Introduction
There are two necessary methods in forecasting the currency market, fundamental analysis and technical analysis.
Fundamental analysis focuses on the economic, social and political forces that drive supply and demand. Fundamental analysts look at various macroeconomic indicators such as economic growth rates, interest rates, inflation, and unemployment. However, there is no single set of beliefs that guide fundamental analysis. There are several theories as to how currencies should be valued.
Technical analysis focuses on the study of price movements.
Forex Technical Indicators
A technical indicator is a tool in the technical analyst's box. Those based on price data include any combination of the open, high, low or close over a period of time. Some indicators may use only the closing prices, while others incorporate volume and open interest into their formulas. The price data is entered into the formula and a data point is produced.
A technical indicator offers a different perspective from which to analyse the price action. Some are derived from simple formulas and the mechanics are relatively easy to understand. Others have complex formulas and require more study to fully understand and appreciate. Regardless of the complexity of the formula, technical indicators can provide unique perspective on the strength and direction of the underlying price action. Here we will list the most commonly used technical indicators and offer a brief description
- Bollinger Bands
- Moving Average Convergence Divergence
- Momentum
- Moving Averages
- Relative Strength Index (RSI).
- Stochastic Oscillator
Bollinger Bands
An indicator that allows users to compare volatility and relative price levels over a period of time. The Bollinger Bands are envelopes based on a moving average and a standard deviation which makes the bands widen or narrow relative to the current market volatility.
95% of price action will take place within the Bollinger bands and thus the Bands act as strong areas of support and resistance when the forex market is without trend. It is possible at times like this to successfully trade the price rising or falling from one Bollinger line to the other. When a trend begins and the volatility of the market increases thus the spacing of the Bollinger Bands will widen, as the trend slows down the Bollinger bands will narrow.
Moving Average Convergence Divergence
An indicator that follows the difference between a pair of moving averages. Developed by Gerald Appel, MACD (moving average convergence divergence) is a trend following momentum indicator that shows the relationship between two moving averages of prices.
Calculation
To calculate the MACD subtract the 26-day exponential moving average (EMA) from a 12-day EMA. A 9-day dotted EMA of the MACD called the signal line is then plotted on top of the MACD. Other lengths of average can be used, but 9-12-26 is the most common "standard" setting.
Function
MACD measures the difference between two moving averages. A positive MACD indicates that the 12-day EMA is trading above the 26-day EMA. A negative MACD indicates that the 12-day EMA is trading below the 26-day EMA. If MACD is positive and rising, then the gap between the 12-day EMA and the 26-day EMA is widening. This indicates that the rate-of-change of the faster moving average is higher than the rate-of-change for the slower moving average. Positive momentum is increasing and this would be considered bullish. If MACD is negative and declining further, then the negative gap between the faster moving average and the slower moving average is expanding. Downward momentum is accelerating and this would be considered bearish.
Application
There are 3 common methods to interpret the MACD:
- Crossovers - When the MACD falls below the signal line it is a signal to sell. Vice versa when the MACD rises above the signal line.
- Divergence - When the security diverges from the MACD it may signal the end of the current trend. For instance, price may continue to make higher highs while MACD makes lower highs. This is an example of bearish or negative divergence and a warning that the up trend may soon be finished.
- Overbought/Oversold - When the MACD rises dramatically (shorter moving average pulling away from longer term moving average) it is a signal the security is overbought and will soon return to normal levels.
Momentum
The impetus of a directional movement, or a technical indicator used to measure directional impetus. Also described as a style of forex trading where one looks for increased impetus as an entry signal. Momentum can refer to a number of things in regard to trading.
Firstly it can refer to 'momentum' as the impetus, or increased activity of an item - such as a stock or index. This can be referred to as gaining momentum or losing momentum
Secondly it is a type of indicator that can be added to a chart as part of technical analysis - this is a Momentum Indicator, which measures the amount of impetus or activity in a stock or index and shows it growing or waning. There are also other types of momentum indicators such as the Relative Strength Index or the Stochastic Momentum Indicator.
Third it can refer to a type of trading or investing, where traders look for an increase in the momentum of a stock or index as an entry point for their trade.
