Analyzing The Currency Market
To effectively analyze the currency market, you need to conduct both a fundamental analysis and a technical analysis. This is not much different than what you would do if you were conducting a thorough analysis of a stock. However, there are a few differences you’ll want to play close attention to.
Everybody can take advantage of the Forex market. You’ve already seen how easy it is to get involved in this market and enjoy the tax advantages, improved leverage and 24-hour access it provides. The next step is learning what makes the market tick. Once you understand why the Forex market does what it does, you can put yourself in a position to profit from it.
In the Forex market, professionals use two types of analysis to both evaluate what the markets are doing and determine where the markets will be going in the future: fundamental analysis and technical analysis. Fundamental analysis is the study of the factors that affect the economies represented by the various currencies. For example, inflation rates and oil prices affect the economy of the U.S. and therefore affect the value of the U.S. dollar. The important thing to understand is that the U.S. dollar generally has a fairly predictable reaction to changes in fundamental economic factors. And if you know what those reactions are going to be, you can profit from them.
Technical analysis is the study of a currency’s price movements on a chart. Forex investors will use charts to forecast what they believe will happen next in the market.
Using charts is an effective way of distilling what has happened in the Forex market into an easy-to-use format. For example, if the price is moving higher on the chart, it will most likely continue to move higher unless something happens to change its direction. It’s like Newton’s first law of motion: an object in motion tends to stay in motion unless acted upon by some other force. Technical analysis helps you identify which direction the price is currently moving in and when it might change direction.
Both fundamental analysis and technical analysis can help you be profitable in the Forex market. Unfortunately, most professionals who use fundamental analysis swear by it and scoff at technical analysis. And vice versa for most professionals who use technical analysis. However, we have a different point of view. We figure that if you have both types of analysis available to you, why not use both? Certainly you have a better chance of success if you use all the tools available.
Numerous fundamental factors, such as the U.S. government, inflation, the U.S. stock market, China, oil and breaking news, affect the currency market. As you monitor these factors and place them on the “Seesaw of Supply and Demand,” you can determine what the long-term fundamental bias of a currency pair is going to be. For instance, if you are looking at the U.S. dollar and you see that the fundamental factors affecting that currency are driving an increase in demand, you know that, overall, the value of the U.S. dollar should be increasing. You can now take that information and conduct a technical analysis to identify the best times to enter and exit your trades.
Technical Indicators
Often you will see technical indicators classified into two categories: trending and non-trending (or oscillating). Practitioners divide technical indicators into these two categories because the trading signals produced by trending indicators are generally supposed to be more profitable during trending markets, and the trading signals generated by non-trending, or oscillating, indicators are supposed to be more profitable during non-trending, or flat, markets.
While that is a nice way to conceptualize these indicators, most indicators usually perform best during trending markets. Fortunately for us, the Forex market usually has a lot of strong trends to take advantage of. We are trend traders, and our strategies are trend-trading strategies, so we tend to look at technical indicators a little differently.
Technical analysis for us is a two-step process. First, we identify the current trend. Next, we sit back and wait until the market tells us it is a good time to jump in and take advantage of the current trend.
Once you have identified the trend of the currency pair you are analyzing, you then need to identify those levels at which the trend has a high probability of stopping or reversing. To do that, you need to identify potential levels of support and resistance.
Support And Resistance
Support is a price level that a currency pair has trouble breaking through to the downside. You will often hear support referred to as the floor of the currency pair price movement. Resistance is a price level that a currency pair has trouble breaking through to the upside. You will often hear resistance referred to as the ceiling of the currency pair price movement. Many new investors in the market are often surprised by the strangely predictable and reliable price action that occurs at levels of support and resistance. Although there is nothing on the chart itself or in the market to demand that all investors begin buying or selling at a given level of support or resistance, they do so just the same.
While there are many explanations for this phenomenon, the most plausible is also the simplest: At support, the majority of investors believe that the currency pair is favorably priced and represents an excellent opportunity to buy once it reaches the support level. At resistance, the majority of investors believe the currency pair is not favorably priced and represents an excellent opportunity to sell once it reaches the resistance level. Whatever the reasons for the levels, you will have an excellent advantage in your trading if you are capable of accurately identifying support and resistance levels in the market.
We mentioned earlier that support and resistance levels are often self-fulfilling prophecies. Let us explain. As more and more investors begin to conduct technical analyses of the Forex market, they will inevitably begin to identify levels of support and resistance that are similar to one another. If only one investor believes that a particular level is a valid support or resistance level, that level probably won’t hold up as support or resistance. However, if thousands of investors all identify the same level as a level of support or resistance, then it most likely will hold up as a level of support or resistance.
So, as you can see, the level itself has no real force behind it. The only reason it serves as a support or resistance level is that thousands of investors say it should, and it acts accordingly. If enough investors predict that a certain price level will act as support or resistance, they can fulfill their own prophesy by buying or selling the currency pair when the price reaches the prophesied level.
And there you have it: Currency Trading 101. The currency market has been the best-kept secret in the financial world for the past few years, but now that you know more about it and understand how it can dramatically affect your portfolio, we hope you will do whatever you can to learn about this market and see what it can do for you.