When it comes to learning how to trade the market, you will have to get your head around both the technical analysis side of trading as well as the fundamental analysis aspect to trading.
Commonly, traders in an over the counter market look to technical analysis to understand short-term price movements, and rely on briefings by economists to understand longterm trends in rates and prices. The analysis undertaken by economists is referred to as fundamental analysis. Technical analysis uses price charts, trading volume and other indicators based on market activity to identify under or overvalued assets.
To understand technical analysis you need to go back to one of its early supporters. Levy (1967) observed that market value is determined by supply and demand and that each is governed by both irrational and rational factors. Technical indicators are based on the assumption that the market is irrational and that technical indicators give early signals of these irrationality which can offer and advantage.
Traders are mainly rational. Irrational behavior does however exist. Historical trends can provide an indication of future direction however the more technical and complex models and inputs become the more susceptible they can be in providing false or mis-leading signals.
A simple example of technical analysis In trading in action can be seen from the following chart relating to US$ v AUD over a five year period from 2009 to 2013. Basic assumptions about the future direction of a currency can be deduced.
The key is to understand the macroeconomic policies and events behind past price trends and what events may impact future currency direction.
Fundamental analysis in trading and investing, in contrast, involves using economic data and other relevant information to form an opinion about a “fair value” for market prices. Think Warren Buffet the value fundamental investing king.
Other examples can include being influenced by relative bond yields, exchange rates are influenced by relative inflation rates and commodity prices:
- higher domestic inflation rates indicate a weaker currency, and vice versa
- higher commodity prices generally indicate that the Australian dollar is stronger
Economists responsible for exchange rate advice have to keep a close watch on variables such as these, as well as any other variables that might influence them such as action by central banks to strengthen or weaken currencies by interventionist action.