Understanding Forex Market Analysis
Reading time: 10 minutes
First things first, only two forces move the market - supply and demand. They are the common denominator for every economic, political, social, scientific, cosmic, and market event. Any market on the planet depends on them - and they are of utmost importance to the bulls and the bears, along with the open positions they hold.
In this article we will describe techniques, styles, approaches and strategies. Interestingly, they all have one particular thing in common - they all attempt to measure supply and demand. Some of them might even be highly accurate, but will almost always lag behind price. Some others, like economic theories used in fundamental Forex analysis, won't be very precise. By changing their sentiment between being bulls or bears at different times, traders are able to create the very market they are trying to analyse, only to then change it again when they open a new trade. As a trader, you need to understand that only through the best Forex analysis of supply and demand can you gain a competitive edge over another trader.
The one defining feature of technical Forex market analysis is that it is chart bound. If you are looking at charts for any reason, you are exercising technical FX analysis. The logical basis for analysing charts is provided by Dow theory, authored by the infamous Charles Dow. Amongst other things, Dow claimed that the market discounts everything. Put simply, Dow was saying that whatever factor has an impact on supply and demand, will inevitably be reflected in the price - which is displayed in real-time on price charts. In fact, pure technical analysis advocates against studying almost anything outside the price chart, because it's unquantified, unreliable data. This brief introduction to technical Forex analytics already highlights its biggest limitation - it analyses what has already been accounted by the market. The bigger question for traders to consider here is: how can I be competitive if what I know is common knowledge?
Price action is a subculture within technical analysis in Forex that has been increasingly popular since Forex trading became available to the masses. The reason for this spike in popularity is that price action, while concurring with the base postulate of Charles Dow's theory, deems most of the tools available to technical traders, such as classic technical indicators, as incapable of providing any competitive edge for the trader. Price action traders draw conclusions from 'naked' charts, with price moves supporting their primary decisions in the creation of data. Everything else, if even considered, is there to support, but not to initiate trading action. In the foundations of price action trading lies an observation that the market often revisits price levels where it previously reversed or consolidated, because of the remnant supply or demand that is still there.
What is 'remnant supply and demand'?
Instead of chasing the market, institutional traders from banks, hedge funds and multinationals only care for their orders being filled at the price they wanted. Their Forex analysis is aimed at where the market is going to be next month, or even next year. If the market moves away from a level that they traded today, their orders will not get cancelled. They hold their positions open until the market returns. These remaining open orders warp the fabric of the market, attracting the price to revisit. This is similar to how mass warps the fabric of time and space, attracting more mass. Price action strategies are most often used in daily Forex analysis.
Charts are a series of price quotes represented graphically. They provide the recorded history of the market. On the '0Y' axis we have price, on the '0X' axis we have time. What is displayed on the field - is the price action itself. No matter which trading style a person chooses - long-term positional or short-term intraday - everything starts with charting. Charting itself is a relatively new technique to the western world. Wall Street has only been using charts for a little more than a century, although in the Far East there are documents containing price quotes in the form of candlesticks dating as far back as 300 years. These are known as 'rice price quotes'.
Candlesticks are the most basic tool available to a technical trader. Using bare candlestick patterns to forecast price movements is a strategy in-of-itself. In addition to learning common patterns, it is best to understand the underlying supply and demand forces that shape them. Aside from studying bare candlesticks, technical traders may also use charting patterns. The most popular being support and resistance lines, trend channels, triangles, and flags. There are many others too. It is important to understand that supporting constructions are not there to predict future market movements. They are only there for the convenience of a trader, and their better understanding of past moves.
The same chart may appear to consist of a variety of patterns to different traders, or perhaps even the same trader at different times, producing opposing signals. This is why supporting constructions should not be the primary argument in your decision making, and perhaps why supply and demand should.
If you have opened your trading platform, you will have definitely seen a technical indicator before. For clarity, let's divide them into two big groups - trend indicators and oscillators.
- Trend indicators - moving averages (MA), MACD (Moving Average Convergence Divergence), ADX (Average Directional Index) or Ichimoku - point out the direction of a trend (but not always the direction of the current price action) and the strength of the trend.
- Oscillators - RSI Indicator, Stochastic, or the Parabolic SAR Indicator - point out the turnarounds.
