Once you have determined what time frame suits you best, the next question you must ask yourself is this: what type of analysis should you use to make proper trade selections? No issue creates more arguments on trading desks than the debate between fundamentalists and technicians.
Fundamentalists scoff at technicians' attempts to forecast future price movement by looking at the present price action on the charts. Hard core proponents of fundamental analysis consider technical analysis not much better than the ancient ritual of divining the future from the entrails of dead animals. News, economic reports and commentary from monetary officials are the primary tools of fundamentalists. Technicians, for their part, dismiss most fundamental data as woefully inconclusive and contradictory, believing instead that any material news will be reflected in the price action of the currency pair and will therefore provide objective clues to future direction.
Which camp has got it right? Neither one. Trading on technicals or fundamentals alone is a sucker's game, akin to wanting to box for the world championship title with one arm tied behind your back. Fundamentalists can talk all they want about the secular global demand for oil that will drive the price of crude to $100/bbl and will take the Canadian dollar to parity with the greenback, but if they choose to short USD/CAD at a grossly oversold level as momentum shows large divergence on the charts, then they will likely lose money on the trade - even if their analysis is ultimately correct. Conversely, a technician could short a major Fibonacci cluster to his heart's content, but if a piece of economic news surprises the market to the upside, his shorts will be run over like jungle shrubbery after an elephant stampede as traders try to cover their positions, ignoring various resistance levels.
Fundamentals for Long, Technicals for Short
Despite these admonitions, the general rule of thumb is that fundamentals tend to have a stronger impact on longer-term trades, while technicals will be more important to consider for shorter-term trades. Over the long term, currency prices will respond to major economic events such as GDP growth, interest rates and current account balances.
Witness, for example, the move in the GBP/USD over 2005 (Fig. 1). During that time, the Federal Reserve Bank of New York proceeded to raise the Fed funds rate by 200 basis points, from 2.25% to 4.25%, while the Bank of England, facing a slowing economy and depressed consumer sentiment, chose to lower the U.K. rates from 4.75% to 4.5%. The interest differential between the two currencies compressed to nearly 0% (by the beginning of 2006, it had reached 0%). Traders who made a long-term bet that U.K. and U.S. short-term rates would converge profited handsomely as GBP/USD declined.
The same dynamic took place in the USD/JPY, except in reverse (Fig. 2). As U.S. rates expanded while Japanese rates remained stationary at 0%, carry traders flocked to the pair, bidding it up by 20% in a matter of months. With analysts in 2006 forecasting the end of the U.S. tightening cycle and the beginning of the Japanese one, these long-term trends may well reverse moving forward, and traders making this fundamental call could reap large gains if their analysis proves to be accurate.
While price action reacts well to fundamental factors over longer-term time frames, technical analysis appears to have the upper hand on shorter time scales. Perhaps one reason why this occurs is that on smaller time frames, information from news flow is not nearly as active or as meaningful; therefore, prices tend to respect established support and resistance levels on the charts as currencies range in tightly defined zones. For example, in this hourly chart of the EUR/USD (Fig. 3), note how price reacts to the swing highs and swing lows, allowing the trader to profit from selling resistance and buying support. For more, see Trading On Support.)
The Bottom Line
Whether you are a long-term fundamentalist or a short-term technician, the FX market can accommodate your style. Although the argument between the two camps will probably never be resolved, the one undeniable truth of trading is that you must use the style that best suits your personality. Otherwise, you are unlikely to succeed, regardless of the soundness of your approach. Therefore, the first question an FX trader should ask him or herself is not "Is this pair going to go up or down?", but "What kind of a trader am I?"