minimize the role of guesswork and conjectures in analyzing the price action. While technical studies can give conflicting signals about the future, the error, if any, is on the part of the interpreter. By recognizing our flaws, we can better our analytical skills, and with better skills, wealth and success will be just a single blink away.
Both types of analysis are useful for examining market action. Your trading style, and attitude to trading will determine which kind of analysis you will find most beneficial. But before making that decision, it is a good idea to study the subject of analysis in slightly greater detail. In the next few sections, our subject will remain the various aspects of forex analysis.
Next, part 6 >> Forex Technical Analysis >>
Previous, part 4 << Currency Pairs and Their Characteristics <<
Forex Lessons in this Forex Trading Course:
Lesson 1: How to read a currency quote
Lesson 4: Currency Pairs and Their Characteristics
Lesson 5: Fundamental Analysis vs Technical Analysis
Lesson 6: Forex Technical Analysis
Lesson 7: Forex Fundamental Analysis
Lesson 9: Choosing the Right Forex Broker
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