TheForex7: Expert Forex Analysis

Forex Analysis

An Introduction and Comparison of Fundamental and Technical Analysis

By this point, you should have a thorough understanding of the different instruments and currencies that are available to you as a forex investor. You should also be familiar with the dynamic forces that cause currencies to rise and fall against one another over time. The logical next step, then, is to apply this knowledge toward the development of both a personalized approach to analyzing currencies and, ultimately, a trading strategy.

Analytical Schools of Thought

The distinction between so-called fundamental analysis and technical analysis—which I alluded to in the introduction to this book—represents the most important dividing line in forex strategy. Fundamental analysts concern themselves with content while technical analysts focus primarily on charts. Fundamental factors range from the economic to the financial to the political, most of which were outlined in Chapter 3. Technical refer to the patterns inherent in price movements, some of which can be discerned visually and others that are revealed only with the aid of computers.

This distinction can also be seen in terms of the external and the internal. Fundamental analysts are partial to the former; they posit that fluctuations in exchange rates are the result of phenomena that exist outside of the currency markets. Their goal is to ascertain both the relationships that exist between exchange rates and the complex macroeconomic forces that drive them. Technical analysts, in contrast, operate entirely within the foreign exchange market and view present exchange rates purely in terms of past rates, and future rates in terms of present rates. They see the currency market as a self-contained system and presume that all fluctuations are primarily the result of patterned buying and selling. The broader factors that drive participants to buy and sell are viewed as irrelevant or even unknowable.

For example, a fundamental analyst might observe that the euro is rising against the US dollar and attribute this to changes in comparative inflation and interest rates. A technical analyst, meanwhile, is content to merely identify the uptrend in the EUR/USD. In constructing a strategy, the fundamental analyst must apply his hypothesis to the future and develop a forecast as to how changes in the fundamental variables that he has identified will drive proportional changes in the EUR/USD. The technical analyst uses both visual and quantitative analysis to determine if the trend is substantial, and whether it is likely to continue.

Another crucial difference between the two types of analysis is the corresponding time horizon that their practitioners typically adopt. Technical analysts focus their microscopes on extremely short time intervals, from days to hours to mere minutes. While technical analysts will concede the existence of long-term price patterns, the majority operates solely within the realm of the short term and effectively fit the profile of day traders. Fundamental analysts prefer to see changes in prices unfolding over weeks, months, and years. Macroeconomic and monetary variables tend to fluctuate in accordance with long-term business cycles of 5-10 years, and exchange rates are perceived to fluctuate accordingly.

In Chapters 5, 6, and 7, I will offer more concrete examples and strategies, but for now, I simply want to clarify this distinction.

Trading vs. Investing

Fundamental analysis and technical analysis are not mutually exclusive, but in fact are two sides of the same coin. A trend in prices can be seen in terms of past prices, or it can be seen in terms of external variables. The ultimate goal of both types of analysis is to identify such trends, forecast their direction, and profit from them.

In practice, forex traders tend to practice either technical or fundamental analysis exclusively. This isn’t to say that technical analysts won’t have any idea of what’s happening macro economically, or that fundamental analysts can’t recognize that a long term fundamental trend has been interrupted by a short-term counter-trend. Rather, the point is that speculators in the forex markets tend to fall very clearly on one side of the line that divides fundamental analysis from technical analysis.

As I intimated in the introduction, most forex participants would call themselves traders. They operate over very short time horizons. Positions remain open for a few minutes or a few hours and span multiple days only on rare occasions. They trade at very specific price points and have equally specific profit goals and limits to the amount of losses that they will accept. Positions are monitored constantly. Leverage of 10 times or greater is a de facto requirement. They stay out of the market when there is a major news release and are indifferent to the direction of a trend, as long as they are sure that it exists. Above all, they are technical analysts. They spend hours scrutinizing charts. The best traders memorize dozens of price formations with obscure Japanese names. Trends are confirmed using a handful of quantitative indicators, without any input from economic variables.

