Lesson 5: How to Analyse Financial Markets?

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I believe in analysis and not forecasting.

Nicolas Darvas

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In the previous sections, we laid the foundations of our evolution to a Professional Forex Trader. 

We learned:

  • What is Forex trading and how to become a Forex trader
  • Basics of financial markets and different financial assets
  • How to trade Forex CFDs and what are the key elements

Now, let’s get our hands dirty and master finding opportunities in the Forex markets.

In this section, we will learn: 

  • how to analyse financial markets to identify the best opportunities
  • how to determine the extent of an opportunity
  • how to distinguish favourable opportunities from unfavourable ones

LET’S GO!

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Financial Markets Analysis

Financial markets analysis is to study market events and past prices to predict future trends.

There are two dimensions when analysing the financial markets: 

  • Fundamental Analysis: evaluation of the impact of economic and political events
    • Can vary anywhere from wars and elections to interest rates and employments
  • Technical Analysis: analysis of the historical price charts to identify patterns
    • With the underlying notion that the history tends to repeat itself

Our trading strategy and assets determine which analysis method(s) to use. 

Some traders use only fundamental or only technical analysis, while others combine them. 

Best strategy is to use fundamental analysis to understand what can change prices and technical analysis to understand how much it can change. 

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Part I: Fundamental Analysis

Fundamental Analysis is the study of the global and local factors influencing the markets.

It helps us to identify short- and long-term trends and changes in the investor sentiment. 

Economic, political, environmental, financial, industrial, social, technological developments are considered as fundamental events. 

These events can be either quantitative or qualitative. 

  • Quantitative Events: economic or financial reports of governments and businesses. 
  • Qualitative Events: immeasurable occurrences such as elections and press conferences. 

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While some might mistakenly consider value investing a mechanic tool or identifying bargains, it is actually a comprehensive investment philosophy that emphasizes the need to perform in-depth fundamental analysis, pursue long-term investment results, limit risk, and resist crowd psychology.

Seth Klarman

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Quantitative Fundamental Events

Quantitative fundamentals show the financial health, performance and psychology of the issuer. 

They can be statistical reports, performance metrics or monetary decisions.

There three main types of report issuers: 

Issuer Type Example Organisation Example Report
Governmental Agency Central Banks Interest Rate Decision
Financial Institution Credit Agencies Credit Rating Report
Private Organisation Public Company Quarterly Earnings Report

How do we analyse quantitative fundamental events?

We compare the results of the current and previous reports.

It helps us to determine whether the performance has improved or deteriorated. 

These conclusions are used to predict market reaction and future investment trends.

For example, if a country’s manufacturing industry report indicates

  • growth: economy is thriving, investments can increase, and currency can gain value
  • shrinkage: economy is contracting, investments can decrease, and currency can lose value

[Image: An image to represent economic growth]

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Qualitative Fundamental Events

Qualitative fundamental events influence the investors’ risk sentiment towards the markets. 

They give clues about the future policies and decisions of the respective organisation.

Understanding the current global and local political, economic, and business environments is important to analyse qualitative fundamental events accurately.

For example, the general elections in the U.S. would have both global and local implications. 

  • There are two main parties – liberals and democrats.
  • Each party has different political and economic agenda. 
  • The economic future would be uncertain until the election results are final. 

[Image: Liberals vs Democrats, if possible, something related with economy]

How investors approach to qualitative fundamental events like elections?

Qualitative fundamentals are incalculable; therefore, they involve a degree of uncertainty.

Uncertainty makes investors to adopt ‘wait-and-see’ approach and slow down investments.

After the elections, the new government’s political and economic policies must be considered. 

The potential trends in the markets would be (hypothetically): 

  • Liberal party wins; pro-trade approach, flexibility in regulations, tax reductions
    • In turn: increased business profitability and rising stock markets
  • Democrat party wins: pro-social approach, stricter regulations, increased taxes
    • In turn: less business profitability and falling stock markets.

Above example is for stock markets; however, for the currency the effect may be the opposite.

Therefore, we should analyse qualitative fundamentals in relation to their effect on our assets. 

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Economic Calendar

Economic Calendar displays pre-scheduled market events in an organised structure. 

It includes the following information for each market event:

  • Event name, date, and time
  • Affected country and currency
  • Result of the previous issue, analysts’ forecast for the current issue, and actual outcome 

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Why Fundamental Analysis is Important for Forex Traders?

As Forex traders, we capitalise on the intraday price changes by trading in short durations.

Price changes occur in the wake of fundamental events and can be short or long term. 

Fundamental Analysis helps us to foresee possible fluctuations before they happen.

Improving our skills will allow identifying opportunities early and take positions in advance.

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What’s hot today isn’t likely to be hot tomorrow. The stock market reverts to fundamental returns over the long run. Don’t follow the herd.

Warren Buffett

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Types of Major Fundamental Events

Some fundamental events are more influential than others.

The impact is essentially based on the deviation between the forecast and the actual outcome.

