Fundamental Analysis vs. Technical Analysis in Forex

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Fundamental Analysis vs Technical Analysis

Forex is perhaps the most popular asset for trading with a daily volume of over 6 trillion. The market is open 24 hours a day for five times a week, with trades actively undertaken in major financial markets around the world. 

While the market offers many opportunities, a trader should be prepared with a trading plan and strategies backed by in-depth market analysis.

This is especially so since foreign exchange trading is subjected to numerous micro and macro factors that provide indications on its current economic situation and future prospects, and traders need to undertake different types of analysis to obtain a complete view of the market.  

As currencies are traded in pairs, it is essential to understand the currencies’ relative strength to one another, in order to decide on the position to take. Traders thus follow a range of methodologies to make predictions on a currency’s performance. 

There are two primary forex analysis methods that traders focus on – 

  • Fundamental analysis
  • Technical analysis

This article discusses the differences between fundamental and technical analysis for a forex trader, and the differences in perspectives and factors considered for both methodologies.

Fundamental Analysis vs Technical Analysis
Image by Buffik from Pixabay

What is fundamental analysis?

Fundamental analysis is the study of news events and economic statistics to determine forex trading opportunities. In addition, traders analyze political, economic, and social events, overall risk sentiment, and economic outlook of the different countries to determine price movements and directions of currency pairs.

The primary purpose behind fundamental analysis is to figure out a currency’s intrinsic or real value, by taking into consideration real-world economic data such as employment, inflation, interest rates and other central bank actions. 

Factors to consider for fundamental analysis of a currency pair 

Here are some of the primary factors and key data used while conducting fundamental analysis of a currency pair. 

Nation’s economy

The strength of a nation’s currency is directly related to its economic performance. The government releases several key reports that indicate the current health and stability of the country. These reports are wide and varied, encompassing the entire nation’s performance, including metrics such as unemployment numbers, housing sales and consumer prices.

 Most of these reports are released regularly at a fixed frequency, and are compared with previous year’s or quarter’s data to provide a macroeconomic view of whether the economy is on a rising or a declining trajectory. 

While each of these indicators serves a purpose, they are often interpreted as a whole for traders and analysts to determine if the nation’s currency would grow, remain stable at current levels, or fall. 

CPI (Consumer Price Index)

CPI or consumer price index is an indicator measuring the cost of living by tracking the changes in prices of consumer goods across a fixed set of categories. It is treated as a metric for change by investors and economists alike and is also used to track inflation. 

A spike in CPI indicates the weakening of the purchasing power of the country’s currency. It also takes the value of exports into context, allowing investors to better gauge CPI’s probable impact on a currency pair. 

GDP (Gross Domestic Product)

GDP or gross domestic product, in simple terms, refers to the market value of all goods and services produced in the country in a given financial year. It is one of the most significant indicators of the country’s economic performance and encapsulates the overall performance of all the industries operating within its boundaries. 

A higher GDP rate is a symbol of increasing production and an improvement in demand for the products and services produced within the country, indicating general strength in the economy. 

GDP
Image by Ramon M from Pixabay

Industrial production

Industrial production data generally refers to changes in output from a country’s industrial sector. These reports may also include capacity utilization of industries, a metric that can be used to analyze the overall demand and productivity of an economy. A high industrial output likely indicates an economy and currency’s strength relative to its peers.

Employment data 

Employment data is a key indicator of economic activity and a proxy for the demand for the goods and services produced in the country. A high employment rate will indicate a country’s productivity and consumption ability and remains one of the most-watched data releases in the economic calendar. 

What is Technical Analysis?

While fundamental analysis considers the overall economic conditions in order to find the intrinsic value of a currency, technical analysis uses historical price data and statistical trends and indicators to identify patterns and opportunities. 

Investors and traders who employ technical analysis believe that future performance can be determined by reviewing past performance data and that prices follow established practices widely watched by other traders.

Technical analysts use charts and graphs to track historical prices and movements in order to identify trends, which will indicate patterns that signal future trading opportunities. 

Some indicators that may be used in technical analysis include moving averages, oscillators, and the determination of support and resistance levels. The key levels identified using these indicators can help traders determine their entry, stop loss, and profit levels.

Factors impacting technical analysis

Technical analysis looks at statistical and historical data to gauge price patterns, and spot rising and falling trends via trend lines or curves, or changes in direction by observing reversal patterns. They can also use current movements to understand probable future trends. 

Here are some of the key indicators and patterns that are commonly looked at in technical analysis. 

Trendlines

Trendlines are straight lines that connect the highs and lows in a chart and are the basis of technical analysis. These help traders understand the current direction of movement for a currency pair. 

Trendlines are angled up when the price action is positive and experiencing higher highs and higher lows. If the trendline is a downward sloping one, it means that the currency pair is weakening and is making lower highs and lower lows. 

