Introduction
Now we come to the reason why this book was written in the first place: to show you how I look at the markets by fusing fundamental and technical analysis. If you type “using fundamental and technical analysis” into a search engine like Google, the chances are that the bulk of the results will focus on fundamental versus technical analysis. Commonly people compare both analytical styles and very rarely do they advocate blending them together.
Fundamental and technical analyses are often portrayed as opposite ways of looking at the market. Some people believe that the two are like oil and water – impossible to mix. However, I don’t believe that is the case and I profess to be a self-taught fundamental/technical analyst of the forex market.
The problem with choosing either technical analysis or fundamental analysis is that there are weaknesses to both of these methods. Fundamental analysis can be too big a field to get a clear grasp on and depends on too many moving parts – economic data, news-flow and central bankers – for a day trader to make decisions on what currencies to buy or sell.
For its part, technical analysis can be extremely subjective. The indicators I mentioned in the technical analysis section have worked for me, but someone else may interpret the price action completely differently. Likewise, there are thousands of chart patterns that I could have filled this book with. However, I only like a select few chart patterns, as in my experience everyone sees chart patterns differently, which reduces their accuracy.
Two negatives cancel each other out, hence by combining fundamental and technical analysis you can keep the good bits about the two methods and scrap the bits that you don’t like or that don’t work for you.
The basic underpinning of my fusion method for FX analysis is as follows:
Fundamentals can determine the direction of a currency in the long term, while technical analysis gives you the short-term buy and sell signals.
How the philosophy works
There are three things you need when you trade the FX market:
Unfortunately I can’t help you with the last point, but hopefully my philosophy will help you to nail the first two.
I was once at an industry function sitting next to an equity fund manager. He said to me he couldn’t understand why anyone would want to trade currencies. “I just don’t know how you can get an edge in this market,” he said, exasperated after many failed attempts.
As an equity trader he was able to do in-depth equity analysis to try to root out companies that he felt were undervalued. He would look at balance sheets, scrutinise company strategy, and find out the ambitions and talents of management. If he felt, based on all of the homework he had done, that the company had potential and, crucially, if the price was right, then he bought the company’s stock. For some reason he did not think this approach worked for forex.
But FX analysis is based on similar principles. Certain conditions have to be met before you buy or sell a currency. Just like the equity analyst you must do your homework and the concept of buy low and sell high works just as well in FX as anywhere else. However, he was right in that it is hard to get an edge in this market as the information that moves currencies is widely available and can get priced in to the market very quickly.
In my approach the homework part is the fundamentals – making sure the price is right is where technical analysis comes in. This may sound like double the work, but I will show you the most efficient way of doing this and I believe the extra effort is worth it.
As with the rest of this book, the best way to describe my philosophy is to show rather than tell how it works, so this part of the book contains a series of case studies that fuse fundamental and technical analysis.
Trading examples
Trading using both fundamental and technical analysis methods allows me to trade specific events, unexpected events or news headlines. These trades may have varying time horizons – some will be short term, others will be long term. Usually they are held for a minimum of one day unless stops or profit targets are triggered.
Sometimes I will have plenty of time to prepare my strategy, at other times I have to devise a strategy on the fly as events are changing quickly. Sometimes I will be right, sometimes I will be wrong.
Hopefully the case studies below give you a flavour of how I use the philosophy so that you may be able to apply some of the ideas in your own trading.
Case Study 1: USDCAD
The background
In September 2012 USDCAD fell to its lowest level for more than 12 months, having declined since June of that year (see Figure 3.1).
Figure 3.1: USDCAD, daily chart
The trigger for the decline was two-fold:
However, by mid-September positive sentiment was starting to drain from financial markets. Added to this, the US central bank had embarked on a third round of quantitative easing. This made some people question just how hawkish the BOC could be.
If the BOC hiked interest rates when the Fed was still loosening monetary policy it could damage demand for Canada’s exports from its biggest trading partner. Therefore, the market’s view on the CAD changed from a positive view based on the potential for rate hikes and firm market sentiment to wobbly market sentiment and the prospect that the central bank could put interest rates on hold for some time.