There are many fundamental economic events which can influence the financial markets:

  • Economic Policies
  • Economic Reports
  • Earnings Seasons
  • Political Events

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Economic Policies

An economic policy is a government’s main plan on the fiscal and monetary affairs. 

  • Fiscal policies: taxation, budgeting, spending – managed by the governmental departments
  • Monetary policies: money supply and interest rates – managed by the central bank

Monetary policies affect Forex markets strongly, while fiscal policies affect stock markets.

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Interest Rates

Interest rate is the periodic commission charged when lending money. 

When we loan money, we pay interest; when we lend money (e.g., bonds), we earn interest. 

Main lenders are central banks, public and private banks, and financial institutions.  

As the top monetary authority, central banks are responsible for deciding baseline interest rate.

Each central bank has its own interest rate policy depending on the country’s inflation targets. 

Other lenders are obliged to comply with the rules and limits imposed by their central bank. 

  High Interest Rate Low Interest Rate
Referred as Hawkish Dovish
Currency has High value Low value
Lending is Expensive Cheap
Who enjoys benefits Lenders Borrowers
Who incurs costs Borrowers Lenders

How do interest rates affect Forex markets? 

Interest rate shows the currency’s intrinsic value – how much the country values their currency. 

  • Central bank increases the interest rate (Interest Rate Hike), the currency gains value.
  • Central bank decreases the interest rate (Interest Rate Cut), the currency loses value.

Example: How to trade Forex when interest rates are announced? 

U.S. Federal Reserve (Fed) meets eight times per year to decide and set the interest rate. 

The decision is announced after each meeting with a press conference and a statement.

Based on the global and local economic conditions, they can raise, lower, or keep the rate level. 

Since U.S. Dollar is the world’s reserve currency, Fed meetings are followed closely.

Every interest decision has a market-wide impact:

  • Interest Rate Hike: USD will gain value; EUR/USD will drop, USD/JPY will rise.
  • Interest Rate Cut: USD will lose value; EUR/USD will rise, USD/JPY will drop.
  • Interest Rate Kept: Market perception of the U.S. and the global economies, and investors’ risk sentiment will determine the reaction.

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Quantitative Easing (QE)

Quantitative Easing (QE) is to increase money supply by injecting cash into economy.

During extreme economic conditions, central banks use QE to stimulate the economy.

They print more money to buy financial assets held by other banks or institutions. 

These assets can be previously issued government bonds or private debts. 

When does a central bank use quantitative easing? 

QE is a rarely used tool to fight adverse economic or financial situations such as:

  • Low Inflation or Negative Inflation (Deflation): dropping retail prices can shrink the economy by reducing business profitability and eventually lead to unemployment. 
  • High Currency Value: expensiveness of the currency can hinder export activities and repel foreign investments into the economy.
  • Large-Scale Crises: situations like Great Recession in 2007 can cause a sector to collapse and demand the government to take control to prevent the crisis to spread to other sectors.

How does quantitative easing affect Forex markets? 

Increased supply and availability of a currency will make it more common and reduce its value.

However, the drop in the currency value may prove to be temporary once the crisis is averted.

EUR/USD currency pair Daily chart: Response to Coronavirus

In normal economic conditions, an interest cut by the U.S. Fed would depreciate USD. However:

  • On Feb 20th, 2020: Coronavirus outbreak in the U.S. hit the news, the demand for USD sunk.
  • On Mar 3rd, 2020: Fed cut interest rates by 0.5% as an emergency measure, USD rose fast.
  • On Mar 20th, 2020: Rumours about a QE by Fed on March 23rd spread, USD lost value.

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Economic Reports

Economy is comprised of multiple dimensions: 

  • Economic Value
  • Employment
  • Production
  • Consumption
  • Governmental Income & Spending
  • International Trade Activity 

Economic institutions measure their performance by gathering and analysing data. 

These data and conclusions are published periodically as economic reports.

We compare each report to its previous issues to understand the economic performance.

Positive results indicate expansion of economy, negative results indicate shrinking of economy.

Comparing multiple issues also reveal growth and shrinkage trends.  

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Economic Value Reports

Gross Domestic Product (GDP)

Gross Domestic Product (GDP) represents the aggregated national economic value. 

GDP is calculated by including the prices of all products and services produced in the country. 

Countries usually publish their GDP reports periodically to measure the change over time. 

Economic performance is assessed through the percentage change between periods.

  • GDP change over 2%: Expansion in the national economy, positive outlook
  • GDP change of 0%-2%: Recession in the national economy, ambiguous outlook
  • GDP change below 0%: Depression in the national economy, negative outlook

Inflation

Inflation is the rate of increase in the local prices of the products and services in a country. 

It is measured by creating a basket of the products and services and calculating the total value.

Rise or fall in inflation is observed by calculating the change between two subsequent reports.

There are three types of inflation based on the source:

  • demand-pull (consumer demand increasing prices)
  • cost-push (production costs increasing prices)
  • built-in (employees demanding higher wages to maintain cost of living)

In the financial markets, there are two key inflation reports: 

  • Consumer Price Index (CPI)

CPI is the main indicator of inflation. 

