Forex traders utilize benefits of fundamental analysis or technical analysis (sometimes both) in order to predict the future direction of a currency pair and initiate the trade in the hope of making profit.
Fundamental analysis attempts to estimate the real value of a currency using economic data, monetary policy stance and political factors such as GDP growth, unemployment rate, inflation, interest rates and political sentiment. On the other hand, technical analysis assumes that all of these information is already reflected in the value of the currency and uses past price activity in order to predict future value of the currency.
Same Question, Different Approaches
Both fundamental and technical analysis methods attempt to solve the same question, that is, to predict the direction prices are likely to take in the future. It is just that each method has different approaches to the question. The fundamental method examines the cause of price movement, while the technical method examines the effect.
The technical trader is convinced that all he / she has to know in order to be able to make accurate predictions is the effect. The causes are irrelevant for technical traders. However the fundamental trader has to know the reason and causes of the price movement.
Most of the time, traders label themselves as either a technical trader or a fundamental trader. However, they are not completely detached from each other and there is a considerable amount of overlap.
Many fundamental traders have working insight for the chart analysis and price action. In the meanwhile, many technical traders have practical knowledge of the fundamental factors such as interest rates, growth, and unemployment rate.
The Clash of Technical and Fundamental Analysis
However, technicals and fundamentals may clash on their prediction about where the value of a currency is directed in the future. This happens frequently at the beginning of big trends. At the early stages of important price moves, the fundamental analysis fails to explain or comply with how the markets appear to behave.
This is because the price discounts already known fundamental factors which means that they are already reflected in the current market price.
Thus, prices are now adjusting itself to the unknown fundamental factors. When some of the biggest bull and bear trends in the history began, there was little or no obvious change in the fundamentals. By the time market players became aware of the reason for the fundamental change, the new trend was already ongoing for a while.
On the other hand, technical traders are used to the situations where price action conflicts with known fundamental factors. Technician knows that the reasons for price movement will be revealed to all market players. It is just that the technician doesn’t see any reason to wait for the additional confirmation.
Technical traders usually find their approach superior over fundamentals because, by definition, technical analysis assumes that every fundamental factor is already priced in and reflected on the chart. This assumption makes the study of fundamentals unessential.
Different Time Horizons
Fundamental analysis is considered as a long term investment approach while technical analysis takes a shorter term approach for analyzing the markets. A change on the monetary policy stance of a central bank could cause a long term trend reversal and create trading opportunities for a period between several weeks to several years. Traders who like to invest in currencies for long run are tended to benefit from fundamental analysis.
However, trading currencies on technical analysis is a short-term oriented approach. Some scalping strategies that are based on technical indicators could last as low as few seconds. Therefore, short term traders use technical analysis more commonly.
Which One is better?
It is hard to say whether fundamental or technical analysis is better since they are useful for different trading strategies on different time frames. Fundamental analysis is useful for identifying undervalued or overvalued currencies and finding trade opportunities in the long run. On the other hand, technical analysis is useful for trading strategies focusing on shorter time periods and timing the order.
As an important final world, I must say that you don’t have to choose between the two approaches. Many forex traders mix both fundamental and technical analysis into their decision making process.
These type of traders look for the trading opportunities where both technical and fundamental analysis agree each other. If technicals and fundamentals indicate contrasting predictions for the future price movement of the particular currency, they tend to be hesitant on triggering the trade order.