Traders in the Forex market often make their trading decisions based on two types of analysis; technical and fundamental. Knowing both kinds of analysis is quite essential before entering any trade in the market, and a trader should understand both kinds of analysis and their relation in the market before making any investment in the Forex market. Learning these kinds of analysis by hard can be a very lengthy process that requires both theoretical and practical experiences, but a successful trader is one who can use this info in accordance with the risk management techniques, which is the essential key in becoming a successful Forex trader.

Fundamental Analysis
Technical Analysis
Risk Management


Fundamental Analysis

In the equities market, fundamental analysis looks to measure a company's true value and to base investments upon this type of calculation. To some extent, the same is done in the Forex, where fundamental traders evaluate currencies, and their countries, like companies and use economic data to gain an idea of the currency’s true value.

All of the new reports, economic data and political events that come out about a country are similar to news that comes out about a stock in that it is used by investors to gain an idea of value. This value changes over time due to many factors, including economic growth and financial strength. Fundamental traders look at all of this information to evaluate a country's currency.

Given that there are practically unlimited fundamental trading strategies based on fundamental data, one could write a book on this subject. To give you a better idea of a tangible trading opportunity, let’s go over one of the most well-known situations, the carry trade.

Carry Trade
The carry trade is a strategy in which a trader sells a currency that is offering lower interest rates and purchases a currency that offers a higher interest rate. In other words, you borrow at a low rate, and then lend at a higher rate. The trader using the strategy captures the difference between the two rates. When highly leveraging the trade, even a small difference between two rates can make the trade highly profitable. Along with capturing the rate difference, investors also will often see the value of the higher currency rise as money flows into the higher-yielding currency, which bids up its value.

Real-life examples of a carry trade can be found starting in 1999, when Japan decreased its interest rates to almost zero. Investors would capitalize upon these lower interest rates and borrow a large sum of Japanese Yen. The borrowed yen is then converted into U.S. dollars, which are used to buy U.S. Treasury bonds with yields and coupons at around 4.5-5%. Since the Japanese interest rate was essentially zero, the investor would be paying next to nothing to borrow the Japanese Yen and earn almost all the yield on his or her U.S. Treasury bonds. But with leverage, you can greatly increase the return.

For example, 10 times leverage would create a return of 30% on a 3% yield. If you have $1,000 in your account and have access to 10 times leverage, you will control $10,000. If you implement the carry trade from the example above, you will earn 3% per year. At the end of the year, your $10,000 investment would equal $10,300, or a $300 gain. Because you only invested $1,000 of your own money, your real return would be 30% ($300/$1,000). However this strategy only works if the currency pair’s value remains unchanged or appreciates. Therefore, most carry traders look not only to earn the interest rate differential, but also capital appreciation. While we’ve greatly simplified this transaction, the key thing to remember here is that a small difference in interest rates can result in huge gains when leverage is applied. Most currency brokers require a minimum margin to earn interest for carry trades.

However, this transaction is complicated by changes to the exchange rate between the two countries. If the lower-yielding currency appreciates against the higher-yielding currency, the gain earned between the two yields could be eliminated. The major reason that this can happen is that the risks of the higher-yielding currency are too much for investors, so they choose to invest in the lower-yielding, safer currency. Because carry trades are longer term in nature, they are susceptible to a variety of changes over time, such as rising rates in the lower-yielding currency, which attracts more investors and can lead to currency appreciation, diminishing the returns of the carry trade. This makes the future direction of the currency pair just as important as the interest rate differential itself.

To clarify this further, imagine that the interest rate in the U.S. was 5%, while the same interest rate in Russia was 10%, providing a carry trade opportunity for traders to short the U.S. dollar and to long the Russian Ruble. Assume the trader borrows $1,000 US at 5% for a year and converts it into Russian Rubles at a rate of 25 USD/RUB (25,000 Rubles), investing the proceeds for a year. Assuming no currency changes, the 25,000 rubles grows to 27,500 and, if converted back to U.S. dollars, will be worth $1,100 US. But because the trader borrowed $1,000 US at 5%, he or she owes $1,050 US, making the net proceeds of the trade only $50.