It reveals the change in the prices of products and services purchased by consumers.  

In stable economies, rising consumer prices can lead central bank to hike the interest rate. 

If the actual CPI result is higher than analysts’ forecasts, the currency might gain value.

  • Producer Price Index (PPI)

PPI is another important inflation indicator.

It measures the wholesale prices which producers pay to buy products like raw materials. 

Rising wholesale prices can increase the consumer prices and increase inflation as a result.

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Employment Reports

Employment reports monitor the participation in the national workforce.

They measure the change in the population who are working on payroll or receiving benefits.

The focus of the report can be on public or private sector or include both.

Higher participation in production and consumption processes creates more economic value.

Therefore, employment is an important indicator of economic growth.

Strong employment figures can translate into multiple conclusions: 

  • businesses have confidence in the economy and invest more in workforce
  • more people can contribute to economic circulation, indicating higher purchasing power
  • citizens are satisfied with the political environment and feel economic security

Employment Change

Employment change reports show the change in the number of new employments over time.

It compares a report to the previous issue and reveals whether hiring trends are strong or weak.

The details can contain sectoral data to show how each industry is performing. 

For example, U.S. Nonfarm Payrolls (NFP) is the most popular employment change report.

It shows the change in the number of new employees excluding the seasonal farming industry.  

A positive result indicates the U.S. economy is growing and adds value to the U.S. Dollar. 

NFP is monitored closely by the markets and has a huge impact on the price of USD pairs. 

Nonfarm Payrolls results

Unemployment Rate

Unemployment Rate is another important indicator of the employment status in an economy. 

It shows the workforce percentage that is unemployed and registered for jobless benefits. 

A low unemployment rate is considered beneficial for the currency. 

Low unemployment means more people are confident to exercise their purchase power.

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Production Reports

Production refers to manufacturing new goods and services to sell locally or globally. 

Economic strength of a country is almost always based on the amount of production.

It allows the country to invest more, control and penetrate markets, and gain global influence. 

Purchasing Managers Index (PMI)

PMI reports measure the wellbeing and performance of Manufacturing and Services industries. 

It is conducted as a survey among purchasing managers of selected companies.

The survey includes questions about the company’s numbers and confidence in employment, production, new orders, prices, suppliers and inventories. 

Positive PMI means that the businesses are reacting well to the current economic conditions.

Negative PMI means that the businesses have started to perceive risks against their operations. 

Industrial Production

Industrial Production is a large portion of the economy in countries like Germany and Japan.

These countries rely on heavy industries such as factory manufacturing, mining, and utilities. 

The health of these industries directly affects the national employment and consumption levels. 

German Industrial Production and U.S. Core Durable Goods Orders are two examples of industrial production reports with strong impact on the financial markets.

Inventories

Inventory reports inform about the number of goods and products stored in the warehouses. 

They are especially prevalent for commodities and published by governments and companies.

For example, energy commodities like Crude Oil and Natural Gas are stored before processing. 

Inventory reports signify the increase or decrease in the demand for such products. 

If the demand is increasing, the amount in the inventories would drop and increase prices. 

U.S. Crude Oil Inventories on WTI Crude Oil

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Consumption Reports

Consumption refers to the consumer activity of purchasing goods and services. 

While production creates potential economic value, consumption realises that potential. 

As the consumption rates go higher, the cash circulation increases and profitability increases.

In turn, trade activities, employment, and production would gain momentum.

Retail Sales

Retail Sales is the sales of goods and products by merchants to end users for consumption. 

The figures in the retail sales reports show the consumption activity over a time period. 

It is often used as the leading indicator of consumer confidence. 

When people feel confident about their economic future, they spend more on retail products. 

This tendency increases the economic activity, adds value to the economy and to the currency. 

Housing & Construction

Politically, Housing and Construction industry show a nation’s ability to expand its territories. 

It also contributes to the economy as a large employment and industrial consumption source. 

Positive reports show the country’s potential to make large-scale investments, to maintain employment rates, and provide demand for industrial production. 

Lending

Corporate lending activity shows the businesses’ confidence in making new investments to expand their business activities.

Retail lending figures show the consumers’ confidence in make large-scale investments like buying new cars or houses. 

Lending reports represent the activity and perceived security of the private financials industry. 

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Other Major Reports

Budget Balance

Budget Balance reports show the difference between the government’s revenue and spending. 

A country’s income is based primarily on taxes, central bank bonds, and public investments. 

Based on the projected income, the government budgets an efficient spending plan. 

Budget surplus means success of fiscal policy and extra funds for the next fiscal period. 

However, if a deficit is observed, the government would excise more taxes to close the deficit. 

Trade Balance

Trade Balance reports calculate the value difference between imports and exports.

It reveals whether the country is selling from foreign countries more than it buys or vice versa. 

Import is buying foreign goods and services; export is selling local products to foreign countries. 

