Tuesday, 22 May 2012

Look Back- Fundamental Analysis

A. Fundamental Analysis

The true movements of currencies are based upon fundamentals – capital flows, trade flows, economic numbers, rumours and news. Technical analysis, on the other hand, is a strategy that calls for focusing upon historical price patterns, all of which are very subjective -- there are a million different technical analysis patterns, any of which a trader can use to argue his/her bias. At any one time, it will be easy for technical analysts to find indicators offering conflicting signals, with some pointing to an upward bias and others indicating a negative bias.
Fundamental analysis on the other hand, is based upon finding the intrinsic value of a currency pair. Fundamentalists focus on the forces that move currencies and how they impact its intrinsic value. Below are some theories as to why fundamental analysis may be superior to technical analysis:


Using Fundamental Analysis to Forecast Long-Term Directional Trends
One of the key advantages of fundamental analysis is the ability to forecast long-term directional trends. Fundamental analysis serves as a guide to gauge whether currencies are undervalued or overvalued. Over the long run, currencies rarely trade in ranges and instead develop strong trends. Therefore it is important to use fundamental analysis to gage the direction of the trend. A classic example is the EURUSD, which has been trending upwards since 2002. This trend can be easily explained by the ballooning US current account deficit, the US government’s waning commitment to a strong dollar, as well as the prospects of a jobless recovery. Big money can be made using fundamental analysis, as traders can take advantage of long-term fundamental shifts
in the markets.

Fundamentals Can Cause Short-term Movements
Besides being able to forecast the long-term directional trend of a currency pair, fundamental analysis can also be used to forecast sudden short-term movements. Economic data, rumors and news all have the potential to impact currency movements. For example, potential intervention by the Bank of Japan kept USDJPY well supported between late May and early July of 2003. Comments from central bankers also move markets - ECB Duisenberg’s comment that a fall in the dollar is “unavoidable” explains the bulk of the 200-pip EURUSD rally on October 6, 2003. Surprises in economic data also move markets – economic data that consistently beat expectations in Australia recently propelled the currency to five-year highs.

B. Technical Analysis
Coinciding with the increasing popularity of computerized trading across all investment arenas is the ability for traders to employ technical analysis. As markets tend to become inundated with information, and as charting applications are able to provide traders with an increasing array of data, technical analysis has become both practical and relevant. Below are some theories as to why traders need to develop an understanding of technical-based trading.

Determine Precise Entry/Exit Points
Fundamental analysis’ most glaring weakness is its lack of precise entry, exit and stop points. Fundamental traders tend to have more of a spontaneous process regarding when they should enter trades. In theory this may not prove too harmful, but in reality it increases the likelihood of a trader becoming more erratic in their style, and more prone to classic money management and psychology mistakes. On the other hand, technical analysis demystifies the market; traders have certain rules and concepts that allow them to determine precise points at which they should place their orders. This facilitates the employment of a disciplined strategy.

The chart below illustrates how a technical trader can determine when to get in and out of the market.

Analyzing Instead of Forecasting
One of the most common complaints about technical analysis is that it fails to consider the very factors that result in the movement of exchange rates; it only looks at statistics and patterns, which are derivatives of market activity, not causes of it. Accordingly, the rationale is that technical analysis is an ineffective tool at forecasting:
it does not look at the causes of exchange rate movement, and hence cannot justifiably determine the future effects of exchange rates.

This is undeniably true. It is, however, misleading. The reason why technical analysis works well is precisely because it does not involve forecasting or predicting – it considers only what is actually going on in the market regarding who is buying and who is selling. This is the true information in the market, and for some traders it is the only information that really matters. The market is simply a battle between buyers and sellers – and thus, technical analysis reasons that looking at the statistics behind this “battle” is all that is really needed to determine what really is going on in the market, and how to profit accordingly.

Error On the Chart
In the first month that the course existed, we noticed that there several errors in the chart. One deals with Fib retracement levels plotted above and how they were used as a trading signal, the other deals with a candlestick. Rather than correct the chart I decided to leave it in and see if anyone noticed the error. So the question is:
What is wrong with the way that we used the Fib retracement level as a trading signal in the above chart? Also, what error deals with a candlestick pattern?

