Combining Technical Analysis with Fundamental Analysis
‘If fundamentals create the brains of the Market, technicals create a spirit and a soul’
Fundamental analysis studies the cause of a market movement while technical analysis studies the effect. These two major methods of analysis are used in order to explain the behavior of any financial market, but also in order to forecast future market conditions.
There are three general approaches when trading any financial market:
- the technical approach
- the fundamental approach
- the combination of technicals and fundamentals
As Warren Buffett said: “Price is what you pay and value is what you get”.
A fundamentalist will focus on the real value, while a technician will focus on the price movement. A wise analyst will always focus on both.
(1) Fundamental Analysis
“Nowadays people know the price of everything and the value of nothing.” -Oscar Wilde, The Picture of Dorian Gray
Fundamental analysis is based entirely on the study of economic, political, strategic, social, and other relevant factors that are able to affect the demand and the supply of a financial instrument in the future.
A fundamental analyst will focus always on value, and as the relationship between value and price is indirect, the fundamental analysis needs some time to get confirmed.
The Fundamental Trader
Fundamental traders weight the market dynamics of a basket of financial assets and analyze all economic releases and other relevant information that may affect them.
When trading Forex, the exchange rate of a currency pair incorporates the economic and geopolitical conditions of the two economies involved.
- Current Macroeconomic Conditions in Relation to the Macroeconomic Circle
- New Economic Data (majorly Inflation, GDP, and Unemployment Rate)
- Political Risks and Social Conditions
- Interest Rates
- Other Monetary Policies
- Central Bank Interventions
The Time Interval
Fundamental analysis is especially important to long-term traders and it is almost irrelevant to short-term traders.
There is an exemption to that rule. The news-traders, who open and close their positions intraday while trading exclusively key fundamental releases. In other words, they trade the short-term while being fundamentalists.
Fundamental Changes Offer the Best Trading Opportunities in Life
A change in major government policy or the release of unexpected macroeconomic data can turn a fundamental forecast upside down. During periods of key changes in the macroeconomic environment, the price swings of a financial instrument can be huge. During those rallies, there is no space for correction or price consolidation. Consequently, when key fundamental changes occur in the market, fundamental analysis becomes the undisputed king. Performing technical analysis during those periods seems useless.
Most profitable trades occur shortly after major political or economic announcements. The great advantage when trading fundamental changes is that the market trends so well that you can make 3,000 pips in a couple of days. Furthermore, as most fundamental changes need some time to be interpreted by the market, you have the chance to enter the market at the early stages of strong movements. Finally, by using a trailing stop order to exit the market, you can follow the price swing at its limits when your profits will always be ensured and secured.
→ Enormous price swings
→ Time to enter the price movement at its early-stage
→ No corrections, no price consolidations
→ Huge Reward/Risk ratio
→ Trailing-stops work ideally, as the market moves straightforward
The Case Study of the American Elections of 2016
Before the American Elections of 2016, there was a clear winner, Mrs. Clinton. The bookmakers offered Mrs. Clinton at x1.2, and Mr. Trump at x5.0. In other words, they gave an 80% probability that Mr. Clinton will win the elections and 20% for Mr. Trump.
The Market Anticipations were not Based on Hard Fundamentals
-Most currency analysts believed that if Mr. Trump gets elected the US Dollar will tank
-But in reality, Mr. Trump wanted a hard currency policy for the US Dollar (as he had said)
-Most stock market analysts believed that if Mr. Trump gets elected the US Stock Markets will tank too
-But in reality, Mr. Trump wanted to cut corporate tax and that means higher profits and higher dividends to the shareholders
Overall, there was a divergence between the market anticipations (as expressed by major analysts) and reality.
What Happened Next
In the next few hours after the election of Mr. Trump, the US Dollar, and the US stock markets indeed tanked. This was due to market psychology and the fear of the unknown.
After a few days of the election, the US stock markets and the US Dollar soared and reached new record highs. That is because hard fundamentals prevailed. Hard fundamentals always prevail in the end.
(2) Technical Analysis
“People create the market, and as people tend to repeat themselves, the market moves also in repetitive circles”
Technical analysis is a method of studying and analyzing mass behavior by using charts, trends, and historical price data. In practice, the technical analysis aims to evaluate the market conditions and to forecast future price movements.
The Computer Revolution and the Derivatives Create Volatility and ‘Shorterism’ in the Market
Technical analysis has become extremely popular since the early 80s. The birth of the personal PC (IBM XT and Apple Mac) combined with the computer software revolution, during that period, made it easy for retail traders to perform technical analysis at their small offices, or even at home.
Note: In 1981, the first PC was announced by IBM. In 1983, the first retail back-testing and optimization trading software for the IBM PC was introduced by Mr. Mendelsohn. It was called ProfitTaker Futures Trading Software.
