Fundamental and technical analysis are at opposite ends of the spectrum. Both methods are used for researching and forecasting future trends in asset prices, and both have their advocates and adversaries.
Fundamental analysis can be used to evaluate a number of trading instruments, such as shares, indices, currencies and commodities. Some traders will weigh up economic factors such as a country’s GDP, unemployment levels, company profitability and the health of a sector before taking a decision to buy or sell.
This is all fundamental data.
Technical analysis differs from fundamental analysis in that the asset’s price and volume are the only inputs. The core assumption is that all known fundamentals are factored into price; thus, there is no need to pay close attention to them.
Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts to identify patterns and trends that suggest what a security will do in the future.
The most popular tools of technical analysis are simple moving averages, support and resistance, trend lines and momentum-based indicators such as stochastics, MACD and RSI.
The hardest part in using fundamental data is how to translate financial and economic data into trading ideas such as buying or selling an asset.
In this article, I’ll go through the advantages and the disadvantages of both fundamentals and technicals to highlight important key features to help you choose which analysis suits your trading style.
Fundamental Analysis in Forex
In the forex market, fundamental analysis looks at economic indicators that may affect the supply and demand of a currency. This is what determines the currency exchange rate. It helps professional and retail traders understand how economic indicators like the unemployment rate or GDP numbers affect a country’s economy and monetary policy which ultimately, affect the level of demand for its currency.
The better shape a country’s economy is, the more foreign businesses and investors will invest in that country, thus increasing the demand of that country’s currency to buy those assets. Investors are attracted to countries offering higher interest rates.
When authorities are increasing the interest rates of their domestic currency, the demand for that currency increases and therefore the currency exchange rate goes up and vice-versa.
Examples of How Fundamental Data Affect the Forex Market
On December 19, 2018:
The Federal Open Market Committee raised the funds rate target range to 2.25%-2.50% as it was widely expected. Market moved up at the news release then paused due to uncertainty during the FOMC meetings and whether to expect future hikes.
On December 20, 2018:
The Philly Fed report missed expectations 9.4 vs. 15.6. This was the worst report since August 2016. Market went down on the release.
On January 3rd, 2019:
Yen crosses collapsed 3-5% in minutes as an enormous wave of yen buying swept through the market. Here’s what set the stage for the drop:
1) It’s the quietest time of the day: It’s before 8 am in Tokyo and New York had gone home for the day. If you’re ever looking for a flash crash in the FX market, between 4-6 pm ET is the time. What made it especially bad is that it’s a bank holiday in Japan all week.
2) Apple’s China news: The market was suspicious of China but Tim Cook came right out saying that a sharp macroeconomic slowdown there was almost-entirely responsible for a roughly 10% drop in revenue guidance.
3) The yen was already near extremes: The tipping point was because the yen was already near extremes on several fronts. The most-obvious one is AUD/JPY and that was also the big mover. It crumbled to the lowest since 2016 and hit stops, then took out the 2016 low, then the 2011 low, then the 2010 low. That would have spread to other yen crosses as they hit multi-month lows (at the very least).
The Advantages of Fundamental Analysis
The methods and approaches used in fundamental analysis are based on sound financial data and news releases. The analysts use statistical and analytical tools to help them construct trading ideas based on their analyses. It requires rigorous accounting and financial analysis to gauge better understanding of everything.
They need to translate financial reports and statements into trading ideas to generate proper buy/sell recommendation.
The Disadvantages of Fundamental Analysis
Conducting fundamental analysis can be time consuming. Carrying out industry analysis, financial modeling and valuation, it is not an easy task, especially if a trader doesn’t know where to get the data and how to analyze it. This is why fundamental analysis is not popular among retail traders.
Assumptions play a vital role in forecasting the financial markets. So it is important to consider the best and the worst case scenario. Unexpected negative economic, political or legislative changes, may cause problems.
As a fundamentalists, you need to keep an eye on news releases and financial reports because these are the tools you have to get data and construct trading ideas.
Technical Analysis in Forex
Technical analysis is based on the Dow Theory, which has three main principles:
- Market action discounts everything,
- Prices move in trends,
- History repeats itself,
Market Action Discounts Everything
The statement “market action discounts everything” forms what is probably the cornerstone of technical analysis. The technician believes that anything that can possibly affect the price – fundamentally, politically, psychologically, or otherwise – is actually reflected in the price of that market.
Price action reflects shifts in supply and demand. If demand exceeds supply, prices should rise. If supply exceeds demand, prices should fall. This action is the basis of all economic and fundamental forecasting.
For Technicians, if prices are rising, for whatever reasons, demand must exceed supply and the fundamentals must be bullish. If prices fall, the fundamentals must be bearish and supply must exceed demand.
Most technicians would probably agree that it is the underlying forces of supply and demand, the economic fundamentals of a market that cause bull and bear markets. The charts do not in themselves cause markets to move up or down. They simply reflect the bullish or bearish psychology of the marketplace.
The logic behind “markets discount everything” is that if everything that affects the market price is ultimately reflected in market price, then the study of that market price is all that is necessary. By studying price charts and a host of supporting technical indicators, the chartist in effect lets the market tell him or her which way it is most likely to go.
Price Move in Trends
The concept of trend is absolutely essential to the technical approach. The whole purpose of charting the price action of a market is to identify trends in the early stages of their development for the purpose of trading in the direction of those trends.
History Repeats Itself
Chart patterns, for example, which have been identified and categorized over the past one hundred years, reflect certain pictures that appear on price charts. These pictures reveal the bullish or bearish psychology of the market. Since these patterns have worked well in the past, it is assumed that they will continue to work well in the future.
They are based on the study of human psychology, which tends not to change. Another way of saying this last premise – that history repeats itself – is that the key to understanding the future lies in a study of the past, or that the future is just a repetition of the past.
The Advantages of Technical Analysis
Everybody loves technical analysis because it is simple and there are tons of resources free online to analyze the markets. Once you understand the basic techniques of analysis, you can begin analyzing any market you want from currencies to stocks and commodities.
The core concept used in technical analysis is Demand & Supply governs the trading market. Thus, it tells you a lot about Traders Sentiments. You can actually judge how the overall market is working. Usually High demand push up the prices, and high supply push down the prices.
Retail traders can use technical tools to tell when to enter and when to exit a trade. For example, some traders use crossing moving averages to spot entry price and exit price.
Technical analysis also provides current information about the market. Price reflects all the known information about an asset. Prices may increase or decrease, but ultimately, the current price is the balancing point for all information.
Traders use chart patterns as a guide to gauge whether the market is moving up or down.
The Disadvantages of Technical Analysis
Retail traders often use too many indicators that spoil the charts and cloud their judgments. Too many indicators can produce confusing signals, which may affect their trading analysis.
Technical analysis does not take into account the underlying fundamentals of a company or a country. This is why only 5% of traders are making real money trading financial markets in the long run.
As you can see both analyses have their advantages and disadvantages. The best approach is to combine both to increase your odds of making the right trading decision.
While technical analysis gives you around 53% chance of being right, adding fundamental analysis will increase your percentage of winning up to 90% and thus, increasing your odds in your favor.