Most of my columns have focused on fundamental analysis as it relates to foreign exchange. Fundamental analysis uses economic statistics, geopolitical events, inter-market relationships, or even natural disasters in an attempt to predict the price effect on a currency pair like the EUR/USD, GBP/USD, or USD/JPY. Understanding fundamentals is an important discipline to develop in becoming a successful trader.
As most traders know, however, technical analysis is also used to predict or anticipate price movements of a market. Over the course of the next few months, I will explain some technical analysis studies that have been helpful in finding value while lessening risk in foreign exchange trading.
Technicians, the term used to describe a trader who uses technical analysis, have often been characterized as traders who examine chart patterns to anticipate future price movements. That is partly true, but it does not fully describe the purpose of a technician. A worthy technician analyzes chart patterns to not only anticipate price movements but also to lessen risk and increase the chance of a successful trade.
The price movement in foreign exchange lends itself to using technical analysis. There is good volatility in foreign exchange. In addition, currency pairs tend to trend. A currency pair is also equally as likely to go up or down over time.
In contrast, a normal stock market—albeit not the one that has characterized the recent bear market—will tend to rise over time. This happens because general price inflation coupled with productivity improvements increases the values of stocks. Also, populations tend to increase, which increases the consumption of goods and raises profits for corporations.
Foreign exchange rates, however, are generally determined by comparing one country’s economy to another’s on a relative basis at a point in time. As a result, if one country’s currency gets stronger because of a robust economy, the higher currency value will make that country’s exports less competitive abroad. Eventually, exports go down, and this will have the effect of slowing the strong economy—making its currency weaker in the process.
The weaker currency country, meanwhile, enjoys the benefit of its exports being more competitive abroad. This eventually strengthens its economy and should lead to a reversal and strengthening of its currency over time. A seesaw pattern emerges over time in foreign exchange rates, with a period when a currency is strong, followed by a period when it is weak. Technical analysis can be used to help unmask a currency pair’s phases of strength and weakness (i.e., the trends).
I like to look at technical analysis as a way to increase the odds of success. Like a card counter at the blackjack table in Las Vegas, the goal of a good technician is to increase the odds of participating in a trend by being cognizant of the price action. Clues to trends come through the use of technical indicators.
There are dozens of different indicators that have been developed over time. Indicators can be trend-oriented like Bollinger Bands, Moving Averages Convergence Divergence, or oscillators like the Relative Strength Index or Stochastic. (Oscillating indicators give an indication of overbought or oversold conditions.) There are also other tools that can give the trader a visual for direction, like a simple trend line, and levels of support or resistance on trend or counter-trend moves, like Fibonacci Retracements.
So how do you catch a trend? Logic says by following a trend-following indicator. Good traders in foreign exchange look for the trend waves. Because currencies can trend up and down, the opportunities for profit are available to the patient foreign exchange trader.
Even though the simple moving average is probably the most basic of technical indicators, there is nothing wrong with using it if it works and the market supports it. So catch a wave and watch your foreign exchange trading profits improve.
Greg Michalowski is chief foreign exchange and economic analyst for FXDD, an online foreign exchange liquidity provider for retail traders and investment managers.
For daily market commentary on the foreign exchange market, visit http://forex.fxdd.com or contact Michalowski at greg@fxdd.com.
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