Export numbers show the foreign demand for the currency, which reflects its global value. 

A positive outcome would indicate that the value of exports was higher than imports.

Thus, the global demand for the currency is high and the national economy gained added value.

Economic Confidence

An economic confidence report is essentially a market sentiment analysis.

It assesses the market confidence about the current status and the outlook of the economy. 

There are three key types of economic confidence reports: business, investor, and consumer. 

  • Business confidence reports are projections of mid-term economic activity such as employment, sectoral growth, and spending. 
  • Investor confidence reports are long-term projections on the economic health and the economic expansion potential. 
  • Consumer confidence reports are short-term indicators of economic activity and reveal the consumer spending potential, which is the largest portion of the national economic activity.

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Earnings Season

Public companies are obliged to publish a periodic financial report to inform shareholders. 

They contain data about the company’s revenues, profits, and dividends in the previous period. 

These reports are known as “earnings reports” and released for every quarter of the year. 

In about a fortnight after the quarter ends, the earnings season begins. 

What is Earnings Season?

During the earnings season, companies publish their quarterly earnings reports. 

They can choose to release the report before markets open or after markets close.

What happens to stock markets in Earnings Season?

Earnings seasons are full of opportunities for Forex traders who trade stocks CFDs. 

Main parameters to monitor are revenue, profitability, earnings per share (EPS) and projections.

Positive results can increase the demand and add significant value to the stock price. 

Negative results, however, would lead the investors to sell their shares and reduce stock price.

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Political Events

Political events like elections, social uprisings, and geopolitical tensions create uncertainty. 

The political instabilities distress the investors and increase the risk sentiment in the market. 

As a result, during political events, investors may exit their investments in the country’s currency and stocks and hurry to safe haven assets like gold. 

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Forex Trading with Fundamental Analysis

The first step of our Forex trading journey is to learn how to open and close positions. 

In the second step, we learn what to trade and when to trade. 

Fundamental analysis is the method we use to identify the next trading opportunity. 

We identify an important economic event, choose an asset, and predict a market direction.

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Don’t worry about what the markets are going to do, worry about what you are going to do in response to the markets.

Michael Carr

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How successful Forex Traders use Fundamental Analysis? 

All successful Forex Traders emphasise the importance of having a solid trading plan. 

Fundamental analysis is an integral part of finding opportunities to exercise our plan.

We don’t randomly choose events from the economic calendar or decide on the spot.

Instead, we specify the assets we want to trade, learn their fundamentals, and trade efficiently. 

Example: Fundamental analysis of a Forex currency pair.

Let’s say we want to make profits by trading EUR/USD currency pair.

We should learn all the factors that affect both Euro and U.S. Dollar individually. 

Each currency is affected by their local economic and political conditions and reports. 

Furthermore, each of these factors have different degrees of influence in different conditions. 

Italian manufacturing report would have less impact on Euro than German employment report.

When U.S. employment is high, rising PPI affects USD more than a drop in the unemployment. 

Therefore, we should identify which reports can strong impact in which conditions.

Then, following the news and events can help us estimate what can happen in the next report.

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Part II: Technical Analysis

Technical analysis is the study of past price movements to predict future movements. 

Basically, we analyse the technical chart of the asset and describe historical price trends. 

These price trends could be:

  • specific price points where the asset struggled to break beyond

Support and Resistance

  • specific price channels in which the asset price fluctuated with a solid uptrend or downtrend

Price Channel

  • specific price patterns that have identifiable shapes

Inverted Head and Shoulders

Once we identify the price trends, we can assess the current movement and make predictions. 

These predictions can include general market direction, upcoming price targets, possible price ranges, the extent of fluctuation, and even the breaking points where the trend can shift. 

As Forex traders, we use technical analysis to determine:

  • the buy and sell signals to open positions
  • the price targets to set Take Profit and Stop Loss orders

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Financial Charts

Asset prices continuously fluctuate due to the perpetual changes in the market conditions. 

Economic events affect the investors’ risk sentiment and drive the demand. 

As a result, the market price of an asset can experience nominal changes in each second. 

These changes can be observed on a financial chart.

A financial chart is a trading tool which displays past prices and real-time price movements.

Prices movements are aggregated in specific timeframes such as 5-minute, 1-hour, or weekly. 

In each timeframe, past prices are aggregated into the specified time points. 

For example, in a daily chart, prices would be divided on a daily basis. 

Each time point shows the opening and closing prices of the day as well as the intraday change. 

Almost all brokers offer a trading platform which incorporates a financial chart.

We use charts to analyse past prices, monitor the live prices, and trade accordingly. 

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Timeframes

We can use single or multiple timeframes to analyse the prices and monitor real-time changes. 

It depends on our trading plan, trading strategy, and the financial asset we are trading.

Short Timeframes

Short timeframes are usually 1-minute, 5-minute, 10-minute, 15-minute, and 30-minute charts.

We prefer them for high frequency trading strategies in which we open and close positions fast.

