Mar 25
Understanding the Basic Comparison Between Fundamental and Technical Analysis
Fundamental Vs. Technical Analysis
1) Definition
2) Influential factors
3) Time horizon and function
1) Definition
(a) Fundamental analysis (definition)
Fundamental analysis plays an important role in the valuation of everything from corporate stock to real estate. In currency Trading, it helps in examining the underpinnings of seemingly random exchange rate fluctuations.
Fundamental analysis is the process of breaking down the impact of political, economic, and social factors on the relative value of a currency. Fundamental analysis evaluate assets based on external events and influences as well as financial statement on the asset itself. It involves assessing the economic well-being of a currency and by extension, the currency. Fundamental analyst finds out how central banks impacts the forex market and how to use the news and key economic events to make trading decision. It focuses on the overall state of the economy.
Interest rates, inflation and GDP are the three main economic indicators used in forex fundamental analysis. They are unmatched by the amount of the economic impact that they can generate when compared to other factors such as retail sales, capital flow, traded balance, as well as bond prices and numerous additional macroeconomic and geopolitical factors.
Once the primary drivers of a currency’s value has been identified, forex participants are then able to make an informed trading decision.
(b) Technical analysis (definition)
Technical analysis is the study of historic price action in order to identify patterns and determine probabilities of future movements in the market through the use of technical studies, indicators and other analysis tools.
Technical analysis boils down to two things
- Identifying trend
- Identifying support/resistance through the use of price chart and or timeframes
Markets can only do three things: Move up, down or sideways.
Prices typically move in zigzag fashion, and as a result price action has only two states.
- Range -When prices zigzag sideways.
- Trend -When prices zigzag higher (uptrend or bull trend) or prices zigzag lower (downtrend or bear trend)
when carrying out technical analysis, it is important to identify supply and demand level on price chart and determine potential entry and exit.
2) Influential Factors
(a) Fundamental analysis (influential factors)
In order to respond to economic releases in a proper way, you need to understand the relationship between statistical reports and exchange rates of the currencies in question. Examples of influential economic indicators and their impact on the prices of currencies;
- Interest Rates
All major central banks set their key refinancing rate. There are two types of monetary policy: easing (lowering the interest rate if the national economy needs a boost; the impact on the currency is negative) and tightening (raising the interest rate in order to slow down rising inflation rate; the impact on the currency is positive).
- Gross Domestic Product
GDP, industrial production, retail sales. Any increase in the published data tells us that the economy is growing. If the releases are strong, look for the appreciation of the currency.
- Inflation
CPI, PPI, WPI, RPI. Higher inflation is negative for the national currency, while lower inflation is positive. In the short-term, however, CPI and other inflation indexes may have an opposite effect on the currency. Significant increases in the inflation gauges may push the central bank to raise its interest rate. This may cause the exchange rate of the currency to rise.
- Unemployment/employment rate
unemployment rate, payrolls, employment/unemployment change, unemployment claims. The higher is employment, the better for the national currency (the opposite with unemployment).
- Trade balance
The total value of the nation’s exports minus the total value of its imports; >0 means a surplus, <0 means a deficit. When a country has a trade surplus, demand for its currency from foreign buyers increases, so the national currency appreciates. In contrast, a trade deficit causes the depreciation of the nation’s currency.
News Flows
- Political, social and other news.
- Economic forecasts from IMF, OECD, World Bank, and other organizations.
- Changes in sovereign credit ratings by Moody’s, Fitch, S&P and other agencies.
Foreign investors tend to seek out politically and economically stable countries. That’s why reoccurring news about political turmoil or unrest draws investments away from the affected country. As a result, its national currency depreciates due to the outflow of foreign investments. Sometimes even politically stable countries experience social disturbances, governmental reshufflings and significant legislative changes. All these events can also influence the currency. Unexpected results of election or referendum can cause great currency volatility. Political statements of national leaders, public engagements of the central banks’ governors can make the currency’s price fluctuate. Some truly unexpected events like earthquakes and other natural disasters. These events are destructive for economies and, consequently, for the exchange rates.
