Should you trade based upon fundamentals or technicals? This is the $64 million question that traders have debated for decades and will probably continue to debate for decades to come.
Technical Analysis Vs. Fundamental Analysis
Technicals are based on forecasting the future using past price movements, also known as price action. Fundamentals, on the other hand, incorporate economic and political news to determine the future value of the currency pair.(For more, check out our Technical Analysis Tutorial and our Fundamental Analysis Tutorial. )
The question of which is better is far more difficult to answer. We have often seen fundamental factors rapidly shift the technical outlook, or technical factors explain a price move that fundamentals cannot. So the answer to the question is to use both. Both methods are important and have a hand in impacting price action. The real key, however, is to understand the benefit of each style and to know when to use each discipline. Fundamentals are good at dictating the broad themes in the market, while technicals are useful for identifying specific entry and exit levels. Fundamentals do not change in the blink of an eye: in the currency markets, fundamental themes can last for weeks, months and even years.
Using Both to Make a Move
Always Pair Strong With Weak
For example, one of the biggest stories of 2005 was the U.S. Federal Reserve's aggressive interest rate tightening cycle. In the middle of 2004, the Federal Reserve began increasing interest rates by quarter-point increments. The Fed let the market know very early on that it was going to be engaging in a long period of tightening and, as promised, it increased interest rates by 200 basis points in 2005. This policy created an extremely dollar-bullish environment in the market that lasted for the entire year.
Against the Japanese yen, whose central bank held rates steady at zero throughout 2005, the dollar appreciated 19% from its lowest to highest levels. USD/JPY was in a very strong uptrend throughout the year, but even so, there were plenty of retraces along the way. These pullbacks were perfect opportunities for traders to combine technicals with fundamentals to enter the trade at an opportune moment.
Fundamentally, it was clear that the market was a very dollar-positive environment; therefore, technically, we looked for opportunities to buy on dips rather than sell on rallies. A perfect example was the rally from 101.70 to 113.70. The retracement paused right at the 38.2% Fibonacci support, which would have been a great entry point and a clear example of a trade that was based on fundamentals but looked for entry and exit points based on technicals. (To find out more on Fibonacci numbers look at Fibonacci And The Golden Ratio.)
In the USD/JPY trade, trying to pick tops or bottoms during that time would have been difficult. However, with the bull trend so dominant, the far easier and smarter trade was to look for technical opportunities to go with the fundamental theme and trade with the market trend rather than to trying to fade it.