Like other financial markets, the forex market has two primary methods of performing market research that traders can then use to base their trading decisions on. These are:
- Technical analysis – Relies solely on historical price action and computed indicators to forecast future exchange rates. Besides price action, a number of other related indicators such as oscillators, volume and moving averages are typically used in technical analysis. Technical analysis can be very helpful for calling short term price movements and for timing market entry and exit points.
- Fundamental analysis – Consists of reviewing the economic and political reasons behind currency moves. Often involves interpreting the micro and macro economic indicators for the currency’s nation in order to determine the relative value of the currency versus another currency. Fundamental analysis can be better for forecasting longer term exchange rate moves.
Basically, both forms of analysis can provide ample opportunities for traders to profit from trading forex. Analysis is a tool, and when placed in the right hands and used in moderation, will generally enhance trading profits and opportunities.
Pros and Cons of Technical Analysis
While some fundamental analysts liken technical analysis to reading tea leaves or palms, technical analysis provides one of the best and most objective tools available for quickly and accurately assessing a market and then trading it profitably.
One of the potential benefits of technical trading consists of the fact that the same data is also being watched by millions of other traders.
This phenomenon can lead to a herd effect in some cases when classic chart patterns can be clearly observed. In essence, the many traders who see the pattern and trade accordingly can help the pattern’s measured move materialize.
Nevertheless, the disadvantage of this is that like minded technical traders tend to position their stops at the same levels. This could magnify a decline or prompt a stronger rally, and might even allow large players to intentionally trigger such stops which they can reasonably anticipate based on their own reading of the charts.
Pros and Cons of Fundamental Analysis
Fundamental analysis in the forex market typically involves taking into account basic economic and political factors for one country relative to another. These factors might include the following:
- Measures of overall economic strength like growth and employment rates
- Interest rates and investment yields
- Trade and current account balances
- Political stability
Fundamental forecasts for exchange rates are typically most useful for longer term time frames and not so much for short term trading. Nevertheless, some fundamental trading strategies have been developed that operate during the volatile period that often immediately follows important economic data releases.
Some traders prefer technical analysis and take issue with fundamental analysis on the basis that:
- Its information is largely already priced into the market
- It is time consuming and complicated to perform
- It often requires an economics background
- It does not give objective trading signals