Chapter 3: Methods of making trading decisions

Chapter 3: Methods of making trading decisions

Fundamental and technical analysis

We must analyse forex pairs to decide whether to buy/sell or hold positions. Without analysis, trading is random and sure to fail. Without analysis, a trader will become one of the crowd who leave the market as losers and disappointed. Analysis is vital for success.

Forex is unique as each trade has two sides. If you buy GBP, you also must sell something else, say EUR. How well this position goes, depends on each economy's fortunes, not just the fortunes of one. This makes forex analysis doubly tricky.

Many of the largest participants in forex are not traders. They are in the market simply to change money from one currency to another or to protect against price fluctuations in an international business transaction. Traders are and try to predict the future price of a pair and profit from the change. Every position is entered to make a profit or loss. To do this successfully, they must analyse the markets.

There are two schools of analysis: Fundamental and Technical. Some people do one or the other, or a bit of both. This is true of private traders, banks, investment management firms and hedge funds. The sophistication level of the analysis varies significantly. It could be anywhere between reading the newspaper to computer modelling and advanced algorithmic trading. Fundamental and Technical analyses are broad churches. There can be cross-over between the two and specialised forms of each.

Fundamental Analysis

Fundamental Analysts attempt to qualify current facts or predict future factors affecting a country’s economy. Fundamental traders study hard facts such as GDP, inflation rate, interest rate and other economic indicators. Interest rates are vital to fundamental analysts. Higher interest rates make a currency attractive until inflation kicks in, making it less attractive despite the interest it pays. There is no formula to work out when this will happen; it will do so when the market feels enough is enough.

Technical Analysis

Instead of needing to weigh up potentially infinite data points, Technical Analysts need just four pieces of data: the open, high, low and closing price. They believe everything everyone knows, expects and fears about and the economy is accurately displayed, moment by moment, by the price. If you know the price of a currency pair, you know all the facts about it but, more importantly, what the market thinks these facts are worth. Technicians look for repeating patterns in the price behaviour, the trends and momentum using charts or computer analysis.

Sentiment and Behavioural Analysis

Sentiment analysis looks at how many people are buying or selling; behavioural analysis looks at why people are buying or selling. These forms of analysis look at the tone or psychology of the market. Sophisticated traders recognise that the market is driven by people buying and selling securities. Sometimes the crowd is super intelligent, and sometimes it is irrational. There is no certainty that irrationality will be correct. Sometimes it goes on for a long time – even years. Traders soon learn, being the only rational person in the crowd can be expensive. The market can remain irrational for longer than you have the money to defend your rational view. If the market is irrational, you should be too. You may have heard the phrase: the market is never wrong and doesn’t fight the crowd. It is true.

The strengths and weaknesses of fundamental analysis in the real world

The majority of investors and long-term position holders make their decisions using fundamental analysis. Fundamental analysis measures a currency’s intrinsic value by evaluating all aspects of the countries' economies in the currency pair. It is true that in the long term, well-managed economies are rewarded with strong currencies. Poorly managed economies are punished with weak currencies. But in the intermediate and shorter-term, other factors come into play and become dominant in traders' time horizons. It is challenging to correctly weigh up all the fundamentals and predict the price accurately. We see that organisations like governments, the IMF, The World Bank, when trying to forecast, have consistently lousy track records in making currency predictions despite their considerable resources. One reason for this is that, even if it is possible to weigh up all the fundamentals accurately, the price is not the currency pair's intrinsic value. The price is the value that traders think it will be and their valuation of these fundamental factors plus their hopes, fears and expectations. In the end, humans decide how currencies move and cause them to move in a very human way. On occasions, the facts can merely be the background to what is making the price.

Doing fundamental analysis and research requires a large team of economists and analysts. Having this at your disposal is only the domain of international institutions, countries, banks and hedge funds. There are plenty of armchair economists, but they are underresourced to make anything more than a guess.

Tip: Some retail traders attempt to profit from the news. This tends to be futile. Retail traders are competing with high frequency and professional traders who have already acted on the news by the time the retail investor joins the fray. By then, the professional is likely to be on the way out of their trade. It is not possible to know anything before the high frequency and professional traders. Don’t try it!

Profitable fundamental analysis is difficult for retail investors. However, it is essential to know the news, know the news coming up, and know what people are expecting for the news. It is vital to know what the market is feeling about this news. What the market feels, expects, hopes and fears about the news make prices go up and down. The market can change its feelings about the news even while the news itself hasn't changed. The same news can be ignored and then become the most important news in the world. Pricing reflects the human response to the news.

The strengths and weaknesses of technical analysis in the real world

The process of evaluating forex through price only is known as technical analysis. Traders and investors use data on market activity, ignoring the news and data. While fundamental analysts attempt to show the intrinsic value of a currency, technical data is meant to provide insight into a currency pair's future activity, including the news, facts, views, expectations, fears, and market participants' greed. Traders and analysts who use technical analysis feel strongly that future performance can be determined by reviewing the past price action and patterns.

Technical analysts generally look at the data for relatively short time periods in their analysis. Fundamental analysts rely on information that is issued weekly, monthly or quarterly. Because of the short duration of data collection in technical analysis, traders and investors tend to use this method more in short-term trading. There is a lot of market action between the news. However, technical analysis can be a beneficial tool to evaluate long-term investments when combined with fundamental analysis. This may be the ultimate weapon.

