Foreign exchange, more commonly known as forex, is the most traded market in the world. Well over $5 trillion of currency is traded in a single day, dwarfing the hundreds of billions traded on stock markets around the world. While the big banks and corporations make up the vast majority of daily forex trading, everyone else in the market is still trading trillions of dollars’ worth of forex each and every day.
There are only two drivers of forex: supply and demand. In turn, both of these are influenced by just one thing: sentiment. However, sentiment is moulded by an endless list of factors and the mood of investors is highly sensitive to the flood of news, data and other developments that happen around the world, particularly as the fast-moving forex market is open 24 hours a day.
Read more on the benefits of forex trading
Still, investors have more tools to aide their forex trading strategies than ever before, allowing them to implement a range of different methodologies and approaches to help them gain an edge in the market. But this has also made the forex market more competitive than ever.
We have a look at the various tools that investors can use when trading forex, as well as some different approaches that can be taken.
What approach should investors use to predict forex movements?
Before deciding what approach to take forex investors need to define the basics of their strategy, including what currency pairs to trade. The majority of trading volumes in the forex market are concentrated on major currency pairs, like EUR/USD, GBP/USD and USD/JPY, but some find opportunity by focusing on other, less popular pairs.
Another major factor that will influence what approach to take is the timeframe in which to trade. Many short-term forex traders will start afresh each day, closing out all of their positions before the end of the day (wherever they are) in order to avoid any drastic price movements that could occur overnight, known as day trading. Others look to hold positions over a slightly longer period, typically between two to 14 days, known as swing trading. Those in it for the longer term use the likes of position trading, which sees traders hold positions for months or even years while trying to refrain from reacting to any up or down price movements in the meanwhile.
Not all types of forex trading are proactive, whereby traders predict where they believe a certain currency to be heading, but reactive, responding to moves in price. This includes momentum trading, when traders believe a notable price movement up or down is the start of a longer-term trend, or range trading, when traders try to spot where the levels of support or resistance have occurred in the past with the expectation those levels will come round again. Range trading is mainly used for currencies that roam up and down in price but have no clear long-term trend.
Read more about the different types of trading strategies
Forex predictions: fundamental analysis vs technical analysis
In order to gain an insight into where the forex market is heading and to muster up a view on what currency pair to trade, two main types of analysis are used: fundamental and technical. Fundamental analysis involves evaluating the many external events and influences that impact the price of currencies such as the state of the economy and financial markets, as well as government and monetary policy. Technical analysis, on the other hand, concentrates solely on the price and predicting future movements in the forex market using patterns and trends identified from historical price charts and statistics.
In a nutshell, fundamental analysis aims to find a currency that is either over-or-undervalued by identifying what the true value based on the external factors that drive price movements. It centres on what impacts the price, but not the price itself. Technical analysis, on the other hand, is all about understanding supply and demand with the expectation that previous market patterns will be repeated, focusing only on the price and disregarding everything else as unquantifiable data.
Take a look at examples of forex trading
Using fundamental analysis to predict forex movements
As the name suggests this is all about analysing the fundamentals of the market, considering all the factors that influence exchange rates - everything from monetary and government policy to the state of the labour and housing markets. The core belief behind fundamental analysis is that it can identify a currency that is mispriced and will eventually correct itself. This is part of the reason why fundamental analysis is generally better at predicting longer-term price movements, although it does have its uses for short-term strategies.
While the list is endless and some events can be unpredictable, such as natural disasters, there are a few key drivers to the price of currencies that should always be at the forefront of any fundamental analysis. These are:
- Economic growth: the state and performance of a country’s overall economy, centred on data like gross domestic product (GDP), which measures whether the economy is growing or shrinking, and at what rate. When an economy is improving it generally translates to a stronger currency as it attracts investors to their financial markets, whereby traders have to use local currency to buy stocks or other financial assets in the country
- Inflation: how fast the price of goods and services is rising affects monetary policy in a country, such as the likelihood of rising interest rates, which in turn weighs on exchange rates. The main measures of inflation to consider are the retail price index (RPI) and consumer price index (CPI)
- Interest rates: this has one of the biggest bearings on the forex market. Higher interest rates generally lead to a stronger currency as, again, it attracts investors to invest their money in savings accounts or other instruments to benefit from the higher savings rates on offer, increasing demand for local currency
- Trade and capital balances: with the forex market international by nature, changes in the amount of money or trade flowing in and out of a country will impact its currency. A currency of a country heavily reliant on exports will fall if those exports drop, for example. For capital, any signs that investors and traders are tacking their money out of the country could be a sign that sentiment is changing, or vice-versa if the flow of investment is growing
- Employment and wages: the level of employment can be correlated to the overall strength of an economy but the movement in wages is equally important. Although rising employment signals that an economy is strengthening, stagnate wages can suggest disposable incomes and the state of the public’s personal finances are not performing as well (or vice-versa)
- Geopolitics: in addition to the swathe of economic data, developments in the political world also weigh on the forex market. With currencies representative of their country, the exchange rate is swayed by government politics and international relations, shaken up by disturbances to the political status quo
Using an economic calendar to predict forex
Fortunately for forex traders there is an easy way to keep up with developments and prepare for the major events that move the price of currencies, the ones that are scheduled anyway. An economic calendar is crucial for anybody trading forex and a guide to the biggest economic and political events that are likely to have an effect, one way or another, on forex and other financial markets.
