Beginner's Guide to TA

09 - Combining Fundamental and Technical Analysis

Typography

Technical Analysis definitely has a magnetic pull. It's difficult to resist the temptation to use the wide array of technical indicators available, creating masterpieces of modern art.

On the left: 4H chart of EUR/USD with various technical methods applied (source: Twitter)

On the right: Kandinsky horizontale (Source: Google Images)

Up to this point, we've explored Support & Resistance, Candle Patterns, Moving Averages, Fibonacci Retracements, Oscillators, Bands, Channels and Envelopes. However, it would be too simplistic to reduce successful speculation to mere technicals. Sure, technical analysis is an easy empirical method, which is actually very useful for:

  • Measuring market sentiment on a given asset
  • Timing potential entries and exits
  • Managing risk.

However, it is rare to find a successful FX speculator that relies on technicals alone. In reality, behind successful FX speculation lies a decision making process that most likely blends technical analysis and fundamental analysis.

Picture this: you are a trader for a hedge fund, prop desk or an asset management shop. You decide to buy USD/CAD. The Chief Investment Officer approaches you for an explanation of why you decided to risk some of the company's capital on your idea. Would you imagine yourself saying something like this:

"…the 211 Day Weighted Exponential Moving Average crossed the 71 Day Simple Moving Average and the Slow Stochastic Oscillator was oversold."

Or something like this:

"…The Bank of Canada decided to cut rates today, which was a little surprising given that recent economic data wasn't all that bad. Furthermore, Crude Oil is still nowhere near a bottom and inflation expectations continue to drop. On top of all that, we just broke out of a consolidation in an evident uptrend."

I think we all agree that a Chief Investment Officer would find it difficult to allocate risk capital to decisions made solely using one's technical prowess. More likely, he or she would want to see a mixture of logical fundamental reasoning and simple technical observations.

The Seductive Side of Technical Analysis

Observe the following chart. What do you see?

The only thing you can actually see is a multitude of indicators. You can't even see the market! A trader with this kind of chart is usually searching for certainty. Technical Analysis can give traders the illusion of certainty and robustness. This of course can be fatal to your account, because any technical measurement is merely a derivative of price.

Technical Analysis is seductive:

  • It's simple and democratic: anyone with a half-decent charting package can add/remove/create indicators;
  • It helps measure sentiment;
  • It helps time entries & exits;
  • without a universally valid framework for forecasting FX moves, it seems like the only way to play the game;
  • It helps us understand traders' positioning: traders resist negative (positive) news when they are long (short) and exaggerate negative (positive) news when they are short (long), and this can be seen on the chart;
  • Market Wizards like Paul Tudor Jones refer to common indicators like the 200 simple moving average. If it works for them, surely it can work for the common retail trader?

However, if you are only making decisions based on charts, how can you explain the times when charts fail you?

It can be frustrating when a solid chart pattern or analysis method suddenly fails. Sure, "it may be one of those days" …but how can you be sure? Furthermore, how can you continue to have confidence in your charting method, without constantly questioning the validity of each signal you get?

What is Price?

All chart patterns & technical methods are based on price behaviour. So it's useful to investigate price a little further. What exactly is price in the first place? What are we actually watching, when we stare at our glamorous charts?

It's too easy to think of "price action" as an independent or impersonal concept. In reality, at any given time, the price of a financial asset is determined by the forces of supply and demand. Edwards & Magee, in 1948, had already defined price action appropriately:

"The market price reflects not only the differing value opinions of many orthodox security appraisers, but also the hopes and fears and guesses and moods, rational and irrational, of […] buyers and sellers, as well as their needs and the resources…"

Edwards & Magee gave a very precise definition that included the psychological aspect of human decision making. Price movement is determined by investors' decisions in response to a complex mix of psychological, sociological, political, economic and monetary factors. Technical Analysis attempts to measure the strength of these moves and to forewarn of potential changes.

In other words: price is the reflection of the aggregate perception regarding the future of the currency pair, stock, bond or whatever asset we're trading. We're observing expectations of future outcomes.

How market participants form their expectations

We now know that we are actually trading expectations, not facts or hard data. But where do these expectations come from? Surely they aren't formed out of thin air…or are they?

Fundamental data, or better stated, the evolution of fundamentals over time, is what drives demand and supply in the FX market. Fundamental analysis is the process through which we should strive to understand how price could react to certain economic events. These events can come in many forms:

  • headline data (for example, PMI reports or housing data)
  • top tier data (for example, central bank decisions or minutes, or NFP)
  • themes (for example, monetary policy divergence between the USA and the Eurozone, or the weakness in the commodity sector)

The release of this data, and the evolution of the themes that the market is currently focused on, changes the economic mindset of participants - and this is what creates the reaction from investors. To be even more precise, it's not even the release of the data or the event that creates a re-allocation of capital: frequently, it's the expectation of such releases/events that gets things moving. This is why we frequently say the market is "forward looking": participants tend to "discount" or "price in" their expectations for future foreseeable events.

