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Currency Analyst since 2010

FX BAZOOKA's guide to Forex analysis

In our view, such notions as “trading” and “trade” aren’t synonyms. To be successful in trading one has to combine trade with a competent market analysis. Many traders tend to adapt analysis to the trade ideas they already have trying to find arguments in favor of these trade ideas. This often leads to losses. The correct approach is to conduct an independent and objective market analysis. The aim of Forex analysis is to show when it makes sense to buy/sell a particular currency pair.

There are 2 types of Forex market analysis: technical and fundamental. Technical analysis relies solely on the price chart. It shows what is happening in the market now and what was happening there earlier. Fundamental analysis explains which fundamental or, in other words, economic factors caused the price moves seen on the chart.

1. FUNDAMENTAL ANALYSIS

 Our experience shows that fundamental analysis is indispensable for an effective market analysis.

Let’s consider an example. The graph shows the dynamics of the EUR/USD pair for the year 2012. All the technical signals favor selling the pair (a "double top" reversal pattern, breakthrough of the 200-day moving average, Fibonacci levels etc). According to the pure technical analysis, we should have sold the pair from $1.2600 (the "neckline") targeting the area of ​​$1.2450. And many traders who ignore fundamental analysis really did that. 

However, a full chart proves that you’d better not trust the technical signals with no fundamental reasoning.  The pair pushed up from $1.2600 after a short-term dip and entered a broad uptrend. The understanding of the fundamental factors moving the market at the time could help traders avoid mistakes. The fact is that at that time the market was expecting for a new round of quantitative easing in the US (a negative factor for the USD). Euro zone’s economy, on the contrary, started stabilizing (positive factors for EUR). So the overall EUR/USD fundamental background was positive, despite all the bearish technical signals.

Let’s study the fundamental factors influencing the exchange rate. Special attention should be paid to the monetary policy of central banks. In our opinion, central banks are the underlying force on the Forex market. "Ease" policy (low interest rates and unconventional monetary measures) lowers the currency, while the "tight" policy (high rates) - strengthens it. As an example, take the drop of the Japanese yen (a rise of USD / JPY) in 2012/13.  Yen depreciated on the back of the aggressive monetary easing led by the Bank of Japan.

Fundamental factors are not an abstract concept. Traders face them daily in a form of economic news, published in the economic calendar. By the way, there are different ways to use the economic calendar. Some market players trade “the news". It means that they open positions in accordance with their expectations for a change in economic indicators (e.g, euro zone GDP is expected to improve – we buy EUR). Others, on the contrary, avoid the news as trading them is associated with certain risks. Such traders prefer to wait for the market to "digest" the news, and enter the already shaped trend. No matter what strategy you choose, we strongly recommend you following the news in order to be aware of the impulses moving the market. Some data releases increase volatility and cause sudden moves on the market. The best example is the US nonfarm payrolls (NFP). The release of this indicator may lead to an unexpected closure of your position under a stop-loss order.

 

 Choosing a currency pair is a crucial moment for a trader.

 

Currencies are traditionally divided into "safe haven" and "risky" currencies. Safe-haven currency strengthens in times of anxiety and uncertainty as investors seek to preserve their assets. Risky currency is a currency of the commodity exporters. Demand for them grows in periods of relative stability in the global economy and politics.

Volatility is the amount of price variation over a certain time period. The more volatile is the pair, the higher are the risks taken by the investor. On the left we see EUR/CHF – a pair of a low volatility. The pair has spent the first part of the year 2013 in the 500-points range, while in the second half of the year the trading range has become even narrower. Such dynamics of the pair is linked to the fact that the Swiss National Bank has set a peg at 1.20 in September 2011. The EUR/CHF pair is more suitable for a short-term trade. On the right side we see a much more volatile GBP/USD pair. This pair is suitable for trading breakouts.

 

Correlation is a relationship between currency pairs. Correlation power varies from 1 to -1. We need to understand that a direct correlation of two currency pairs means a high interdependence, but does not guarantee a total identity of their moves. It is important to remember that the correlation strength over time may vary.

 

EUR/USD and GBP/USD have a strong direct correlation

Here are the points to consider:

  • Buying or to selling two positively correlated currency pairs at a time doubles your risk (e.g. buy EUR/USD and buy GBP/USD) – you open two almost identical positions.
  • Trading the highly correlated pairs in different directions is counterproductive (e.g. buy EUR/USD and sell GBP/USD) – such positions do simply cancel each other. 

