Part 5 - Fundamental Analysis vs Technical Analysis

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.

Conclusion

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.

Part 6 - Technical Analysis

In the previous chapter we took a look at the two kinds of analysis briefly, and discussed the various advantages and problems associated with making use of them. In this chapter we’ll examine technical analysis in greater detail.

If you’re dismayed by your inability to correctly interpret price movements in light of technical data, you may find the information in this article invaluable. If you’re a beginner, remember that each indicator has a particular configuration in which it generates the most reliable signals. Just like we cannot use a spade in a task better suited to a screwdriver, it is wrong to use the RSI for analyzing a trend which is better analyzed by a combination of moving averages.

Two important rules of technical analysis are to keep it simple, and to be strict and disciplined with money management and risk controls. Technical tools are not infallible, and their greatest use is in identifying and acting on the scenarios which offer the best risk/reward potential for the trader. In the absence of certainty, even the most capable technical trader will be in danger of seeing his account wiped out, if he doesn’t take the necessary steps for ensuring that he is properly controlling his risk allocation. Once those steps are taken, we are cleared to go on our journey to riches and prosperity.

Let’s take a look at the various tools used by the technical analyst in evaluating and understanding the price action.

Oscillators

Price action has no limits. The price of a currency pair can theoretically move anywhere between zero and infinite on the charts, and while in practice there is always an upper limit, it is extremely difficult to estimate where it should be. For example, based on today’s prices in EURUSD at around 1.35, we would regard 1.50 a very high price. But while this is true, how about 1.45, or 1.55? Since all those prices are “high” on an arbitrary definition, we would have great difficulty in placing a stop loss or take profit order anywhere on the charts. It is clear that we need to confine the price action into a more practical range within which we can interpret the developments more conveniently.

This lack of precision in defining a high or low price for a currency pair within a specific time frame is overcome by the usage of oscillators. There are a large number of oscillators developed through the past decades each of which depends on a different formula, but all of them aim at rearranging the price data mathematically in a way that will facilitate the designation of oversold or overbought levels. An oversold value indicates that the price is too low in comparison to where it has been in the past. Conversely, an overbought reading indicates that traders have driven the quote too high in their excitement. Both cases suggest that a contrarian trade may be profitable.

Oscillators fluctuate between a predefined upper and lower value, beyond which an oversold and overbought level is defined. As the price moves to the overbought level, the trader will contemplate a sell order. When the indicator signals an oversold price, the trader will consider placing a buy order. Oscillators are defined according to the price pattern where they function best. Some are used best in a trending market, while others are suited better to ranging or periodic markets. Examples of those that function best in a ranging environment are the RSI and Stochastics indicators. In contrast, the Williams oscillator and the MACD are thought to emit their most useful signals in a trending market.

Many experienced traders are skeptical of the validity of overbought and oversold readings on an oscillator even under the best of circumstances. It is important to remember that oscillators reduce the arbitrariness in defining what a high or low price is, but do not eliminate it altogether. For example, while an RSI reading at 80 is regarded as an overbought value, the price in many cases ignores this contention and keeps charging on, reaching 85-90, even 95 without looking back.

In order to avoid this problem, many make use of the concept of divergence/convergence between price and the indicator. As the divergence/convergence phenomenon is rarer in practice, greater significance is attached to its occurrence. A bearish divergence is the situation where the oscillator registers lower highs, while the price is making higher highs. In this case it is thought that the uptrend is running out of power. A bullish convergence occurs when successive lower lows of the price are coupled to successive higher lows of the oscillator. This is thought to signal that the downtrend is losing momentum. In both cases, a contrarian trade is advisable.

The RSI, Stochastics, Average True Range, Williams Oscillator, MACD, Force Index are a few of the indicators that are in common use among currency traders.

Moving Averages and Trend Indicators

Oscillators find the greatest use in ranging markets. But while ranges offer many profitable trades to those who like to concentrate on them, it is a fact that many of the greatest traders in history were trend followers. Trends can be overwhelmingly profitable for those who can capture them in time and possess the tools necessary for understanding and exploiting them. The fundamental analyst has his economic theory, his statistical tools, and analytical skills to depend on while studying trends, while the technical analyst makes use of certain indicators tailor-made for trend analysis.

