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What is Fundamental Analysis?

Fundamental analysis mostly refers to the use of economic data to predict forex price movements. While technical analysis focuses on historical price action and repeating behavior, fundamental analysis takes into consideration the demand and supply for a currency based on the current and expected return in holding it.

Demand and supply of a currency are influenced mostly by central banks and monetary policy. When a central bank decides to add to money supply or lowers interest rates, the value of the local currency goes down since there is more of it in circulation and the rate of return on assets denominated in that currency is lower. On the other hand, when a central bank decides to lessen money supply or increases interest rates, the value of a local currency goes up since there is less of it in circulation and the rate of return on securities denominated in that currency is higher.

What influences the central bank's decision to adjust monetary policy by adding or reducing money supply and by increasing or decreasing interest rates? This is where economic data comes in.

Bear in mind that the central bank's mandate is to maintain price stability. When an economy is doing well, inflation tends to climb and the central bank would need to tighten monetary policy by reducing money supply or hiking rates. When an economy is performing poorly, inflation tends to drop and the central bank would need to loosen monetary policy by increasing money supply or cutting interest rates. This is just a general simplified view of monetary policy changes, which will be covered in the next section, but of course there are plenty of other economic factors that could influence central bank decisions.

Traders who use fundamental analysis often make use of an economic calendar to keep track of how economies are doing. These calendars list down the upcoming data releases, usually for major economies, and their potential impact on price action. There are reports that could trigger a large or long-term effect on forex movements while there are other reports that result to small reactions only. Economic calendars also typically include the previous report's result and the analysts' consensus for the upcoming release in order to give the trader a basis of comparison in whether or not improvements were seen.

Aside from economic events, market sentiment also usually factors in fundamental analysis. This refers to traders' appetite for risk, with higher-yielding riskier currencies usually rallying when confidence is up and lower-yielding safe-haven currencies climbing when confidence is down.

This can be gauged by looking at equity market performance, as stock indices generally surge when risk is on. When traders are feeling risk averse in general, this cautious trading behavior can also be monitored in global stock exchanges. Commodity prices are also sometimes used in gauging market sentiment, as covered in the latter sections.

While using a combination of technical indicators can help confirm price movements and filter out false signals, most traders opt to conduct multiple time frame analysis for additional confirmation. This method simply involves looking at the same currency pair across various time frames, from the short term 15-minute to the long-term daily or weekly charts. The reason behind this approach is that some trends are more visible on longer-term time frames. Meanwhile, some reversal signals or potential entry levels might be clearer on shorter-term time frames. With that, it helps to have both a bird's eye view of price action then to zoom in to determine exact entry or exit levels for a trade.

In this example, the daily time frame of the currency pair is showing a very clear trend but it can be difficult to determine precise entry points for a long trade simply based on this chart.

Zooming in to the 1-hour time frame of the same currency pair can be helpful in pinpointing possible Fibonacci retracement levels or breakouts of nearby inflection points, which would confirm that the ongoing trend will continue. There are no definite rules that state which time frames you should look at, as you have to determine this based on your trading style or what works for you. If you are a swing trader, you might be more comfortable looking at the daily chart and the 4-hour chart. If you're a scalp trader, you might want to watch the 1-hour chart then zoom in to the 15-minute time frame. Some traders find price action longer-term time frames too slow and they'd rather take quick moves with tight stops based on short-term time frames. Other traders are not too comfortable about fast price movements on minute charts so they'd rather trade the long-term charts and hold on to their trades for days or weeks. Of course there are a few advantages and disadvantages to favoring certain time frames. For instance, the advantage of sticking to longer-term charts is that it allows the trader to maintain his bias without having to check intraday charts every now and then. The disadvantage, however, is that this approach generates fewer trade signals. On the other hand, the advantage of looking at shorter-term time frames is that the trader is able to spot several trade opportunities very often. However, transaction costs for these trades could pile up and eat part of the profits. This also requires the trader to be flexible and able to change biases quickly. Another factor to consider, apart from one's trading style, when it comes to deciding which time frames to trade is capital. Trading shorter-term charts usually requires lower margin while longer-term trades may require a bigger account to avoid getting a margin call.