A small portion of forex participants fall under the heading of investors, with a time horizon measured in weeks or months or longer. Only under extreme circumstances would a position be opened and closed on the same day. Forex investors have higher profit hurdles, measured in hundreds of PIPs. As a result, they are also typically prepared to accept paper losses in the short term. Positions are checked a couple times a day at most for the purpose of fine-tuning strategy. Leverage is ultimately unnecessary, though it can be employed on a modest scale if it’s consistent with one’s particular strategy. Most importantly, investors are usually fundamental analysts. Forex investors won’t blindly trade a trend unless they think that they have an idea as to what’s causing it. Quantitative measurements of trend strength are less important than identifying the financial economic variables that underlie said trend.

You can see then that investors and traders are very different. The analytical prisms through which they view the forex markets drive very different approaches to trading.

Where Do You Fit In?

It seems silly to ask you to decide, once and for all, whether you are a trader or an investor, especially because there is some synergy between the two. At the same time, I think it’s important to determine which type of analysis you find more attractive and, consequently, which approach to forex is most appropriate for you.

For now, why not at least acknowledge your knee-jerk reaction? Did you enjoy the discussion of the macroeconomic variables in Chapter 3? Are you eager to untangle the fuzzy connections that exist between financial markets and fundamental variables? Are you a big-picture thinker that likes to theorize about how everything fits together? Simply, do you enjoy the study of economics, reading economic reports, etc.? If so, then you are probably a fundamental analyst.

On the other hand, perhaps you found the first half of Chapter 3 arcane and boring. Did your eyes gloss over during the discussion of interest rate parity and capital flows? Are you skeptical that the fundamental connections between economic fundamentals and exchange rates can be discerned with any accuracy, if they exist at all? Are you the kind of person that enjoys looking for patterns in information sets? Do you have a quantitative mind? If so, then you are probably a technical analyst.

One’s chosen approach to analysis must also be consistent with personality and trading strategy. For example, are you attracted to the fast pace of the forex markets, or are you more interested in watching trends slowly unfold? Are you impulsive? Patient? Which currencies are you interested in trading? What are your profit goals? Are you seeking a supplemental income or a padded retirement account? What is your tolerance for risk? How much time do you plan to devote to trading forex? Do you intend for it to be a hobby or a full-time pursuit? How much equity capital are you prepared to commit?

You can work backwards from your answers to these questions to determine which type of analysis is more suitable for you. If you have a few hours a week, $5,000, and you are looking to diversify an existing financial portfolio, you’re almost certainly an investor. If you intend to pour all of your savings into forex (which, incidentally, is not really advisable) and plan to spend every night after work parked at your computer; if you would get bored by a slow market and would call yourself impatient; if you are comfortable with competition and attracted to leverage, then you are a trader.

Superior Efficacy of Fundamental Analysis

I am often asked the question, “Which type of analysis is better: technical analysis or fundamental analysis?” As I explained in the introduction, I am personally inclined toward fundamental analysis, due primarily to what I believe is its superior efficacy. The fact of the matter is that there are demonstrable and observable connections between exchange rates and underlying economic data. Sometimes, these relationships are only obvious in hindsight. Other times, they are plagued by contradictions and manifest themselves in counterintuitive ways. They disappear frequently, and reappear just as frequently.

However, exchange rates do not behave arbitrarily, appearances aside. Significant movements are closely correlated with actual, perceived, or expected changes in underlying fundamentals. Those who are able to correctly discern these connections will be rewarded for their efforts, both financially and intellectually.

Unlike technical analysis, fundamental analysis doesn’t become less profitable when competition increases. If market dynamics are such that rising interest rates are causing a currency to rise proportionately, this relationship will not be undone if too many people are aware of it. On the contrary, it will become even stronger. If too many traders detect the emergence of a technical trend, on the other hand, it may be arbitraged away before it can fully emerge.

That’s not to say that technical analysis can’t be profitable. On the contrary, for a small minority of traders it can be tremendously profitable. From the standpoint of its practitioners, its appeal lies in its economy (no pun intended). While fundamental analysis posits airy connections between economic variables and exchange rates, technical analysts purport to operate in a more scientific realm. Trades are not based on whims, but on quantifiable and observable patterns in prices. Trends are confirmed based on concrete principles, and trades are executed only when quantitative indicators support them.