What about Quants, High-Frequency Traders, Machines?

More and more trading today takes place with the participants being a computer program. On the sell-side – market-making – computer transactions account for all trading in major currencies. Far from being sinister, this is a natural progression. It's no longer possible for a human trader to be fast enough. They would have to have already checked counterparties' creditworthiness and position size limits before making the transaction. With computers, all this is done within a split second. There is no thinking involved; the computer is merely matching orders.

Away from the market-makers and lower down the chain, banks, corporations, and brokers use computers to do more efficiently what traders used to do manually. Some trading still takes place by OTC squawk box trading. This is trading in exotic currencies and minor crosses. The forward forex market is also still traded to some extent between humans. But the trend is towards all trading being screen-based and eventually automated. Machines are good at doing fast and accurate calculations without getting exhausted. Faster trading is inevitable.

What is a Quant?

Quantitative analysis is simply applying statistical techniques to the fundamentals or technicals of the forex market. Quantitative techniques can be simple in ensuring an arbitrage is kept in line, or more sophisticated with many inputs into its decision-making process. The execution of the quant trading method will be automatic and done by machine. Once the program has been developed and tested rigorously, it will be left to its own devices. The last ten years has seen significant growth and enthusiasm for this style of trading. However, some say the results of the enormous amount of effort and the greatest brains and millions of dollars of research funding may be producing rather disappointing results. Net growth in this area of analysis will likely continue. The skill required to have any edge over the other quants means that only those with deep pockets can afford the greatest teams of minds that can outperform the other great minds at other hedge funds. There is no place for retail investors in this type of trading.

What do High-Frequency Traders do?

It was 2014 when many people first heard about high-frequency trading (HFT) for the first time. Michael Lewis published his book Flash Boys and revealed to the outside world the dark and evil world of HFT. Most early adopters mentioned in the book had already exited from the business at the time of publication as HFT’s hey-day was over. Two things to be aware of: it was a legal form of market abuse and secondly, it only really worked profitably in the stock market. What made this extreme form of trading profitable was only available on exchange-traded instruments such as shares. The front running was only doable when you had information available to certain participants trading on a Stock Exchange. This information was made available, for a fee, by the stock exchange to the high-frequency traders. It was like a first-class ticket. For a high charge, you got to be first in line. Forex is not traded on a Stock Exchange, and therefore the mechanism for the profits from HFT is not there. For forex traders, there is nothing to fear from high-frequency trading. In fact, the presence of high-frequency trading is a benefit to private investors by adding liquidity. This means that even small private traders benefit from almost negligible spreads between Bid and Ask. Without HFTs, spreads would be wider, and trading costs higher.

The Rise of the Machines

As time marches on the use of computers in trading will increase. This is inevitable and not a bad thing. Computers operate tirelessly, at lightning speed and can take over from humans one-day. Private investors now have access to programs that allow computers to do their bidding for them; however, there has been limited consistent success.

Tip: Computers struggle to play chess better than any human being. Chess is a game between two people with fixed rules, moves, and size of the board. The market is infinitely more complex than that. People design computer programs. The computers execute calculations quickly without error. But there's always a person behind the program. For the foreseeable future, people will drive the markets, and the price will react to the opinion of people either trading and investing or their machines doing it for them.

Gurus, Analysts and Economists

Traders and investors hope that certain people exist who know everything and will tell them what to do. There is a gurus industry; analysts and economists willing to tell you with absolute confidence what will happen and how to make money – for a fee. The reality is their track records are poor. Unlike weather forecasters who too have a poor track record, they are unwilling to admit their frailty. Because we wish these superhumans existed and were accessible to us, we are willing to part with our money to charlatans hoping they are that special person.

Tip: An elite group has the ability to forecast with some degree of accuracy and consistency, but they generally work exclusively for banks and hedge funds (or for themselves). Private investors will never hear from them. Why would they ever share their views with the public – certainly not for a few thousand dollars. Market analysis is an industry with good doctors and .

Making your decisions

Evaluating the news and weighing it up correctly from the other market participants' perspective is very difficult to do. Therefore using fundamentals on their own is potentially a futile task. Trading news announcements is also difficult as you are joining the well-informed institutional crowd, possibly as they take their profits. For longer-term investing, fundamentals prevail and fundamental analysis will work. If you envisage holding positions for months and years, a good grasp of the market's fundamentals is essential.

Trading in the shorter term or the very short term, such as day trading, timing becomes the most important thing to get right. Fundamental analysis does not deliver timing. It only answers the question ‘what’, but it does not answer the question ‘when?’. On the other hand, the only question technical analysis answers is ‘when?’, while it does not answer the question ‘what?’. In short-term trading, the question ‘when?’ is vital to get right. Most traders who use technical analysis may never look at the fundamentals at all. Yes, they are aware of the news announcements as indicators of potential dangers ahead. They believe that all the fundamentals are known and correctly evaluated in the price. If you know the price, you know all the fundamentals, and, more importantly, what the market has decided they are worth.

Tip: Traders are becoming more and more sophisticated, and the tools for the quantitative trader are becoming more accessible. While they may never compete in a high-frequency trading game, those with a strong mathematical background can compete with a quant or algorithmic trader.

Importantly, if you choose technical analysis as your preferred technique, you are at no disadvantage to the large institutions. Because you are much smaller and agile, you may actually be at an advantage.

Read more about Fundamentals in our glossary