As you probably know, there are two main groups of trading strategies, each relying on a different kind of market data to reach decisions. Technical analysis, beloved by day traders and particularly suited to the forex market, involves making decisions based on price history and market movements. Fundamental analysis, on the other hand, looks at the underlying economic data to make predictions. Both are complex topics; but what about the interaction between the two?
How the two methods differ
Most traders will find themselves specialising in one of the two strategies. Indeed, fundamental traders are famous for their sceptical attitude towards the efficacy of ‘charts’ – a scepticism that’s thrown back at them gleefully by technical traders if their predictions work out.
The main criticism of technical analysis by fundamentals purists – ‘fundamentalists’ – is familiar to many retail investors from warnings on investment advertisements: Past performance does not indicate future results. For such fundamental traders, even when a technical pattern such as ‘head and shoulders’ occurs, this is simply evidence of the ‘self-fulfilling prophecies’ of technical analysis.
Technical analysts tend to be less interested in academic arguments about why patterns form, and instead focus on back-testing and trading using these strategies. Particularly in the forex market, and above all with currencies like the Japanese Yen – where technical analysis has existed for centuries – chart patterns seem to be a real and predictable part of the market environment.
Charting is not without its critics, but of all the markets where it is practised, and it is practised in all markets, forex is probably the best suited. The absence of real insider information, vast volumes and the presence of automated traders using technical strategies all contribute to a market where both technical and fundamental strategies can prove highly profitable.
Can they be combined?
These two schools of thought needn’t be in conflict. Very few technical traders would argue that knowing about the balance of payments, economic data, and inflation of the target currency’s national economy is unimportant. Likewise, even diehard fundamental traders would be wary of a long position in a currency where multiple technical indicators were warning of an imminent reversal.
Everyone has their favourite strategies and pet opinions; one of the attributes of successful traders is being able to understand how all of these interact, and having the necessary breadth of information and experience to know which signals to prioritise.
Normally, combined analysis involves a fundamental view being supported by technical analysis for market timing purposes. In nearly all cases, this is what it means. It is of course possible to check fundamental metrics to confirm a view you’ve formed solely from chart work, but this is a much rarer practice. Much of what is discussed in this article applies to traders approaching combined analysis from either direction. Nevertheless, they must be taken with a pinch of salt, as each trading situation is unique and contains risk of different kinds.
Easy wins with combined analysis
Sometimes, the work of combining technical and fundamental strategies is simple. If you have an underlying view based on fundamental analysis, simply monitor the price until there are also favourable technical signals and enter the trade. This is known as market timing.
Market timing is easy to understand in theory, but a tough skill to develop in practice. If you’ve worked out a fundamental strategy for a trade, you may become highly impatient with waiting for technical market conditions to be favourable – the planned price levels for the trade may even be passed before this happens.
Issues with combined analysis
Alongside impatience, fear of losses may have a strong negative effect on the performance of combined strategies. Short of switching to a fully automated strategy, one method for maintaining trade discipline is to make a checklist of conditions for entering a trade, including both fundamental and technical factors. If one of them is not met, traders do not make the deal.
Other problems include an information gap most forex traders have, with much greater familiarity with charting and technical patterns than fundamentals. Traders without a strong grounding in economics – who may still be very successful – need to at least be aware of what metrics to follow for a thorough fundamental analysis. Another alternative is to read the many free reports on forex fundamentals put out by banks and brokerages on a regular basis.
Always remember that ‘full’ fundamental analysis that you may be familiar with from equity trading isn’t possible in the forex market – there is no equivalent to the balance sheet or statements for a currency, with even national economic data not the sole influence on a global reserve currency. And so, the same level of detailed fundamental information is simply not available.
An example of a combined analysis
Let’s say you are going bullish on the Japanese economy. You think the Yen is historically undervalued, Japanese industries have a healthy mix of imports and exports, and that they are less likely to be impacted by inflation increases. After reaching this fundamental decision, perhaps even with a price target for where you think the JPY should be, you start to look at some charts.
Straight away you notice that USD/JPY is flashing up as oversold on the RSI. You check the charts for various timeframes, trying to see if there are multiple conflicting or converging trends taking place across them, and believe that the JPY is at a key support level after recent downward price movements. You might check for well-known candlestick patterns, or even use a point and figure chart to try and remove as much noise as possible from the price signal.
Eventually, you decide to enter the trade, using technical analysis to set a stop loss near the key support level, with a take profit just shy of your target price. In this case, you are combining technical and fundamental analysis with the former providing your stop loss and the latter your take profit levels.
The trade closes successfully.
That would be an example of technical analysis confirming the original fundamental rationale. Let’s imagine a different version:
Having formed your fundamental long JPY view, you check the charts and find the RSI is at 80. This is in overbought territory, but you tell yourself that it is likely just an effect of the recent JPY rally, which you are sure has much further to go to reach your price target.
Charting tells you JPY is approaching a key resistance level which you are sure it will easily break through based on your price target. JPY is continuing an impressive rally which saw it soar past an old support level around a week ago. On the candlestick chart a bearish doji star appeared in yesterday’s session – but you can’t see it on the hourly charts, and anyway, you aren’t superstitious.
Confident in your fundamental case, you enter the trade with a stop loss on the ancient support level, now far below the current price. You are confident your price target will be met, so you set your take profit at exactly the forecast price to maximise profits.
Of course, the trade fails, and because of dubious risk management, the loss is considerable.
Technical indicators to check before entering a trade
When you have a fundamental view on a currency pair, consider making the following technical confirmations for where to enter (and exit) your trade:
- RSI, money flow index, or another oscillator such as Bollinger bands. These will help you identify any likely reversals.
- Support and resistance levels. This is critically important as you should use these to set stop losses or take profits. Always set the stop loss just above the relevant level, and the take profit just below (in a long trade).
- Any obvious patterns. Candlestick patterns are probably the most controversial and subjective part of technical analysis, but they are also the oldest and some of the best liked by their advocates.
Always remember that neither technical nor fundamental analysis can give you a complete market picture by themselves. It is always necessary to form your own view based on as many properly digested inputs as possible.
How Rakuten can help
Combining different strategies can help you transform your trading, especially with risk reward prudence and proper position sizing. To begin testing out your skills, sign up for a free demo account today and start placing trades without risking any of your capital.