If the trendline is flat, it indicates that a currency pair is trading in a range, where there is no significant driver to move the price in any one direction. 

trendlines
Image by Csaba Nagy from Pixabay

Continuation patterns

After a period of significant price movements where trends are prevailing towards one direction for some time, trendlines may be observed to become more gentle. This is known as a continuation pattern, where prices continue in the particular trend but at a slower pace and momentum.

Carefully analyzing the trendlines would enable the trader to draw the price pattern and identify potential reversals. 

Wedges

Wedge patterns can be used to identify a breakout either on the upper or the lower side once the price breaks the formation. These are denoted by two converging lines moving in the same direction. The distance between these lines continues to reduce until the price exceeds the lines on either side. 

Wedges angled down symbolize a pause during an upward movement, whereas wedges angled up showcase a temporary reprieve to a falling market. 

Cup and handles

While some patterns can indicate both the downside and the upside, the cup and handle is a bullish continuation pattern that showcases an incoming significant uptrend. As the name suggests, the formation is symbolized by two handles with a cup in between. 

The handles have a “V” shape almost of the same size while the cup is “U” shaped,. The right handle is the most critical as it showcases a minor pullback. Once the handle is complete, prices may break out to new highs or resume their trend higher. 

Flags

Flags are two parallel trend lines that can slope up, down, or sideways. A flag typically indicates a pause amidst the current trend – a down-sloping flag shows a break during an up-trending market and vice versa.  A flag formation usually comes with a decline in volume, which recovers once price breaks out of the formation. 

Triangle

Triangles are one of the most common trend lines you are likely to find while performing the technical analysis of a currency pair. These are short-term patterns and can last up to a few months.

The three most common types of triangles are:

  • Ascending – has a flat upper trend line and a rising lower trend line suggesting a potential breakout
  • Descending – has a flat lower trend line and a falling upper trend line suggesting a possible break downwards 
  • Symmetrical – two symmetrical lines converging each other, suggesting a potential breakout without indicating the side

Head and shoulders

The head and shoulders pattern can form at market top or bottom, in a series of three pushes. It indicates a bearish (the reverse head and shoulder is a bullish indicator) formation signifying a potential downside. Here, there are three formations, a trough or an initial peak followed by a larger one and the final one similar to the initial. 

If an uptrend faces a head and shoulder, there is a high chance of a trend reversal, resulting in a downtrend. It is characterized by a dip in volume during the formation and a sharp jump once the requisite price action occurs.

Distinctions between Fundamental Analysis and Technical Analysis

Here are the aspects that differentiate fundamental and technical analysis – 

Time Horizon 

In most cases, fundamental analysts take a long-term approach in their trading as compared to technical analysts, as fundamental traders often wait longer until a currency’s intrinsic value is reflected in the market, if at all. 

On the other hand, technical traders react to movements of prices on charts shown by patterns and indicators, which provide more short-term opportunities to trade.

However, a fundamental analyst may also make a short-term play around important events and announcements where price tends to see bigger moves. Technical analysts can also undertake trades based on analysis of patterns over longer timeframes, looking at patterns on a daily or weekly chart.

Tools 

A fundamental investor is more concerned with understanding the currency’s current performance using macro and microeconomic factors. In comparison, a technical investor primarily focuses on its charts and movements to determine the right time to enter and exit a currency trade. 

Approach

A fundamental investor seeks to unearth the intrinsic value of a currency in comparison with another, while a technical trader considers that the current price already incorporates all the requisite information and focuses on the patterns that its price movement forms. These results in both types of traders looking at different opportunities and timing to enter the market.

timing to enter the market
Photo by Chris Liverani on Unsplash

The shortcomings of fundamental and technical analysis

Both fundamental and technical analysis have their respective pros and cons. Fundamental analysis can be reasonably time-consuming primarily since currencies are traded in pairs, and traders must be aware of the dates and events of major economic releases for both countries in the pair. This will include having to follow news in different time zones and preparing trading strategies accordingly. 

On the other hand, technical analysis requires the studying of charts and patterns, and understanding technical indicators. 

With the increasing adoption of technical analysis and automated trading tools by other institutional and individual traders, technical analysts will need to react quickly in order to capture trading opportunities. 

How can technical and fundamental analysis be utilized together?

While some traders may advocate the advantages of one over the other, using just one analytical method may limit the effectiveness of a trading strategy.

Fundamental and technical analyses can be complementary and come hand in hand while trading. Fundamental analysis allows visibility of the broader trends and identifying the currency pairs to trade in. In contrast, technical analysis provides more precise information on the time and price levels to enter a trade. 

Using both techniques in tandem will allow traders to build a more robust trading strategy, and make more well-rounded decisions when entering trades.

Final thoughts

Fundamental and technical analyses are both tools to help one with analyzing the forex market and supporting trading decisions. Learning to utilize the unique perspectives of technical and fundamental analyses and applying it in the context of one’s individual strategy will allow for developing a viable trading strategy. 

Contact us at Ortega Capital for more information.

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