Furthermore, due to the increased popularity of the derivatives market, financial trading has become very volatile and very short-term oriented.
Both facts boosted the need for a tool that can analyze the short-term market behavior. There isn’t a better tool to do that job than technical analysis.
The Major Assumptions of Technical Analysis
These are the five (5) basic assumptions of Technical Analysis:
1. Information is already incorporated in the current prices
2. Prices are moving in trends
3. Price movements are usually not random
4. Historic trends are usually repeated and create price patterns
5. There is no particular time-frame you must trade the market
The Technician Trader
A technician believes that the price forms trends and trends repeat themselves. A technician will try to identify distinct price formations and to execute trades using historical price data. History plays a major role in technical analysis.
The six (6) categories in Forex Technical Analysis
A technical will apply a wide variation of charting tools, including support and resistance levels, major trendlines, indicators, oscillators, pivots, chart patterns, and many more. These are the six categories of tools in Forex Technical Analysis.
- Number Theories (Mainly Fibonacci and Gann numbers)
- Wave Theories (Elliott Wave Theory and Harmonic Patterns)
- Indicators and Oscillators (MACD, RSI, ADX, etc.)
- Chart Patterns and Candlestick Patterns
- Price Gaps (High-Low, Open-Close)
- Moving Averages (Mainly Simple and Exponential MAs)
Trend-following indicators help traders to identify strong trends (MACD, MAs, ADX, etc.). Oscillators help traders to identify potential price reversals (RSI, Stochastic, Force Index, etc.).
These are some major technical analysis tools:
- Moving Average Convergence Divergence –MACD (Identifying trends)
- Relative Strength Index –RSI (Triggering reversals -30/+70)
- Average Directional Movement Index –ADX (measuring the strength of the trend)
- Gann Numbers (Price / Time Equivalents, primary Gann angles are: 1X2, the 1X1, and the 2X1)
- Fibonacci Ratios (mainly 0.618, 1.618, 0.382) –Find more here: http://tradingfibonacci.com/index.php/fibonacci-trading/fibonacci-sequenceGaps (an up price gap is considered a sign of market strength, and a down gap is a sign of market weakness)
- Elliott Wave Theory (5-wave advances followed by 3-wave declines) –Find more here: http://tradingfibonacci.com/index.php/fibonacci-pattern/elliott-wave-patterns
- Harmonic Patterns (ABCD formation) –Find more here: http://tradingfibonacci.com/index.php/fibonacci-pattern/harmonic-trading
(3) Combining Technical and Fundamental Analysis
Many of us believe that the most effective method of trading Forex or any other financial market is by combining technical and fundamental analysis.
Weighing the two Methods in our Decision Making
Depending on the timeframe, the applied strategy, and the prevailing market conditions, there are times when fundamental and technical analysis can become irrelevant.
Table: The importance (weight) of technical and fundamental analysis of different strategies
MARKET CONDITIONS / STRATEGY
Key News Releases
Don’t Underestimate any Knowledge
You mustn’t underestimate either fundamental or technical analysis.
This is why:
-If you underestimate the fundamental analysis you will end up trading only prices and not values. This means losing entirely the real value behind the assets you hold. Don’t ever do that mistake in long-run periods, you will lose all your money.
-If you underestimate the technical conditions of the market you will lose completely the market sentiment. Don’t ever do that mistake in short-term periods. Feeling the market sentiment is very crucial no matter if you follow it or not. What the market thinks is very important information.
Seeking for Confirmation
In the long-term, new fundamental conditions must align with the key price trends.
- Bullish fundamental changes must be followed by bullish technical indicators, or they aren’t confirmed.
- Bearish fundamentals changes must be followed by bearish technical indicators, or they aren’t confirmed.
In other words, when the fundamentals meet the technicals, and one confirms the other, a successful trade is born.
Technical analysis studies the price and fundamental analysis studies the value. As a general rule, in shorter timeframes, technical analysis is more effective than fundamental analysis, due to the lack of fundamental changes in values. In longer timeframes, fundamental analysis is the king, as the market sentiment follows the large players. In any case, don’t underestimate any of these two major market forces. Most professional traders combine both approaches for achieving superior results. If you can’t combine them, prefer to evolve into a fundamentalist and trade long-term. Becoming a technician and trade solely short-term is much more demanding than the average trader can think, and it is better to avoid it.
Personally, I see technical analysis and fundamental analysis as two components of a successful trading system, the 3rd component is money management. Here is how it works:
→ Use fundamental analysis to decide what to buy
→ Use technical analysis to decide when to buy it
→ Use money management to decide how much to buy
The way I see it: ‘If fundamentals create the brains of the Market, technicals create a spirit and a soul’ and if you want to have a successful and balanced trading career you need to have both brains and a spirit.
■ Forex Forecasting Methods: Technical vs Fundamental Analysis
George M. Protonotarios, November 2016