The fundamental picture is ever evolving. It's like a slideshow, where each slide represents "the fundamental influences of a session" (like the NY session or the EU session). But without knowing what was on the slide before it, it's impractical to guesstimate what will be on the slide after it.

But which fundamentals contribute to forming expectations, and why?

Paying attention to the primitive illustration above, the most important question is: who can "force" the FX market in a certain direction? Who has the most influence? The answer is of course: Central Banks and Treasury Heads.

They hold the thick sticks. All it takes is the Bank of Japan to be "actively checking prices" at their agent banks for the word to spread along the grapevine and alert market participants. So, which fundamentals matter to the people that matter? What do the policy makers base their policies on? The list certainly encompasses:

  • Interest rates (yields)
  • Inflation (growth)
  • Employment/Housing/Mortgages
  • Capital Inflows/Outflows (directly correlated with the various Equity Indexes)
  • Imports/Exports

By now, you're probably thinking: "how am I ever going to keep track of everything?" Here's the key: the market is made up of humans, and humans cannot possibly keep track of all variables at the same time. So what happens is that the market focuses only on a few themes and stories at any one time.

How to keep track of the matters that matter

If you want to stay in tune with the evolving fundamental picture, the first step is to pull up an economic calendar in the morning, and take a good look at the market moving events due for the day. This is valid for FX, as it is for Futures, Equities and Bonds as well, because these market movers are telling us something about the economy. All investors are interested. Here is what a calendar looks like:

Once you verify that there are important events on tap, be sure to look at what the market is expecting.

You may find it helpful to review prior events, to see (a) how often there is a hit or miss and (b) what tends to happen when forecasts are off.

By comparing the forecast with the previous print, you can discover whether the market is discounting a better number or a worse number. This can help you plan for possible scenarios, but keep in mind that:

  • one data print cannot generally alter the course of a trend, if there is one (exceptions are Central Bank meetings and NFP);
  • not every event offers a tradable opportunity;
  • definitely do NOT trade right before news - that's called gambling.

A little bit on scenario planning:

  • If the market is in an uptrend, and the market has a positive expectation, then a negative surprise will probably have the largest temporary impact, but might also be ignored as the week progresses;
  • If the market is in a downtrend, and the market has a negative expectation, then a positive surprise will probably have the largest temporary impact, but might also be ignored as the week progresses.

There is usually an initial response, called "knee-jerk reaction", which is short-lived, full of action, and where most traders get chopped up. Then, there is a secondary reaction, where traders have had some time to think about the release. It's at this point that the market decides whether the release should generate a move. Was the outcome expected or not? Was it with or against the market's expectation, and is the market currently moving in a logical fashion?

These are quick questions that can help you digest the constant stream of headline events in an actionable manner.

More on economic data prints

So now that we know how to use an economic calendar (which should be checked daily), what are the market movers that usually generate the most volatility and, in some cases, opportunities?

a) Central Bank Meetings: it is not a wise thing to trade around a central bank meeting. But central bank meetings can set the tone for the days ahead, which can be traded on the back of the theme (if there is one). Central banks set the price of money by controlling the short term lending rate. Generally speaking, when a central bank increases interest rates it attracts capital to the country because investments will yield more. This is all positive for the domestic currency. The opposite is also true: if a central bank decreases interest rates, then it is negative for the domestic currency.

But even more important than the interest rates themselves is the general direction of interest rates. If a central bank is pointing at rising rates, then the market will already be in "buy the dip mode". Another important factor, in this day and age, is the amount of alternative accommodative policies (like Quantitative Easing in its various forms), which increase the money supply and thus are negative for the domestic currency.

b) Central Bank Minutes: it is generally not wise to trade around the minutes of a central bank meeting, although these can provide valuable details as to the central bank's members' true policy direction and preferences. The minutes can confirm or contradict the actual decision taken previously.

c) Employment Reports: it is generally not wise to trade right before employment reports and definitely not around NFP. Employment reports are important because jobs create income which turns into spending and thus into GDP growth. The monthly US NFP report is the most volatile news release in the FX markets. In Europe, the most highly watched is the German jobs report.

d) PMI & ISM: The Purchasing Managers Index and the Institute of Supply Management survey the corporate purchasing managers in the economy and therefore provide a good "feeling" of the strength/weakness of the economy. In addition to watching the composite number (above or below 50), the sub-components can be used to gauge the strength/weakness of any sub-sector like jobs, orders, warehouse stocks, etc. These data prints can lead to tradable market reactions.