Long-term price trends are obsolete in such trading styles. 

How do we use each timeframe?

  • 30-minute timeframe is used as the longest time period to assess the overall direction
  • 5-minute and 10-minute timeframes are used to determine the ranges and price targets
  • 1-minute timeframe is used to decide when to enter and exit positions

5-Minute Price Chart

Medium Timeframes

Medium timeframes include 1-hour, 2-hour, 4-hour, 8-hour, daily, and weekly charts. 

Day trading strategies, with same-day or few-days closing of positions, use medium timeframes. 

Short-term price trends are overlooked in day trading strategies.

How do we use each timeframe?

  • Weekly and daily timeframes help determine the general direction and long-term targets
  • 8-hour and 4-hour timeframes are used to understand the price ranges and pivot points 
  • 2-hour and 1-hour timeframes are used to decide when to enter and exit positions

1-Hour Price Chart

Long Timeframes

Long timeframes include weekly, monthly and yearly charts.

Position trading strategies of keeping a trade for a few months prefer long time frames.

Long-term trading is usually rare in Forex trading. 

How do we use each time frame?

  • Monthly and yearly charts help determine the general direction and long-term targets
  • Weekly charts are used to understand the possible price movements to reach targets

Monthly Price Chart

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Chart Types

There are three main chart types we use: line chart, bar chart, and candlestick chart.

Chart Types Bar

Line Chart

Line chart marks each time point’s closing price and connects them with a continuous line. 

Opening prices are not marked; therefore, the change within a time point is not shown. 

The simplicity of the line charts is useful to identify large-scale price patterns in a timeframe.

Line Chart

Bar Chart

Bar chart shows separate vertical lines for each time point, instead of connecting them. 

A bar’s peak indicates the highest price and bottom indicates the lowest price of the time point.

Opening and closing prices are marked with small horizontal lines like hyphens (“-”). 

The opening price is marked on the left of the line, and the closing price on the right. 

If the left hyphen is lower than the right hyphen, it signifies a price increase in that time point. 

When it is the other way around, it shows that the price had dropped.

Bar Chart

Candlestick Chart

Candlestick chart shows the same information but uses candle-like rectangles instead of bars. 

Price increases are shown with green candles while price drops are shown with red candles.

In a green candle, the candle’s floor is the opening price and the ceiling is the closing price.

In a red candle, the candle’s ceiling is the opening price and the floor is the closing price.

Lines reaching beyond the floor and ceiling show the highest and lowest prices of the time point. 

Candlestick chart is often considered as the easiest chart type to analyse and interpret. 

Candlestick Chart

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Trend Types

A price trend refers to the general direction of the market price in the observed time period. 

It shows the current tendency of the investors to buy or sell the asset. 

There are three main price trends in the financial markets: bullish, bearish, and ranging.

Bullish

A bullish trend refers to the upwards movement of prices. 

The term bull refers to the attacking movement of a bull – diving at the target with its horns and throwing it into the air. 

When the markets have an optimistic outlook, investors tend to go long and buy more.

The increased demand lifts the prices and forms an uptrend. 

Bullish Trend

Bearish

A bearish trend refers to the downwards movement of prices. 

The term bear refers to the attacking movement of a bear – grabbing the target with its paws and swatting it on the ground.

When the investors have a pessimistic outlook on the markets, they tend go short and sell more. 

The decreased demand drops the prices and forms a down trend. 

Bearish Trend

Ranging

A ranging trend refers to the flat movement of prices. 

In times of uncertainty, investors become hesitant and avoid large-scale investments. 

The demand level is maintained, and the asset price bounces within a certain price range. 

Ranging Trend

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Technical Analysis Tools

There are several technical analysis methods to determine the trends.

Methods can be manual like drawing tools or automated like technical indicators.

Certain methods can be used alone, while others can yield better results when combined. 

Usefulness of technical analysis methods depend on the financial asset and our trading strategy. 

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Basic Technical Indicators

Basic technical indicators are based on manual tools such as drawing lines. 

They are especially practical when we want to mark important price points. 

We use basic indicators to

  • identify the past price levels which the market struggled to break beyond
  • connect multiple price levels which may have a relationship with each other. 

Important price points often correspond to specific fundamental events at those times.

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Support and Resistance

Support and Resistance (S&R) are the past price points which were struggled to break beyond. 

When we identify such price points, we use a horizontal line to mark the price.

  • Support: when the asset price is approaching from above (i.e. falling) 
  • Resistance: when the asset price is approaching from below (i.e. rising) 

S&R is the most common technical analysis to set price targets for Take Profit and Stop Loss.

The expectation is that the next time the price approaches this level, it would struggle again. 

Support and Resistance

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Trend Channels

Trend Channels are used to describe a specific bullish or bearish pattern in the asset price.

  • Bullish Trend: When the asset price is rising consistently, regardless of small fluctuations
  • Bearish Trend: When the asset price is falling consistently, regardless of small fluctuations

A pattern is observed as a linear relationship between the closing prices (and respective opening prices) of consecutive time points in a specific time window.

