Analysis of the Forex and CFD markets is crucial to minimize loses and gain profits in trading. Like all the things in life, you must have a proper forex trading strategy to trade the currency markets. This article will help you get going by outlining the various types of forex trading strategies used by traders.
In order to achieve success in forex and CFD trading, one also needs to show patience, discipline and have experience. Besides the many analytical disciplines mentioned in this article, techniques of risk management also play a crucial role in determining success.
A high success rate in forecasting exchange rates is nowhere near a simple endeavor. As once said by the former Fed Governor, Alan Greenspan,
“… having endeavored to forecast exchange rates for than half a century, I have understandably developed significant humility about my ability in this area…”.
Moving forward, there are three main approaches to Forex forecasting. These include:
- Technical Analysis
- Fundamental Analysis
- Sentiment Analysis
Potentially, technical analysis is the most popular forex trading strategy. This is true especially for retail traders, as a majority of them hold relatively short trading time-horizons, a field where technical analysis has surpassed fundamental analysis. However, one shouldn’t conclude that technical analysis cannot be employed for longer timeframes.
The primary question remains – what exactly is a technical analysis? This discipline of forex market analysis is grounded on three basic foundations:
- Markets exhibit trend – On the establishment of a trend, there is a greater possibility of the price following the trend direction than going reverse. While this holds for all financial markets, the forex market is specifically renowned for its stable and often prolonged trends. This foundation is further emphasized by the bandwagon effect – people want to join the general action of the crowd when the price begins to rise (or fall).
- History has a habit of repeating itself – With regards to the markets, it has been observed that specific price patterns that have worked before are likely to work again. As humans make up a majority of the market participants (still), the behavioral pattern exhibited by them are inclined to repeat to a certain extent. This is exactly what we are provided by the chart patterns – They explain the market’s underlying psychology and the market participant’s expectations that often turn out to be self-fulfilling.
- Everything gets discounted by price – The dismissal of fundamental factors in technical analyses is one of the primary reasons behind its popularity. While the combination of fundamental and technical analysis is possible, a pure chart is sufficient to obtain a technical image of the market. The sole focus is on price and nothing else, because the price is influenced by the buying and selling actions of fundamental traders, hinting towards their views about a currency. For instance, if a currency is not liked, the traders will tend to sell it, resulting in the lower trending of its price, and vice versa. This last premise of technical analysis signifies that price discounts all other fundamental factors, making it unnecessary to follow any other charts except the price-chart.
To understand what technical analysis is exactly about, it is essential to know its basic foundation. So, to conclude – Technical analysis positions the financial instrument’s historical prices to obtain an accustomed price, along with chart patterns that can be instrumental in projecting the future price movements.
In the toolbox of technical analysis, nearly all tools serve the main purpose of recognizing trends and trend reversals in the initial stages itself. In both, long-term and short-term trading, technical analysis exhibits good results, while providing precise entry and exit points – which fundamental analysis fails to. Even though it is easy to understand and use the basic technical analysis tools, a little trading experience is necessary to properly apply them on the price chart.
It is also argued that technical analysis is both sciences as art since two traders will never look at a technical chart in exactly the same way. However, to increase the trading success rate, you will have to identify the technical levels correctly, which are also being watched by most of the traders across the globe.
For more on the subject, read: A Deeper Look at Technical Analysis and Multiple Time Frame Analysis.
Fundamental analysis relies completely on economic factors, monetary, fiscal, and political policies to estimate where a currency should be trading, and it is a popular forex trading strategy used by longer-term traders. Typical users of this type of forex trading strategy are banks, hedge funds, and other institutional players.
For an assessment of the exchange rate which appears to be fundamentally justified, several influences are analyzed. A few of these influences include the forecasted rate of economic growth of the country in question, the monetary policy of the central bank, inflation figures, unemployment rate, and the trend of the interest rates. However, understanding how everything links together require a deep understanding of macroeconomics, and the lead times are long, and this is one of the reasons why fundamental analysis is not as popular as technical analysis.
Time horizon is a major obstacle in fundamental analysis. The fundamental analysis tends to help to predict what will happen with an FX rate six months and onwards. This makes it different from technical analysis, which is applicable in case of long-term and short-term trading. Out of the many reasons for such a trend is that the exchange rate stays undervalued or overvalued relative to the equilibrium rate and for a long time. Sometimes a currency can deviate for years from its estimated value.
Additionally, economic factors tend to fluctuate regularly. It is the same for equilibrium exchange rates. It can be said that fundamental analysis does not provide any exact exit and entry point for trades, as we get from technical analysis.
Several fundamental models are based on different economic theories which reveal a poor track record. However, a little knowledge of fundamental analysis can help when used as a compass to determine where the market is moving in long-run.
Even if retail traders don’t necessarily include fundamental analysis to their forex trading strategy, all retail forex traders pay attention to market reports and news, as the outcome of economic indicators will increase random market volatility. The economic indicators are published in the economic calendar which shows actual, the forecasted and the previous numbers of indicators such as the unemployment rate and inflation.
Some the retail traders will try trading on such reports by guessing if the actual number can be higher or it can be lower than the forecasted number. Though a surprise in any actual number can create significant volatility, such an approach might be quite risky and usually accounts a small portion of the scope of what fundamental analysis is.
In conclusion, we can say that fundamental analysis is using information about the current state of a country and its economic indicators, plus its monetary and fiscal poliicsy to try to figure out where a currency should be trading.
Sentiment analysis is the third analytical discipline that we will explain. Such kind of analysis has the primary objective of measuring the sentiments of the market participants. Understanding the sentiments of the investors – whether it is bearish or bullish, helps in understanding the market better. It also helps in forecasting future possible price movements. But evidence suggests that market sentiment is also a coincident indicator. This implies it does a good job to confirm the current trend. However, it doesn’t provide any clue about where the exchange rate is moving. Thus, it can be assumed that if the investors are bullish on a particular currency, such an increase in demand should be reflected in the exchange rate and not at a particular point in the future.
The existing market sentiment can be easily assessed by analysis of CFTC’s Commitment of Traders report (CoT). This report is usually published every Friday. It reflects the positioning of the investor on the previous Tuesday. You can find the latest figures and charts in the InvestingCube economic calendar.
The CFTC’s CoT report can be used as a contrarian overbought/oversold indicator. For instance, in case that traders are holding extreme long positions in Japanese Yen when compared to CoT levels in the past, it can be assumed that there is some reduced buying power left. This is also applicable when the sentiment reaches bearish levels and traders are extremely net short, in such a situation, we can anticipate that the selling pressure in the JPY will decline in the weeks and months ahead.
However, if you trade only using the CoT report, then you wil notice that markets might stay overbought/oversold for a significant time. Thus the CoT indicators are poor if you are trying to determine where a currency pair will be trading in the next week, but it can help to determine where a currency could be trading in a few months. The indicator it self should be combined with technical analysis and other news.