Good example of an inverse correlation: EUR/USD and USD/CHF

Dollar index (DXY) is the change of the US dollar versus 6 currencies (EUR, JPY, GBP, CAD, SEK and CHF). If the DXY is in an uptrend, we’ll be looking for opportunities to buy the US dollar in the major currency pairs. If the DXY in is a downtrend, we’ll be looking for opportunities to sell the US dollar (see graphs).

It is strongly recommended to pay attention to the other financial markets while trading currencies. Try to make your own forecasts for the raw materials prices – this will help you in trading currencies!

Direct correlation of AUD/USD rate with gold prices is a good example. If you expect higher gold prices, it makes sense to consider buying the Australian dollar. Such a pattern is caused by the fact that Australia is a major gold exporter, so its economy strongly depends on the price of the resource.

Another good example: the inverse correlation of USD/CAD and oil prices. Canada is the largest supplier of oil to the US. Buy the Canadian dollar, if oil prices in the world rise

Tip for beginners: do not trade more than two pairs at a time! We recommend you to choose one or two pairs, to study all the factors affecting them and to monitor the economic background and news.

2. TECHNICAL ANALYSIS

Technical analysis means the analyzing the past prices to forecast future market dynamics. Analysis is performed using graphical methods and technical indicators. Technical analysis is important because it is studied by most traders. The phrase “history repeats itself” can be adjusted as follows: “the behavior of market players repeats itself”. When a trader tries to understand the market, he seeks to put everything in order in his mind and identify recurring patterns and trends. We assume that by learning how the market participants acted in the past, it’s possible to predict how they will likely behave in the future.

A common mistake of newbies is applying too many indicators to the price chart. As a result, they “overanalyze” the market and lose sight of the most important thing – the price, which, in fact, is the main source of information for the trader.

FX BAZOOKA suggests a simple, but effective approach to technical analysis. We base our research on the following elements:

  1. Trends
  2. Japanese candles and models
  3. Divergence
  4. Zigzag + Fibonacci
  5. Ichimoku

First of all, we’d like to underline that everything in the market is determined by the psychology of its participants. If all traders consider a certain line to be a support line, than it actually is one, and the buy orders are clustered nearby. 

Many traders are taking Japanese candles for granted. Yet they represent a superb analytical tool and help to visualize the price. Let’s compare the candlestick chart with the simple line chart: candles provide much more information. Here we can see a “hammer” candle which was followed by the upside price movement.

In addition, pay attention to the combinations of the candles. We recommend tracking trend reversal models and using them to trade. These models perfectly reflect the logic of the market. For example, at the chart below you see a reversal pattern called “evening star”. The combination of candles makes it clear that the bulls failed to continue the upward movement: after a big bullish candle there’s a small one, followed by a long bearish candle – the bears have clearly seized the initiative and reversed the trend down. As for the continuation patterns, they are less effective because they are more difficult to recognize, they produce less impressive moves and can be confused with reversal patterns.

As for the numerous technical indicators, remember that they are only derived from the price. Indicator equals price plus some formula. Thus, constant monitoring current values ​​of the indicators won’t give the trader new information, but may rather confuse and mislead him. That’s why we use oscillators only to see whether they diverge with the price chart or not. You may look for divergence on any oscillator. The divergence between the price and the indicator suggests that market participants are losing confidence in the current trend. As a result, the divergence demonstrates that the trend’s direction is likely to change or that there’s going to be a sizeable correction.

We recommend using Zigzag indicator together with the Fibonacci lines to determine the depth of correction. Note that Zigzag helps to filter out the market “noise”, i.e. to separate random fluctuations in the price from the main trend, so traders can ignore the false moves.

We also strongly recommend the Ichimoku indicator, which represents a complete trading system and allows one to assess the situation in the market at first sight (to read more about Ichimoku go to Technical Analysis – Oscillators – Ichimoku).

You also need to keep an eye on the changes in the market’s sentiment, namely the positions of large speculators. This can be done with the help of the CoT report (COT, commitments of traders), which is published by the US regulator called CFTC. When net long or short positions reach critical level, the likelihood of the current trend’s reversal increases.

To make a conclusion, it’s necessary to combine types of Forex analysis examined above. One should use fundamental analysis to determine the direction of currency pair’s movement and technical analysis to find the optimal entry points.

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