As you've learned in the previous sections, technical indicators and price action tend to move in tandem. For instance, when stochastic starts heading lower from the overbought zone, the corresponding currency pair usually sells off. On the other hand, stochastic climbing out of the oversold area indicates that the currency pair could rally. There are instances, however, when technical indicators and price action seem to be showing different results. Traders refer to these scenarios as divergences. Divergences take place when indicators make different highs or different lows. To be specific, higher highs in price and lower highs for the technical indicator constitute a trading divergence. So does lower highs in price and higher highs for the technical indicator. Meanwhile, lower lows in price and higher lows for the technical indicator or higher lows in price and lower lows in the indicator are also divergences.

These may be a challenge to remember at first so it might be easier to group these trading divergences into two main categories: regular and hidden. A regular divergence suggests a reversal in price action. In an uptrend, price usually makes higher highs but once the technical indicator shows lower highs, it could mean that the trend is about to turn.

In a downtrend, price usually makes lower lows but once the technical indicator draws higher lows, it might be a sign that the trend is almost over.

A hidden divergence indicates that the current trend is likely to resume. In an uptrend, price usually makes higher lows but when the technical indicator starts making lower lows in a pullback, it could be a sign that the correction is over and that the previous trend could resume

In a downtrend, price tends to make lower highs but once the technical indicator draws higher highs in a retracement, it could be a signal that the pullback is over and that the previous downtrend could carry on.

Divergences tend to work better in longer-term time frames than in shorter-term ones, as trends are more visible on those charts. Aside from that, there are also some requirements that must be fulfilled before trading a valid divergence. For one, successive highs and lows must be connected. You must also make sure that the highs or lows on the price are vertically aligned with the highs or lows in the technical indicator.

Of course there are some instances when divergence fails and you simply have to be prepared with a good risk management strategy in these cases. To lessen the odds of this happening to you though, you might want to consider a multiple time frame analysis, as discussed in the next section.

Harmonic price patterns comprise another set of chart formations involving Fibonacci retracement and extension levels. The rule of thumb in trading these patterns is to wait for the entire formation to be completed before entering any long or short positions.

There are six main kinds of harmonic price patterns, namely the ABCD, the three-drive, the Gartley, the crab, the bat, and the butterfly. The last three chart pattern names are based on the animals that the chart patterns resemble. This makes it easier for traders to remember what kind of harmonic price pattern is forming.

First off, the ABCD pattern is comprised of lines AB and CD known as the legs and line BC, which is the retracement. Here are the bullish and bearish illustrations of the ABCD pattern.

For this pattern to be valid, the length of leg AB should be around the same as the length of leg CD.

Next, the three-drive pattern is similar to the ABCD pattern, except that it has three legs and not just two. This is also a variation of the basic 5-3 Elliott Wave pattern discussed in the previous section.

For this pattern to be valid, the legs of the three-drive need to be equal in length. Aside from that, the time it takes for each leg to be completed should also be equal.

In the 1930s, stock market advisor Harold McKinley Gartley applied scientific and statistical methods to come up with a set of harmonic price patterns guiding traders on what to trade and when to enter trades. The most basic among these patterns is the "222 Pattern" found on Gartley's book entitled Profits in the Stock Market.

These 222 patterns form as corrective formations in the middle of an overall trend, telling the trader when to take a trade and take advantage of the trend continuation at a bargain price. These reversal points are marked by Fibonacci retracement and Fibonacci extension levels.

For the pattern to be valid, it should have the following characteristics:

1. Move AB should be the .618 retracement of move XA.
2. Move BC should be either .382 or .886 retracement of move AB.
3. If the retracement of move BC is .382 of move AB, then CD should be 1.272 of move BC. If move BC is .886 of move AB, then CD should extend 1.618 of move BC.
4. Move CD should be .786 retracement of move XA

The crab, bat, and butterfly patterns are simply variations of this basic 222 pattern, based on varying levels of the Fibonacci retracement and extension points.

