Basic
Forex forecast methods: Technical analysis and fundamental analysis
This article provides insight into the
two major methods of analysis used to forecast the behavior of the
Forex market. Technical analysis and
fundamental analysis differ greatly, but both can be useful forecast
tools for the Forex trader. They have
the same goal - to predict a price or movement. The technician
studies the effect while the
fundamentalist studies the cause of market movement. Many successful
traders combine a mixture of both
approaches for superior results.
Technical analysis is a method of
predicting price movements and future market trends by studying charts
of past market action. Technical
analysis is concerned with what has actually happened in the market,
rather than what should happen and takes
into account the price of instruments and the volume of trading,
and creates charts from that data to use
as the primary tool. One major advantage of technical analysis is
that experienced analysts can follow
many markets and market instruments simultaneously.
Technical analysis is built on three
essential principles:
1. Market action discounts
everything! This means that the actual price is a reflection of everything
that
is known to the market that could affect
it, for example, supply and demand, political factors and market
sentiment. However, the pure technical
analyst is only concerned with price movements, not with the
reasons for any changes.
2. Prices move in trends Technical
analysis is used to identify patterns of market behavior that have long
been recognized as significant. For many
given patterns there is a high probability that they will produce
the expected results. Also, there are
recognized patterns that repeat themselves on a consistent basis.
3. History repeats itself Forex
chart patterns have been recognized and categorized for over 100 years
and the manner in which many patterns
are repeated leads to the conclusion that human psychology
changes little over time.
Forex charts are based on market action
involving price. There are five categories in Forex technical
analysis theory:
Indicators (oscillators, e.g.: Relative Strength Index (RSI)
Number theory (Fibonacci numbers, Gann numbers)
Waves (Elliott wave theory)
Gaps (high-low, open-closing)
Trends (following moving average).
Some major technical analysis tools are
described below:
Relative Strength Index (RSI):
The RSI measures the ratio of up-moves
to down-moves and normalizes the calculation so that the index
is expressed in a range of 0-100. If the
RSI is 70 or greater, then the instrument is assumed to be
overbought (a situation in which prices
have risen more than market expectations). An RSI of 30 or less is
taken as a signal that the instrument
may be oversold (a situation in which prices have fallen more than
the market expectations).
Stochastic oscillator:
This is used to indicate
overbought/oversold conditions on a scale of 0-100%. The indicator is based on
the observation that in a strong up
trend, period closing prices tend to concentrate in the higher part of the
period's range. Conversely, as prices
fall in a strong down trend, closing prices tend to be near to the
extreme low of the period range.
Stochastic calculations produce two lines, %K and %D that are used to
indicate overbought/oversold areas of a
chart. Divergence between the stochastic lines and the price
action of the underlying instrument
gives a powerful trading signal.
Moving Average Convergence Divergence
(MACD):
This indicator involves plotting two
momentum lines. The MACD line is the difference between two
exponential moving averages and the
signal or trigger line, which is an exponential moving average of the
difference. If the MACD and trigger
lines cross, then this is taken as a signal that a change in the trend is
likely.
Number theory:
Fibonacci numbers: The Fibonacci number
sequence (1,1,2,3,5,8,13,21,34...) is constructed by adding the
first two numbers to arrive at the
third. The ratio of any number to the next larger number is 62%, which
is a popular Fibonacci retracement
number. The inverse of 62%, which is 38%, is also used as a Fibonacci
retracement number.
Gann numbers:
W.D. Gann was a stock and a commodity
trader working in the '50s who reputedly made over $50 million
in the markets. He made his fortune
using methods that he developed for trading instruments based on
relationships between price movement and
time, known as time/price equivalents. There is no easy
explanation for Gann's methods, but in
essence he used angles in charts to determine support and
resistance areas and predict the times
of future trend changes. He also used lines in charts to predict
support and resistance areas.
Waves
Elliott wave theory: The Elliott wave
theory is an approach to market analysis that is based on repetitive
wave patterns and the Fibonacci number
sequence. An ideal Elliott wave patterns shows a five-wave
advance followed by a three-wave
decline.
Gaps
Gaps are spaces left on the bar chart
where no trading has taken place. An up gap is formed when the
lowest price on a trading day is higher
than the highest high of the previous day. A down gap is formed
when the highest price of the day is
lower than the lowest price of the prior day. An up gap is usually a
sign of market strength, while a down
gap is a sign of market weakness. A breakaway gap is a price gap
that forms on the completion of an
important price pattern. It usually signals the beginning of an
important price move. A runaway gap is a
price gap that usually occurs around the mid-point of an
important market trend. For that reason,
it is also called a measuring gap. An exhaustion gap is a price gap
that occurs at the end of an important
trend and signals that the trend is ending.
Trends
A trend refers to the direction of
prices. Rising peaks and troughs constitute an up trend; falling peaks and
troughs constitute a downtrend that
determines the steepness of the current trend. The breaking of a trend
line usually signals a trend reversal.
Horizontal peaks and troughs characterize a trading range.
Moving averages are used to smooth price
information in order to confirm trends and support and
resistance levels. They are also useful
in deciding on a trading strategy, particularly in futures trading or a
market with a strong up or down trend.
The most common technical tools:
Coppock Curve is an investment tool
used in technical analysis for predicting bear market lows.
DMI (Directional Movement
Indicator) is a popular technical indicator used to determine whether or not
a currency pair is trending.
Unlike the fundamental analyst, the
technical analyst is not much concerned with any of the "bigger
picture" factors affecting the
market, but concentrates on the activity of that instrument's market.
Fundamental
analysis
Fundamental analysis is a method of
forecasting the future price movements of a financial instrument
based on economic, political,
environmental and other relevant factors and statistics that will affect the
basic supply and demand of whatever
underlies the financial instrument. In practice, many market players
use technical analysis in conjunction
with fundamental analysis to determine their trading strategy. One
major advantage of technical analysis is
that experienced analysts can follow many markets and market
instruments, whereas the fundamental
analyst needs to know a particular market intimately. Fundamental
analysis focuses on what ought to happen
in a market. Factors involved in price analysis: Supply and
demand, seasonal cycles, weather and
government policy.
The fundamentalist studies the cause of
market movement, while the technician studies the effect.
Fundamental analysis is a macro or
strategic assessment of where a currency should be trading based on
any criteria but the movement of the
currency's price itself. These criteria often include the economic
condition of the country that the
currency represents, monetary policy, and other "fundamental"
elements.
Many profitable trades are made moments prior to or shortly after
major economic announcements.
Euro Exchange Rate
