As a trader analysing financial markets, it is important to have a solid approach to make trading decisions and place trades, to build a solid strategy. When constructing a strategy, it is important to understand the three main types of Forex market analysis – technical, fundamental, and sentiment. Each type of analysis has its own strengths and weaknesses, so it is important to be aware of all three, in order to have a well-rounded view of the market.
Deciding which type of analysis to use when trading Forex is important. Each method has its own advantages and disadvantages. Technical analysis looks at past price movements to try and predict future price action. Fundamental analysis looks at economic factors that could affect currency prices. Sentiment analysis looks at how psychology affects trading decisions. All three types of analysis should be used in conjunction to get the best results. In this article, we will explore each type of analysis in detail.
We will look at:
Technical Analysis
If you’re new to the world of Forex trading, you may have heard the term “technical analysis” thrown around. But what is technical analysis? Simply put, it’s a method of evaluating markets by studying past data, mainly price and volume. Technical analysts believe that by looking at historical data, they can identify patterns that will help them predict future market behaviour.
While there are many techniques that fall under the technical analysis umbrella, which include, but are not confined to:
- Support and resistance
- Dow Theory
- Trend and trendlines
- Candlestick charting
- Fibonacci retracements and extension
- Elliott Wave analysis
- Pivot points
- Momentum indicators and Oscillators
By learning these different technical analysis techniques, it is possible to build a strategy that can define likely market direction, plus provide entry levels, alongside stop loss levels and take profit targets. Learn more at our Learning Hub.
Fundamental Analysis
Fundamental analysis is a technique that is used to evaluate a market by looking at the underlying economic and financial factors that might impact that market. When Forex trading, this type of analysis can be used to make trading decisions as well as to determine the fair value of a currency.
Traders who use this approach often look at things like economic indicators and data, central bank activity, earnings reports and company trends and geopolitical events in order to make informed decisions. While there are many different ways to analyse Forex markets, fundamental analysis is one of the most popular methods among traders.
In particular when Forex trading, traders who use a fundamental analysis approach would monitor and analyse the following:
- Central Bank events: This would include Central Bank Meeting decisions, statements and press conferences, the publication of Central Bank Meeting Minutes, and speakers from the major Central Banks. Learn more about Central Banks And Monetary Policy.
- Economic data: Economic data releases, particularly from Tiers 1 and 2 of the major economies, can have a significant impact on the currency for that economy. Fundamental analysis of the possible data release and the chances of that data being above or below the consensus data is key.
- Interest rate differentials: One of the biggest drivers of the value of Forex pairs is the differential between interest rates along the government yield curve for different economies.
- Geopolitical events: Geopolitical events like elections, acts of God (such as earthquakes, and hurricanes), plus trade and military conflicts can all impact Forex markets. Analysis of these types of geopolitical events is possible, but can be very difficult and is subject to potentially large analytical errors.
Sentiment Analysis
Sentiment analysis is a way of gauging how people feel about something. It can be applied to any type of content or data, including social media, reviews, articles etc. and it can be used to understand the general feeling around a certain topic. It is a branch of data science that analyses people’s emotions, opinions, and attitudes. This can be used to discover how a group feels about certain topics.
As a market trader, it is essential to understand what sentiment analysis is and how it can be used to your advantage. By analysing markets and trader sentiment, you can potentially predict future market trends and make more informed decisions about where and when to place trades.
Forex market sentiment indicates the general attitude of traders toward a particular currency (like, say the US Dollar) or a currency pair (such as EUR/GBP). It is the crowd psychology of a currency market, its tone or its feeling, as shown through the activity and price movement of the Forex pair.
There are various measures of Forex market sentiment, which include but are not confined to:
- The Commitment of Traders (COT) Reports: These are published by the Commodity Futures Trading Commission (CFTC) and measure changes to the number of longs and shorts by large speculators in the Forex Futures markets.
- Position Summaries by Broker: Many Forex brokers publish the total percentage of trades that are currently short or long in any specific currency pair.
- Forex futures Open Interest: This measures the open positions in the Forex futures markets and can offer a gauge of sentiment in any particular currency.
How to combine these in your analysis
Some traders are purists, they prefer to just use one type of analysis, so maybe concentrate on technical analysis, looking only at the chart to make trading decisions. Other traders prefer to focus on market fundamentals to make trading decisions. And others rely heavily on market sentiment. However, many traders use a combination of these different types of analysis to build a robust trading strategy. The key is to find a system that works for you, in your timeframe and that is robust under testing.
In summary
Which form of analysis you use in your trading is up to you, and we have only dipped into the main types of analytical approaches that you can use when Forex trading. We would suggest educating yourself as much as possible about these different fields of analysis to find what resonates best with you, and critically which type of analysis results in steady profits over time. Good luck with your analysis and trading!