However, imagine that there was another crisis in Russia, such as the one that was seen in 1998 when the Russian government defaulted on its debt and there was large currency devaluation in Russia as market participants sold off their Russian currency positions. If, at the end of the year the exchange rate was 50 USD/RUB, your 27,500 Rubles would now convert into only $550 US. Because the trader owes $1,050 US, he or she will have lost a significant percentage of the original investment on this carry trade because of the currency’s fluctuation - even though the interest rates in Russia were higher than the U.S.

You should now have an idea of some of the basic economic and fundamental ideas that underlie the Forex and impact the movement of currencies. The most important thing is that currencies and countries, like companies, are constantly changing in value based on fundamental factors such as economic growth and interest rates.

You should also have an idea how certain economic factors impact a country's currency. Many of the economic factors that affect the Forex market are announced monthly, and you can find their details in economic calendars, along with the previous, actual and forecast data. Knowing these factors, evaluating them and speculating correctly can be a gold mine for any investor.





Technical Analysis

One of the underlying tenets of technical analysis is that historical price action predicts future price action. Since the Forex is a 24-hour market, there tends to be a large amount of data that can be used to gauge future price activity, thereby increasing the statistical significance of the forecast. This makes it the perfect market for traders that use technical tools, such as trends, charts and indicators.
It is important to note that, in general, the interpretation of technical analysis remains the same regardless of the asset being monitored. There are literally hundreds of books dedicated to this field of study, but in this tutorial we will only touch on the basics of why technical analysis is such a popular tool in the Forex market.

Minimal Rate Inconsistency
There are many large players in the Forex market, such as hedge funds and large banks, that all have advanced computer systems to constantly monitor any inconsistencies between the different currency pairs. Given these programs, it is rare to see any major inconsistency last longer than a matter of seconds. Many traders turn to technical analysis because it presumes that all the factors that influence a price - economic, political, social and psychological - have already been factored into the current exchange rate by the market. With so many investors and so much money exchanging hands each day, the trend and flow of capital is what becomes important, rather than attempting to identify a mispriced rate.

Trend or Range
One of the greatest goals of technical traders in the Forex market is to determine whether a given pair will trend in a certain direction, or if it will travel sideways and remain range-bound. The most common method to determine these characteristics is to draw trend lines that connect historical levels that have prevented a rate from heading higher or lower. These levels of support and resistance are used by technical traders to determine whether or not the given trend, or lack of trend, will continue.

Generally, the major pairs - such as the EUR/USD, USD/JPY, USD/CHF and GBP/USD - have shown the greatest characteristics of trend, while the currency pairs that have historically shown a higher probability of becoming range-bound have been the currency crosses (pairs not involving the U.S. dollar). The two charts below show the strong trending nature of USD/JPY in contrast to the range-bound nature of EUR/CHF. It is important for every trader to be aware of the characteristics of trend and range, because they will not only affect what pairs are traded, but also what type of strategy should be used.

Common Indicators
Technical traders use many different indicators in combination with support and resistance to aid them in predicting the future direction of exchange rates. Again, learning how to interpret various technical indicators is a study unto itself. If you wish to learn more about this subject, we suggest you read some books in the technical analysis field.

A few indicators that we feel we should mention, due to their popularity, are: Bollinger bands, Fibonacci retracement, moving averages, moving average convergence divergence (MACD) and stochastic. These technical tools are rarely used by themselves to generate signals, but rather in conjunction with other indicators and chart types and patterns.

Types of Forex Charts

Let’s take a look at the three most popular types of charts:

1. Line chart

2. Bar chart

3. Candlestick chart

Line Charts

A simple line chart draws a line from one closing price to the next closing price. When strung together with a line, we can see the general price movement of a currency pair over a period of time.

Here is an example of a line chart for EUR/USD:

Bar Charts

A bar chart also shows closing prices, while simultaneously showing opening prices, as well as the highs and lows. The bottom of the vertical bar indicates the lowest traded price for that time period, while the top of the bar indicates the highest price paid. So, the vertical bar indicates the currency pair’s trading range as a whole. The horizontal hash on the left side of the bar is the opening price, and the right-side horizontal hash is the closing price.