When we identify this relationship, we draw two diagonal lines that are almost parallel. 

Trend Channel

The first diagonal intercepts opening prices, and the second diagonal multiple closing prices. 

As the degree to which the lines are parallel increases, the more accurate is the trend channel.

A third line can be drawn in between to monitor within-channel movements and pivot points.

Trend Channel with Midline

The function of trend channels is like support and resistance points. 

  • Upper Line: works as a resistance level; if the price breaks above, the trend can change
  • Lower Line: works as a support level; if the price breaks below, the trend can change
  • Midline: works as a pivot level; if the price breaks beyond, the trend aims next channel line  

Trend ends when the price breaks out of channel, and we can expect a new trend to form. 

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Convergence Lines

Convergence lines are used when there is a specific trading volume pattern in the markets. 

Large price fluctuations are often followed by a period in which fluctuations slowly fade away.

As a result, a shape that resembles a tilted triangle forms in the price chart.

Formation of Convergence

We draw two diagonal lines in the opposite direction to describe this volume decrease pattern.

The first line is drawn between the initial peak and the subsequent lower peaks. 

The second line is drawn between the initial dip and the subsequent higher dips. 

These two lines would indicate the convergence of the price and eventually intersect. 

Convergence Lines

The point of intersection is often where the asset price will break out of the convergence trend. 

When complemented with direction indicators, convergence lines can signal opportunities. 

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Advanced Technical Indicators

Advanced technical indicators use past quantitative data to predict future price movements. 

They are based on mathematical factors like mean, standard deviation or variance. 

Indicators automatically compare the factors of a previous period and the current period.

There are four main types of technical indicators, based on the quantitative data they use: 

  • Trend
  • Momentum
  • Volatility 
  • Volume

Advanced technical indicators are usually grouped into two according to their functions:

  • Leading technical indicators are used to generate trading signals to enter or exit trades 
  • Lagging technical indicators are used to determine trends as they form or fade. 

Their effectiveness depends on the behavioural habits of the market or asset we are analysing. 

In other words, an indicator can be effective for technology stocks but useless for commodities. 

Most trading platforms with financial charts also have built-in technical indicators. 

Using the indicators menu of the platform, we can add the relevant indicators to the chart. 

Independent trading platforms like MetaTrader 4 also allow adding custom technical indicators.

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Trend Indicators

Trend indicators calculate the average price of each time point in a specific period.

The average prices of each time point are connected with a continuous trend line on the chart.

This average price line reveals the general price trend and serves as a baseline for the live price. 

Its direction – upwards or downwards – shows the general market trend of the analysed period.

How to read the Trend Indicators?

In trend indicators, we check whether the current price level is above or below the trend line. 

  • If the current price is above the trend line, the current market trend is bullish
  • If the current price is below the trend line, the current market trend is bearish

Large distance to the trend line indicates that the trend is strong, and the market is biased.

However, if the market conditions are too extreme, a recovery movement could happen soon. 

Frequently used Trend Indicators

Moving Averages (MA)

Moving Averages are laggingtechnical indicators, calculating the price average of a period. 

They serve as a baseline to understand whether the market is bullish or bearish.

We use MAs to identify current trends and trend reversals, and to set support and resistance. 

Moving Average 

Moving Average Convergence Divergence (MACD)

MACD is a lagging indicator, consisting of two price average lines: fast-moving and slow-moving.

We use MACD to analyse the changes in a trend’s strength, direction, momentum and duration. 

  • The slow-moving average line serves as a baseline.
  • The fast-moving average line serves as a trend signal. 

When the fast line crosses below the slow line, a new downtrend can be formed. 

In the opposite scenario, a new uptrend can occur. 

The sustainability of a new trend is inferred from another MACD component: the histogram.

  • If the histogram is strong, the new trend can continue.
  • if the histogram is fading, the new trend is likely to be a short one. 

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Momentum Indicators

Momentum indicators help us understand if an existing trend is strengthening or weakening. 

They measure velocity of the price as the variance in the speed and direction of price changes.

Average of closing prices in a period is compared to most recent closing price as the momentum.

Momentum indicator is located as a separate window below the price chart. 

The momentum line oscillates simultaneously with the current market price. 

How to read the Momentum Indicators?

We observe the difference between the recent closing price and the average:

  • If the momentum line is heading a higher or a lower limit, momentum is accelerating.
  • If the momentum line is returning to baseline from a limit, momentum is decelerating.
  • If the momentum line is staying closer to the baseline, momentum is stable.

A high momentum can reinforce the trend or abruptly reverse it into the opposite direction.

Frequently used Momentum Indicators

Relative Strength Index (RSI)

RSI is one of the most popular leading momentum indicators. 

It measures the current trend’s momentum of change in strength, velocity, and magnitude. 

RSI

RSI has one upper and one lower limit, set at 70 and 30 (or 80 and 20) respectively. 

When the line crosses beyond a limit, the market is saturated and overbought or oversold.