The fundamental analyst’s job at this stage is to monitor the data flow and communications from the central bank to find out how dovish the BOC really is and how likely it is they would keep interest rates on hold rather than raising them over the next few months.
The trade
This is where the technical analysis comes in.
I monitor technical developments in the currency pair as well as keeping abreast of the fundamental back drop. This does not mean that I need to be stretched thin watching the charts 24/7. I try to keep an eye on the chart three times a day: one at the open, one midway through the session and one at the end of the day.
In this instance I was looking at two North American currencies, so I needed to follow their time frame (GMT -5 hours). If you are based in Europe and you can’t stay awake until the end of the North American trading day then you can check the next morning. It is also worth looking at the price chart after key data releases like PMI data, CPI, GDP and retail figures.
For this trade, by keeping up to date with the price action I noticed bullish sentiment for CAD starting to drain from the market. The first sign came on 14/15 September, when the market tried to push lower but ended up closing higher on the day. This was followed by another positive candlestick. The long lower shadow but positive body shown in Figure 3.2 (first circle), is always a warning sign for traders that the downtrend may be about to reverse.
Confirmation of this reversal came at the end of September when the daily candlestick formed a hammer pattern (second circle). This is when the body of the candle is negative but it has a long lower wick. Even though the price ended lower on the day, the bears could not push the market any lower. This suggests buying interest in the market and is a key reversal pattern.
Figure 3.2: USDCAD
Where would the market go from here? This uptrend could be as long as a piece of string, but there are a few indicators that could help me. Referring to Figure 3.3, you can see that by late October 2012 this cross was close to the top of the daily Ichimoku cloud – above this level at 0.9940 would signal the start of a technical uptrend.
Figure 3.3: USDCAD Ichimoku cloud chart
The market would always be sticky around this level. Interestingly, not only was the price approaching a key resistance level that could trigger some selling pressure, but the BOC was also holding a meeting.
The market felt that a dovish BOC was on the cards and continued to sell the CAD leading up to the meeting (USDCAD continued up). Thus, the risk was that the BOC would be less dovish than expected, thus triggering a sell-off in USDCAD (buying of CAD).
This is exactly what happened. The BOC indicated that it was concerned about indebted Canadians (hence no rate cut) and although it might not hike rates straightaway it was thinking about it. This triggered a sell off in USDCAD from 0.9980 to 0.9920.
Trading strategy
Case Study 2: USDJPY
The background
After the US central bank announced its third round of quantitative easing in the middle of September 2012 the market started to act strangely. Rather than weaken on the back of the Fed’s pledge to buy unlimited mortgage-backed securities, the dollar started to exhibit signs of strength, particularly versus the yen. Usually USDJPY weakens with stocks and commodities, but not so this time.
Here are some of the fundamental reasons for USDJPY strength:
As a fundamental analyst with a time frame of two to three weeks I have to decide:
Essentially I am trying to find out if USDJPY has further upside during this time frame or if it is time to sell.
From a fundamental perspective, I may decide that Japan’s economic fortunes looked worse than the US’s and its central bank would embark on more aggressive monetary easing to weaken the yen and thus boost exports. The last thing to look at is the chart of USDJPY and the US-Japan interest rate differential as the two move closely together. This is shown in Figure 3.4.
Figure 3.4: USDJPY and the interest rate differential
This chart confirmed my fundamentally-built assertion that USDJPY may move higher. The rate spread is moving in the dollar’s favour, which supports further USDJPY gains. It has already had a big upward move, so when should I enter this trade? Time to move to technical analysis.
The trade
After breaking above the daily Ichimoku cloud at the start of October this pair was in a technical uptrend. The next step is to identify the strength of the uptrend and then any resistance levels of note that could thwart the bulls.
The first thing I did was take a look at the long-term momentum indicator on the daily USDJPY chart. To do this I used the Relative Strength Index. See Figure 3.5.
Figure 3.5: USDJPY, daily chart
The RSI suggests that this cross is starting to look overbought. This tells me that I might be a bit late to the party and should wait for a pullback before I enter a long position.