In addition, the forecasting power of technical analysis is often self-fulfilling. For example, if every trader expected the EUR/USD to plunge when it hit the psychotically important level of $1.50, then a flurry of anticipatory sell orders would all but ensure such a result. In addition, if a steep rally in a currency pair brought the rate well above what fundamentals justified, it would probably be reflected in various technical indicators. Technical analysts would respond by selling the pair, and a correction would become self-fulfilling.

Perhaps the strongest argument in favor of technical analysis is that it is flexible and broadly applicable to most asset and securities markets. By now, you must have realized that if you fancy yourself as a fundamental analyst, you will need to learn a unique framework for analyzing currencies. Throw out everything you learned about the stock market and the bond market, and start from scratch. On the other hand, if you were a technical analyst in your previous life as a commodities trader, making the transition to trading currencies should be fairly uneventful. That’s not to say that you won’t need to spend some time acquainting yourself with the peculiarities of forex. At the very least, though, you don’t need to learn an entirely new analytical approach.

As will become clear in Chapter 6, however, technical analysis can be quite arbitrary. It is impossible to devise cut-and-dried trading rules since market conditions are always changing, and since patterns that repeat themselves are likely to be arbitraged away. An exchange rate is unlikely to behave in exactly the same way over time, despite what technical indicators may imply. In fact, most technical analysts will admit that their goal is to merely be right 60% of the time. After taking transaction costs (spreads) into account, this implies that it can only be slightly more accurate than the flip of a coin.

In addition, technical analysis is intellectually unsatisfying. Why is the euro rising against the dollar? Because fear has reached an apex and greed is rising, of course! As an explanation, this is only slightly more profound than the notion that supply exceeds demand, or vice versa. While this might in fact be relevant within the scope of technical analysis, it lacks punch. Personally, I would feel much more comfortable betting on a rising euro if I understood that it was being driven by changes in specific economic variables, rather than by the abstract idea that it was previously “oversold.” It reminds me of Plato’s Allegory of the Cave: technical analysts are chained to the wall and see only the shadows—the prices—while fundamental analysts live in reality and try to see what’s actually causing those shadows. But I digress.

Most importantly, the recent track record of technical analysis does not inspire much confidence. According to publicly available data, only 25% of retail forex accountholders earn a profit in any given quarter. (This figure ranges from 20%-40%, by quarter and by broker. If the same survey were conducted on an annual basis, the overall figure would no doubt be even lower!) Given that the overwhelming majority of accountholders are day traders, this does little to boost the case for technical analysis.

This fact was reinforced by a 2011 Federal Reserve Bank research paper titled “Technical Analysis in the Foreign Exchange Market.”1 The paper compared the results of nearly 100 academic studies from the modern financial era and came to the following conclusion: “Technical Trading Rule profitability has been declining since the late 1980s. . . . Major currencies no longer trend reliably but markets in newly trading currencies appear to display some profit opportunities from technical rules. This finding suggests that traders in major currency markets have arbitraged away technical patterns but those patterns still exist in emerging markets.” As a result of the “financial arms race,” profits inure to those with the fastest computers and smartest algorithms: “The excess returns to relatively simple rules based on filters or moving averages had disappeared by the early 1990s, but returns to more complex or sophisticated rules have persisted.”

Technical analysts should be alarmed by these conclusions. Where competition is high (for major currencies), technical trading rules tend to be unprofitable. The same can apparently be said for trading rules that are too simplistic. The implications are straightforward enough: to earn consistent profits in technical analysis, you should stick to obscure corners of the market (where spreads are higher) and/or develop more complex trading rules.

Blending Technical and Fundamental Analysis

Ultimately, I think the smartest strategies should incorporate aspects from both schools of thought. Technical and fundamental analysis alike can claim concrete strengths and weaknesses. Whether they are effective at any given time depends on prevailing market conditions, one’s time horizon for investing, etc. Let’s face it: exchange rates are influenced by both technical and fundamental factors, and investors that focus exclusively on one type of analysis do so at their peril.

In Chapter 7, I will introduce a strategic approach to currency investing that is based on both types of analysis. For the sake of simplicity, I will first introduce each one separately, beginning with a fundamental analysis.