IG has an economic calendar designed around forex trading, mapping out the upcoming events that need to be considered.
This details when the main economic data will be released and when other major events will take place, like international political meetings or scheduled speeches from world leaders or the heads of the main central banks, such as the Federal Reserve (Fed), the European Central Bank (ECB), the Bank of England (BoE) and the Bank of Japan (BoJ).
It is important to remember that different economies are driven by different external factors, meaning economic data deemed important in one country is not in another. For example, the UK economy is dominated by services, making the performance of the UK service sector more influential to forex than it is in a country like China, where its economy is still based on manufacturing.
Click here to read the latest news that affects forex markets
Using technical analysis to predict forex
While fundamental analysis is looking to identify the reasons why exchange rates will move in the future, technical analysis does not concern itself with why prices move. All technical analysis is done using price charts, which show the historical performance of an exchange rate.
The concept of technical analysis is all centred on supply and demand, using a variety of tools to find trends and patterns in the past in the belief that those same patterns and trends will happen again. Technical analysts believe you can gauge a lot from just a chart, with these patterns and trends signalling the mood of the market and any changes in sentiment. The aim is to identify them before they happen in order to capitalise on the opportunity.
Technical analysis is most often used for short-term strategies, such as day trading or swing trading. While there are a variety of ways to conduct technical analysis there are some historical data points that often occur: the opening price, the highest price, the lowest price and the closing price. These can be treated as common parameters when conducting technical analysis.
What technical tools are used to predict forex?
In order to forecast future movements in exchange rates using past market data, traders need to look for patterns and signals. Previous price movements cause patterns to emerge, which technical analysts try to identify and, if correct, should signal where the exchange rate is headed next. There are a variety of tools available for traders to identify patterns and signals.
Identifying trends to predict forex
A series of patterns evolves into what is known as a trend, which suggests that the latest movement in the exchange rate is the start of a longer-term trend that is expected to last for a certain period of time based on how trends have panned out previously.
The three types that forex traders look for are uptrends, downtrends and sideways trends, which, as suggested by the names, refer to which direction the rate is headed. If technical analysis identifies the start of an uptrend then the exchange rate has just started to head higher and should continue to climb, for example. Importantly, because forex is traded in currency pairs it means that the start of an uptrend for one currency equates to the start of a downtrend for another. If an investor is trading GBP/USD, for example, the pound can only gain at the dollar’s expense or vice-versa.
There are a number of tools that can be used as part of technical analysis to identify trends, but the most widely used ones centre around moving averages:
- Moving averages: this is one of the most widely used tools used to find trends in the forex market. The moving average aims to smooth out historic price data, calculating the average exchange rate of a set period of time. For example, the 20-day moving average is the average rate over 20 days, and this is recalculated each day. On day 21, the first day is dropped from the calculation. This allows traders to look how the current rate compares to the average, which will filter out any sudden or unexplained movements that could distort the historic price data
- Moving average convergence divergence (MACD): this takes the moving average over a short timeframe and an average over a longer timeframe. Traders look for when the short-term moving average crosses over with the long-term average. If the short-term moving average surpasses the longer-term average then it generally suggests that exchange rates are heading higher
Read the beginner’s guide to trend trading
Test the strength and stability of trends when predicting forex
Identifying trends is all well and good but investors should take further steps to gain a better understanding. This can be done by using further tools which test the strength of the trend, or how volatile the trend is likely to be, for example.
Some of the most widely used tools are:
- Ichimoku: the Ichimoku Cloud, also known as Ichimoku Kinko Hyo, is an indicator that not only identifies trends but also defines where support and resistance lies to test the strength or momentum of the trend. It involves a series of calculations that, unlike other indicators, not only forecasts where the levels of support and resistance are at present but where those levels will occur in the future, making it an invaluable tool for forex traders
- Relative strength index (RSI): this index is an indicator of momentum that compares the average gain made when an exchange rate has risen over a set period of time, for 14 days as an example, compared to the average losses made in the same period. This provides an idea of whether a currency is set to become overvalued or undervalued in the near future
- Average true range (ATR): ATR measures the volatility of a trend, but does not identify trends itself. ATR is a type of moving average that compares the highs and lows of an exchange rate over a set period of time with the most recent closing price, producing the ‘true range’ for the five most recent trading days, which is then averaged out to produce the ATR
- Standard deviation: standard deviation is a way of measuring the size of price moves with the hope of identifying whether or not movements in the future will be more or less volatile. Again, this does not identify trends but whether volatility will increase or decrease moving forward
- Bollinger bands: this sets a band that an exchange rate generally trades within, with the size of the band widening or narrowing to reflect recent volatility. When a rate moves outside of the band it suggests it is about to break higher or lower
Using an econometric approach to predict forex
While traders have a variety of tools at hand to improve their technical analysis, they all serve different purposes and each have their limitations, which is why they must be used together if a crystal clear picture is to be painted.