Moving Averages
An average of price, or some other data value, plotted over time. A moving average is referred as such because it is recalculated at each consecutive point in time. Moving averages are used in technical analysis The effect is to produce a line that smoothes out fluctuations in the original data.
Types of Moving Averages
Simple moving average (SMA): The unweighted mean of the previous n data points in the time series. For example, a 10-day simple moving average closing price is the mean of the previous 10 days' closing prices. The larger the value of n, the greater the smoothing effect and the more the MA line is displaced from the original data.
Weighted moving average (WMA): The weighted mean of the previous n data points in the time series. The weighting is generally (but not necessarily always) linear. That means a relative weight of 1 is assigned to time period t, with each previous period's value assigned a lower weight on down to a relative weight of 1/n assigned to time period t-n. The WMA is more responsive to recent movements than the SMA.
Exponential moving average (EMA): An exponentially weighted mean of previous data points. The parameter of a EWMA can be expressed as a proportional percentage. For example, a 10% EMA has each time period assigned a weight that is 90% of the weight assigned to the next more recent time period.
Relative Strength Index (RSI)
RSI is an extremely useful, reliable indicator which is a favourite of many forex traders.
CalculationThe RSI is generally calculated using a 14 day time period (and this is generally the default setting of many trading software packages) however other time periods can be used such a 9 day for a faster setting and 25 day for a slower setting.
The Formula is:
RSI = 100 - 100 / (1 + RS)
RS = AG / AL
AG = Average Gain over RSI Period
Gain = Price - Price.x (when Price > Price.x)
AL = Average Loss over RSI Period
Loss = Price - Price.x (when Price <>
x = Momentum Period
Application
In general terms the RSI is an overbought/oversold indicator. In practice below 30 is considered being an oversold indication and when the RSI crosses 30 to go up, this is a buy signal. At the other end of the scale a value above 70 is considered overbought and when the RSI crosses to go below this, it gives a sell signal.
It should be noted that the RSI will form chart patterns similar to those found on the main chart, such as a double top, head and shoulders etc which may not show up in the stock/indices price, but which will give and an indication as to pending change ahead.
The RSI will also form support and resistance levels, just like the main chart and it may also diverge from the main chart direction indicating change. For example, the stock/index may make a new high, but the RSI doesn't - that's a bearish indicator. Conversely the stock/index may make a drop to a new low but the RSI moves sideways or upwards - that's a bullish indication. In these cases the price will usually follow the direction the RSI has just shown.
Stochastic Oscillator
In general terms a Stochastic level below 20 would be considered oversold, where as a level above 80 would be considered overbought. However, Lane did not believe that a reading above 80 was necessarily bearish or a reading below 20 bullish. A buy or sell signal can be generated by the Stochastic when the indicator passes back above the 20 level for a buy signal or below the 80 level for a sell signal.
There are different types of Stochastic Oscillator and reference may be made to a Fast Stochastic or a Slow Stochastic. These are generated by using different settings - as detailed in the calculation below. The Fast Stochastic can be useful for quick trades - made in short time frames. The Slow Stochastic is more smoothed and loses a lot of 'noise' that can lead to confusion with the Fast Stochastic.
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Fundamental Analysis
Fundamental analysis focuses on the economic, social and political forces that drive supply and demand. Fundamental analysts look at various macroeconomic indicators such as economic growth rates, interest rates, inflation, and unemployment. However, there is no single set of beliefs that guide fundamental analysis. There are several theories as to how currencies should be valued.
The role of interest rates
Using the interest rates independently from the real economic environment translated into a very expensive strategy. Because foreign exchange, by definition, consists of simultaneous transactions in two currencies, then it follows that the market must focus on two respective interest rates as well.