A combination of repeating price patterns with Fibonacci analysis yields another branch of technical analysis known as Elliott Waves. This is named after its founder Ralph Nelson Elliott who analyzed 75 years' worth of stock data before formulating and compiling his theories in a book entitled The Wave Principle. He discussed how price movements are not completely random and that markets traded in repeating cycles. He noted that the upward or downward swings in price action are a result of a collective market psychology, central to which are emotions of traders. In his book, he outlined ways in which traders can catch trends at ideal prices as he detailed methods of catching market corrections and continuations. One of the most basic wave patterns discussed in his book is the 5-3 pattern, wherein the first five waves are the impulse waves and the last three waves are corrective waves.

The first wave consists of the initial move upwards (or downwards in a downtrend) which is sparked by a sudden influx of buyers (or sellers), spurred to take long (or short) positions and causing the price to make a big rally (or selloff). The second wave occurs in the opposite direction of the first one as traders book profits off a key inflection point or start to believe that the asset or currency pair is already overvalued (or undervalued). This leads to a move lower (or higher) but not beyond the initial price before the first wave started. The third wave takes place when more buyers (or sellers) pay attention to the asset and see that it is moving in a strong trend. This pullback allows them to get in the trend at a relatively good price so they set their long (or short) orders and push the price up (or down). The fourth wave happens because traders once again think that the asset is becoming overvalued and that it may be time to book profits once again. The fifth and last wave occurs to extend the price rally to a point wherein it becomes extremely overvalued (or undervalued), before the trend starts to reverse. The first, third, or fifth impulse waves may have a chance of being extended, which means that they can be longer than the other two impulse waves. Again, this depends mostly on market psychology or sentiment. Apart from that, fundamental and technical factors may also combine for a stronger push in price action. What's particularly interesting about Elliott Waves is that you can see these impulse and corrective waves occur in longer-term time frames and even as you zoom in to much shorter-term time frames, such as the 1-minute chart. Elliott has mentioned that there are roughly 21 wave patterns illustrating this phenomenon. These depend on the strength of the waves or the sharpness or shallowness of each pullback. These can be in the form of zig-zags, flat formations, or triangle patterns – all of which have the same general appearance as the 5-3 wave pattern. What's important to note about these Elliott Waves are the three cardinal rules. First is that the third wave can never be the shortest impulse wave. Second is that the second wave can never go beyond the start of the first wave. Third is that the fourth wave can never cross into the same area as the first wave.

Aside from technical indicators and Japanese candlestick patterns, another main component of technical analysis is chart formations. Remember that the concept behind technical analysis is that price patterns tend to repeat themselves, which means that these chart patterns more or less result to the same price behavior later on.

The sheer number of classic chart formations may seem intimidating and difficult to memorize at first but this comes with practice. More often than not, the names of the chart formations describe how the patterns look like on the charts.

For instance, the double top and double bottom patterns are one of the easiest ones to remember. A double top looks like two peaks in price action while the double bottom looks like two lows.

These are considered reversal signals, as a break beyond the neckline of the formation suggests the start of a new trend. To trade this, you can set a buy order above the neckline of a double bottom or set a sell order below the neckline of a double top.

Drawing necklines take practice but a good rule of thumb to remember is to simply connect the price turn in between the bottoms or the tops with a horizontal line.

A variation of the double top and double bottom is the triple top and triple bottom, which are also reversal signals. These are rare finds though but can be potent signals of a new trend.

A more complex reversal chart pattern is the head and shoulders. When it forms on top of an uptrend, it is a sign that a selloff might take place if price is able to break below the neckline.

Conversely, an inverse head and shoulders pattern forming at the bottom of a downtrend is a sign that price will turn and may move in an uptrend after breaking above the neckline.