Perhaps the most useful of all trend following indicators is the moving average. This indicator adds up the closing prices of a predefined period (like five minutes, two hundred hours, or ten days), and divides them by the moving average period, reaching at the indicator’s present value. The main reason of using the moving average is determining a mean value around which the price action fluctuates. The difference between an ordinary numerical average and a moving average is that the value of the moving average is constantly updated: as the price registers new highs or lows, the moving average also follows it, but at a slower pace.

There are two kinds of moving averages. The simple moving average (SMA) is the one that we have described in the previous paragraph where the prices of each period receive the same weighting in the calculation of the moving average. In other words, the price of five minutes ago is of the same value as the price of five days ago in determining the value of the moving average. The other kind, the exponential moving average, is a little different in that it gives the prices of the latest period a higher weighting, that is, the indicator is much more sensitive to price changes in the latest period than it is to the values registered weeks or months ago. The exponential moving average is not that useful when used in conjunction with the price action itself. Many traders choose to use the exponential moving average together with a simple moving average of about the same period, and interpret the crossover or divergence/convergence between those two trend indicators as entry or exit points.

Apart from the moving average, an important indicator favored by many technical analysts is the Bollinger Band. This indicator can be used, in combination with others, for predicting the breakdown of a range pattern, but it is also useful for determining entry or exit points in trading trends. During the course of a trend there are many periods where the trend calms down, and price settles into a consolidation pattern. The Bollinger bands are used to predict the end of these patterns, and to open positions as the consolidation phase concludes.

There are many other kinds of indicators which can be used in combination with others to generate trade signals for trend patterns. Once could even write his own indicator with a little bit of practice and understanding of market dynamics. The predictive power of the indicators, while valuable, are most fruitful when they are coupled to prudent money management methods which we’ll discuss a while later.

Price Patterns

Both in trending and ranging markets, it is possible to break down the price action into various smaller scale patterns where the market consolidates and prepares the next phase of the movement. Similar to the concept of tension and resolution in both music and literature, prices move as tension is created during the consolidation phase, and resolution of the tension draws the market forward as the consolidation pattern breaks down.

There are many kinds of price patterns. During the development of a trend, triangles of all kinds are ubiquitous. In a range pattern, consolidations occur at the support and resistance levels of the price action, but the breakout fails to breach those levels. It is also possible to recognize many short-term range patterns developing during the course of a major trend: the successive legs of the trend follows the breakdown of those range patterns in succession.

Technical analysts divide price patterns into reversal patterns and continuation or consolidation patterns, but as we discussed shortly before, as branches of a main trend break down, reversal patterns can be found in the course of a trend too. A continuation or consolidation pattern (such as triangles) signals that the trend is ongoing, but is going through a phase of rearrangement, as market participants reevaluate their strategies, and readjust their positions. A reversal pattern signifies that the underlying price action is losing its power: the present dynamics behind the market action may soon be invalidated by market developments.

The use of price patterns in technical analysis is widespread, but it must be born in mind that in many cases the formations discussed by the technical analyst is obvious and actionable in hindsight only.

Conclusion

There are a vast number of tools available to the technical trader. While this richness can be useful for identifying and evaluating different scenarios, it can also be confusing for the novice and experienced trader alike. The power of technical analysis lies in the precise nature of its predictions, but there’s nothing precise about setting up the correct configuration of indicators which will generate the most useful predictions.

In spite of these facts, technical analysis is the most widespread method for the study of the market action. It is used by millions of traders all over the world, and consequently, its predictions possess a kind of power that is often thought to be unique to religions: as its dictates are confirmed by the collective behavior of vast numbers of technical traders, only the reckless will deny the value of technical studies.

Next, part 7 >> Fundamental Analysis >>

Previous, part 4 << Currency Pairs and Their Characteristics <<