Without the apparatus for making sense of the currency market, any trade represents a pure gamble. There are two broad schools of analysis, which are not mutually exclusive.

• Fundamental analysis
  • Balance of trade: Currencies that are associated with long-term trade surpluses will tend to strengthen against those associated with persistent deficits, simply because there is net buying of surplus currencies corresponding to the excess of exports over imports. Trends are important too. An improving balance of trade should cause the relevant currency to appreciate relative to those associated with a deteriorating or stable balance of trade.
  • Relative inflation rates: If country A is suffering a higher rate of price inflation than country B, then A’s currency ought to weaken relative to B’s in order to restore “purchasing power parity.”
  • Interest rates: International capital flows seek the highest inflation-adjusted returns, creating additional demand for high real interest-rate currencies and pushing up their rates of exchange.
  • Expectations and speculation: Markets anticipate events. Speculation on, say, the future rate of inflation may be enough to move the exchange rate, long before the actual trend becomes apparent.

Fundamental analysis is the application of the micro and macroeconomic theory to markets, with the aim of predicting future trends. So what fundamental forces drive currency markets?

It should be understood that these economic forces act in concert. It is a supremely difficult task, however, to establish where the sum of interacting economic forces will take the market. The solution, some argue, lies in technical analysis.

• Technical analysis

Technical analysis is concerned with predicting future price trends from historical price and volume data. The underlying axiom of technical analysis is that all fundamentals (including expectations) are factored into the market and are reflected in exchange rates.

The tools of technical analysis are now freely available to private investors in support of their trading decisions. It cannot be overly stressed, however, that such tools are only estimators and are not infallible.

The following is the briefest of introductions to the technical analytical tools used to identify trends and recurring patterns in a volatile marketplace. Aspiring Forex dealers are advised to undergo proper training in technical analysis, although true proficiency comes with practice, endurance, and experience.

• Charts
  • Line Chart: AA graphic depiction of the exchange rate history of any currency pair over time. The line is constructed by connecting up daily closing prices.
  • Bar chart: A depiction of the price performance of the currency pair, made up of vertical bars at set intra-day time intervals (e.g. every 30 minutes). Each bar has four “hooks,” representing the opening, closing, high and low (OCHL) exchange rates for that time interval.
  • Candlestick chart: AA variant of the bar chart except that it depicts OCHL prices as “candlesticks” with a wick at each end. Where the opening rate is higher than the closing rate the candlestick is “solid”. Where the closing rate exceeds the opening rate, the candlestick is “hollow.”
• Support, resistance, channels, and triangles

Support and resistance thresholds are common features of all tradable financial commodities, including currencies. Breaches of such thresholds are taken as evidence of a fundamental change in market sentiment towards a currency.

Support and resistance often form coherent patterns over time in the shape of channels.

• Support

A support level is detected if you can connect up several under-points of the exchange rate cycle on a straight line. This is taken to indicate market reluctance to sell below certain rates of exchange. The more under-points that can be connected, the more evidence there is of a support level.

The support level may change with the passage of time. If the straight line inclines upwards then we speak of “upward support.” Where the line is horizontal we identify “sideways support.” Where the line slopes downwards we diagnose “downward support.”

• Resistance

Resistance levels indicate a reluctance to buy a currency above given exchange rates. A resistance level is detected if it is possible to connect a succession of upper points in the exchange rate cycle with a single straight line.

As you would expect, one encounters upward, sideways, and downward resistance.

Channels are identified by superimposing support and resistance levels on a single line chart. Channels can slope upward, sideways or downward.

• Triangles

Where resistance and support lines converge towards one another over time, “triangles” are formed which can be upward, sideways or downward sloping.

Triangles indicate declining profitability over time. Resistance and support levels superimposed on a chart will help predict the time of convergence. What we are seeking are “breakouts” that could go in either direction and which are likely to be “explosive,” presenting opportunities for profitable trading.

The slope of the triangle and the behavior of the pricing cycle in the approach to the predicted intersection of resistance and support may indicate the likely direction of the breakout. For example, if the exchange rate cycle is in a clear upward phase, the breakout is likely to be upwards too. There are some real opportunities here, but also much risk.

• Indicators
  • Moving averages
    • Simple: Where past and present data are assumed to be of equal importance and are weighted equally.
    • Weighted: Where current data is considered more important than past data and is weighted more heavily. The weighting factor takes the form of a “smoothing constant” that increases exponentially over time.

  Moving averages smooth out the peaks and troughs of the exchange rate cycle over a rolling period and indicate the presence of a trend.

  There are two main types of moving averages:

  If prices lie below two or more moving averages, this is taken as a bearish signal, and vice versa.

  • Stochastic oscillators
    • A “%K” line that measures the difference between the most recent closing price and the deepest trough as a percentage of the difference between the highest peak and the deepest trough, measured over a given period (e.g. 14 days).
    • A “%D” line that tracks the three-period (e.g. day) moving average of %K.

  Stochastic oscillators are momentum indicators that purport to tell you when to buy or sell. They are composed of two elements:

  A rise in %K over %D is interpreted as a buy signal, and vice versa.

  When the oscillator touches 80, the currency is considered overbought. An oscillator below 20 is considered to indicate an oversold currency.