The next step is to identify potential support levels that could act as good entry points. The nearest level is 79.65 – a recent low. Below here the level is 78.80 – a triple top that dates back to September that should act as fairly solid support. These levels are shown in Figure 3.6 with a line and a circle respectively.
Figure 3.6: USDJPY, daily chart
Now that I have identified entry levels, it is time to start looking for potential profit targets. Two key resistance levels can be seen on the daily chart: firstly 82.00 – the high from April, then 84.00, the high from March. These levels are also marked in Figure 3.6.
Trading strategy
Case Study 3: GBPUSD
The background
The UK economy had a terrible first half of 2012 and was plunged into its first double dip recession for 30 years. During the third quarter of the year things started to pick up. The service and manufacturing sector PMIs surprised to the upside, the economy created jobs at its fastest pace for 20 years and inflation fell, helping to boost retail sales.
Thus, leading up to the release of the Q3 data economists were looking for a healthy rebound of 0.6% for GDP, after a 0.4% contraction in the second quarter. In fact the data was stronger than that – the actual expansion was 1% for Q3, the fastest pace of growth for five years!
However, there was a catch – some of the growth was down to one-off factors like an extra working day in Q3 relative to Q2 because of the Queen’s Diamond Jubilee and there was a boost from ticket sales for the 2012 London Olympics.
Even the Office for National Statistics found it hard to quantify exactly what effect these events had on growth, but some economists deemed the actual growth rate to be more like 0.3% to 0.4%. While this is a big improvement from the second quarter it is more moderate than the 1% headline figure suggested.
This made it hard to determine the impact of this data on sterling. To complicate matters even further, the Bank of England had been expected to boost their asset purchases the following month. As a fundamental analyst I had to ask myself a couple of questions before I dived into a sterling trade:
Thus, the fundamental analysis is painting a fairly mixed picture for the future price movements of sterling.
The interest rate differential between the UK and the US, which moves fairly closely with GBPUSD, though mildly sterling positive, was not giving a clear indication of where GBPUSD would go next, as shown in Figure 3.7.
Figure 3.7: UK-US 10-year bond yield spread and GBPUSD
The trade
There are a couple of ways to trade sterling in this environment. I could have become a buyer after a few of the data prints started to come in during August and September in anticipation of sterling appreciation, or I could have waited for the actual data release itself.
GBPUSD was extremely volatile around the time of the release of Q3 GDP, however, if I was long sterling, I would have been profitable. This is shown in Figure 3.8.
Figure 3.8: GBPUSD
Let’s say I decide to trade the actual Q3 GDP release. A few days before it would be worth taking a look at how sterling had been trading over the last month or so. I identified key levels of support and resistance as well as determining the prevailing trend. This is shown in Figure 3.9.
Figure 3.9: GBPUSD – daily chart a couple of days before the GDP release
What you should notice from Figure 3.9 is:
You may also recognise the beginnings of an imperfect ascending triangle, although I think the support and resistance lines tell a good enough story that we don’t need to get any more technical than this.
So what should I do?
I was expecting a big number from the GDP data release, yet sterling had been falling along with broader market sentiment in recent days, so it might be worth looking to pick up GBPUSD on dips to around 1.5950. If GBPUSD broke decisively below this support zone (shown in Figure 3.10) then going long would be a bad strategy.
So, I could look to profit on a big GDP number that would push GBPUSD back towards 1.6300.
The day after the unexpectedly positive GDP data, GBPUSD was continuing to move higher, and was above 1.6100. The next major level to watch for is 1.6200 – a support zone from late September. If the market can get above this level then it may have a chance at re-testing 1.6300. Thus, it is worth keeping an eye on this cross as there are a couple of profit-taking opportunities.
If GBPUSD does break above 1.6200, then 1.6300 is a major resistance zone and is a triple top for this pair. Unless something big happens on the fundamental front (a shift to a more hawkish stance from the BOE, for example), it would require a very big push from the bulls to break this level. I would consider taking profits at around 1.6260.
If 1.6300 is decisively broken in the coming weeks then I would look to re-enter a long trade, but keeping hold of the trade in the hope that this level will be cracked this time around is too risky for me.
