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3 Types of Forex Market Analysis – Technical, Fundamental, Sentiment

3 Types of Forex Market Analysis – Technical, Fundamental, Sentiment

Conducting your own analysis of currency markets is one of the most critical skills you’ll develop as a Forex trader. It doesn’t matter if you’re a novice or an experienced veteran, you need to be able to look at the market objectively if you’re going to execute profitable trades.

While there are many different ways to sift through market activity, traders typically rely on three core types of analysis to understand what’s happening in foreign exchange. Each one provides a different view into what’s behind price movements and provides indicators you can use to adapt your trading strategy.

Ideally, you'll use all three holistically to derive the most realistic perspective —the key to a long a profitable trading journey.

Three types of analysis

Forex market analysis is usually conducted in three categories, each requiring different data and skills:

  1. Technical Analysis
  2. Fundamental Analysis
  3. Sentiment Analysis

Technical Analysis

Forex technical analysis looks at historical patterns in a currency’s price to work out the best time to enter or exit a trade. Not surprisingly, this often makes it the first type of analysis traders look to daily.

Because forex is the biggest and most liquid financial market, charting price movements can provide clues about levels of supply and demand that would otherwise be hidden from view. Price charts will also visualise behavioural patterns such as which direction currencies are trending most strongly.

Technical analysis can also be conducted by using indicators. Many traders opt for this approach as it arguably makes market signals easier to read, simplifying trading decisions.

Dow Theory for Technical Analysis

Much of what we now call technical analysis is based on the Dow Theory (derived from studies of the Dow Jones Industrial Average) and carries the following assumptions:

  • Price is all-important. It reflects the impact of all market forces acting in unison at any point in time.
  • Prices typically follow the direction of the trend. ‘The trend is your friend’ is a common saying among traders.
  • Price movements are historically repetitive. This results in similar behaviour on charts.

How to Identify Trends Using Technical Analysis

A market trend or market direction will often reveal itself if you analyse the movement of the price. An uptrend in price is usually indicated by a series of ‘higher high’ and ‘higher low’ swing points. A downtrend is generally indicated when a series of ‘lower lows’ and ‘lower highs’ appears on the chart.

Traders can also use trendlines in technical analysis to gain another perspective on a trend.

Fundamental Analysis

Fundamental analysis focuses on a given currency’s interest rate and the factor’s that can affect it, such as inflation, gross domestic product, manufacturing output, employment, and other measures of economic growth. Traders don’t try to make value judgements as to whether those numbers are ‘good’ or ‘ bad'; instead, they consider how the numbers might impact the currency’s interest rate.

There is a calendar of regular economic data releases that traders need to follow in order to understand how changes in the global economy might affect the future movement of interest rates.

If markets are in a higher-risk mode, investors will shift their positions to currencies that offer a higher interest rate. In that sense, higher rates could mean more demand for a currency and potentially drive its price higher in forex trading.

When investors are feeling more risk-averse, positions tend to shift to safe-haven currencies where gains may be lower. Still, overall price volatility tends to be more stable, reducing the risk of losses.

Sentiment analysis

Understanding market sentiment is the third type of forex analysis. Traders use it to understand if markets are overwhelmingly moving (or preparing to move) in one direction, and to what extent a majority of traders might be committed to that direction.

For example, if an overwhelming number of traders appear to be bullish on the Pound, it means they believe its price will go higher.

Another reason to conduct sentiment analysis is to understand better when to exit a forex trade. If a large pool of traders has already bought a currency, they will eventually become a large pool of sellers when the market indicates they should close out the trade.

In our scenario that will make the Pound vulnerable to a rapid price drop if sentiment indicates the pool of buyers is set to change course and sell.

A Fourth Option: Weekend Analysis

While not a standalone type of analysis in the strictest sense, conducting analysis on the weekend can provide a big picture perspective. As most financial markets are closed at the weekend, you can survey the landscape calmly, without having to react to situations as they are unfolding.

Weekend analysis can also help you adjust your trading strategy for the coming week, a bit like an architect preparing the blueprint for a building to ensure things go smoothly.

Putting analysis techniques to work

The best approach to market analysis is to use all three types to gain the broadest possible view of what’s happening. That means:

1. Using fundamental analysis to identify long-term trends

Looking at a country's interest rate, and economic indicators that affect it like GDP and inflation can give you insight on the strength of the economy. That can pount to likely demand for its currency.

2. Using technical analysis and indicators to find the best entry points for a trade

By applying technical analysis techniques like multiple time frame analysis, or looking at indicators like Relative Strength Index, you can find the ideal place and time to enter a trade.

3. Using sentiment analysis as final confirmation before opening a position

Observing the net number of traders going short or long can tell you where the underlying sentiment in the market is, and the future direction it might take.

Closing note

While there are many different ways to analyse the market, there is no one perfect method. The most successful traders use a combination of all three.

Once you understand what to look for on a price chart, technical analysis becomes less daunting. Fundamental analysis can help you spot the bigger trends. And sentiment analysis will give you insight into what direction the market is likely to go.