Combining Technical and Fundamental Analysis in Forex Trading
Understanding how to combine technical and fundamental analysis can significantly enhance your trading strategy. These two methods provide different insights, much like how a spoon and a fork are designed for different types of food. Using them correctly together can give you a well-rounded approach to trading. Let’s dive into how to effectively integrate these two forms of analysis and apply them in a real trading scenario.
Understanding Technical and Fundamental Analysis
Technical Analysis
Technical analysis involves using historical price data, charts, and various indicators to predict future market movements. Traders use tools like support and resistance levels, moving averages, and chart patterns to identify potential entry and exit points.
Fundamental Analysis
Fundamental analysis, on the other hand, focuses on evaluating economic indicators, financial statements, and macroeconomic factors to determine the intrinsic value of an asset. In Forex trading, this often means analyzing factors such as interest rates, employment data, and geopolitical events to assess the strength or weakness of a currency.
Using Fundamental Analysis to Determine Trade Direction
Fundamental analysis helps you identify which currencies are strong and which are weak. By evaluating macroeconomic data, short-term sentiment, and intermarket analysis, you can form a bias about the direction of a currency pair. For example, if you expect a central bank to cut rates, that currency might weaken, while a currency from a country with rising interest rates might strengthen.
However, predicting a central bank’s actions doesn’t mean you should trade immediately. It’s essential to align short-term sentiment with the broader macroeconomic view. For instance, if the short-term sentiment supports your fundamental outlook, it’s a good time to trade.
Using Fundamental Analysis to Determine Trade Direction
Once you’ve identified the trade direction using fundamental analysis, use technical analysis to find precise entry and exit points. Here’s how to combine them effectively:
- Determine the Trade Direction: Use fundamental analysis to identify which currencies are expected to strengthen or weaken. This gives you the direction for your trade.
- Identify the Optimal Entry Point: Use technical analysis to find high-probability entry points. Look for support and resistance levels, moving averages, or chart patterns that confirm the direction indicated by fundamental analysis.
- Set Stop-Loss and Take-Profit Levels: Based on technical indicators, set your stop-loss and take-profit levels to manage risk and lock in profits.
Example: Trading Strategy for JOLTS Job Openings
Step 1: Analyze Federal Reserve Priorities
The first step is to understand what data points the Federal Reserve is currently focused on. If the Fed is focused on a particular piece of data, that data point will have significant volatility because the Fed bases its interest rate decisions on it. To quickly determine the Fed’s current focus, use our Professional Economic Calendar, which includes a fundamental guide. This resource helps traders stay updated on the data points that matter most to the Fed, providing a strategic advantage.
Step 2: Use High-Low Expectation Forecasts
Professional traders rely on high-low forecasts to gauge market expectations accurately. Here’s a detailed look at why these forecasts are crucial:
- Institutional Forecasts: Professional economic calendars include high and low estimates from top institutions. This broader range of expectations offers a more comprehensive picture of potential outcomes.
- Market Shocks: When a report exceeds the high estimate or falls below the low estimate, it’s a huge shock to markets because no analyst expected it. Such deviations often result in sharp market movements.
- Lightning Bolt Feature: This tool immediately signals a deviation above the high or below the low of analyst expectations. When a deviation occurs, the lightning bolt feature alerts traders instantly, allowing them to act without delay.
Understanding High-Low Forecasts
Economic forecasts are derived from surveys of credible institutions, each providing their best estimate on upcoming data points. Retail calendars typically present the median of these estimates, which can be misleading. The median forecast doesn’t reveal the full range of expectations and, therefore, doesn’t indicate how surprising an actual data release is compared to the extremes of analysts’ projections. In contrast, professional economic calendars include both high and low estimates. This additional information shows the analysts’ expectations at the extreme ends of their projections. Great trading opportunities arise when data releases fall outside these high and low estimates, creating market shocks that move prices significantly.
Step 3 - Choosing the Most Volatile Instrument to Trade
Using insights from institutional reports, traders can select the most responsive currency pairs. For example, if USD/JPY is particularly sensitive to economic data as outlined by the City Economic Surprise Index and JOLTS shows a significant deviation, this pair could be an ideal target for trading.
- City Economic Surprise Index: This report identifies currency pairs that react strongly to economic surprises. It highlights pairs that are sensitive to data deviations, helping traders focus on the most responsive markets.
- Risk-Reversal Report: This report shows market positioning, revealing a buildup of call or put options on certain currency pairs. Understanding these positions helps traders choose a pair that may have orders susceptible to getting liquidated upon the release of an economic data point.
- CFTC Report: This report details hedge funds' positions. For example, if many big players are long the EUR/USD but then data comes out in favor of the USD, some of those funds might have to unwind their positions, leading to an outsized move. Good thing you didn’t trade the GBP/USD.
Trade Execution Steps
- Confirm FED Focus: Ensure the Federal Reserve is currently emphasizing employment data. If employment is a primary focus, the JOLTS report will likely move the market. Remember, if the central bank is focused on a data point, it’s because they use that data point to make decisions on rates, leading to volatility.
- Check Forecast Ranges: Before the data release, review the high and low forecast expectations for the event. Plan to trade only if the actual data significantly exceeds the high estimate or falls below the low estimate. This strategy ensures you act on genuinely surprising data, likely resulting in follow-through reactions.
- Monitor Revisions: Check for any conflicting revisions in the data, as these can alter the initial market reaction. Make sure the primary release and any revisions align to support your trade.
- Enter Trade Promptly: Once you confirm the deviation, act quickly to enter your trade. Enter within the first 30 seconds. Speed is crucial, as market reactions to significant data surprises happen rapidly.
- Set Stop and Take Profit:
- Stop-Loss: Place your stop-loss below the low of the initial spike candle to protect against adverse movements.
- Take Profit: Aim for 15-30 pips for tier 2 events like JOLTS, adjusting based on market conditions and volatility.
Managing the Trade
- After the Initial Run: Look for a shallow pullback around a 23% Fibonacci retracement or near support/resistance levels. This initial pullback can provide an opportunity to enter the trade again after taking some profits from your first entry.
- Break Even: Move your stop-loss to break even as soon as possible to protect your gains. In general, the stronger the release, the shallower the pullback. If the market doesn't buy off your S&R level and continue to the highs of the one-minute candle and break, something could be off.
- Reentries: If your initial position is stopped out at break even, consider reentering at deeper retracements, such as the 38% or 50% Fibonacci levels. Use nearby support and resistance levels to guide your reentry points.
Conclusion
Combining technical and fundamental analysis can provide a comprehensive approach to Forex trading. Use fundamental analysis to determine what to trade and in which direction. Then, apply technical analysis to pinpoint precise entry and exit points. This strategy ensures you’re trading in line with broader market trends while optimizing your entries and exits for better profitability. By following these steps, you’ll be well-prepared to trade effectively, leveraging the same strategies that professional traders use.
If you have any questions or need further clarification, feel free to reach out. Happy trading!