This is the interest rate differential, a basic factor in the markets. Forex Traders react when the interest rate differential changes, not simply when the interest rates themselves change. For example, if all the G-5 countries decided to simultaneously lower their interest rates by 0.5 percent, the move would be neutral for foreign exchange, because the interest rate differentials would also be neutral. Of course, most of the time the discount rates are cut unilaterally, a move that generates changes in both the interest differential and the exchange rate. Forex Traders approach the interest rates like any other factor, trading on expectations and facts. For example, if rumor says that a discount rate will be cut, the respective currency will be sold before the fact. Once the cut occurs, it is quite possible that the currency will be bought back, or the other way around. An unexpected change in interest rates is likely to trigger a sharp currency move. Other factors affecting the trading decision are the time lag between the rumor and the fact, the reasons behind the interest rate change, and the perceived importance of the change. The market generally prices in a discount rate change that was delayed. Since it is a fait accompli, it is neutral to the market. If the discount rate was changed for political rather than economic reasons, a common practice in the European Monetary System, the markets are likely to go against the central banks, sticking to the real fundamentals rather than the political ones. This happened in both September 1992 and the summer of 1993, when the European central banks lost unprecedented amounts of money trying to prop up their currencies, despite having high interest rates. The market perceived those interest rates as artificially high and, 29 therefore, aggressively sold the respective currencies. Finally, Forex Traders deal on the perceived importance of a change in the interest rate differential.
Financial factors
Financial factors are Vital to fundamental analysis. Changes in a government's monetary or fiscal policies are bound to generate changes in the economy, and these will be reflected in the exchange rates. Financial factors should be triggered only by economic factors. When governments focus on different aspects of the economy or have additional international responsibilities, financial factors may have priority over economic factors. This was painfully true in the case of the European Monetary System (EMS) in the early 1990s. The realities of the marketplace revealed the underlying artificiality of this approach.
Political crises influence
A political crisis is commonly dangerous for the Forex because it may trigger a sharp decrease in trade volumes. Prices under critical conditions dry out quickly, and sometimes the spreads between bid and offer jump from 5 pips to 100 pips. Unlike predictable political events (parliament elections, interstate agreements conclusion etc), which generally take place in an exact time and give market the opportunity to adopt, political crises come and strike suddenly. Currency traders have a knack for responding to crises. The traders should react as fast as possible with risk management to avoid big losses. They have not much time to take decisions, often they have only seconds. Return on the market after a crisis is often problematic.
Monetary Operations by Central Banks
All central banks and the U.S. Federal Reserve System (FRS) as well, affect the foreign exchange markets changing discount rates and performing the monetary operations (as interventions and currency purchases).
For the foreign exchange operations most significant are repurchase agreements to sell the same security back at the same price at a predetermined date in the future (usually within 15 days), and at a specific rate of interest. This arrangement amounts to a temporary injection of reserves into the banking system. The impact on the foreign exchange market is that the national currency should weaken. The repurchase agreements may be either customer repos or system repos. Matched sale-purchase agreements are just the opposite of repurchase agreements. When executing a matched sale-purchase agreement, a bank or the FRS sells a security for immediate delivery to a dealer or a foreign central bank, with the agreement to buy back the same security at the same price at a predetermined time in the future (generally within 7 days). This arrangement amounts to a temporary drain of reserves. The impact on the foreign exchange market is that the national currency should strengthen.
Monetary operations include payments among central banks or to international agencies. In addition, the FRS has entered a series of currency swap arrangements with other central banks since 1962. Also, payments to the World Bank or the United Nations are executed through central banks.
Intervention in the United States foreign exchange markets by the U.S. Treasury and the FRS is geared toward restoring orderly conditions in the market or influencing the exchange rates. It is not geared toward affecting the reserves.
There are two types of foreign exchange interventions: naked intervention and sterilized Intervention. Naked intervention, or unsterilized intervention, refers to the sole foreign exchange activity. All that takes place is the intervention itself, in which the Federal Reserve either buys or sells U.S. dollars against a foreign currency. In addition to the impact on the foreign exchange market, there is also a monetary effect on the money supply. If the money supply is impacted, then consequent adjustments must be made in interest rates, in prices, and at all levels of the economy. Therefore, a naked foreign exchange intervention has a long-term effect.
Sterilized intervention neutralizes its impact on the money supply. As there are rather few central banks that want the impact of their intervention in the foreign exchange markets to affect all corners of their economy, sterilized interventions have been the tool of choice. This holds true for the FRS as well. The sterilized intervention involves an additional step to the original currency transaction. This step consists of a sale of government securities that offsets the reserve addition that occurs due to the intervention. It may be easier to visualize it if you think that the central bank will finance the sale of a currency through the sale of a number of government securities. Because a sterilized intervention only generates an impact on the supply and demand of a certain currency, its impact will tend to have a short-to medium-term effect.
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