Here is an example of a bar chart for EUR/USD:

A bar is simply one segment of time, whether it is one day, one week, or one hour. You must know what time frame a bar refers to.

Bar charts are also called “OHLC” charts, because they indicate the Open, the High, the Low, and the Close for that particular currency. Here’s an example of a price bar:

Open: The little horizontal line on the left is the opening price
High: The top of the vertical line defines the highest price of the time period
Low: The bottom of the vertical line defines the lowest price of the time period
Close: The little horizontal line on the right is the closing price

Candlestick Charts

Show the same information as a bar chart, but in a prettier, graphic format.

Candlestick bars still indicate the high-to-low range with a vertical line. However, in candlestick charting, the larger block in the middle indicates the range between the opening and closing prices. Traditionally, if the block in the middle is filled or coloured in, then the currency closed lower than it opened.

Here is an example of a Candlestick chart for EUR/USD:

In the following example, the ‘filled colour’ is black. For our ‘filled’ blocks, the top of the block is the opening price, and the bottom of the block is the closing price. If the closing price is higher than the opening price, then the block in the middle will be “white” or hollow or unfilled.

Some other charts are drawn in other colours, where they simply substitute green instead of white, and red instead of black. This means that if the price closed higher than it opened, the candlestick would be green. If the price closed lower than it opened, the candlestick would be red. Some believe that those colours enable the trader to observe the movements of the prices faster.

Here is an example of a candlestick chart for EUR/USD :

The purpose of candlestick charting is strictly to serve as a visual aid, since the exact same information appears on an OHLC bar chart. The advantages of candlestick charting are:

• Candlesticks are easy to interpret, and are a good place for a beginner to start figuring out chart analysis.

• Candlesticks are easy to use. Your eyes adapt almost immediately to the information in the bar notation.

• Candlesticks and candlestick patterns have cool names such as the shooting star, which helps you to remember what the pattern means.

• Candlesticks are good at identifying marketing turning points – reversals from an uptrend to a downtrend or a downtrend to an uptrend.

Risk Management

The Forex market is one of the most volatile markets in the world. The speed and enormous size of the Forex market are unlike anything else in the financial world, besides, the Forex market is uncontrollable - no single event, individual, or factor rules it. Currency markets are highly speculative and volatile in nature, where any currency can become very expensive or cheap in relation to another in a matter of days, hours, or sometimes, in minutes. This unpredictable nature of the currencies is what attracts an investor to trade and invest in the currency market.

The most important question a trader should ask himself is not only how much profit he is looking for, but how much loss can he actually take. Although accepting loss is very hard to swallow by any trader, it is an essential key in risk management in order to reach the greater good of making profit.

In order to apply proper risk management to a trader’s portfolio, some questions need to be answered first:

- What are the trader’s investment goals?
- What is the maximum loss the trader can accept?
- What is the time frame through which the trader wants to reach his goal?
- What is the level of risk the trader is willing to take?

Answering these questions is the first step in having success in the Forex market. Without having answers to all these questions, the trader will be closer to losing his money than having an actual investment. The trader should then apply the following rules in risk management.

Risk Management Golden Rules:
1) Have a target for every trade in the market, and be ready to exit the trade when the target is reached. Without a target you are basically just tagging along, and it won’t be soon before a trade catches you with a big loss.
2) Never enter a trade without having a stop loss. Stop loss orders are counter-intuitive because you do not want them to be hit; however, you will be happy that you placed them!
3) Never trade against the Trend. Trading against the trend is very dangerous, especially if you get caught in a losing trade. If you are trading with the trend you can be assured that it might be a matter of time before you see your trade turn into a profit.
4) Be mentally prepared and avoid emotional trades. If you just had a loss in the market it is better to stay away for some time before resuming your trades; emotional trades are the first step in losing your money because you will not be thinking clear.
5) Enter the market only when you see an opportunity. The market can sometimes be very risky and you don’t have to press “Buy” or “Sell” every time you watch the market. There is sometimes a third and much better option: just keep watching!
6) Diversify the risks you take in the Forex market, i.e. do not put all your eggs in one basket. If you trade more than one item try to diversify the risk by trading in items that are not related to each other.