C. Short Term Trading
Many new forex traders find it difficult to determine whether they want to be a long-term or short-term trader. While there are justifiable reasons to be either type, in the end traders are looking for the trading style that is most profitable. Short term trading is one possible means to that end. Here are some of the advantages of short-term trading.
  • Prices are driven by order flow, which is more predictable over the short term
  • Long term trading is subject to greater volatility
Easier to Predict Order Flow in the Short Term
Due to greater leverage and lower transaction costs, short-term active traders have flocked to the FX market due to its benefits. Since many of these short-term traders review the same technical analysis patterns to base their trading decisions, many of the moves seen in this market are self-fulfilling prophecies. The reason for this is because if you have knowledge of where the most significant technical levels are located at any point in time and also realize that the majority of the other traders in this market base their trading decisions on the same technical analysis, this provides a trader with a strong idea of where order flow lies at any given price.
Therefore, one can predict with a good degree of precision the real factor that drives market prices, namely order flow. With longer time frames – such as daily, weekly, and monthly charts – the flow of orders is harder to predict; more technical patterns and interpretations are possible, as well as input from a greater number of fundamental factors that will affect the market in the long-term. Because of this, order flow – and hence exchange rate movement – becomes more difficult to predict in the long run.

Long Term Trading is More Volatile
With long-term trading, there are many factors that drive currency prices which are extremely difficult to predict. In addition to long-term technical patterns, there is the increased importance of long-term fundamental factors, such as capital flows and trade flows. In addition to the increased number of factors that need to be considered is the fact that currency pairs are more volatile over longer periods of time – meaning that long-term traders may in fact lose more than their short-term counterparts. For example, a trader looking to get in and out of positions within a single day is most likely dealing with a range of no more than 100 pips; a long-term trader, however, must be prepared to cope with the fact that currency pairs can easily move several hundred pips or more. If a trader is on the wrong side of a long-term trade, the loss could potentially be devastating.

Long-term traders typically rely on fundamental factors to base their trades, such as economic data releases and interest rate differentials seen over time. While such fundamental factors in fact cause movements in the market, the problem is that such fundamental factors are too difficult to predict over the long term and leave long term traders overly exposed to adverse market movements, which often cannot be seen or predicted until it is too late.
The above chart depicts three profitable entry points on three separate trading days by putting short term technical analysis to work. Substantial profits could be reaped from these three opportunities alone.

D. Long Term Trading
Many new forex traders find it difficult to determine whether they want to be a long-term or short-term trader. While there are justifiable reasons to be either type, in the end traders are looking for the trading style that makes them the most profitable. Long term trading is one means to that end.

Short term trading is subject to excessive volatility
Short term trading patterns can change in seconds or minutes. It is very difficult to trade and subject to too many external factors such as breaking news releases or large flow. In short term trading there are frequently false breakouts that can throw many traders off. Why deal with this excess stress when large profits can be made with long-term trading? Yes, there is also volatility in long-term trading – however, as long as stops are placed at the proper levels, the overall trend tends to remain intact, and the significance of day-to-day fluctuations is largely minimized.

Large profits are made with long-term trading
Forex markets are trending markets. This means that traders do not need to be glued to their trading screens 24/7 in order to make money. Too much stress is involved in short-term trading, as the market must be constantly watched and each small move becomes a major event. Since most traders do not trade full time, and certainly are not watching the markets 24 hours a day, short-term trading simply too demanding and quiteunfeasible. With most traders, the psychological difficulties of short-term trading get the best of them, and the traders may end up taking profits too early or cutting losses too late. If traders pre-commit to a long-term target and stop, they can make money while erasing the need to know where the EURUSD is trading at every minute. In fact, substantial profits can be made with long term trading. It is highly unlikely for short-term traders to ever claim that they can make 1907% in 10 months of 3296% in 18 months. Below are examples of how large profits could have been made if traders held their positions long-term.

USDCHF
Hold short position from 1/2002 to 6/2003 = 4395 pips in profit = approx $32960 on 1 lot of 100,000 units, using $1000 in margin = 3296% in 18 months

USDCAD
Hold short position from 1/2003 to 10/2003 = 2543 pips in profit = approx $19070 on 1 lot of 100,000 units, using $1000 in margin = 1907% in 10 months

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