An econometric approach to forex is one of the most technical that can be pursued. Econometric models differ strategy to strategy, as each trader chooses what factors they believe influence the currency markets the most. These factors are considered the key variables that affect the exchange rate of a particular currency, which are then injected into a generic calculation to generate a prediction about future movements in the market.
This is also a particularly good model considering that the main variables that weigh on one currency differ from those that weigh on another, and that the relationship between currency pairs also varies. For example, a trader trying to calculate where the USD/CAD exchange rate will head over time might consider the likes of the interest rate differential between the two countries, or their GDP or income growth rates.
Using the relative economic strength approach to predict forex movements
Much of the economic data that can trigger some of the sharpest movements in the forex market are interlinked. The state of GDP, inflation and wage growth dictate how central banks decide monetary policy, for example, and government policy can centre on trade or capital flows (US President Donald Trump’s trade war with China and the rest of the world has been inspired by this).
Predicting what direction exchange rates are heading by painting a picture of the overall health of an economy is called the relative economic strength approach. This doesn’t forecast what the exchange rate should be, but allows traders to decide whether they think it is heading higher or lower.
Predicting forex markets using purchase power parity
While the relative strength approach only tries to predict the direction of exchange rates, the purchase power parity (PPP) approach tries to predict what the actual exchange rate should be. PPP is based on the assumption that the price of goods and services should be equalised in different countries.
The infamous Big Mac index is the best and simplest example. This measures the price of a McDonald’s Big Mac in different countries around the world as an indicator of how currencies were performing. The idea is to work out what exchange rate would be needed to make a Big Mac that costs $5.00 in the US and €4.50 in Europe to be worth the same. On this occasion, the EUR/USD exchange rate would need to be $1.11. If the current exchange rate is above or below that then, according to the PPP approach, it is possibly over or undervalued.
Predicting forex using interest rate parity and real interest rates
The principle of interest rate parity (IRP) is the same as PPP, but instead of evaluating the price of goods in different countries it focuses on the cost of different financial assets with the view that they should all yield the same returns once adjusted for each country’s interest rate.
Similarly, the real interest rate (RIR) model is based on the principle that a country with higher interest rates will see its currency appreciate against a currency from a country with lower interest rates, because higher rates attract foreign investment and increase demand for the local currency.
Predicting forex using balance payment theory and asset market model
These two models concentrate on the flow of trade and investment in and out of different countries and how they impact exchange rates. The concept behind the balance payment theory is that a country’s currency will depreciate if it imports more goods and services than it exports, and appreciate when a country’s trade balance is running at a surplus.
The asset market model is similar but concentrates only on the flow of foreign investment in and out of countries, assuming higher levels of foreign investment drives that country’s currency higher and that lower levels cause depreciation.
Using sentiment to predict forex movements
The last approach to consider is based on sentiment, which, as noted earlier, is what drives the supply and demand that results in exchange rates moving. For other types of trading, such as in stocks, volumes are often used to determine the sentiment of the market: lower trading volumes can suggest the mood is souring while growing volumes can imply higher levels of interest and activity.
Read more about market sentiment and how to trade it
However, the problem with forex in this regard is that it is traded over-the-counter (OTC), meaning tracking trading volumes is nigh-on impossible. Still, there are ways around this. The best way to analyse the sentiment within the forex market amid a lack of volume data is the forex futures market, which gives an idea of how traders feel about exchange rates in the future rather than now. If the price of currency futures is markedly different to spot prices then it could imply whether the sentiment is bullish or bearish.
The most widely used tool for this is the Commitment of Traders report published by the Commodity Futures Trading Commission, which details the long and short positions taken by investors on currency futures.
While the futures market allows traders to gauge sentiment in the market it is worth noting that the size of the forex futures market is tiny compared to the spot market. The mood of the futures market, therefore, can not necessarily be regarded as a cemented signal of what the wider market feels.
Read more on what moves forex markets
Conclusion: investors need all the tools they can to trade the forex market
The amount of tools and data that need to be used to trade forex effectively can seem overwhelming to those looking to dip their toe in the market, but this is why it is even more important to utilise all the resources at your disposal because it is highly likely that the millions of others trading forex around the world are also using them. Technical analysis is common knowledge for most forex traders, while the general fundamentals that affect the forex market in general, like GDP data, are also easily accessible to everyone else.
With fundamental analysis looking for potential reasons why an exchange rate might move in the future and technical analysis demonstrating the effect of past events, the pair should be used hand-in-hand with one another by forex traders. This also minimises the individual drawbacks of each, with fundamental analysis often criticised for what is known as a ‘random walk’, whereby commentators try to attach a news story or flow of data to a previous price movement without really knowing whether or not it caused that movement. Meanwhile, technical analysis is being used by others in the market and can’t give traders a competitive edge on its own.