Forex has the distinction of being the most traded market globally. Nearly $6 trillion is being traded every day, and the Forex market is vastly bigger than the aggregate trading volume in stock markets worldwide. Even as monolithic corporations and banks account for the majority of global trading each day, the remainder of the participants still get to trade trillions of dollars in the same duration. The best way to analyse the Forex market help investors to profitability.
Getting your basic trading strategies in place
Basically, the drivers behind the Forex market are just two – supply and demand. The only chief determinant impacting these drivers is ‘sentiment’. The sentiment is shaped by a multitude of factors. Investor mood remains susceptible to data, news and sundry developments in various world regions. The fact that the Forex market is open 24/7 only adds to investors’ impressionability.
The best ways to analyse the Forex market are a set of approaches and tools. These deepen investors’ insight into the workings of the market.
Nearly all trading volumes are focused on major currency pairs. But, sometimes, less popular forex pairs are also avenues of profit for maverick investors.
Trading time-frame Closing out all of their positions before the day’s end, a good number of forex traders begin from the beginning every day. This they do in order to side-step any overnight drastic price movement. Others aim to hold positions extended over a longer period. This general stretches anywhere between two to fourteen days and is called swing trading. Long term swing traders utilise swing trading. This involves traders holding positions for long time periods (months, even years). All the while, they try to abstain from reacting to price movements.
Reactive trading – momentum trading & range trading
There are some kinds of forex trading that are other than proactive. Rather than forecast where they think a given currency is heading, there are a set of reactive trading strategies, answering price movements.
Momentum trading is when traders think a conspicuous price movement is the beginning of a long term trend.
Range trading is when traders try to hone in on where past support/resistance levels have, anticipating the return of those levels again. Range trading is focused at currencies that experience price fluctuations but sans a distinct long term trend.
Avenues open to fundamental analysis and technical analysis
The fundamental and technical analysis seeks to give an insight into the market direction and trending forex currency pairs.
Fundamental analysis is concerned with assessing the different external events as well as fundamental factors that impact currencies. The latter would include the state of the financial markets and the economy, besides monetary as relevant government policy.
Technical analysis is involved with price and the forecasting of future market movements, employing trends and patterns derived from historical price charts and statistics.
In short, the fundamental analysis seeks to find out a currency that is over or undervalued by determining the true value on the basis of external factors impacting price movements. Obversely, technical analysis is about making sense of supply and demand in the anticipation that foregoing market patterns will be repeated. The concentration here is solely on the price, ignoring the remainder as unanalysable data.
Forecasting Forex movements with fundamental analysis
Those using fundamental analysis are convinced that they can thereby find out the currency that is mispriced, taking steps that would correct the incorrect pricing. This kind of analysis is focussed on long term strategies. It is relatively seldom used for short term strategies.
Some of the factors impacting fundamental analysis directly are Economic Growth, interest rates, inflation, trade & capital balances, geopolitics, and wages & employment.
- Economic growth – Economic growth is defined in terms of Gross Domestic Product, or GDP. This measures the growth rate of the economy. A stronger economy denotes a more attractive currency. This bolsters up the national economy as the local currency is widely used in trading across national stock markets ;
- Interest rates – These are a major influence. Higher interest rates denote a stronger currency. Investors are attracted to invest in savings accounts. This leads in turn to a higher demand for local currency ;
- Inflation – the rate of price increase reflecting goods and services is a determinant in monetary policy. Inflation is also understood in terms of Consumer Price Index and Retail Price Index ;
- Trade & Capital Balances – the forex market being inherently international, the national currency is affected by the amount of money/trade flowing in and out. Exports decline and witness currency price decline. The volume of capital being kept in the country or being invested abroad is also a good indicator of market sentiment ;
- Geopolitics – politics does impact the forex market. National currencies are impacted too by international relations and disability/stability therein ;
- Wages & Employment – wage movement is as important as employment level. Stagnant wages nullify to a good extent whatever benefits rising employment might be attempting to bring in.
The economic calendar as an analytic tool
Scheduled events that might impact price movement are shown in an economic calendar. The calendar lists all scheduled economic and political events that might have an effect on the Forex market.
