There are two main schools of thought when it comes to market analysis in forex trading: technical analysis and fundamental analysis. Although these are not mutually exclusive, the majority of the traders will fall into any of these two categories.
Both technical and fundamental analysis comes with their own benefits and drawbacks. Let’s have a look at both these analytical approaches.
Technical Analysis in Forex
Technical analysis for forex trading is the methodological study of the previous market data like trends, prices, and volume. It comes in handy to understand the market and to make important trading decisions by predicting price movements. You will hear that technical analysis is an art rather than a science. It is because there can be a lot of nuances when you are trying to predict future price movements based on technical analysis. Thus, such nuances can lead to completely different conclusions if not taken care of correctly.
Technical analysis provides a basic framework to the analyst where he can efficiently make informed decisions by studying the current price actions by considering the previous historical occurrences.
Primary Tenets of Technical Analysis
Here are the three basic components of technical analysis:
Price moves in observable trends
Price results in a discount on everything else
Pricing history tends to repeat itself
Price Moves in Observable Trends
Technical analysts believe that trends in the market move in a non-random and predictable way that trained and professional eyes can observe easily. A trend is more likely to emerge from different trading activities. And with time, the trend moves back to the original phase as it matures. All this happens before the emergence of a new trend phase.
Price Results in a Discount on Everything Else
Technical analysts believe that the price trends reflect all essential information to the market participants. Besides, any new piece of information will be quickly reflected in the price trend.
Pricing History Tends To Repeat Itself
A forex trader should know that the markets display a recursive and repetitive nature within the price data. Though you won’t find any two patterns in the price history looking exactly the same, there can be a high resemblance that you cannot explain by randomness or noise. You can see these repeating patterns in charts, candlestick patterns, volume, and other price-related data.
Advantages of Technical Analysis
Let’s quickly overview some of the benefits of technical analysis for forex traders:
- Technical analysis tools are applicable to the decision-making process to any timeframe.
- Technical analysts can make use of different studies like moving averages, channels, trendlines, support and resistance, swing highs and lows, and others to analyse current market trends.
- The primary job of the trader is to look for the most favorable trading opportunities that are available in the market to execute the trade. Technical analysis helps in entering, managing, and leaving the market efficiently and methodically.
- A lot of concepts and ideas within technical analysis can be developed into different algorithmic trading by coding them. Such automated systems are useful to mitigate the negative emotions that are associate with trading.
- By performing in-depth chart analysis and studying price action in detail, you can better understand the sentiments to equip yourself with the much-needed information both during selloffs and runups. Besides this, it will also help you in getting insights into the future performance of the options to position yourself on the right side.
- Technical analysis is simpler as compared to fundamental analysis. Technical models are easier to build and implement as the primary building block or variable is price action.
Drawbacks of Technical Analysis
Some disadvantages of the technical analysis are:
- Your technical analysis tool can sometimes provide conflicting or mixed signals.
- You might end up overanalysing to the point that you will be paralysed to make an action. It is important to know that trading is all about dealing with probabilities rather than certainties. Reduce the clutter, go back to basics, and use only one tool to avoid analysis paralysis.
- Certain biases can influence the way you perceive or gather information from the charts.
- As technical analysis is more of an art, traders can look at a price chart completely, resulting in two opposite interpretations.
Fundamental Analysis in Forex
Fundamental analysis seeks to determine the value of a position or security by the assessment of the available economic data. The fundamental analysts will attempt to estimate the overall conditions of the economy with the help of data like employment, GDP, interest rates, inflation, federal interventions, and more.
Fundamental analysts closely monitor the central bank activity while taking into account the interest rate decisions, speeches, and meetings by higher-ranking officials. The foremost priority of the fundamental analysts is to gauge the overall market conditions via different economic reports to find the loophole that can bring tremendous trading opportunities. Fundamental traders usually try to capture slight price moves during a highly volatile time. They are often termed as short-term traders who focused more on whys rather than whats.
One significant dive of a country’s currency value is the interest rate. When the interest rate of a particular country is higher as compared to others operating in similar economic conditions, there are high chances that foreign investment will flow into the country. Investors are always inclined towards higher yields.
Advantages of Fundamental Analysis
Let’s now take a look at some common benefits of using fundamental analysis:
- Though major reports and economic news can quickly drive market prices, fundamental analysis can help you explain price movements better.
- Taking a fundamental approach will help you better understand the global market as it offers a broad insight into the market conditions.
- The trader’s job is to find the valuation associated with the financial instrument. Fundamental analysis can help analysts to find the discrepancy between the actual value and the currently traded price.
- Fundamental analysis helps in crafting a long-term view of the currency pair. Most of the data is analysed on a relative basis; it will help in knowing the current trends of one indicator to predict the potential impact on currency pairs over the long run.
Drawbacks of Fundamental Analysis
Some disadvantages of the fundamental analysis are:
- It is quite easy to become a victim of information overload as fundamental analysis is a broad and deep subject. Digesting all that information can be overwhelming, which can lead to confusion.
- This is not suited for the short-term investment as reports and economic data are released throughout the month. Thus, fundamental analysts focus on the long-term horizon.
- Though the data available is clear-cut, the finding can be highly subjective. One analyst can believe that a higher interest rate means that the economy is growing, but the other analysts can hold a completely different view.
- This analysis option provides insight into the broader picture of the market; you won’t get objective and reliable information about when to enter and when to exit the market. In forex trading, timing is everything.
Both fundamental and technical analysis have their own pros and cons. Which one you should use to analyse the market trends will depend on your specific trading goals.
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