There are various ways to analyze the forex market. Though there are various methods to analyze the market the sole purpose of all forms of analysis is the same i.e. to find out the good trading opportunities within the market. When broadly classified, there are three main ways of forex market analysis. They are Fundamental analysis, Technical analysis and sentiment analysis. Let’s look at these types of analysis in details.
In finance, Fundamental analysis is the analysis of business’s financial statements (Usually to analyze the business’s assets, liabilities, and earnings). This definition seems much valid in the case of stock market. But when analyzing the futures and forex market, fundamental analysis is about analyzing the over all state of the economy. As a forex trader, one will basically consider the factors like interest rates, production, employment, GDP, housing, manufacturing, and many more. In short, fundamental analysis in forex market is trying to know if the country’s economy is doing well because country’s currency value is directly affected by the country’s economic conditions.
Fundamental analysis studies the political, economical, sociocultural and physical environmental factors that have an impact on the Forex market. These factors are important because market actually react to these information generated by these factors. Long term trends on the markets and huge moves are observed because of the fundamental factors behind it. Fundamental reports act as a catalyst in the market creating high volatility. Economic forces, economic indicators, fundamental announcements, geopolitical environment, and human psychology are mainly responsible for driving the prices.
While we talk about fundamental analysis we look at the market moving economic indicators. Economic indicators can have a great impact on the foreign exchange market. Knowing how to use that information can increase profitability of the traders. Those economic indicators are released in a specific interval of time. One can know the dates and time of the release of economic indicators by looking at the economic calendars which are freely available on the internet. Now let us look at the some of the most important market moving economic indicators.
- Interest Rate Decision
Interest rates are generally adjusted by the central banks of the countries. The main motive of the adjusting the interest rate is to control the inflation. Inflation is controlled by controlling the supply of money in the economy. If the inflation is high, central bank increases the interest rate which will gradually decrease the money supply in the economy because increasing interest rates means loan is being expensive and the deposits becoming attractive. This will decrease the money supply in the economy making the value of the currency stronger and the inflation to fall.
- Employment Situation Report
Employment data are usually released by the department of labor. It deals with the employment situations of the country. These are the data that are concerned with the employment situations.
- The unemployment rate:
Unemployment rate reflects the number of unemployment people expressed in terms of percentage. Unemployment rate seriously have a huge impact on the economy so does in its currency. High employment rate is always favorable in the economy while the low employment rates are unfavorable situations. And the currency value also falls as the job market declines.
- The Non-farm Payroll
Forex market tends to be highly volatile during the release of NFP data. NFP is the statistics released by the U.S. Bureau of Labor Statistics whose objective is to represent the total numbers of paid U.S. workers of any business, excluding the following workers:
-General government workers
-private household employees
-Workers of nonprofit organization that provide assistance to individuals
- Average workweek
This data represent the average number of hours per week worked by the employees in the non-farm section.
- Average hourly earnings
This data represents the average hourly earning rates of the employees working in the major industries.
- Consumer Price Index (CPI)
CPI is the major tool for knowing the inflation of a particular country. Inflation is rise in the generalprice level. Broadly speaking, when the CPI report is positive country’s currency reacts bullish to it and vice versa.
- Gross Domestic Product (GDP)
GDP stands above the rest of the economic indicators. GDP reflects the aggregate measure of total economic production within a country during a specific amount of time. GDP includes personal consumptions, Government expenditures, private consumptions and foreign trade balance. GDP extremely covers wide area of economy so it is one indicator that says a lot about the health of the economy. Positive gross domestic product releases are good for the foreign exchange traders since good GPD means the stronger economy.
Fundamental analysis can be very useful for the long term investors. A day trader might find the fundamental analysis quite useless. Fundamental analysis helps to have a bigger picture of a currency or where the currency is heading in the long run. Fundamental analysis works best for the position traders.
Technical analysis is another great form of analysis. Technical analysis is study of price action of the market itself rather than the goods. Technician believes that “the market is always right.” In another words, rather than trying to consider all the factors that will influence the demand for assets, cost of assets and supply curve to determine the price of a security, technician believes that all of these factors are already factored into the demand and supply curves and, thus, the price of the security. Financial security’s price is influenced by psychological factors as well. Greed, Fear, cognitive bias, misinformation, expectations, and other factors enter in to the price of a security, which probably makes the analysis of the factors nearly impossible. The technical analyst, thus, disregards all these factors and focus on price with the intention of finding secrets in that action that have predictive potential.
Though technical analysis is thought to be an ancient method of analyzing markets and prices, its history has been poorly recorded. We do not have recorded evidence of technical analysis being used in ancient times, but it is conceivable that technical analysis, in some form, was used in the distant past in freely traded markets.
Principles of Technical Analysis
A fundamental principle of technical analysis is that a market’s price reflects all necessary information; therefore their analysis looks at the history of a security’s trading pattern rather than external drivers like economic, fundamental and other happenings. Therefore, price action is likely to repeat itself due to investors collectively tending toward patterned behavior – hence technical analysis focuses on identifiable trends and conditions. Following are the basic principles of technical analysis.
a) Market action discounts everything
Based on the assumption that all market related information is already reflected by prices, technicians believe it is crucial to understand what investors think of that information, known and perceived.
b) Prices move in trends
Technical analysts believe that prices have directions, that is up, down, or sideways (flat). The basic definition of a price trend was originally put forward by Dow Theory.
c) History tends to repeat itself
Technical analysts believe that investors collectively repeat the behavior of the investors that had been previously shown by the previous investors. For a technical trader, the emotions in the market may seem random, but they exist. Investor behavior repeats itself so often; technicians believe that recognizable (and predictable) price patterns will keep occurring on the price chart. Technical analysis is not just limited to the price charts, but it also considers the price trends and directions. For example, many technical believers monitor surveys of investor sentiment. This research gauges the attitude of market participants, specifically whether they are bullish or bearish. Technical traders use these surveys to help determine whether a trend will continue or if a reversal could develop; they are most likely to anticipate a change when the surveys report extreme investor sentiment Surveys that show extremely bullishness.
Though technical analysis was widely used by practitioners, its popularity was not mirrored in the academic community. But as the time passed by, academic community also agreed to the fact that the technical analysis helps in market forecasting.
When trading in the forex market one should actually know who the market participants are and what they think of the market. Each market participants have their own view of the market whether bullish or bearish. Market actually reflects what all trader, me, you, pros, and all other market participants think about the market. As a retail trader, no retail trader can move the forex market. For example if you are highly bullish with the EUR/USD it doesn’t matter to the market. So we should know who the big players are and can follow them in order to be in the right direction of the market.
Now we should understand that each type of analysis has its own benefits and specialty. As a trader, blending all these three types of analysis gives the best result. It would be dumb to trade without caring any aspects of the fundamentals while it would be really absurd to trade without having the technical knowledge of the markets.