Another group of chart patterns is the triangle formations. These can be descending, ascending, or symmetrical.

There is no hard and fast rule in saying whether these formations result to reversals or continuations. When price is consolidating tighter towards the rightmost tip of the triangle, it is a sign that a breakout may occur in either direction. Traders try to catch an up or down move by setting buy and sell orders outside the triangle.

Last but not least, another popular group of chart formations are the flags and pennants. These are typically treated as continuation patterns, as price simply consolidates for a short while inside a flag or pennant before resuming its ongoing trend.

There are other kinds of chart patterns such as wedges or cup and handle formations, which will be covered in a later section.

As opposed to leading indicators which generate early trade signals, momentum or lagging indicators give confirmation signals when the trend has already found directional momentum. Because of that, lagging indicators are also known as trend-following indicators.

One of the most basic examples of lagging indicators is the moving average crossover system. This can employ either simple or exponential moving averages with different parameters in combination to come up with buy or sell signals. When the shorter-term moving average crosses above the longer-term moving average, it is considered a buy signal. When the shorter-term moving average crosses below the longer-term moving average, it can be a sell signal.

Some traders opt to use a number of moving averages in combination. Conservative rules suggest that when the moving averages are arranged in a descending manner from top to bottom, it could be a sell signal. When moving averages are arranged in an ascending manner from top to bottom, it could be a sell signal.

Another kind of lagging indicator is the MACD, which is short for moving average convergence divergence. As the name suggests, this method also makes use of moving averages but focuses more on the convergence or divergence of these indicators.

The MACD chart also includes the histogram, which keeps track of the difference between the moving average. The criss-crossing lines at the bottom, which is the actual MACD, shows the moving average of the difference between the moving averages.

As mentioned in an earlier section, it is not important to memorize how these indicators are derived but that it is more crucial to understand how to apply them. While the MACD may seem like a complicated tool at first, it pretty much functions in the same manner as moving averages.

When the MACD lines move closer to each other, this means that the actual moving averages are converging and that a market turn might be in the cards. On the other hand, when the MACD lines move apart form each other, this means that the actual moving averages are diverging and that the trend is getting stronger. In a way, MACD can also be treated as both a leading and lagging indicator.

Trading using the MACD can also make use of the crossover method. When the MACD lines cross, it indicates the start of a new trend. Waiting for a few histogram bars to grow larger can be a way of getting confirmation that the trend will be strong.

As with leading indicators, the parameters of lagging indicators can also be tweaked to suit the trader's style and preferences. Generally speaking, shorter periods tend to result in more trade signals but with the higher chance of getting false ones. Longer periods generate fewer trade signals, which means that one might miss out on a few good trade opportunities.

When it comes to using leading indicators, a good way of remembering how they work is to understand that they "oscillate" between two points, hence the name oscillator. This means that they bounce back and forth from point A to point B, which is another way of saying that what goes around comes around.

When an oscillator reaches the overbought zone or gives a sell signal, it eventually goes down along with price action. When an oscillator reaches the oversold zone or gives a buy signal, it then moves up along with price action.

As you can see from the illustration, once stochastic hit the overbought zone above 80.00, price eventually went down along with the oscillator's movement. When stochastic reached the oversold area below 20.00, price eventually went up along with the oscillator's movement.

Of course the magnitude of the move still depends on a number of other technical and fundamental factors, and these are not necessarily indicated by the leading indicator's movement. In other words, the move up can be stronger than the move down or vice versa, depending on the market trend.

Another example of a leading indicator is the RSI or the relative strength index, which functions mostly like the stochastic. When RSI reaches the overbought area and gives a sell signal, price moves down. When RSI reaches the oversold area and gives a buy signal, price moves up.

The parabolic SAR (stop and reversal) is a special kind of leading indicator which also provides exit signals. Aside from that, this oscillator is usually applied as an overlay on price action to better allow the trader to visualize his entries and exits.

