Forex Forecasts: Basic Forex Forecasting Techniques
Reading time: 9 minutes
This article will provide traders with a detailed understanding of Forex Forecasts, including an overview of the main methods of forecasting that exist, the different ways of forecasting currency changes, such as Purchasing Power Parity, Relative Economic Strength, and much, much more!
The Forex Market
It's not an exaggeration to say that the Forex (FX) market is the largest financial market in the world, especially with a daily volume of $1.5 trillion. The FX market has no physical location and no central exchange. Instead, the foreign exchange market operates through a huge electronic network of banks, corporations, and individuals trading one currency for another.
What is Forex Forecasting?
When entering the Forex market, it's better to come prepared - and that's where Forex forecasting comes into play. Forecasting in FX means predicting current and future market trends by utilising existing data and various facts. Being an analyst, one should rely on both fundamental and technical statistics in order to predict the directions of the economy, the stock market, and individual securities.
For those who trade Forex, knowing the techniques of how to forecast the FX market can be the resounding difference between those who trade successfully, and those end up losing money. As soon as you start to learn about Forex trading, you should also start learning how to forecast the FX trading market. This article has been prepared with the purpose of helping you to learn the basic Forex forecasting techniques, and how to apply them in your FX trading.
Overview of the Main Methods
There are a number of methods available to a trader when forecasting the Forex market. Each system is used to gain an understanding of how Forex works, and how various fluctuations in the market can affect traders, and consequently currency rates. Technical analysis and fundamental analysis are the most commonly used methods used by professional traders.
Methods of Forecasting
Although these methods differ, each one can help Forex traders to understand how rates are affecting the trade of a certain currency. Experienced traders and brokers who are well acquainted with each method can use a mixture of the two with great efficiency. The first method used by Forex forecasters is technical analysis.
There are three basic principles which are applied in order to make projections. These principles are based on the activity in the FX market in relation to current events, trends in the movements within prices, and past Forex history. At the time of each market action, almost everything important from supply and demand, current politics, and the current state of the market in question is taken into consideration. It is widely believed that Forex prices are a direct reflection of events currently taking place in the world.
A trend in price movement is indeed another factor taken into account when utilising technical analysis. This means that there are patterns in FX market behaviour which have been regarded as a significant contributing factor in movements within the Forex market. These patterns are often repeated over certain periods of time, and are often an essential factor when predicting the Forex market. There is another factor which should be taken into account while making Forex forecasts - and that is history. There are determined patterns in the FX market, and they are usually comprised of reliable factors.
In addition, there are also several charts that should be taken into serious consideration when forecasting the FX market through technical analysis. Five categories which must be looked at are: indicators, waves, trends, gaps, and number theory. These charts can be complicated - and whilst novice traders may find them difficult to follow - most professional FX brokers will have a good understanding of these charts, and will provide their clients with well-informed advice about foreign exchange trading.
The second method of FX forecasting is fundamental analysis, which is used by experienced traders as well as brokers, to forecast trends in Forex. This type of analysis is also used to predict the future of price movements formed on events that have not occurred yet. This may range from political to geopolitical changes, environmental factors, and even natural disasters.
A considerable amount of factors and statistics are applied in order to predict how certain events will affect supply and demand, along with rates in the FX market. This method shouldn't be regarded as a reliable factor on its own, though it can be used in line with technical analysis to form an opinion about the various changes in the FX market.
As you can see, for those who are involved in Forex trading, a basic comprehension of how the system works is crucial. Understanding the methods which allow traders to make Forex forecasts and trading signals may help traders to be more successful in their trading. Professional traders and brokers can utilise both technical and fundamental analysis when they have to make definitive decisions about the Forex market.
When an individual trader uses them together, it can provide them with useful and indispensable information about the movement of currency trends. Learning how to make Forex predictions is hard and takes time, but having that extra knowledge will prove to be invaluable in your Forex career.
The Ways of Forecasting Currency Changes
We would like to show you how you can forecast the Forex market by exemplifying Forex forecasting methods. It is quite a challenging task to generate a forecast of good quality, but we will describe four methods of doing so based on a level of high proficiency.
Purchasing Power Parity (PPP)
This method is perhaps the most popular one due to its inclusion in economic textbooks. The PPP forecasting technique is rooted in the theoretical 'Law of One Price', which in fact states that identical goods in various countries should have identical prices. That also implies that there should not be any arbitrage opportunities for someone to buy something cheap in one country, and then sell it in another in order to gain profit.
Based on this principle, the PPP approach of forecasting Forex predicts that the exchange rate will change to counteract changes in prices, and this is due to inflation. For instance, let us suppose that prices in the US are anticipated to increase by 4% over the next year, whilst prices in Canada are expected to rise by only 2%.
Thus, the inflation difference between these two countries is 2%. In turn, this suggests that prices in the US are anticipated to rise faster in comparison to prices in Canada. Hence, the PPP method would actually forecast that USD would have to depreciate by nearly 2% to keep prices between both countries in relative equality.
Relative Economic Strength
This approach looks at the power of economic growth within various countries, in order to make a currency market forecast concerning the direction of exchange rates. The logic behind this approach is that a powerful economic environment and high growth has a bigger likelihood of attracting foreign investors.
Therefore, in order to purchase investments in the yearned country, an investor would have to purchase the country's currency. This creates an increased demand that should eventually cause the currency to appreciate. The same will happen due to another factor that may draw the investors' attention - interest rates.
High interest rates will undoubtedly attract investors looking for the highest yield on their investments, causing demand for the currency to increase. On the other hand, low interest rates may result in investors avoiding investing in a country, or alternatively borrowing the currency of the country with low interest rates, to fund other investments. If we compare this approach to PPP, relative economic strength does not forecast the actual position of the exchange rate, but instead, provides a general sense of the currency's behaviour (appreciate or depreciate), and the overall feel for the movement's strength.
The next method of currency market forecasts involves gathering factors that you anticipate to affect the movement of a particular currency, and then creating a model that relates those factors to the exchange rate. The factors applied in econometric models are usually based on economic theory, however, any variable can be added if it is thought to considerably influence the exchange rate.
Time Series Model
The last method we will present to you is the time series model. This approach is entirely technical in nature, and is not formed on any economic theory. One of the time series sub-approaches is the autoregressive moving average process. The reason for utilising this method is based on the idea of using past behaviour data and price patterns to predict future price behaviour.
We have discussed Forex trading forecasting and the main techniques to used by professional traders. We have also exemplified the methods of forecasting the direction of exchange rates. As you can see, the application of certain techniques requires complete understanding, and certain trading skills. Not every technique will be suitable for everyone - it is a subjective matter. For novices, forecasting can be a tedious task - especially in the early stages of their career - but it is worth doing, as the benefits have the potential to improve profitability.
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.