Figure 3.10: GBPUSD
Trading strategy
Case Study 4: AUD
The background
The Aussie dollar belongs to the bloc of commodity currencies that tend to be sensitive to the overall risk environment. Australia is a large producer of commodities so it is no wonder that AUD moves with:
These factors also determine Australian monetary policy.
Figure 3.11 shows the close relationship between AUDUSD and the commodity sphere.
Figure 3.11: AUDUSD and the Thomson Reuters/Jefferies commodities index
Figure 3.12 shows how AUDUSD also moves closely with interest rate differentials.
Figure 3.12: AUDUSD and the interest rate differential between Australian 10-year government bond yields and US 10-year government bond yields
From a fundamental perspective the odds had been stacking up against the Aussie since the first few months of 2012. For example, commodity prices had been falling, China – its biggest trading partner – had seen its economic growth slow, its mining boom looked to be over and then the Reserve Bank of Australia embarked on a rate cutting cycle.
There was little to suggest the Aussie was going to rally any time soon. Instead, China had still not embarked on more monetary policy stimulus to try to boost its economy and the RBA remained in dovish mode. In this instance the fundamentals are not giving us a particularly good picture of the Aussie. It is time to check the technical picture to see if it is saying the same thing.
The trade
AUDUSD is sensitive to risk, and as such can be jostled around by overall market factors alongside domestic ones. This can help the cross to remain stronger than the fundamentals would suggest. As you can see in Figure 3.13, AUDUSD was trading in a range from July to October 2012.
Figure 3.13: AUDUSD range-bound (July to October 2012)
There are two things that I notice from this chart:
Looking at other Aussie crosses
Sometimes the best trading opportunities are not always found when you only trade your chosen currency against the US dollar; sometimes it pays to look outside of the box. For example, while AUDUSD was stuck in a range, sterling was continuing to climb against the Aussie and remained in an uptrend.
A long GBPAUD trade offered another opportunity to trade the Aussie. This cross might have been more enticing for some traders than AUDUSD since it was still in an uptrend. A GBPAUD long trade had a strong fundamental basis as the interest rate differential between the UK and Australia had been narrowing of late, which should be GBP supportive. The RBA in Australia was embarking on a rate cutting cycle, while the Bank of England had kept rates on hold. This gave the pound the advantage over the Aussie dollar as you can see in Figure 3.14.
Figure 3.14: GBPAUD and the UK-AU interest rate differential
So what about the technical picture? For this I am going to look at the daily Ichimoku cloud chart (see Figure 3.15) for GBPAUD to get a sense of:
Chart 3.15: GBPAUD
Figure 3.15 shows GBPAUD is still in a technical uptrend. After falling back from 1.5900 it managed to stay above the top of the cloud, which is now key support. There are also a couple of key resistance zones to watch including 1.5900 and also 1.6200 – the high from May 2012 (these are circled in the chart).
Recent price action has been bullish, including the last candlestick, which is a bullish engulfing pattern. This suggests that the bulls are on the side of GBP and there may be further upside for this pair.
At this stage I have two options:
Usually I am an advocate of waiting for a better level – after all, only fools rush in. However, you could argue that the decline has already happened, and after holding support above the top of the daily Ichimoku cloud this is a good entry point. Either way, my first target would be 1.5900. Only if the price successfully clears this level would I hold the position to test 1.6200.
Trading strategy
Case Study 5: Gold
This case study is about gold. It is not exactly a currency, but some people trade it a bit like a currency. Gold is often priced in dollars and so it is sensitive to price movements in the US currency. Some people also believe it is a viable alternative to fiat money (what we call today’s currencies). In the past the value of money was determined by gold, but that system was ended in the 1970s.
Thus, the yellow metal has a close relationship with the FX world and many FX brokers also allow you to trade precious metals alongside FX.
The background
Gold is very sensitive to changes in US monetary policy because it is traded in US dollars, so when the dollar is weak the price of gold tends to move higher as you need more dollars to buy an ounce of gold (and vice versa when the dollar is strong).
During the summer months of 2012 the US economy showed signs of slowing down and the Fed started to sound concerned about the rising unemployment rate and slowing growth in job creation. Some Fed members, including the Governor Ben Bernanke, started to drop hints that more QE may be on the cards. On 13 September the Fed announced it would embark on its most aggressive form of QE in its history and would make unlimited asset purchases.