e) Retail Sales: yet another important data print. Consumption spending makes up to 70% of the GDP and therefore consumer demand is fundamental for the health of the economy. The general trend in retail sales can often be more important than the headline number, because of cyclical factors (Christmas, Easter, Weather, etc). Retail Sales can lead to tradable market reactions.

f) Consumer Confidence/Economic Confidence surveys: The volatility is usually much lower than other releases. Confidence reports are a "sentiment" indicator built by economists. After all, without confidence there is no spending or investing, and there is no growth. In export driven economies like Japan, Canada and Germany, these reports are watched closely. These data prints can lead to tradable market reactions

g) Consumer Price Index (CPI): Controlling inflation is generally the prime objective of the central banks. Therefore, inflation data is directly connected to monetary policy. Higher inflation generally pushes the domestic currency higher, on the back of the expectation of rising interest rates. The opposite is also true: softer inflation data is generally negative for the domestic currency, as the central bank might have to lower rates. These data prints can lead to tradable market reactions.

Putting it all together: a recent opportunity on USDCAD

As of January 19th 2016, the Loonie had been the worst performing currency over the past quarter. This weakness was due to Crude Oil having fallen continuously over the course of 2015, which caused job losses in the Canadian energy sector and took its toll on manufacturing activity as well.

On January 20th the market was on the lookout for the Bank of Canada policy decision, and the accompanying statement by Governor Poloz. CPI, Employment, Ivey PMI, Housing were all trending lower heading into the Bank of Canada's decision. Regarding rates, consensus was for no change but there was a small chance of a 0.25% cut given the general situation. Governor Poloz had said back in December 2015: "The bank is now confident that Canadian financial markets could also function in a negative interest rate environment."

So what were the possible scenarios that could play out, and what was the probability of each scenario?

  1. Bank of Canada raises rates and talks hawkish = least probable outcome, given the worse fundamental background AND the strength of the trend.
  2. Bank of Canada holds rates stable and gives neutral/hawkish talk = rates may remain stable but there was definitely a low chance of Poloz talking down the situation.
  3. Bank of Canada holds rates and talks dovish = probably the most likely outcome.
  4. Bank of Canada cuts rates and talks dovish = the rate cut was a very minor possibility, but the dovish statement from Poloz was a given.

What happened next?

If we're only observing a chart, then we can notice how the orders around the day's low at 4550 were taken, and the orders around 4500 (Big Round Number) were also probed but resisted and pushed USD/CAD back up. Technically speaking, we've had a large reversal intraday and the drop was bought - all in the context of a clear uptrend on the Daily charts. So looking long would be the right course of action for a pure chart reader.

But what about the chart reader, that also pays attention to the day's fundamental flavour? The message from Governor Poloz, who declined to forecast the Loonie's fate, focused on the currency's "shock absorber" role in protecting the Canadian economy from the impact of falling Oil prices. Hence, he downplayed domestic economic developments (which helped form the market's dovish expectations) by saying that CAD has been a hostage to Commodities. This implied that the Bank of Canada could tolerate even more weakness in its currency.

The outcome, then, was scenario B: rates on hold, but less dovish/slightly encouraging talk. The fundamental backdrop has changed, and it would seem logical to sell USD/CAD, at least in the near term.

Who had the better handle on the situation? The pure technical trader, or the trader that keeps an eye on the charts and an ear on the evolving fundamental developments?

In the following 2 days, the market fell from a high near 1.4700 to a low of 1.4110, with two evident breakout situations that may not have made sense to the pure technical trader, but were golden opportunities for those tracking the ever-evolving fundamental picture.

Key Points:

  • Technical Analysis is useful for measuring market sentiment, managing risk, and timing entries & exits;
  • Technical Indicators are derivatives of Price, so you should understand the nature of any indicator you place on the chart. Know what it is, how it's built, and what you need it for.
  • Price, on the other hand, is the aggregate perception of the future value of the FX pair at hand. In other words, the price of any FX pair at any given time is based on expectations, not facts.
  • Market expectations are based on the evolving fundamental environment, and some economic releases carry more weight than others.
  • Understanding market expectations allows you to understand market reactions and arrive at logical conclusions.
  • By using simple technical analysis to complement logical fundamental reasoning and scenario generation, you have greater odds of surviving & thriving in the market, than those that choose to ignore them.
Pepperstone
Pepperstone is authorised and regulated by the Australian Securities and Investment Commission (ASIC) and the Financial Conduct Authority (FCA). We take pride in our strong culture of regulation and compliance. The security of our client funds is of paramount importance. Pepperstone maintains segregated client accounts with National Australia Bank (Australia) and Barclays (UK).
More from the author