The ChoosaBroker Trading Academy

5.6. Foreign Exchange Market Strategies

Trading and investing in the financial market is a complex exercise that requires the use of a scientific basis rather than guesswork. Primarily, there are two methods for forecasting foreign exchange market rates – Technical Analysis and Fundamental Analysis. In this lesson, we will try to understand how each of these processes work.

Technical analysis and fundamental analysis, the two major schools of thought when it comes to approaching the foreign exchange market, are at opposite ends of the analytical spectrum. Both techniques have been successfully employed for researching and forecasting future trends in the Forex market, and like any investment philosophy, both have their fair share of advocates and critics.

Foreign Exchange Technical Analysis

Technical analysis can be defined as the study of historical foreign exchange rates to identify future trends in a currency’s price. The study of technical analysis is based on three key assumptions:

1. The price of an underlying asset reflects all that is known about that asset.

2. Asset prices move in trends and such movements follow established patterns that can help generate buy and sell signals.

  • 3. Once a price trend has been established, it tends to continue until fresh evidence suggests a reversal. Price trends can be broadly classified in to three categories –
  • Uptrend – Depicted by a series of higher price highs and higher price lows.
  • Downtrend – Represented by a series of lower price highs and lower price lows.
  • Sideways Trend – Consists of almost equal price highs and equal price lows.
Let us review 5 of the most popular technical analysis tools in the following segment.

1. Price Patterns

Certain patterns that get plotted on a currency’s price chart have the tendency to consistently reappear and produce the same outcomes. Price patterns can be either reversal or continuation. A reversal pattern indicates that the current trend will change upon the successful completion of the formation. The most popular reversal patterns include head and shoulders, double tops, double bottoms, and rounding bottoms. A continuation pattern signifies that the ongoing trend will resume once the pattern has been completed. Triangles, flags, pennants and wedges are the most reliable continuation patterns.

2. Candlestick Formations

Candlesticks formations were developed by Japanese rice traders more than two centuries ago. A candlestick consists of a real body, an upper shadow and a lower shadow. Like classical price patterns, candlestick formations can also be categorized as reversal and continuation. Common candlestick reversal patterns include the hammer, hanging man, engulfing and piercing lines. Doji and doji star are the most common candlestick continuation patterns.

3. Technical Oscillators

A technical oscillator graphically depicts short term overbought and oversold conditions within a currency pair’s price. Relative Strength Index and Stochastic are the two most widely applied technical oscillators. Oscillators function under the assumption that as momentum begins to change, the number of active buyers and sellers likely to trade at current market price also decrease. Consequently, in a rising bull market, a change in momentum indicates that price has reached an upper resistance zone and is likely to decline. Contrarily, during a falling bear market, a change in momentum suggests that price is close to a support area and could soon bounce higher.

Oscillators are most effective in range-bound markets. During such consolidation phases, their ability to correctly spot overbought or oversold market conditions is greatly enhanced, resulting in a higher percentage of profit-making trades.

4. Fibonacci Retracements

In technical analysis, Fibonacci retracements are drawn by taking two extreme points on a Forex price chart and then dividing the vertical distance with the key Fibonacci ratios of 23.60%, 38.20%, 50.00% and 61.80%. Horizontal lines are drawn on these levels to signify possible support and resistance zones. An ongoing trend is likely to resume once a currency pair retraces to one of these above listed ratios.

5. Elliot Wave Theory

The Elliot Wave Theory asserts that crowd behaviour in financial markets ebb and flow in clear trends, and these ebbs and flows can help identify a certain structure in price movements. In the Elliott Wave market model, prices always alternate between an impulsive phase and a corrective phase. Understanding the current phase of a foreign exchange pair can help forecast its future direction.

Foreign Exchange Fundamental Analysis

Fundamental analysis in the context of the foreign exchange market can be broadly defined as the interpretation of economic data to forecast changes in an underlying currency’s price. Important macro-economic releases like changes in the interest rate, inflation data, GDP growth rates and employment figures have a direct impact on the value of a currency. Given the influence of these indicators on Forex rates, it is important to know beforehand when they are scheduled for release.

There are thousands of fundamental indicators but most of them have very little bearing on the Forex market. We will discuss the 4 most important below.

1. Interest Rates and the Role of Central Banks

Central Banks lay at the heart of foreign exchange fundamental analysis. A Central Bank serves as a nation’s principal financial authority. Its primary role is to control the supply of money within an economy by altering the interest rate at which it offers loans to commercial banks.

If the Central Bank reckons that an increase in consumer spending is necessary to stimulate the economy, it can lower the short term rates at which commercial banks borrow. This will then be passed on to the consumer, who can now avail loans at lower cost, thereby boosting consumer spending. In contrast, if inflation is roaring and a tightening of the economy is deemed necessary, the Central Bank may opt to increase the benchmark interest rate. This will make loans more expensive, which subsequently leads to a contraction in consumer spending.

2. Consumer Price Index

The Consumer Price Index tracks changes in the cost of living. High inflation erodes the value of a country’s currency. This deflates purchasing power and negatively impacts the standard of living. However, if changes in consumer prices are in line with changes in consumer’s income, inflation can be favourable for the economy. Under such circumstances, spending and investment both get a boost, helping the economy grow faster.

3. Unemployment Rate

The unemployment rate tracks the number of people within a country who are actively seeking work. It is expressed as a percentage of the total work force. When the unemployment rate soars higher, consumers have less disposable income, which, in turn, negatively affects consumption and GDP. When the unemployment rate is relatively low, consumer confidence climbs higher. They spend more, resulting in an uptick in economic activity. This gets translated to stronger GDP growth.

4. Gross Domestic Product Growth

Gross Domestic Product (GDP) is an important barometer of the overall health of an economy. It is defined as the total monetary value of all the goods and services that were produced in a country during a specified period of time. When the GDP growth rate increases, it is a sign that economic activity is accelerating. A contraction in the rate indicates a shrinking of economic activity.

Final Few Thoughts

Trading and investing in the foreign exchange market does not revolve solely around the success of your buy and sell strategy. The often overlooked aspect of risk management also plays a critical role. Never risk more than 5% of your total capital on one single trade; and don’t take trades that don’t offer a minimum risk-to-reward ratio of 1:2. Learn to control your losses, and you will have a chance to enjoy long-term success. For further support look at our reviews of the Best London UK brokers and best broker for day trading.

Ready to trade? We reviewed the top FX brokers and top CFD brokers for you!

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