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Analyzing the Forex Market
by Duane Davis

Definitive Guide
Basically, with any type of investing (or trading), there are two types of analysis that one can do before deciding on a trade:

  1. Fundamental analysis

  2. Technical analysis
Fundamental Analysis

Fundamental analysis consists of looking at a country's economic, social and political forces. The currency of a country whose economy is strong and stable, is likely to go up while the currency of a country whose economy is weak, is likely to go down. In other words, if a country's economy is doing well, the currency will also do well. The better a country's economy, the more trust other countries will have in that particular currency.

In the case of the US Dollar, when there's an announcement by the Federal Reserve that the Fed Funds interest rate will be raised by .25%, it's very likely to have an affect on the dollar. Similarly, if the Bank of England decides that it's going to lower interest rates, then it's very likely that it will affect the value of the British Pound. These announcements (or at least the prospect of such announcements) are referred to as 'fundamental analysis'.

Technical Analysis

Technical analysis is the study of price movement. Most traders that prefer technical analysis will argue that there is no need for fundamental analysis because the 'fundamentals' are already reflected in the price of that particular market and therefore, it's already reflected in the price chart.

In the U.S., as the day of the Fed meeting grows closer and the economists voice their opinions as to what the Fed is likely to do, to a certain extent the value of the U.S. Dollar will be affected. Then, when the announcement is finally made, the market for the dollar will react accordingly. If the prospect was for lower interest rates and the value of the Dollar goes down before the Fed meeting and the announcement turns out that rates are to remain unchanged, any losses in the Dollar will suddenly be reversed. But all of this is already reflected in the price chart. By looking at charts, you can identify trends and patterns which can help you find good trading opportunities.

Because most currencies have a tendency to trend for weeks or even months at a time, spotting a trend and trading in the direction of that trend can be very rewarding. Technical analysis can help you identify these trends in their earliest stages.

When trading in the Forex markets, both types of analysis are just as important. Although technical analysis may have certain advantages, there's nothing like knowing that a government has just raised (or lowered) its interest rates.

Most of today's technical indicators were developed as recent as the 1970's by such people as Gerald Appel, Larry Williams and Welles Wilder, just to name a few.

Data Providers

There are many different providers of Forex data and price charts. Some can be found free on the internet, but we prefer a more professional approach. While it is not out goal to endorse any particular data provider, the charts in this book have been provided by TradeStation.

Price Charts

Through the years, traders have used different ways of plotting price movements on charts. Here are a few:

Bar Charts – By far the most popular and widely used.

Line Charts – Very useful for looking at the overall trend of a market.

Candlestick Charts – Similar to bar charts, but more graphical.

Bar Charts

Most traders prefer bar charts, but in the 24-hour Forex markets, bar charts are not quite as meaningful as they might be in other markets. In markets that close at the end of the day and remain closed overnight, a 'daily' bar chart represents what happened in that market during the course of a 'normal business day'. The first trade of the day (the open price) is designated on the bar as a horizontal line extending slightly to the left of the bar. The last trade of the day (or the settlement price) is designated by a horizontal line extending slightly to the right of the bar.
image

But in the Forex markets, trading is continuous from the open on Sunday night to the close of trading on Friday night. Thus, the open and close of each day are a little less meaningful.

On a weekly basis, however, the open and close are very meaningful. At the end of trading on Friday, the closing price represents the market value that traders are comfortable with for the next few days. Similarly, on Sunday night, the open price represents a true continuation of that market and there are many times when the Sunday night open is somewhat different from the Friday night close. This difference in price can be seen on bar charts as a 'price gap'.

Line Charts

A line chart is constructed by connecting the closing prices of each bar.

image

Line charts are best used with indicators such as moving averages and oscillators.

image

Candlestick Charts

Candlestick charts show the same information as a bar chart, but in a more graphic format.

image

Here's a closer look at the same chart:

image

The price range in a candlestick chart is the same as in a bar chart. The real difference lies in the area between the open and close prices. In a Candlestick chart, the area is enclosed and is referred to as the 'body'. Traditionally, if the body in the middle is filled or colored in (black in the chart above), it indicates that the price closed lower than where it opened. Thus, with Candlestick charts, it's very easy to see the negative bars in the chart vs. the positive bars. In this chart, the price is obviously in an uptrend. When the price is moving up, most of the bars will be hollow or unfilled (white in this chart).

When the body of a Candlestick bar is long as compared to most of the other bars in the chart, it indicates that there was intense buying or selling pressure. Similarly, short bodies imply that there was very little direction to the market that day.

Here are a few advantages of using candlestick charts:

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

Candlesticks are good at identifying marketing turning points.

Candlestick patterns have names for various formations such as Doji, Shooting Star, Hanging Man, etc. These names help to describe what the pattern means and the affect it may have on future prices.

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