This caused the dollar to fall sharply, and gold to soar.
The trade
Gold’s relationship with the dollar means it is sensitive to QE. Thus, the moment that the Fed started throwing some hints that more QE was on the cards, traders should have started to monitor the gold price. This is also where technical analysis can be used.
After peaking in February the gold price had fallen from just below $1800 per ounce to below $1550 at the end of May. Not a small decline in three months! However, it was starting to look oversold. If there wasn’t a fundamental driver to keep the gold price weak then maybe it was about to change trend.
As you can see in Figure 3.16, during the summer months there were some tentative signs that gold was starting to recover at the same time as some Fed members were dropping hints about the possibility of more QE.
The first thing to notice is that the low in gold price was in May 2012. For the next two months it traded in a range, and gains were capped. A gold bug would have been interested in the fact that it was also making a series of higher lows, which suggested that a breakout to the upside was a possibility.
Figure 3.16: Gold daily chart
If you had monitored gold throughout the summer months, then you may have been aware that a breakout was on the cards and so decided to buy around $1580 – after another higher low in early July.
If you hadn’t been that quick then you could have still entered a perfectly decent trade once gold broke out of the top of its range at $1600 in mid to late July. Even if you didn’t buy at the bottom, you still managed to catch the break and you would have exposed yourself to plenty of upside. Figure 3.17 shows the breakout in early August.
Figure 3.17: Gold – daily chart: I have zoomed in on the break out that started in early August
Now that you are in the trade, how long do you stay in it? There are two things I look at:
From a fundamental perspective, when the economic data in the US started to pick up in late September that should have been a warning sign. If QE is tied to economic performance in the US, then when the economy starts to strengthen the Fed may end QE. Thus, throughout this trade it was important to keep an eye on the US economic data releases to ensure you were aware of the latest developments.
The next thing to look for were important reistance zones. As we got to late September the gold price was approaching $1800 – the high from February. This level had stopped gold early in the year, thus it may do so again.
The potential for a premature end to QE3 from the Fed combined with a tough resistance zone at $1800 would have been good justification to exit this trade. As you can see in Figure 3.18, gold then fell to nearly $1700 per ounce over the first half of October.
Figure 3.18: Gold, daily chart – the trend comes to an end
Trading strategy
Case Study 6: EURUSD
EURUSD had a volatile 2012, but after reaching a high of 1.35 in February and a low of close to 1.20 in July it ended the year roughly where it had started at around 1.30. EURUSD is the most traded currency pair in the world, but the last five months of 2012 required great skill and patience.
The background
The fundamentals shifted dramatically at the end of July when EURUSD was languishing close to 1.20, a level it hadn’t seen since the peak of the Greek crisis in 2010. At that point the head of the ECB said that the bank would do everything in its power (as long as it was within its mandate) to protect the euro. The market saw this to mean that the ECB would stand behind the currency and protect it from speculative attacks. The euro soared.
The trade
When the head of the ECB says he will protect the currency then one would expect the euro to rally. Indeed it did. Between July and October 2012 EURUSD rose nearly 10%, as illustrated in Figure 3.19.
Figure 3.19: EURUSD daily chart (June to October)
The next step was to check the technical picture. The level of 1.20 was important for this cross as it was the lowest level for two years, thus it is a technically important support zone. The fundamentals and the technicals match up for this trade, but the difficulty is jumping on the back of the uptrend in time. If you missed the boat in July, there were other opportunities, but you had to be patient.
For example, three times during August EURUSD either expereinced a pullback or a sideways move. These would have been good entry points. I have circled the potential entry points in Figure 3.20.
Figure 3.20: EURUSD daily chart
At some point you want to think about your exit. As this was such a large move, some may choose to get out after a certain profit threshold has been reached – say 200/300 pips. This is often an approach that I use.
Then if the trend is on-going I will try to get back into the trade, but I will book my profit first. The other option is to use a trailing stop loss (see the risk management section for more on this). This protects your profits through an uptrend and can be a safe way to trade in trending markets.
