The Beginner’s Guide to Technical Analysis Combining Fundamental and Technical Analysis

On the left: 4H chart of EUR/USD with various technical methods applied (source: Twitter)
On the right: Kandinsky horizontale (Source: Google Images)
Up to this point, we’ve explored Support & Resistance, Candle Patterns, Moving Averages, Fibonacci Retracements, Oscillators, Bands, Channels and Envelopes. However, it would be too simplistic to reduce successful speculation to mere technicals. Sure, technical analysis is an easy empirical method, which is actually very useful for:


Measuring market sentiment on a given asset 
Timing potential entries and exits 
Managing risk.

However, it is rare to find a successful FX speculator that relies on technicals alone. In reality, behind successful FX speculation lies a decision making process that most likely blends technical analysis and fundamental analysis.

Picture this: you are a trader for a hedge fund, prop desk or an asset management shop. You decide to buy USD/CAD. The Chief Investment Officer approaches you for an explanation of why you decided to risk some of the company’s capital on your idea. Would you imagine yourself saying something like this:
“…the 211 Day Weighted Exponential Moving Average crossed the 71 Day Simple Moving Average and the Slow Stochastic Oscillator was oversold.”
Or something like this:
“…The Bank of Canada decided to cut rates today, which was a little surprising given that recent economic data wasn’t all that bad. Furthermore, Crude Oil is still nowhere near a bottom and inflation expectations continue to drop. On top of all that, we just broke out of a consolidation in an evident uptrend.”
I think we all agree that a Chief Investment Officer would find it difficult to allocate risk capital to decisions made solely using one’s technical prowess. More likely, he or she would want to see a mixture of logical fundamental reasoning and simple technical observations
.


The Seductive Side of Technical Analysis
Observe the following chart. What do you see?

The only thing you can actually see is a multitude of indicators. You can’t even see the market! A trader with this kind of chart is usually searching for certainty. Technical Analysis can give traders the illusion of certainty and robustness. This of course can be fatal to your account, because any technical measurement is merely a derivative of price.
Technical Analysis is seductive:



It’s simple and democratic: anyone with a half-decent charting package can add/remove/create indicators; 
It helps measure sentiment; 
It helps time entries & exits; 
without a universally valid framework for forecasting FX moves, it seems like the only way to play the game; 
It helps us understand traders’ positioning: traders resist negative (positive) news when they are long (short) and exaggerate negative (positive) news when they are short (long), and this can be seen on the chart; 
Market Wizards like Paul Tudor Jones refer to common indicators like the 200 simple moving average. If it works for them, surely it can work for the common retail trader?

However, if you are only making decisions based on charts, how can you explain the times when charts fail you?

It can be frustrating when a solid chart pattern or analysis method suddenly fails. Sure, “it may be one of those days” …but how can you be sure? Furthermore, how can you continue to have confidence in your charting method, without constantly questioning the validity of each signal you get?

What is Price?

All chart patterns & technical methods are based on price behaviour. So it’s useful to investigate price a little further. What exactly is price in the first place? What are we actually watching, when we stare at our glamorous charts?

It’s too easy to think of “price action” as an independent or impersonal concept. In reality, at any given time, the price of a financial asset is determined by the forces of supply and demand. Edwards & Magee, in 1948, had already defined price action appropriately:

“The market price reflects not only the differing value opinions of many orthodox security appraisers, but also the hopes and fears and guesses and moods , rational and irrational, of […] buyers and sellers, as well as their needs and the resources…”

Edwards & Magee gave a very precise definition that included the psychological aspect of human decision making. Price movement is determined by investors' decisions in response to a complex mix of psychological, sociological, political, economic and monetary factors. Technical Analysis attempts to measure the strength of these moves and to forewarn of potential changes.

How market participants form their expectations

We now know that we are actually trading expectations, not facts or hard data. But where do these expectations come from? Surely they aren’t formed out of thin air…or are they?

