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Forex analysis techniques for institutional investors
There are many factors that influence price movements on the foreign exchange market, which is why in this article we’ll discuss the key analysis techniques used by institutional investors, such as hedge funds, to try and predict the direction of a currency in order to make profitable investments.
What is forex?
The foreign exchange market, or forex as it’s often referred to, is the largest financial market in the world, with trillions of dollars being traded every day. As such, successful institutional and retail investors alike will analyse forex markets in order to profit from the swings of different currency pairs.
Despite the fact that a lot of foreign exchange trading activity remains in global financial hubs such as New York, London and Tokyo, the forex market is different to the stock market in more ways than one. Firstly, the market is open 24 hours a day, five days a week.
Secondly, instead of buying shares in companies, investors buy currency pairs. Some of the most frequently traded forex pairs include EUR/USD, USD/CAD and EUR/JPY. Within these pairs, investors are buying one currency and selling the other – essentially betting that one currency will increase in value, relative to the other one decreasing.
Much of forex trading is trying to figure out which currency in a pair is going to be worth more over a certain period of time – this is forex analysis.
Methods for forex analysis
There are many factors that can influence the forex market – including political events (elections and referendums), economic trends, international trade, or decisions from central banks (such as the Bank of England, the US Federal Reserve and the European Central Bank) regarding inflation and interest rates.
Because there are so many factors to consider, investors use a variety of methods to analyse the market and to help with making buy and sell decisions regarding specific currency pairs. These methods can be technical or fundamental in nature.
Fundamental and technical analysis techniques are considered opposites, but analysts and investors assessing the forex market will often use elements of both because the range of influential factors is so diverse.
For example, fundamental analysis, which considers the effects of gross domestic product (GDP), inflation, interest rates, unemployment and other key economic data is an integral part of gauging the health and performance of an economy. This, in turn, is imperative to understanding how one currency’s value may fluctuate against another.
To put this in another context, if an investor were to conduct fundamental analysis on a company to evaluate its stock, they would look at the business’s sales, cash flow and debt. In doing this, they would come up with a figure of what the company’s stock should be worth (based on their analysis). Depending on how that figure compares with the current price of company stock, it could hint that the stock is either over or undervalued. If it’s undervalued, then logic would suggest its value will increase and vice versa.
Looking again at how this fundamental analysis can be applied to forex trading, a hedge fund running fundamental analysis on USD/CAD will find information on GDP and inflation in the US more helpful than the same data for Canada. The fund is also likely to keep a close eye on any US news that could affect the US economy, in order to predict short and long-term price movements. As well as major political events, this could include budget or central bank announcements and changes to economic policies.
Technical analysis, on the other hand, focuses on statistical trends gleaned directly from trading data, such as price movement and trading volume. This is the opposite of fundamental analysis because rather than focusing on what’s driving an economy, it’s based on the idea that future price movements can be predicted based on past price changes and trading activity.
Technical analysis can be done both manually and automatically. Manual technical analysis means an investor, such as a hedge fund, would make buy and sell decisions based on the results of analysing technical indicators, like those mentioned above.
Automated technical analysis, however, involves software to spot certain signals and indicators and translate them into buy and sell decisions. This could have an edge on manual technical analysis as trading decisions made by software are purely objective, in the sense that they aren’t tainted by human emotions and behaviours like greed or fear of loss.
In addition to the above techniques, many successful hedge funds will take the time to run analytics over weekends when markets are closed – this can be a good way to gain an even greater perspective. Weekend analysis also gives investors the chance to focus on their work, without having to react to market changes, as well as an opportunity to put a plan in place for the week ahead.
Hedge funds tend to use a variety of all these analysis techniques to gain the widest perspective of how the markets are likely to perform in future. However, analysing the markets is just one step to a successful trading strategy, the next is actually applying the results.
At the very core of trading, it’s imperative that both retail and institutional investors use the results of their analysis to direct their investment strategy. Diverting from these results can be a risky business. That said, it’s also just as important to think critically of the principles of forex market analysis.
With this in mind, here are some additional points that investors should consider when applying the results of their analysis to their trading decisions:
Know what’s driving the market and why
There is no exact science to predicting market trends, but it’s important to understand the forces that push markets in certain directions. In the case of forex trading, many drivers can be attributed to the relationships between different markets. It’s therefore important to know why these relationships exist in order to understand how they’re likely to change over time and why.
For example, if the stock market of a particular country shows signs of recovering following a recession, it could simply be a sign that investors are expecting the economy to recover – but not always. On the other hand, the momentum of a country’s stocks could be fuelled by speculation. As prices increase, large institutional investors are likely to be attracted to those stocks, possibly for the sake of short-selling them if they believe the said stocks to be overvalued.
For these reasons, investors should continually ask themselves why certain market trends are unfolding the way they are.
Long-term index charting
Hedge funds should chart important indexes for each market they’re invested in for long time frames. Doing so enables them to determine relationships between markets. For example, it can be helpful to know if a single market moves in solitude or in tandem with another as this will help narrow down the potential drivers that influence the change.
Concurrence among markets
Knowing when a turning point is going to happen in a market can be incredibly useful when it comes to determining an entry or exit point for a trade. For this reason hedge funds will often chart a range of financial instruments on a short and long-term basis to gain additional perspective of whether or not the markets are reaching a turning point consensus.
This makes it possible to take advantage of the consensus by entering a trade in an instrument that is likely to be affected by the turning point.
Perfecting one’s timing
One of the keys to a successful trading strategy for many hedge funds dealing with forex comes down to finding the best entry point in order to maximise profit on a particular trade. If they start by finding the turning points on a longer timeframe, they can then refine their entry point by gradually switching to shorter time frames.
To summarise, there are two primary methods of analysing forex markets and investors may consider running additional analysis when markets are closed. It is, however, equally important to put the results of an analysis to good use in order to have a successful trading strategy.
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