As you can see from the illustration, dots form above the price when a selloff is about to take place. On the other hand, dots form below the price when a rally is about to happen.

It may not be wise to jump in a long or short trade the moment a single dot appears below or above price action. One can wait for two or three dots to form before entering a position on the next candle then exiting when one or two dots form in the other direction.

Stochastic and RSI can also be used to identify trade exits by checking if the oscillator has reached the opposite end and is signaling a possible reversal. For stochastic, a crossover could signify a potential market turn. For RSI, a move below the middle 50.00 level could be an early sign that the trend is weakening.

Of course the parameters of these leading indicators can be tweaked to suit your trading style. More often than not, shorter-term parameters can generate more signals while longer-period ones give fewer signals. You can try different settings to filter out the false signals and to come up with a system that generates optimal results.

Technical indicators are grouped into two main classifications: oscillators or leading indicators and momentum or lagging indicators. Moving averages, as discussed in the previous section, typically fall under the category of lagging indicators but the parameters can be modified or shifted to allow it to act as a leading indicator.

As the name suggests, leading indicators give trade signals when the trend is just about to start. In other words, leading indicators give early trade signals.

On the other hand, lagging indicators give trade signals when the trend is already taking place. This means that lagging indicators give confirmation trade signals.

There is no right and wrong when picking whether to use a leading indicator or a lagging indicator. Some traders decide to use a combination of both, with the leading indicator serving as an alert for a new trend and the lagging indicator acting as confirmation for a trade entry.

As you can see from the chart above, the stochastic hints that a new trend is about to take place while the MACD gives the go signal for the trader to enter a trade in the direction of the new trend.

Some argue that using only one or the other can give erroneous trade signals. After all, sticking with only a leading indicator can give false signals, telling the trader to enter a trade the moment a new trend seems to start. On the other hand, using only a lagging indicator can give late signals, with the trader not able to take advantage of the majority of the price movement or entering a trade when the trend is almost over.

At the end of the day, it is up to the trader to determine which technical indicators he is most comfortable with and which ones he thinks could yield the best returns. Trial and error is often key to figuring out which indicators and which parameters could lead to profitable results.

In the next sections, the different kinds of leading and lagging indicators will be discussed. Note that it is not important to memorize how the indicators are derived but that it is more crucial to have a clear understanding of how they work and how they can be applied to forex trading.

This section covers the basic technical indicators used in forex trading, the most common of which is the moving average.

As the name suggests, this kind of technical indicator measures the average closing price of the currency pair for a specified period. For example, using the moving average (20) on an hourly chart takes the average of the closing price for the past 20 hours.

There are two main types of moving averages: simple and exponential. This has to do with the method in which the average is generated, with the simple moving average taking the sum of the closing prices then dividing by the number of time periods and the exponential moving average assigning weights to more recent time periods.

Either way, the goal in using moving averages in technical analysis is to smooth out price action and get a better idea of how future price movement will fare. Simple moving averages allow you to see a general idea of past price action while exponential moving averages incorporate the latest price volatility.

Moving averages can be used as a single indicator or as a group. As a single indicator, this is often used to generate buy or sell signals based on price crossovers. It can also be treated as a dynamic support or resistance level in a market trend.

Using multiple moving averages is also useful for crossover systems. For instance, a trading system can specify that buy signals would be generated when the moving averages are arranged from shortest-term to longest-term. A sell signal could be generated when the moving averages are arranged from longest-term to shortest-term from top to bottom.

Which kind of moving average should you use? This depends on the type of trading strategy you are planning on using. In particular, traders who are more aggressive with their entry orders and are inclined to enter trends as soon as they start may prefer a short-term exponential moving average since this is very sensitive to recent price action. The downside to this method though is that it can be prone to fake outs.

As for exits, moving averages can also give signals to close a trade when a new crossover has taken place. This is usually seen as a sign that a reversal is forming and that it may be time to book profits