This contributed post is for informational purposes only. Please consult a business, financial and legal professional before making any decisions. We may earn money or products from the affiliate links in this post.
If you’re day trading the foreign exchange market, you may be wondering which analysis type returns the best results in short-term trading.
In this article, we cover the two most popular types of analysis – technical and fundamental analysis – and show which analysis type works better in day trading the Forex market.
What is Technical Analysis as it relates to Day Trading?
Technical analysis is an analytical discipline which relies purely on the analysis of price movements and charts.
Technical analysis is based on three major premises:
- The price discounts all fundamental information,
- Markets like to trend, and
- History repeats itself.
Let’s take a look at them one by one to get a better understanding of what technical analysis is about.
1 – Price discounts all fundamental information
According to this premise, technical analysts believe that all you need to follow is the price-chart of a currency pair.
All public and non-public information are almost immediately discounted by the price, as market participants immediately act on that information.
The price follows the overall knowledge of market participants regarding a specific currency pair and prices-in all available reports, news and expectations, suggesting that you don’t have to follow the news at all when trading the market from a technical standpoint.
2 – Markets like to trend
Almost all technical tools are based on identifying trends and trend reversals early in their development.
Market participants act as the price starts to move up or down, adding to the move with their own buy and sell orders and eventually accelerating the trend even further.
This causes trends to form – and last – in financial markets.
Take Bitcoin for example – as the price started to rise, even more buyers joined the market causing the price to rise even further.
Related: How To Make Money In 2019 and Beyond
3 – History repeats itself
The third premise of technical analysis says that history repeats itself. Since the majority of market participants are humans who act on emotions, making their moves more or less predictable, technical analysts can use historical prices to anticipate potential future moves.
An interesting example for this are chart patterns, such as head and shoulders, double tops and bottoms or wedges – they’ve worked well in the past, and technicians anticipate that they’ll work equally well in the future.
Day trading the Forex market involves using different trading styles and techniques and making very short-term trading decisions, usually on very short time-frames such as the 30-minutes or 1-hour ones.
While the basic premises of technical analysis can be applied to those timeframes as well, the best results are usually returned on higher time-frames such as the daily timeframe.
For technical analysis to work, many market participants have to look at the same levels and consider them as important, and this simply works better over longer timeframes where critical technical levels or chart patterns become more obvious than on shorter timeframes.
What is Fundamental Analysis as it relates to Day Trading?
Fundamental analysis, on the other side, tries to measure the equilibrium or fair value of an exchange rate by following fundamental macro-releases of countries, such as interest rates, inflation rates, economic growth, unemployment rates, trade balances and more.
If an exchange rate is overvalued or undervalued in comparison to its equilibrium or fair value, fundamental traders will look to sell or buy that currency pair, respectively.
For day traders, the main problem with fundamental analysis arises with the fact that fundamental factors build up gradually, often over a period of a few months or even years, and exchange rates can thus differ from their equilibrium exchange rate for a long period of time.
Simply knowing the fair value of an exchange rate won’t do much for day traders who’re interested in price movements in the next couple of hours.
For that reason, many retail traders focus on news trading which can create significant volatility in currency pairs in the very short-term.
For example, if interest rates or inflation rates change to a larger extent than markets had forecasted (i.e. to a larger extent than had been discounted in the current price), this will usually create large trading momentum as the fair value of an exchange rate would change with the new data-point.
Watch: What is Volatility?
Final Words: Which Analysis Works Better for Day Trading?
Since day traders are focused on taking trades during the day, holding them open for a few hours or one day at most, they need an analytical discipline that provides results in the very short-term.
While technical analysis works better on higher time-frames, day traders focus overly on technical levels to trade the Forex market.
However, certain technical tools still need additional confirmation to enter a day trade, such as waiting for an additional 1-hour or 4-hour candlestick to close in the direction of the breakout if you’re trading with a breakout strategy.
Traders who use the daily chart could enter immediately on the close of the daily candlestick in the direction of the breakout.
This issue is closely related with so-called fake breakouts, which refer to the situation when the price reverses soon after breaking out of an important technical level.
On shorter-term timeframes, fake breakouts are more common than on longer-term timeframes.
Fundamental analysis returns mixed results over short-term timeframes, as exchange rates can differ from their fair fundamental value for a significant amount of time.
While traditional fundamental models simply don’t work for day trading the Forex market, day traders can still use macro-releases and news to anticipate the future direction of exchange rates.
Nevertheless, traders who decide to employ a news trading strategy need to be aware that spreads can widen significantly immediately after a report is released unless they trade with a broker which features fixed spreads.
Finally, day traders will likely see the best results if they combine technical analysis with news-following, as technical breakouts in shorter-term timeframes are mostly triggered by unexpected and surprising market news.
Phillip Konchar is the Head Tutor at My Trading Skills, an online provider of on-demand financial education for margin Forex traders. Over the past 10 years he has provided trading education and market analysis to a range of financial institutions and specializes in the application of technical analysis in margin trading.