Market saturation indicates gradual loss of momentum, and a potential trend reversal.

We can use RSI in conjunction with trend indicators to generate trading signals.

Stochastic Oscillator

Stochastic Oscillator is a leading momentum indicator.

We use Stochastic Oscillators to estimate a price point which the trend will reverse from. 

It calculates the average of the price ranges of each time point in a specific period.

This average is compared to the last closing price to understand the momentum.

Stochastic Oscillator

If the line oscillates above the 80 (or 70) limit, the market is overbought.

In an overbought market, investors tend to increase their short positions. 

If it falls below the 20 (or 30) limit, the market is oversold, and investors might start buying. 

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Volatility Indicators

Volatility indicators are measurements of the extent of price fluctuations in a financial asset. 

The primary goal is to determine how much the price can move, regardless of the direction.

They calculate the difference between highest and lowest prices of each time point in a period.

The differences are averaged and compared to high-low difference of the current time point.  

Volatility indicators add two lines to the chart – one follows the highs and one follows the lows. 

How to read the Volatility Indicators?

We use volatility indicators to understand how high or low an asset can go after a market event. 

The lower line serves as the support level, and the upper line is used as the resistance. 

When a time point is closed beyond one of the lines, a reversal is likely in the next one.

This indicator type is especially reliable when the volatility level in the markets are stable.

Frequently used Volatility Indicators

Bollinger Bands 

Bollinger Bands is the most popular lagging volatility indicator.

It adds two continuous lines to the price chart. 

These lines show the progression of average high and low prices. 

Bollinger Bands

When the price approaches either band, price volatility slows and market changes direction. 

Bollinger Bands are often used together with MA to create two price fields with three pivots.

The field between the upper band and MA line indicates the volatility of the bull market. 

The field between the lower band and MA line indicates the volatility of the bear market.

Average True Range (ATR) 

ATR is a lagging indicator that reflects the degree of price volatility in terms of pips.

It calculates the average price movement in a period and compares it to the current time point. 

Average True Range 

If the daily price volatility is close to the average, any new trends are likely to remain short-term. 

If there is still room for movement, a new trend formation can be advantageous. 

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Volume Indicators

Volume indicators measure the change in the trading volume in the markets. 

Trading volume is the primary predictor of price changes, volatility, direction, and new trends. 

As the demand rises or falls significantly, trading volume will increase towards a single direction. 

The accumulation of the trading activity will accelerate the rise or fall of the asset price.

How to read the Volume Indicators?

The strongest trends are always accompanied by high trading volumes. 

We use volume indicators to confirm if a materialising price direction is a true trend or not. 

Frequently used Volume Indicators

Chaikin Oscillator

Chaikin Oscillator is a leading technical indicator. 

It generates trading signals by observing the money flow in and out of the market. 

When investors pour money into the market, more long positions are opened, the price rises. 

When the money is withdrawn, investors are shorting their investments, and the price falls. 

Chaikin compares the money flow and the price movements.

The goal is to determine the possible highs and lows in short-term and mid-term trends.

On Balance Volume (OBV)

On Balance Volume is a leading indicator.

It aims to predict upcoming price movements from the changes in the trading volume.

On Balance Volume

The idea is that when the trading volume increases strongly, a significant trend would follow. 

Otherwise, the price movement would return to the level it had started from.

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Forex Trading with Technical Analysis

Technical Analysis is one of the most important aspects of our Forex trading journey. 

First, we should make sure that we know how to read a price chart accurately.

Then, our focus must be on how to apply basic technical indicators and infer price targets. 

Basic technical indicators help identifying position entrance points and price targets to exit.

Once we are confident about the basics, we can proceed with advanced technical indicators.

Advanced indicators are keys to distinguish actual price movements from the noise. 

Fundamental analysis can reveal which of the four quantitative variables are most useful. 

For example: 

  • Cryptocurrencies are extremely volatile, and trends are harder to observe. 
  • Major currencies are relatively less volatile, but their trends are more material.  

After we determine the best predictors, we should choose 2-3 technical indicators accordingly. 

Our indicators should be complementing with each other, instead of giving the same signal. 

For example:

  • Determining trends using a Moving Average
  • Complemented with Chaikin Oscillator to confirm the volume of the trend.  

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Part III: Combining Fundamental and Technical Analyses in Forex Trading

The nature of Forex trading is about analysing the past and predicting the future. 

The most profitable traders in this industry always create a comprehensive trading plan.

A good trading plan combines both analysis types and sets the limits of our trading strategy. 

How to combine fundamental and technical analysis in Forex trading: 

Step 1: Fundamental Analysis – Finding a market-moving event

Economic Calendar

We go to our broker’s or analyst’s website and navigate to the economic calendar. 

AUD Economic Calendar

We check the events of the day and identify the ones can impact the markets greatly. 

Events are usually marked with a symbol that signifies its level of importance or influence. 

Identifying an Economic Event

Reserve Bank of Australia (RBA) will announce Interest Rate Decision at 13:30 (GMT +10:00).

