There is a selection of tools and ways a trader can analyze the Forex market to develop buy and sell trading ideas and forecast future currency trends. There are three main groups of market analysis:
- Technical Analysis
- Fundamental Analysis
- Sentiment Analysis
Technical analysis is a type of forex analysis that involves studying price charts to forecast where a currency pair will trend in the future. In other words, technical analysis is the study of price movements or price action using data, mostly found in charts.
A trader that employs technical analysis will rely on all sorts of technical indicators to better gauge the price movements and to confirm price patterns.
The most common type of technical analysis is support and resistance trading, where a support level simply represents an area on the chart from where the price was rejected at least two times. Inversely, a resistance level simply represents an area on the price chart from where the price reacted lower at least two times.
Note: Simply connect two bottoms to draw your support level and connect at least two tops to draw your resistance line.
Example of how to identify currency trends by studying charts and price movements:
The market is like a rollover coaster as it has ups and downs and never moves in a straight line. To be able to identify the market trend or market direction all you need is the price. Usually, a series of higher high and higher low swing points is considered an uptrend while a series of lower lows and lower highs is considered a downtrend.
A trader can also use trendlines, which are technical tools available on all trading platforms, to better gauge the trend.
Technical indicators are another tool that can help you make better trading decisions. One of the most common indicators used by traders is the oscillators which can signal overbought areas from where the price can possibly move lower and oversold areas from where the price can possibly rally.
In the above figure, we have an example where we used the stochastic indicator to spot possible reversal zones on the price chart. Normally when the stochastic indicator shows a reading above 80 it signals an overbought trend and a possible reversal and inversely when the stochastic indicator shows a reading below 20 it signals an oversold trend and a possible reversal.
Fundamental analysis is a type of Forex analysis that involves studying economic trends and geopolitical events that might affect the supply and demand of a currency. In short, fundamental analysis is the study of economic news and the economic outlook of the country.
The most important economic data includes:
- Interest Rates
- GDP (Gross Domestic Product)
- Unemployment Rate
Because the USA is home to the largest economy in the world, the USA macro data tends to have the biggest impact on the Foreign exchange market.
The best approach to fundamental analysis is to take it step-by-step. The first thing to understand is the most likely impact the economic news will have on the currency exchange rate. Usually, these fundamental forces that drive the market price can be the catalyst for some big trend developments in the currency market.
For example, interest rates are one of the biggest drivers of FX rates. When central banks such as the FED or the ECB change the rates the market reacts with bigger-than-usual volatility creating bigger trading opportunities.
Sentiment analysis is another form of analyzing the markets that can be used to gauge how other investors and traders feel about a particular currency pair. Sentiment analysis can be used as a contrarian indicator and the premise behind this approach is that crowds are usually wrong, so trading against them over time will pay off.
The simplest method to gauge market sentiment is to look at the COT report which provides a breakdown of how traders are positioned in the market. Normally, this strategy implies that if the majority of speculators are buying very aggressively you should take a trade in the opposite direction which, in this case, is selling.
Note: The same rule applies in the case when speculators are selling an extreme number of contracts. This means you should fade them and buy instead.
When you start trading there are a lot of variables to consider and you’ll need to work hard to find out what works best for you. There are many different ways to analyze the market, but there is no perfect method, but knowing these three types will definitely help you make better trades, and help you understand the kind of trader you are.
Once you have a firm grasp of what to look for on a price chart, all those graphs will no longer look too complicated. On the other hand, the fundamental analysis will help you capture bigger trends and subsequently bigger profits. Last but not least, sentiment analysis can give you further insights into what direction the market is more likely to move in.