In my 10+ years experience in the Forex trading industry, one of the most common debates I’ve seen traders engage in is fundamental analysis vs. technical analysis. Which one is better? Which one should be used for trading?
For me, it’s a no-brainer: the answer is both. Even if you are an intraday trader trading off the tiniest moves in the Forex market, having some idea of the fundamentals can alert traders to changes in regulations that effectively alter the game. So, at the very least, fundamentals are important because they may affect regulation, which affects all traders regardless of their approach. Because traders need to be aware of regulatory changes that inherently alter the game of trading, they will benefit from monitoring fundamentals in some way.
For trend-following traders who do not trade intraday but rather hold positions for days, weeks, or months at a time, being fluent in both fundamentals and technicals is even more important. Below is a step-by-step approach outlining how traders can combine fundamental and technical analysis. This is especially applicable to swing and position traders.
1. The Strategy
Fundamentals tell you what currency markets to trade and in which direction. Technicals can then be used for timing and to manage risk precisely. Put the two together and, potentially, you have a winning strategy.
2. The Fundamentals of Supply & Demand
At the heart of both fundamental analysis and technical analysis is supply and demand. When the force of demand is strong relative to the available supply, price serves to reconcile the imbalance by going higher. To witness how this works in fundamental analysis, traders can keep an eye on three things: budget balances (surpluses and deficits), trade balances, and monetary policy.
Budget & Trade Balances
If a nation is running twin deficits – meaning a budget deficit under which the government spends more than it takes in, thus necessitating debt issuance, and a trade deficit, in which imports are greater than exports – the fundamental factors are weighted towards currency weakness and capital flowing out of the country. Perpetual budget deficits increase the likelihood that the debt will need to be monetized; in other words, that the central bank will need to simply print money and loan it to the government, an event undertaken when the private market does not wish to lend money to the government in question.
As with budget deficits, trade deficits show a country is importing more than it is exporting, and thus is naturally doing more selling of its own currency to buy goods and services created in other countries. This has the effect of decreasing a currency’s value.
On the supply side of the macro equation is the policy put forth by the central bank. Is it aggressively inflationary, meaning it will do what is needed to push prices higher. Central bank policy is extremely important, as for all practical purposes central banks can push prices higher if they have the will to print money and spend it accordingly.
Part of the reason why many traders shun fundamental analysis is because it can seem like information overload. To avoid that problem and to ensure one has a data set that is small enough to analyze and important enough to utilize, traders can focus on just those aforementioned points: budget balances, trade balances, and monetary policy (whether the central bank wants to devalue the currency via low interest rates and expansion of the money supply or increase its value by tightening interest rates and reducing money supply). All of this information is routinely reported by both mainstream media and official government bureaus. Simply ignore the other fundamental information and you will be able to easily focus on the data that matters.
3. Technical Analysis (TA)
Traders utilizing technical analysis are also prone to over analysis, and the solution is the same: focus only on the technical factors that matter. While there are an infinite number of technical approaches that can work, what I’ve found to work best for me is to focus on these four factors:
Support & Resistance (S&R)
Anywhere you can draw a horizontal line that marks a zone where price tends to bounce off is a meaningful point you can trade around. This does not need to be overcomplicated; simply find the zones that stick out. They are your S&R levels, and when the market reaches them, the odds favour a reversal similar to what has occurred when the market previously reached those levels.
The 200 Exponential Moving Average (200 EMA)
I generally shun indicators, but the 200 EMA is one I’ve found to be effective time and time again. For whatever reason – probably because it is monitored by many institutional funds, and thus has become somewhat of a self-fulfilling prophecy – the 200 EMA behaves similar to S&R levels, in that price tends to reverse or consolidate when it reaches there.
Perhaps the area that warrants the most study is that of candlesticks. Mastering the 14 keycandlestickpatterns to the point where you can identify them instinctively, will greatly benefit you in understanding the psychology of the market and the battle between bulls and bears. That said, candlestick patterns are context sensitive, such that trading them in isolation without reference to the wider picture – both in terms of technicals and fundamentals – is not advised. This leads on to the fourth factor . . .
This is the most important factor. A S&R level in and of itself is not terribly meaningful, but when we see it with a reversal candlestick pattern and/or the 200 EMA, it takes on greater significance. The more technical signs that are telling you the same thing, the higher the probability that the trade will work as you expect.
4. Example Trades
Here are a couple of example trades that utilise the mix of fundamental and technical analysis outlined above. In both cases, the starting point is what is happening to the respective currency pair at a fundamental level, looking at their budget and trade balances, along with any monetary policies that affect them. The next step is to look for a trade set up indicated by a confluence of S&R, the 200 EMA and a candlestick pattern. Please note that the idea of these trades is merely to illustrate how you might marry some basic fundamental principles with a few key technicals to create a simple trading strategy. It’s intended as a stimulus to get you thinking so that you research and design your own trade set ups. In other words, it’s a starting point – not the Holy Grail!
Before getting into the trade examples – here’s a quick word about exits. These depend largely on the trader’s reward/risk ratio, and where they put their stop loss order. I prefer to place my stop loss between the support zone I enter at and the next one below it; I’ve found this effective in reducing the times I get taken out due to price spikes. I then target a reward/risk of at least 3:1, sometimes greater if there is a resistance zone that is far away and achievable in light of the fundamentals.
The chart below of the AUD/JPY currency pair illustrates a potential entry using this method. The Australian dollar is running twin surpluses (i.e. the government is running a budget surplus, whereby it is collecting more than it spends, while the country is running a trade surplus, in which exports surpass imports) and has a relatively high interest rate. On the other hand, the Japanese yen has been running twin deficits (the opposite condition of twin surpluses) and an interest rate near 0%. We see price showing reversal candlesticks at support, and a resistance level very far away that allows for a very favourable reward/risk ratio.
This trade actually did not work out for me, which illustrates another essential point: the necessity of taking small losses. Not every trade is going to be a winner, but so long as opportunities are taken and losses are kept small, this is not a problem. It is the big losses that are fatal, and it is the fear of taking trades that causes traders to miss the winners. Psychology is likely the biggest obstacle to success: taking small losses and bouncing back from them when setups appear is essential to success, and is the real reason success remains so elusive to so many.
This example is of the U.S. dollar/Singapore dollar currency pair. The U.S. has been running twin deficits for over a decade while, on the other hand, Singapore has been running trade surpluses consistently. This macroeconomic situation helps us identify the asset to trade (USD/SGD) and the direction to trade it (short USD, long SGD); from there, we simply need technicals to help time the trade. The chart below illustrates one such example.
As this article illustrates, trading does not need to be complicated and fundamental and technical analysis are not irreconcilable. When traders focus on the key elements of each, and ensure that the two analysis techniques are integrated properly to complement one another rather than to negate one another, then they should enjoy a marked improvement in their trading results.