What Moves The Markets?
There are two major ways to analyze financial markets: fundamental analysis and technical analysis. Fundamental analysis is based upon underlying economic conditions, while technical analysis uses historical prices to predict future movements. There is an ongoing debate as to which methodology is more successful. Short-term traders prefer to use technical analysis, focusing their strategies primarily on price action, while fundamental traders focus their efforts on determining a currency‘s proper valuation, as well as future valuation.
It is important to take into consideration both strategies, as fundamental analysis can explain technical analysis movements such as breakouts or trend reversals. Technical analysis can explain fundamental analysis, especially in quiet markets, causing resistance in trends or unexplainable movements.
Fundamental Analysis
There are two main factors that impact exchange rate movement from a fundamental perspective: capital flows and trade flows. Both of these components constitute a country‘s balance of payments. The balance of payments quantifies the amount of demand for a currency over a given period of time.
Capital Flows
Capital flows measure the net amount of a currency that is being purchased or sold due to capital investments. A positive capital flow balance implies that foreign inflows of physical or portfolio investments into a country exceed outflows. A negative capital flow balance indicates that there are more physical or portfolio investments bought by domestic investors than foreign investors.
Capital flows can be classified into two categories - Physical Flows and Portfolio Flows:
Physical Flows:
Physical flows of capital typically fall into one of three categories:
Foreign direct investment - constitutes an entirely new foreign investment
Joint ventures - a partnership between a foreign and a domestic entity
Third party licensing agreements - the purchase of patented software applications, business processes, and brand names.
Physical flows are important to watch, as they represent the underlying changes in actual physical investment activity. These flows shift in response to changes in each country‘s financial health and growth opportunities. Changes in local laws that encourage foreign investment also serve to promote physical flows.
Portfolio Flows:
Equity Markets
As technology enables greater ease with respect to the transfer of capital, investing in global equities markets has become far more feasible. Accordingly, a rallying stock market in any part of the world serves as an ideal opportunity for all investors, regardless of geographic location. As a result, a strong correlation has developed between a country‘s equity markets and its currency. If the equity market is rising, investment dollars are coming in to seize the opportunity. Alternatively, falling equity markets will have domestic investors selling their shares of local publicly traded firms only to seize investment opportunities abroad.
In terms of relative strength, historical evidence shows that the stronger the performance of a country‘s equity market, the stronger its currency appreciation. A Relative Strength Index (not to be confused with the Welles Wilder RSI) is just a numerical way see which equity markets have performed the best over a given period time. A high RS (80-100) denotes strong relative performance. As evidenced in the 12-month relative strength data below, countries such as New Zealand has had a high relative strength, which has correlated with a significant appreciation of the NZD/USD.
The attraction of the equities markets over fixed income markets has increased over the years. Since the early 1990s, the ratio of foreign transactions in US government bonds relative to US equities has declined from 10:1 to 2:1. As a result, currency traders closely follow the global equity markets to predict short and intermediate term equity based capital flows. The most commonly watched stock indices are the Dow Jones Industrial Index (Dow), S&P 500, NASDAQ, NIKKEI, DAX and FTSE.
Fixed Income Markets
Just as the equity market is correlated to exchange rate movement, the same holds true for the fixed income market. In times of global uncertainty, fixed income investments can become particularly appealing, due to the inherent safety they provide. As a result, economies boasting the most valuable fixed income opportunities will attract a greater share of foreign investment; and naturally this will first require the purchase of the country‘s respective currency.
A good gauge of fixed income capital flows are the short and long-term yields of international government bonds. It is important to monitor the spread differential between the yield on the 10-year US Treasury note and that on foreign bonds. The logic behind this is that international investors tend to place their funds in countries with the highest yielding assets. Therefore, if US assets have one of the highest yields, this would encourage more investments in US financial instruments, hence benefiting the USD. Investors can also use short-term yields such as the spreads on 2-year government notes to gauge the short-term flow of international funds. Current yield spreads are approximately:
Trade Flows: Measuring Exports vs. Imports
Trade flow is the foundation of all international transactions. Just as the investment environment of any given economy determines its currency valuation, trade flows represent a country‘s net trade balance. Countries that are net exporters, meaning they export more to international clients than they import from international producers, will experience a net trade surplus. Countries with a net trade surplus are more likely to have their currency rise in value, since their currency is being bought more than it is sold due to a strong inherent demand for the currency for trade purposes.
Countries that are net importers - meaning they make more international purchases than international sales - experience what is known as a trade deficit, which has the potential to drive the value of the currency down. In order to engage in international trade, importers must sell their currency to purchase goods or services. Clearly a change in the balance of payments has a direct effect on currency levels. Therefore, it is important for traders to keep abreast of economic data relating to this balance and understand the implications of changes in the balance of payments.
Technical Analysis
Mass psychology, fueled by the human emotions of fear and greed, is a main driver of currency price fluctuations. For the trader looking to take advantage of this volatility, perception is reality and technical analysis is really the only viable form of analysis reflecting this. Technical analysis in its simplest form allows traders to integrate the psychology of past price action into current analysis. Technical analysis allows speculators to get a better handle on the emotional extremes of buyers and sellers and accurately directs them to levels where greed and fear are at their strongest. Understanding how to spot these extremes through pattern recognition and indicator analysis equips traders with a valuable edge that cannot be matched by any other methodology. Thus all traders looking to profit form short term movements must develop a solid understanding and feel for important technical concepts if they are to succeed in the long term as a short term FX Trader.
