Trading, the opportunity and the risk. All you have to do is to invest in a stock and wait for its value to rise. You can also invest in one of your favorite currencies and wait for the exchange rate to get better. Sounds simple, right? Well… if you know how to predict the price movement, it is indeed simple, but the plain fact is that not many people know how to do it.
It is the reason for the development of two main paradigms of the market predictions – fundamental and technical analysis. Let’s explain, in a nutshell, what they mean.
What is fundamental analysis?
Fundamental analysis relies on the economic and political events. For example, the yearly report of Apple will affect the Apple stock. Another example can be the monthly inflation rate in Japan that affects the Japanese Yen exchange rate.
And what about technical analysis?
When you analyse the market using technical analysis tools, you don’t really care about the economic and political events. Technical analysis tools use various indicators, which are the result of mathematical calculations. For example, the moving average indicator calculates the average of a number of previous values. Sounds complicated? Maybe it is, but you don’t really need to know how it’s calculated, rather how it’s used.
So, how is it used?
Both fundamental and technical analysis usage is based on statistics from the past.
In other words, how the market usually reacts to certain events. At the end of the day, no one among us is a prophet, but we can make educated guesses.
Let’s see some examples.
On 4th May in the UK some economic data was released. Overall it feels like the economy in the UK is recovering, but we see that the GBP exchange rate raised a little bit following the announcements and then dropped.
What conclusions can we make about the behaviour of GBP following these specific events? In order to answer this question we need to look at the previous announcements and see if there is a consistent pattern of behaviour. Please note that even if we find such a pattern, you still can’t be 100% sure that the behaviour will be the same next time, since there are more factors that affect the exchange rate of GDP, but it may be a good indicator that helps us to predict future movements.
Technical indicators work similarly.
Let’s take a look at two moving average indicators, one that uses 50 samples (the orange one) and one that uses 20 samples (the blue).
You can see in the chart above that these two indicators intersect and it is considered as a signal. Since the 20 samples moving average is moving down, the signal reflects a potential drop of the exchange rate.
Again, it’s only an educated guess and you are invited to check what the statistics are when it comes to this kind of signal.
We can not predict the future for sure, but we can try to understand how the market reacts to various events.
As much as we analyze it more in depth, we will be able to optimize our investments.
And no, it’s not simple, but it is worth the effort.