Trend indicators work well in trending markets, whereas oscillators work well in ranging markets. At least they do in theory. There are a couple more that are in between, such as Bollinger Bands. They use both a variation of an MA to track the trend, as well as the price range channel to hint on the turnarounds. Finally, there are volume based indicators. These are interesting because although trading volume has always been used in financial trading as a defining factor for supply and demand, accurately measuring it within a Forex spot market is impossible. This is because Forex spot is an OTC (over-the-counter) market.
Technical indicators are, for lack of a better word, imperfect. They lag behind the price, often being redrawn upon the candle closing. They are used regularly in combinations to complement each other, because otherwise they fail completely. And when you hear professional traders advising beginner traders to keep their charts clean and simple - they are talking about not abusing the technicals. Lastly, trading strategies that are based purely on technical indicators can hardly provide a competitive edge.
Fundamental FX market analysis does not use price charts, but rather economic data such as interest rates, inflation rates, or trade balance ratios. The theory behind fundamental analysis is that markets may misprice a financial instrument in the short run, yet always come to the 'correct' price eventually. For the period of this 'mispricing', a trading opportunity is subsequently created. Fundamental FX trading analysis is hardly a style that provides precise points for entering or exiting trades. However, if used knowledgeably, it is a great tool to predict long-term price movements. The catch with purely economic based fundamentals is that even though countries are much like companies, currencies are not quite like stocks.
A company's financial health is directly relevant to its stock price. For countries however, an improving economic performance does not necessarily equal growth in its currency's relative value. In fact, a currency's relative value is a function of many factors ranging from national monetary policies, to economic indicators, to the world's technological advancements, to international developments, or even natural disasters.
Economic Theories and Raw Data
Besides the market sentiment, there are also a few economic theories that work on locating disparities in the current price of a currency and its 'true' value. Here are a few examples:
- Purchase Power Parity (PPP) - assumes that goods should cost the same after the currency rate adjustment. If they don't, good trading opportunities present themselves.
- Interest Rate Parity (IRP) - basically the same as PPP, except that goods are financial assets in this case, and their purchase in different countries should yield the same after the interest rate adjustment.
- Balance Payment Theory (BPT) - deals with a country's trade balance. If more goods and services are imported than exported, the national currency will depreciate.
- Real Interest Rate Definition Model (RIRDM) - exactly the same as IRP. A currency with higher interest rates will appreciate against the currency with lower rates, through being a more attractive investment.
- Asset Market Model (AMM) - much like the trading balance, except that measures inflow and outflow of foreign investment. The more foreign investment, the higher the national currency appreciates.
Aside from the aforementioned theories, raw national economic data has a say in Forex weekly analysis. Employment data, interest rates, inflation, GDP (Gross Domestic Product), trade balance, retail sales, durable goods and other indicators all can have a short term effect on the market upon their publication. If you would like to track this sort of data, you can do so with our Forex calendar.
This is possibly the most straightforward method of measuring supply and demand other than through price action, although it is not without its limitations. The method is based on measuring open interest (open trades), which is the key to supply and demand. It's an idea borrowed from the stock market: wherein, if trade volumes are rising, while open interest is dropping, the chances are that market sentiment is changing. The Forex spot market is traded over-the-counter, so tracking trading volume, or measuring open interest is impossible. The next best thing to help traders gauge market sentiment is the 'Commitment of Traders' report for the Forex futures market. There are only two problems associated with this:
- First of all, Forex futures' daily volume is only $100 billion, compared to the Forex spot market, which is worth $1.5 trillion.
- Secondly, among the most successful traders, there aren't only speculators, there are also hedgers, who trade in a completely different, and opposing way. For instance, if speculators buy harder with the stronger bullish trend, speculators sell harder with the stronger bullish trend.
Most traders tend to use strategies that work for them, whether it be technical analysis, fundamental analysis, or a mixture between the two. Undoubtedly, interest rates, inflation rates, trade balances, market sentiments and other fundamentals can show traders the bigger picture. However, in the short term, currencies rarely move in a straight line, which means that there is plenty of short-term price action to take advantage of. In that domain, technical analysis can be very effective. Whatever type of analysis you use, make an effort to trace its logic back to supply and demand market theory. If it still makes sense, go for it. If it doesn't, think about it some more.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.