Technical analysis examines past price and volume data to help determine potential price movements. Technical analysis focuses primarily on the formation of charts and indicators to capture major and minor trends, identify buying/selling opportunities, and assess the extent of market reversals. Depending upon time horizon, traders can use technical analysis on an intraday basis (5-minute, 15 minute, hourly), weekly or monthly basis.
Important Technical Concepts in FX
Different markets such as equities and futures tend to focus and place importance on very different technical indicators. FX is no different and places more validity in a select group of concepts. Some of the most widely used indicators in FX are:
Fibonacci Retracement Levels
This is a popular retracement series based on mathematical ratios arising from natural and man-made phenomena. The Fibonacci series is series of numbers; each consisting of the sum of the two preceding numbers. It begins: 1,1,2,3,5,8,13,21,34, (etc). The relationship between these numbers occurs repeatedly. The ratio of two number which follow each other is always 0.618. This is called the "golden ratio". If ratios are calculated using alternative numbers in the series, the ratio will approach 0.382. Furthermore, the mean of two successive numbers is 0.5.
These relationships are used to derive how far a price has rebounded or backtracked from its underlying trend. This ability to predict swing areas in the market operates under the premise that humans adopt a "herd mentality" and will react in a predictable manner, regardless of trend direction and speculation of where the index should be. The most important retracement levels are: 38.2%, 50% and 61.8%. For example, in technical analysis, a 38.2% retracement level is often interpreted as a continuation of a trend whereas a 61.8 % retracement may imply that a trend change is occurring.
Oscillators
If you believe in the "trend-is-your-friend" tenet of technical analysis, moving averages are very helpful. Moving averages tell the average price in a given point of time over a defined period of time. They are called moving because they reflect the latest average, while adhering to the same time measure.
The moving average however is a lagging indictor, so it does not necessarily signal a change in trends. To address this issue, using a shorter period, such as 5 or 10 day moving average, would be more reflective of the recent price action than the 40 or 200-day moving averages.
Alternatively, moving averages may be used by combining two averages of distinct time- frames. Whether using 5 and 20-day MA, or 40 and 200-day MA, buy signals are usually detected when the shorter-term average crosses above the longer-term average. Conversely, sell signals are suggested when the shorter average falls below the longer one.
The most popular method of interpreting a moving average is to compare the relationship between a moving average of the currency‘s exchange rate with itself. A buy signal is generated when the exchange rate rises above its moving average and a sell signal is generated when the exchange rate falls below its moving average. This type of moving average trading system is not intended to get the trader in at the exact bottom nor out at the exact top. Rather, it is designed to keep the trader in line with the exchange rate trend by buying shortly after the exchange rate bottoms and selling shortly after it tops.
There are three kinds of mathematically distinct moving averages: Simple MA; Linearly Weighted MA; and Exponentially Smoothed MA
Simple Moving Average
A simple, or arithmetic, moving average is calculated as the sum of a predetermined number of prices for a number of time periods, divided by the number of time periods. The result is the average price over the time period. Simple moving averages apply equal weight to the prices. It is calculate using the following formula:
Simple Moving Average = SUM (closing prices) / n, where n is the number of periods.
Exponentially Smoothed Moving Average
An exponential (or exponentially weighted) moving average is calculated by applying a percentage of today‘s closing price to yesterday‘s moving average value. It is the preferred one because it assigns greater weight for the most recent data, and considers data in the entire life of the instrument. Naturally the older the price becomes, the less weight it is assigned.
Oscillators
As the market gyrates, prices tend to overshoot, or overextend. Oscillators are derived from the underlying currency to provide signals regarding these overbought and oversold conditions. They are very useful especially during trading ranges or at the begging of new trends.
The three most important rules when applying oscillators include:
The signals are most useful at the extremes of their scales.
Crossings of the equilibrium line and crossings between oscillator lines usually generate direction signals
Warnings and/or signals are triggered when a divergence occurs between the price of the underlying currency and the oscillator.
Candlestick Analysis
Candlestick trading‘s primary purpose is to determine current market psychology through the use of pattern recognition. CS traders believe that candlestick‘s easy to read color depiction of price action gives traders better Explanation into market psychology and price action and thus make it a better indicator in determining short-term market fluctuations. Candlesticks bars are composed of a currency pair‘s open, high, low and close. The body of the candlestick represents the difference between the open and the close and will be shaded green if price closed up and red if price closed down. Wicks depict the high and low of the respective time period.
Bollinger Bands
A volatility based indicator using moving average envelopes, which incorporate a stastical component. The statistical side of the indicator incorporates two standard deviations, which in statistical theory implies that 95% of price movement should be contained with in the two bands. This also makes the bands self-adjusting to changing market conditions. The indicator is most commonly displayed with two bands (at standard deviation levels) and a 20 period moving average over the underlying currency pair but it is not unusual to see it on a chart as a stand alone indicator.
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