Forex Trading

When trading on the foreign exchange market, the best way to make money is to attempt to predict where a currency price will be in the future, and then act on that prediction.  Analysts sift through mounds of data from the past and present to get an accurate picture of the overall climate of a currency, and then make an educated guess as to what is going to happen from there.  There are two main schools of thought in forecasting on the forex market, and each method has its own advantages.

Fundamental analysis is a system of forecasting that is based on the law of supply and demand.  By combining political, economic, environmental, and other forms of data, analysts attempt to understand the market forces that are acting on a particular currency.  Probably the most important pieces of this data are interest rates around the world.  When countries change their prime interest rates, it has a rippling effect on the strength and weakness of its own currency and those of its trading partners.  Money tends to flow into a country that has a relatively high rate, as investors seek to capitalize on the ability to earn more interest in that country.  As more investors pile into that country’s bonds and other interest bearing instruments, demand is increased, raising the price of the currency.  Conversely, a falling interest rate will cause investors to pull their money out of the country and invest it somewhere else, decreasing the currency’s demand.  Of course, rising interest rates can also cause that stock market to decline, which may or may not bring the currency with it.  Other factors that are studied by fundamental analysts are weather, seasonal cycles, and political factors such as changes in leadership. 

While fundamental analysis studies the causes of a currency’s price fluctuation, technical analysis focuses on the effects.  By studying and performing calculations on charts of past price activity, technical analysts attempt to predict market trends and currency movements.  The main theory behind this method of forecasting is that the markets move in predictable patterns based on psychological factors such as reactions to economic news.  By recognizing these patterns as they are occurring, one can then extrapolate the prices out to a point in the future, and then act accordingly.  Some of the different methods of doing this are Bollinger Bands, Relative Strength Index, Moving Average Covergence / Divergence (MACD), and the Elliott Wave Theory.  Some calculations involve a method of using moving averages of past prices to draw lines on the chart, and it is the interaction of these lines along with the price chart itself that creates triggers, which are signals to the trader that it is time to buy or sell. 

For example, the MACD involves the drawing of one line based on the difference between the 12 and 26 day moving averages, and another line based on the 9 day moving average.  When these lines cross, it creates a signal to the trader to buy or sell, depending on the positioning of each line on the top or bottom.  Other calculations are more long-term, such as the Elliott Wave Theory.  This premise theorizes that markets move in historic patterns of 8 waves, based on the oscillation of the public’s optimism and pessimism.  The common thread between all calculations is that history tends to repeat itself, and by recognizing this fact and studying historical price action, analysts can predict where a currency price will go in the near future.

All forex investors that do any sort of research before trading use either fundamental or technical analysis.  Although there are those who tend to stick with one camp, many forex traders find that using some techniques from both methods is the solution that gives them the best chance for success.