The other option, which is the hardest in my view, is to try to pick the top. Very few people do this with much accuracy. However, in this instance there were a couple of tell-tale signs, both fundamental and technical, that there would be selling pressure around three months after the uptrend started:
Both of these signs scream exit to me. Not many people get out of a long trade at the very top. If you get out within 100 pips of the top that is fairly good going.
Figure 3.21 shows the culmination of the trend.
Figure 3.21: EURUSD
Trading strategy
Case Study 7: EURGBP
EURGBP is renowned for being particularly volatile, but it can provide some interesting trading opportunities. Back in July 2012, just before the ECB made its pledge to protect the euro, it was at a multi-year low below 0.7800. Thus, it looked ripe for a recovery or relief rally just as the ECB made its pronouncement about the euro. Figure 3.22 shows EURGBP for 2009 to 2012.
In this trade the technical reason to buy EURGBP came before the fundamental reason. That is fine – when technical and fundamental drivers meet it can mean a powerful reversal for some crosses.
Figure 3.22: EURGBP (2009 to 2012)
The trade
The reason to go long EURGBP at this stage was driven by the technical picture first. Back in mid-2012, EURGBP had reached its lowest level since 2008. This made me wonder if the cross was oversold and due a pullback. From a fundamental perspective it was fairly easy to see why the euro was so weak against GBP:
After selling off sharply since early July the technical signals said this trend may be due a break, while the fundamental signs said that there could be further weakness to come.
The pledge from the ECB (see case study 6 for more detail) at the end of July shifted the fundamentals more in line with the technical signals and made this an interesting long trade in my view. Figure 3.23 shows the low in late July in more detail.
Figure 3.23: EURGBP
As you can see this trend wasn’t smooth and it was a bumpy ride. At some points I was tempted to get out. However, even when the pullbacks were sharp and unexpected, as long as the cross kept making higher lows, I decided to stay in the trade. Figure 3.24 shows the development of the trend.
Figure 3.24: EURGBP making higher lows (August to September 2012)
At the end of October I thought I spotted a pattern on the chart that can signal a reversal – it is called a head and shoulders pattern and is shown in Figure 3.25. This pattern – with the right and left-hand shoulders roughly level, and a peak in the middle for the head – can suggest a break to the downside if the cross goes through the neckline, which is the horizontal line on the chart.
I decided to get out at that point – just below 0.80. I felt that the technical picture was telling me that the uptrend had come to an end, added to that some market commentators had started to doubt the strength of the pledge made by the ECB.
Figure 3.25: EURGBP with head and shoulders pattern
I ended up being wrong. EURGBP didn’t fall through the neckline, it bounced off it. I got out too quick and ended up missing another 150 pips of profit. This is illustrated in Figure 3.26.
Figure 3.26: EURGBP
In the event this trade was still profitable, just not as profitable as it could have been.
Trading strategy
Fusion philosophy wrap-up
By using fundamental analysis alone you miss out on key buy and sell signals given by the price action. By only using technical analysis you miss the broader context in which a currency is trading, which can leave you unaware of some major events that could cause volatility in the price action.
There are pros and cons of each type of analysis, but the main message of this book is to advocate fusing the two methods to get the best bits of both and improve your trading. You may have met hard-core technical analysts who sneer at fundamentals and think they are a waste of time. Likewise you may have met fundamental analysts who think that technical traders are taking the easy route out and don’t want to do the hard work that fundamental analysis entails.
My theory does not ask you to sign up to one method or the other. I don’t believe that is a practical way to approach your trading. To be a good trader in the FX market you can’t afford to ignore fundamental or technical methods – you need to know both.
The case studies above were designed to show you how my trading strategy uses economic data, central bank decisions and communications, and breaking news, alongside support and resistance levels, Ichimoku clouds and moving averages.
This section was arranged to show that I look at the market in a particular order:
I find that for the majority of the time determining the context and the fundamental backdrop needs to come before the technical analysis. But for success in trading it is important to always be flexible – as shown in case study 7, sometimes the technicals come first.
In Part D I move on to look at risk management, which is the final aspect of my trading approach.