A good economic calendar gives details of when main economic data is scheduled for release. It likewise gives guidance as to when there will be press conferences involving the respective heads of Central Banks throughout the world. Scheduled speeches from world leaders are not ignored, either.
Technical analysis as the basis of forecasting Forex market
Technical analysis hinges upon the how, as removed from the why, of price movement. This tool focuses on supply and demand, employing strategies and applications that determine repeatable trends and patterns. Price charts are indispensable in technical analysis, a primary feature of the former being exchange rate historical performance depiction.
A chart is the repository of all consequential information. Trends and patterns therein signal market mood and sentiment change. The aim is to forecast such happenings so that the trader may obtain profit.
Swing trading, day trading, and such short term strategies are subject to technical analysis. The constant historical data points include the highest price, the opening price, the closing price and the lowest price.
Technical analysis – Patterns and Forex forecasting
Patterns become a trend. Analysts read this as the most recent exchange rate movement that could start a long-term trend, lasting as long as preceding trends. The trend types are downtrends, uptrends, and sideways trends. When technical analysis determines an uptrend’s start, the exchange rate has only just started climbing and will go on doing so. You should note that forex is traded in currency pairs, a currency’s uptrend is accompanied by the downtrend’s start for the other.
Applications involving moving averages are very common in technical analysis – moving averages, moving average convergence divergence.
- Moving averages – The moving average seeks to smooth out historic price data, reckoning the average exchange rate in a certain time period. For instance, the 20-day moving average is the average rate over 20 days. On the 21st day, the first day is removed from the calculation. This demonstrates how the current rate compares vis a vis the average. The comparison filters out unanalysable movements that might make the historic price data appear distorted.
- Moving average convergence divergence (MACD) – This considers the moving average over the course of a short time frame, and an average over a longer time frame. The application seeks to discover the point in time when the short term moving average crosses over the long term average. When the short term moving average goes above, and beyond the longer-term average, the appreciation of exchange rates is forecasted.
Testing trend stability and strength
Not only the strength but also the volatility of trends can be tested. Popular applications include – Relative Strength Index/RSI; Ichimoku; Standard deviation; Average True Range; Bollinger Bands.
- RSI or Relative Strength Index – The index is a momentum indicator, comparing the average gain achieved when an exchange rate has appreciated over a certain time period, vis a vis loss incurred in the same time period. This becomes a sound basis for predicted if a currency is going to be undervalued or overvalued in the foreseeable future ;
- Ichimoku – The Ichimoku Kinko Hyo, or Ichimoku Cloud, not only determines trends but also determines the location of support/resistance. It is concerned with calculations that not only determines the location of support/resistance at this moment. It also determines the location of such levels in the future.
- Standard Deviation – This application measures price movement size. The aim is to determine if or not future movements will have the tendency to volatility. This is a volatility indicator, rather than a trend indicator ;
- ATR or Average True Range – ATR has the measure of trend volatility. However, it does not determine trends. ATR is a moving average type aiming to compare the highs and lows of an exchange rate over a certain time period with the latest closing price. This brings forth the true range for the five latest trading days. The true range is averaged out to present the ATR;
- Bollinger Bands – this application determines a band that an exchange rate usually trades within. The latest instances of volatility are shown by band size widening/narrowing. A rate is near to breaking higher or lower when a rate moves out of a band.
The econometric approach
Each application and tool at the disposal of traders must be used in conjunction with the others. Each has its limited competence, and only by using all of these together can there be a possible fuller picture obtained.
Depending on the perspective the trader has he chooses an econometric model out of several. He has his own list of factors believed to have the most impact on the market. These are only the most vital factors affecting the specific currency’s exchange rate. Predicting future market movement is the objective here.
Econometric models are suited to currency pair studies, not the least because each member of a pair might exhibit features out of concordance with each other. Likewise, there’s a relationship of variations underlying different currency pairs as well.
For instance, a trader seeking to determine the future direction of the USD/CAD exchange rate might have to consider the respective GDPs/growth rates or the differential interest rates of both countries.
The relative economic strength approach
Economic data is interlinked within its components. Wage growth, inflation and GDP influence how central banks forge monetary policy. Government policy can be focussed on trade/capital flows. Determining in advance the direction exchange rates are heading by describing the general health of an economy is the relative economic strength approach. This does not make predictions as to exchange rates but allows traders to make up their minds regarding if they think the rate is going to ascend or plunge into decline.