Fundamental data, or better stated, the evolution of fundamentals over time , is what drives demand and supply in the FX market. Fundamental analysis is the process through which we should strive to understand how price

could react to certain economic events. These events can come in many forms:

headline data (for example, PMI reports or housing data) 

top tier data (for example, central bank decisions or minutes, or NFP) 

themes (for example, monetary policy divergence between the USA and the Eurozone, or the weakness in the commodity sector)

The release of this data, and the evolution of the themes that the market is currently focused on, changes the economic mindset of participants – and this is what creates the reaction from investors. To be even more precise, it's not even the release of the data or the event that creates a re-allocation of capital: frequently, it's the expectation of such releases/events that gets things moving. This is why we frequently say the market is “forward looking”: participants tend to “discount” or “price in” their expectations for future foreseeable events.

The fundamental picture is ever evolving. It’s like a slideshow, where each slide represents “the fundamental influences of a session” (like the NY session or the EU session). But without knowing what was on the slide before it, it’s impractical to guesstimate what will be on the slide after it.

But which fundamentals contribute to forming expectations, and why?

Paying attention to the primitive illustration above, the most important question is: who can “force” the FX market in a certain direction? Who has the most influence? The answer is of course:

Central Banks and Treasury Heads.

They hold the thick sticks. All it takes is the Bank of Japan to be “actively checking prices” at their agent banks for the word to spread along the grapevine and alert market participants. So,

which fundamentals matter to the people that matter? What do the policy makers base their policies on? The list certainly encompasses:

By now, you’re probably thinking: “how am I ever going to keep track of everything?” Here’s the key : the market is made up of humans, and humans cannot possibly keep track of all variables at the same time. So what happens is that the market focuses only on a few themes and stories at any one time.

How to keep track of the matters that matter

If you want to stay in tune with the evolving fundamental picture, the first step is to pull up an economic calendar in the morning, and take a good look at the market moving events due for the day. This is valid for FX, as it is for Futures, Equities and Bonds as well, because these market movers are telling us something about the economy. All investors are interested. Here is what a calendar looks like:

Once you verify that there are important events on tap, be sure to look at what the market is expecting.

You may find it helpful to review prior events, to see (a) how often there is a hit or miss and (b) what tends to happen when forecasts are off.

By comparing the forecast with the previous print, you can discover whether the market is discounting a better number or a worse number. This can help you plan for possible scenarios, but keep in mind that:

A little bit on scenario planning:

There is usually an initial response, called “knee-jerk reaction”, which is short-lived, full of action, and where most traders get chopped up. Then, there is a secondary reaction, where traders have had some time to think about the release. It's at this point that the market decides whether the release should generate a move. Was the outcome expected or not? Was it with or against the market's expectation, and is the market currently moving in a logical fashion?

These are quick questions that can help you digest the constant stream of headline events in an actionable manner.

More on economic data prints

So now that we know how to use an economic calendar (which should be checked daily), what are the market movers that usually generate the most volatility and, in some cases, opportunities?

a) Central Bank Meetings: it is not a wise thing to trade around a central bank meeting. But central bank meetings can set the tone for the days ahead, which can be traded on the back of the theme (if there is one). Central banks set the price of money by controlling the short term lending rate. Generally speaking, when a central bank increases interest rates it attracts capital to the country because investments will yield more. This is all positive for the domestic currency. The opposite is also true: if a central bank decreases interest rates, then it is negative for the domestic currency.

But even more important than the interest rates themselves is the general direction of interest rates. If a central bank is pointing at rising rates, then the market will already be in “buy the dip mode”. Another important factor, in this day and age, is the amount of alternative accommodative policies (like Quantitative Easing in its various forms), which increase the money supply and thus are negative for the domestic currency.

b) Central Bank Minutes: it is generally not wise to trade around the minutes of a central bank meeting, although these can provide valuable details as to the central bank's members' true policy direction and preferences. The minutes can confirm or contradict the actual decision taken previously.

c) Employment Reports: it is generally not wise to trade right