RBA Interest Rate

It’s a big event which can have a strong impact on the value of Australian Dollar (AUD).

Forecast & Previous

First, let’s see what analysts are expecting. 

In the Forecast column, we see that RBA is expected to keep the interest rates at 0.75%. 

RBA Interest Rate Previous & Forecast

Next, we check the Previous column to understand the scope of change. 

RBA can raise, cut, or maintain the interest rates, and each can have different effect.

We see that, in their previous meeting, RBA had decided to set the interest rates at 0.75%.

Integrating the Information

Comparing Forecast and Previous we predict that Actual expectation is an interest rate cut. 

RBA is expected to keep the interest rates the same at 0.75%. 

We know that if they keep the interest rates, the Australian Dollar is likely to maintain value.

Comparing to the Past

Before we proceed with trading, we should perceive the potential impact of this decision.

We analyse the previous interest rate decisions to understand RBA’s interest rate habits. 

Past RBA Interest Rate Decisions

Historical data shows that the rates were cut from 1.00% to 0.75% only a few months ago.

This is a rather short time period to make another major change in the policy. 

Choosing a Market Direction and a Financial Asset 

We conclude our fundamental analysis with a final inference:

We should take into consideration that due to Coronavirus the market demand has fallen.

Therefore, under abnormal economic conditions, RBA may consider a possible recession.

As a result, their main goal would be stimulating the economy as a precaution. 

When the decision is announced; if RBA sets the interest rates:

  • At the same level as forecasted, AUD may maintain value. 
  • Lower than the current level, AUD may gain value. 
  • Higher than the current level, AUD may lose value. 

Let’s be on the safer side this time and trade only AUD/USD currency pair for this once. 

Tip: we can also infer that RBA is actually expecting an economic recession. We can investigate the underlying factors and improve our general economic projections as well as identify the possible trading opportunities which can arise as a result.

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Step 2: Technical Analysis – Identifying the potential impact of the event

Price Chart

We predicted that Australian Dollar could gain value, and AUD/USD currency pair can rise. 

In order to capitalise on it, we must understand the current price conditions of AUD/USD. 

So, we go to our trading platform and open AUD/USD price chart. 

We see that AUD/USD is trading at 0.6533

AUD/USD 1H Chart Before Decision

In order to verify the current trend, we will use two advanced technical indicators: 

  • Moving Average (MA) – a lagging trend indicator
  • Relative Strength Index (RSI) – a leading momentum indicator

The price has broken above the MA line and RSI is near 50 level.

Indicators are showing that investors are preparing long positions for an expected rise.

Interest rate decisions usually lead to high volatility. 

However, there are always specific price levels which the pair will struggle to break beyond. 

In this event, we will use resistance for Take Profit and support for Stop Loss.

Our large resistance is at 0.6585 and our large support is at 0.6500

These are known as support and resistance, depending on the direction of approach.

Support & Resistance

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Step 3: Making a Trade – Taking advantage of the opportunity

1. Position Size & Pip Value

Now that we verified the trend and set the support and resistance, we are ready to go! 

Let’s say we have $20,000 in our account as available trading margin. 

Our trading plan sets 3% margin rule and we allocate maximum $600 to this position. 

(Further information will be provided in Lesson 6: Risk Management)

We have 400:1 leverage in AUD/USD; so, we can open a position size of 240,000 (2.4 Lots)

With this position size, our pip value is $24; each pip movement will yield $24 profit or loss.

2. Opening the Position & Spread

Earlier, we noted that if RBA cuts the interest rates AUD/USD could rise on this occasion.

AUD/USD is currently trading at 0.6533.

So, we open a Buy position of 2.4 Lots on AUD/USD at the price of 0.6533. 

Our broker applies 3 pips spread on AUD/USD, and our position is opened at -$72. 

3. Setting Take Profit (TP) and Stop Loss (SL)

Since this is a Buy position, we will profit when AUD/USD increases.

Thus, our TP should be higher than and our SL should be lower than the market price.

We will set Take Profit and Stop Loss levels using resistance and support levels, respectively.

We had determined that AUD/USD can face 

  • Resistance at 0.6585 – this will be our Take Profit.
  • Support at 0.6500 – this will be our Stop Loss.

With 52-pip profit and 33-pip loss potentials, we achieved a 1.58:1 return/risk ratio

4. Event Occurs and Markets React

The moment of truth has come! 

RBA announced its Interest Rate Decision and cut the interest rate to 0.50% unexpectedly. 

RBA Interest Rate Decision

As soon as the announcement is made, the markets react, and AUD loses value initially.

However, after 40 pips drop, the market evaluates the decision under current conditions.

And AUD/USD rises above 0.6640 price level.

Market Reaction After the RBA Interest Rate Decision

5. Closing the Position

When AUD/USD falls, our TP order triggers at 0.6585 and closes the position automatically. 

With our 52-pip profit potential and $24 pip value, we earn $1248 from the position!