Fundamental analysis and technical analysis are the two most widely used methods for making trade decisions in the Forex market. Fundamental analysis helps Forex traders understand the “fundamental” characteristics of a currency. Analyzing fundamentals such as interest rates, trade balance and monetary policy allows a trader to forecast future price moves and make profitable trades. Technical analysis helps Forex traders understand the past price action of a currency. By analyzing significant price changes of a currency, a trader is better able to forecast future prices. Both types of analysis have advantages and disadvantages – the key to profitable trading is in maximizing the positives, and minimizing the negatives, of each.

Fundamental Analysis:

For traders who feel the need to understand why a currency’s price has moved, fundamental analysis has several advantages. Fundamentals often explain a price move by describing an established correlation or a casual relationship.

Gold and the Australian Dollar:

Understanding that a 10% increase in the price of gold, one of Australia’s largest exports, preceded a price increase in the Australian Dollar helps a trader understand why the price move happened. Better yet, the trader can then use fundamental analysis to predict future price moves by monitoring the price of gold, forecasting its potential affect on the Australian Dollar.

Mixed Signals: Risk Aversion and the U.S. Dollar

While explanations are present in fundamental analysis, it is not always so easy to find and understand them. Once fundamentals are determined the difficult work begins: How should the information be interpreted? How can the interpretation be used to forecast future prices?

Fundamental analysis suggests the two following relationships:

Favorable U.S. GDP often results in appreciation of the U.S. Dollar (which is logical, as improved GDP indicates strengthening of the U.S. economy)

Risk aversion (i.e. the market worrying the world economy will implode) results in appreciation of the U.S. Dollar (which is logical, as the U.S. Dollar is viewed as the world’s “safest” currency)

The challenge with fundamental analysis lies in how we interpret conflicting information. On one hand, release of very strong U.S. GDP data could send the currency much higher. On the other hand, strong GDP data could also suggest the worst of a global financial crisis is over, causing a more positive market outlook and investment in “riskier” currencies relative to the U.S. Dollar – sending the Euro and British Pound higher, and the U.S. Dollar lower!

So is strong U.S. GDP good for the Dollar, or bad for the Dollar? Fundamental analysis, as a predictive methodology, will usually answer with “it depends.”

Technical Analysis

If fundamental analysis attempts to answer “why,” technical analysis seeks to answer “where.” Where on a price chart did the Japanese Yen find the most resistance? In what price range did the Yen spend most of the day? Where did the Yen break out of congestion and start the most recent upward trend?

Technical analysis uses price charts to better understand where price has been and where it could be going. By analyzing the price action of a currency a trader can see visually that, despite trying five times in one day, Yen sellers were unsuccessful at driving the price of the Yen below 98.00. This information suggests that based on price action alone, a profitable trade could be buying the Yen at 98.10 with a Stop Loss order at 97.90 (as past price action showed failed attempts below 98.00).

While technical analysis gives us clues about future price moves, by examining past price moves, it is not perfectly predictive. Just because a currency stalled at a particular price several times in the past does NOT guarantee it won’t rapidly break through that price the next time. Technical analysis alone often fails to answer why a currency moved, only where it has moved. So many factors contribute to why the price action occurred that it can be difficult to interpret past price action in a way that predicts future price action.

The Best of Both Worlds

While academic types may debate which type of analysis is superior, a profitable Forex trader simply learns to apply the best aspects of fundamental analysis AND the best aspects of technical analysis. Since fundamental analysis and technical analysis each provide a unique view of the same picture, their use as complimentary methods can be quite successful.

Fundamental analysis may suggest the British Pound is likely to crash due to several aspects of a worsening economy. However, this move could happen in a day, a week, or a month. Technical analysis may not explain why the Pound is likely to depreciate, but it may indicate likely price levels where this could occur. If prices break lower through a significant support level it may indicate that the crash, as suggested by fundamental analysis, is likely to occur very soon! Many traders use fundamental analysis to establish a “big-picture” forecast for the currency, and then rely on technical analysis to hone in on the best entry and exit points that will increase the profitability of that big-picture view.

Who Am I?- A Forex Trader’s “Identity”

There are as many “flavors” of Forex traders as there are ice cream flavors and inevitably every new trader will struggle to find their identity. Should I focus on fundamentals since I have the inclination to understand why? Should I stick with technical analysis since I have a keen eye for patterns? These questions can’t be answered easily, but ultimately a Forex trader must employ a method of analysis that increases the probability of consistently profitable trading. Both fundamental analysis and technical analysis give the Forex trader a plethora of knowledge, but in Forex market it’s the application of knowledge that is power…or profit!