(b) Technical analysis (influential factors)
The primary influential factor that determines technical analysis is the historic price level of the currency. If a certain price held as a major support or resistance level in the past, forex traders will keep an eye out for it and base their trades around that historical price level. Decision is made from analysis based on either one or all of the following secondary factors
- Price indicators
The Relative Strength Index (RSI) is one of a few price indicators. It measures the number of up-moves to down-moves in a ratio and then computes this ratio into a regular number. The RSI number could be anywhere from 0–100. If you have a number that is higher than 70, this suggests that the instrument is over purchased. If the RSI number is lower than 30, then the instrument may be over sold.
The Stochastic Oscillator is used to measure oversold and overbought conditions. When a currency is in a strong uptrend, the indicator will show on the high end of the period range. When a currency is in a strong downtrend, the indicator will show on the low end of the period range. The range is measured from 1% to 100%.
The Moving Average Convergence Divergence (MACD) measures two momentum lines. It measures the changes in direction, duration, strength, and momentum in the currency.
- Number theory
The Fibanocci Numbers is a number theory that follows a sequence. The first seven numbers in the sequence are 0,1,1,2,4,8,16. The ratio of one number to the next higher number is always 61.8%. The numbers are calculated by adding the previous two numbers together. The theory is that waves in Forex tend to follow the Fibanocci Numbers principle. It measures the waves of support and resistance to a price point at any range in the theory.
- Waves
The Elliot wave principle is a major subject when discussing wave data. The basic theory that Elliot proposed is that the market fluctuations happen in waves. The most perfect wave pattern is five waves forward followed by three waves back. Elliot theorized that investors move back and forth regularly in optimistic and pessimistic patterns.
- Gaps
Gaps are places in a chart where trading has not occurred. These gaps normally occur if there has been a major market event. A major financial announcement, earnings report, or other major event can trigger a gap.
There are several types of gaps. Up gaps are formed if the lowest price of the day is higher than the highest price of the previous trading day. Down gaps are opposite of up gaps. Up gaps are seen as a sign of currency strength, and down gaps are seen as a sign of market weakness. Breakaway gaps indicate the beginning of a new price move. Runaway gaps, also known as a measuring gap, usually occur in the middle of a trend. Once the investor sees an exhaustion gap, this is a signal that the trend is coming to an end.
- Trends
Trends are perhaps the easiest technical analysis indicators to understand. Trends indicate which way the currency is moving. A change in the trend may indicate that the trend has changed. Recognizing the trends is vital to success in the Forex markets. There are three types of major trends. These trends include the Bull trend, the Bear trend, and the Treading Trend. In a Bull trend, the markets are trending upwards. The Bull trend will see a series of highs and lows where the highs are gradually going higher and higher each day. The Bear trend is where the markets are generally trading on a down trend. In a Bear market, there are a series of high and low price points that gradually go lower and lower. In a Treading trend, the series of highs and lows do not change much from day to day. It is difficult to spot any uptrend or downtrend in a Treading trend.
In order to make the most educated decision on your trading choices, it is important to learn and recognize the major factors that influences technical analysis for proper entry and exit.
(3) Time Horizon and Function
(a) Fundamental analysis (time horizon and function)
- Time Horizon: Long-term approach
- Function: Investing
The majority of investors who want to evaluate long-term investment decision start with a fundamental analysis by reviewing financial statements, economic factors, including the overall strength of the economy, press release, analyst report and analyst estimates.
Fundamental analysis results in a value assigned to the security in review that is compared to the security’s current price. Investors use the comparison to determine whether a long-term investment is worth buying because it is undervalued or if it is worth selling because it is overvalued.
(b ) Technical analysis (time horizon and function)
- Time Horizon: Short-term approach
- Function: Trade
Technical analysis use data from short period of time to develop the pattern used to predict market movement. Analyst use data on market activity such as historical returns and volume of trades to chart patterns in market movement. Technical data is meant to provide insight into the future activity of the market. Since the duration of data collection is short for technical analysis, they are mostly used in short-term trading. Analyst who use technical analysis feel strongly that future performance can be determined by reviewing patterns based on past performance data.
Conclusion
- The goal of fundamental analysis is to come up with a fair value of a company by evaluating all aspects of the business, along with the industry, the market as a whole, and the domestic and global environment.
- The goal of technical analysis is to evaluate data — such as historical returns and price changes — to chart patterns that can be used to estimate future price movement for securities and the market as a whole.
