If you trade any type of financial market for a significant amount of time, you will start to try and form some type of system. You will then inevitably start to focus on fundamental or technical analysis, or perhaps a little of both. Understanding the difference between the two types of analysis is the first thing you should focus on when trying to decide what type of trader you wish to be.
First, a bit of a disclaimer
It doesn’t matter which type of analysis you decide to use, you can be profitable. However, neither one of these types of analysis are 100% guaranteed. Just because you become a good analyst either from the technical or fundamental side of things doesn’t mean that you will necessarily make money. As traders, what we are looking at is the most likely scenario, not working with certainties. The long game is what you should focus on, meaning that you take trades based upon what is likely to happen, understanding that it won’t always work out.
Most retail traders focus on technical analysis, because it can be somewhat easily defined. What I mean by this is that you look for things like support, resistance, trendlines, moving average crossovers, and the like. For example, a trader that is using technical analysis to trade markets will look at the totality of price action.
With technical analysis, you may get a setup such as the following:
The EUR/USD pair has pulled back from the move higher. By using your Fibonacci retracement tool, you recognize that we have pulled back 50% from the highs, which is an area where most Fibonacci related traders would be interested in going long. Beyond that, we have the 200 day exponential moving average just below the candle on the daily chart, which of course shows support. Finally, the candlestick formed a hammer, which is also bullish. In that scenario, a technical analysis based trading system would more than likely be telling the trader to go long.
The technical analysis based trader is paying attention to what price does, not necessarily anything that it should do. You simply follow what the market tells you as far as price is concerned, and this makes the trading of financial markets a bit easier. This is because you don’t have to think through a lot of different variables other than what price is doing and whether or not it fits your definition of a technical set up. If you choose other factors to get involved with trading, such as the fundamental analysis - something that we will get to in a moment - then things can get a bit more complicated.
Fundamental analysis focuses on economic factors and what a market “should do.” What I mean by this is that you will take economic figures and announcements and try to figure out where price is going. All things being equal, if interest rates are rising in one country over another, then that currency should rally over the other one. Let’s just say that interest rates are expected to continue to rise in the United States, while the ECB is expected to sit still for the foreseeable future. If that’s the case, then the EUR/USD pair should eventually fall based upon interest rate differentials. There are a multitude of announcements that you could be looking towards, perhaps the GDP figures, employment, and of course interest rate outlook.
Ultimately, the Forex does tend to move in the directionality of expected interest rate moves. However, there are some other issues that can arise, such as geopolitical situations. For example, the Brexit has played havoc with the value of the British pound for some time. This is because there is a lot of uncertainty, and not necessarily because of interest rate outlook. However, in a sense even that route will lead to interest rates, at least in the long term. The thought of course is that there is a lot of uncertainty when it comes to the British economy as they leave the European Union, and we don’t know what they are going to do with trade involving the EU. The EU is of course the largest trading partner of the United Kingdom, so this obviously could have a major negative effect on the British economy. People are essentially either fleeing from the British pound due to fear, or the fact that they believe the Bank of England will have to keep interest rates extraordinarily low as the economy slows down. In the end, even the opaquest reasons eventually lead to interest rates, although it may not necessarily be immediately apparent.
A blend is typical
The most typical way that traders will get involved in the market is a blend of both types. For example, using the Brexit as a backdrop, we know that the British pound has struggled for some time. A technical trader will least understand the very basics of that situation and recognize that selling the British pound makes more sense overall.
They understand the fundamentals of very negative for the British pound, although they don’t get too heavily involved with all the nuances of economic announcements. They just know that the sentiment is negative. With that information, they then start looking for selling patterns on candlesticks, or failure at resistance, or some other type of scenario where we break down through support as examples.
By using both types of analysis, even though most traders who use a blend probably use about 80% technical analysis, the reality is it gives you a bias in which to trade the market. After all, the longer-term fundamental biases exactly what determines the trend, while the technical analyst simply looks for signals to get involved.
There is no correct way to trade the currency market, although it should be noted that technical analysis is much simpler than fundamental, because at the end of the day fundamental analysis suggests what “should happen”, ignoring what is on the chart. Therefore I believe that most people use a little bit of both to make their trading decisions.