Forex Trading - Types of Market Analysis

Forex Trading – Types of Market Analysis

In this chapter, we will learn about the different types of market analysis. There are three types of analysis used for the market movements forecasting −

  • Fundamental Analysis: This is the analysis of social, economic and political factors that affect currency supply and demand.
  • Technical Analysis: This is the study of price and volume movement.
  • Sentiment Analysis: Apart from mini and micro analysis of data, this is the analysis of the mindsets and sentiments of traders and investors.

Fundamental Analysis and Technical Analysis (FA and TA) go hand-in-hand in guiding the forex trader through the way the market (prices) may go under the ever changing market conditions.

Fundamental Analysis

Fundamental analysis is analyzing the currency price forming, basic economical and other factors influencing the exchange rate of foreign currency.

It is the analysis of economic and political information with the hope of predicting future currency price movements.

Fundamental analysis helps in forecasting future prices of various foreign currencies. Forecasting of prices is based on a number of key economic factors and indicators that determine the strength of a country’s economy. The factors may also include various geopolitical aspects that may impact the price movement of a currency pair.

This analysis is not used to get the specific numbers for the exchange rates of various currencies. Instead, it helps in determining the trend of the forex spot market over a certain period.

If the fundamental analysis hints at a positive outlook for a particular currency pair, it indicates that the price of that pair would experience an upward trajectory movement in the near future. A negative outlook indicates a declining price movement of currency pair in coming future. A neutral instance on currency pair indicates a flat (not much +ve or – ve side movement) movement in the near future.

When to use fundamental analysis for the forex market?

Whenever a forex trader receives information about the state of a country, he conducts a fundamental analysis to gauge the impact of this on various currency pairs.

Forex traders and investors always look into reports (fundamental analysis reports) based on critical economic data before trading (particular currency pair) on forex market. These reports (FA) also enable them to minimize the risk factors involved in executing forex transactions.

The Fundamental Analysis report for any market (equity, commodity, FX etc.) helps in decision-making over medium to long term exchange rate prediction (in case of FX market). On the other hand, Technical Analysis provides information for short-term predictions.

The market’s momentum can easily reverse or an extreme volatility can be seen in a matter of minutes after an important announcement or press release is made by the central bank. Information related to the status of the local and global economies can have huge impact on the direction in which the forex market trends.

Key factors influencing fundamental analysis

Let us now learn about the key factors that influence fundamental analysis. The factors are described below in brief −

Interest Rates

The interest rates set by the central bank is one of the most important factors in deciding the price movement of currency pairs. A high interest rate increases the attractiveness of a country’s currency and also attracts forex investors towards buying.

GDP Growth

A high GDP growth rate signifies an increase in the total wealth of the country. This points towards the strengthening of the country’s currency and its value rises relative to other foreign currencies.

Industrial Production

A high industrial growth in any country signifies a robust country economy. A country with robust economy encourages forex traders to invest in country forex currency.

Consumer Price Index (CPI)

The Consumer Price Index (CPI) is directly proportional to the prices of goods and services in the country. If the CPI index is too high (above the central bank benchmark of CPI), there is a high probability that central bank is most likely to lower interest rates to bring down the rate of inflation and stabilize the growth rate for the country’s economy.

Retail Sales

A country’s retail sales data gives an accurate picture of how people are spending (people income level) and the health of its economy at the lowest level. A strong retail sales figure shows that the domestic economy of a country is in strong shape; it points towards positive growth rates in the future.

Apart from these above points, the traders and investors also look into other factors of fundamental analysis like employment statistics, national debt levels, supply and demand balance, monetary policy, political situation, trade deficit, commodity prices, housing prices and capital market growth.

Technical Analysis

Technical analysis helps in the prediction of future market movements (that is, changing in currencies prices, volumes and open interests) based on the information obtained from the past.

There are different kinds of charts that help as tools for technical analysis. These charts represent the price movements of currencies over a certain period preceding exchange deals, as well as technical indicators. The technical indicators are obtained through mathematical processing of averaged and other characteristics of price movements.

Technical Analysis (TA) is based on the concept that a person can look at historical price movements (for example currency) and determine the current trading conditions and potential price movement.

Dow Theory for Technical Analysis

The fundamental principles of technical analysis are based on the Dow Theory with the following main assumptions −

Price discounts everything

Price is a comprehensive reflection of all the market forces. At any point of time, all market information and forces are reflected in the currency price (“The Market knows everything”).

Prices usually move in the direction of the trend

Price movements are usually trend followers. There is a very common saying among traders – “Trend is your friend”.

Trends are classified as −

  • Up trends (Bullish pattern)
  • Down trends (Bearish pattern)
  • Flat trends (sideways pattern)

Price movements are historically repetitive. This results in similar behavior of patterns on the charts.

Sentimental Analysis

The participants in every market, the traders and the investors have their own opinion of why the market is acting the way it does and whether to trade in the direction of market (towards market trends) or go against it (taking contrary bet).

The traders and investors come with their own thoughts and opinions on the market. These thoughts and opinions depend on the position of the traders and investors. This further helps in the overall sentiment of the market regardless of what information is out there.

Because the retail traders are very small participants in the overall forex market, so no matter how strongly you feel about a certain trade (belief), you cannot move the forex markets in your favour.

Even if you (retail trader) truly believe that the Dollar is going to go up, but everyone else (big players) is bearish on it, there is nothing much you can do about it (unless you are one of the big investment banks like – Goldman Sachs or some ultra-rich individual like Warren Buffet).

It is the trader’s view on how he is feeling about the market, whether it is bullish or bearish. Depending on this, a trader further decides how to play the perception of market sentiment into trading strategy.

What type of analysis is better?

Forex trading is all about trading based on a strategy. Forex trading strategies help you gain an insight of the market movements and make moves accordingly. We have already studied that there are three types of analysis methods.

  • Technical analysis
  • Fundamental analysis
  • Sentiment analysis

Each strategy holds equal importance and neither can be singled out. Many traders and investors prefer the use of a single analysis method to evaluate long-term investments or to gain short-term profit. A combination of fundamental, technical and sentimental analysis is the most beneficial. Each analysis technique requires the support of another to give us sufficient data on the Forex market.

These three strategies go hand-in-hand to help you come up with good forex trade ideas. All the historical price action (for technical analysis) and economic figures (for fundamental analysis) are there – all you have to do is put on your thinking cap (for sentimental analysis) and put those analytical skills to the test.

In order to become a professional Forex trader, you will need to know how to effectively use these three types of Forex market analysis methods.