PPP or purchasing power parity as an analytic tool
The PPP attempts to predict the actual exchange rate. As per PPP, the price of goods and services ought to be amenable to equalisation throughout the world.
The notorious Big Mac Index is the simplest instance you can look at. The performance of currencies around the world is correlated with the price of the Big Mac in different countries. You have to calculate the exchange rate required to make a Big Mac costs $5.00 in the US, and Euro 4.50 in the EU to be worth the same. In this instance, the EUR/USD exchange rate will have to be $1.11. If the exchange rate is above or below that, then it is over/undervalued.
Interest rate parity and real interest rates
IRP or interest rate parity, instead of assessing the price of goods and services in different countries, concentrates on the cost of various financial assets. This is done with the objective that these assets should yield the same returns, following adjustment for each country’s interest rate.
Likewise, the RIR or real interest rate is founded upon the principle that a country with higher interest rates will experience currency appreciation vis a vis a lower interest rate country’s currency. Higher interest rates denote higher foreign investment.
Forecasting Forex market with analysis using balance payment theory and asset market model
These models deal with the flow of trade and investment impacting various countries and the affect this has on the exchange rate. The balance payment theory postulates that a currency will fall in value if it imports more goods and services than it exports. Conversely, the same would be appreciated when a country’s balance of trade can demonstrate a surplus.
The asset market model focuses on just the flow of investments. Here, the assumption is that higher levels of foreign investment are drivers behind that country’s currency appreciation. The opposite follows when investment levels are lower.
Analyse the forex market on the basis of market sentiment
It is true that supply and demand move exchange rates. It is market sentiment, moreover, that moves supply and demand. Amid a lack of trading volume data, the best way to analyse market sentiment is the forex futures market. This gives traders’ feelings as to future exchange rates, as opposed to the present moment. The sentiment could be bullish or bearish when the currency futures price is starkly at variance with spot prices.
The relevant application in this regard is the Commitment of Traders report published by the Commodity Futures Trading Commission. This gives the long and short positions taken by investors on currency futures.
That we leave out the spot market in this reckoning gives us a grave disadvantage, considering that the forex futures market is minuscule compared to the spot market.
Technical analysis – A few Forex indicators more
Forex indicators work as tools that are intrinsic to trading platforms. They offer short term as well as long term forecasts or an overview of the state of a currency pair.
The forex indicators traders most find useful include – Moving Averages; Oscillators; Stochastics; Fibonacci Retracement Lines; RSI/Relative Strength Index; Bollinger Bands.
Since we have already touched upon moving averages, RSI and Bollinger bands above, we will limit ourselves to the other three here.
- Oscillators – Forex oscillators point out the moment the market reaches a limit, leading to anticipation of correction of the current trend in the other direction. For instance, when a price climbs too high, it is said to be overbought. The price stays stable or slips down a bit. On a negative correction taking place, the price rises thanks to new traders entering the market. Obversely, an oversold market leads to a positive correction. Generally, it is best to sell overbought and buy oversold forex pairs.
- Stochastics – Stochastic oscillators are meant to indicate overbought and oversold zones. These indicators also point out likely price reversals. The slow stochastic is the one most commonly used. Stochastics help you find good entry and exit points.
- Fibonacci Retracement Lines – based on the Fibonacci sequence, these lines seek to discover support/resistance levels on a trading instrument. The premise is that markets retrace or react by smaller portions of a larger move. These parts are predictable. Traders make use of certain Fibonacci ratios to decide upon target prices or place stop losses.
Prices have been observed to really have extensions and retracements so that forex facts meet forex theory.
Given that there’s no flux in the market over the weekend, that’s the right time to get your priorities in order. Do a weekend analysis to that end!
There is no straightforward best way to analyse the forex market. Time frame and information access govern the outcome of analyses. The short term trader, with delayed access to data but real-time access to quotes, must go for technical analysis. On the other hand, traders able to access up-to-the-minute information as released in the form of news updates and data may find fundamental analysis more useful. PrimeFin and ETFinance have the tools and applications to help you analyse the Forex market.