Updated on September 2023 by Sharon Lewis.
As a trader analysing financial markets, it is important to have a solid approach to making trading decisions and placing trades to build a solid strategy. Understanding the three main types of forex market analysis – technical, fundamental, and sentiment – can help you construct a stronger trading strategy.
Deciding which type of analysis to use when trading forex is important. Each type of analysis has its own strengths and weaknesses, and an understanding of all three can provide a well-rounded view of the market.
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 can 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 is a method of evaluating markets by studying past data, mainly price and volume. Technical analysts believe that by looking at historical price data, they can identify patterns that will help them predict future market behaviour.
There are many analysis 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
Example: Technical Analysis of GBP/USD
Here’s an example of how technical analysis can be used to study the price movements of GBP/USD. Remember that this is meant to give you an idea of what technical analysis looks like in practice and should not be thought of as trading advice.
- Open the GBP/USD chart for historical price information.
- Choose the technical indicators you want to use for analysis. Common ones for currency pairs include Moving Averages, Relative Strength Index (RSI), and Bollinger Bands.
- Calculate and plot the selected technical indicators on the chart. For example, you can plot the 50-day and 200-day moving averages.
- Analyse the chart to identify trends, such as uptrends, downtrends, or sideways movements. Pay attention to how the price is changing in relation to the moving averages.
- Search for common chart patterns like head and shoulders, double tops/bottoms, or flags that may indicate future price movements.
- If you’re using oscillators like RSI, look for overbought or oversold conditions that might suggest potential reversals.
- Based on your analysis, determine entry and exit points for trading or investment.
- Implement risk management strategies like setting stop-loss orders to limit potential losses.
- Choose to go long or short and place your trading order accordingly.
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 is a technique that is used to evaluate a market by looking at the underlying economic and financial factors that might impact that market. 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 to make informed decisions. While there are many ways to analyse forex markets, fundamental analysis is one of the most popular methods among traders.
Traders who use a fundamental analysis approach would monitor and analyse the following:
- Central bank events: This would include central bank policy decisions, statements and press conferences, the publication of central bank meeting minutes, and speeches from the major central bank committee figures. 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 of those economies. US economic data can especially impact economies across the world. 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 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), and 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.
Example: Fundamental Analysis of S&P 500
Take this example of analysing the price movements of the S&P 500 index in the context of an upcoming Federal Reserve interest rate decision. Keep in mind that this is only an example and should in no way be construed as trading advice.
- Collect information about the upcoming Fed interest rate decision, including the previous and expected outcomes.
- Familiarise yourself with key economic indicators that influence the Fed’s decisions, such as inflation, employment data, and GDP growth.
- Assess how the market is currently pricing in the expected rate decision. This can be done by examining futures markets and options pricing.
- Review historical data to see how the S&P 500 has reacted to previous interest rate decisions. Look for patterns or trends.
- Consider the broader economic outlook, including factors like trade tensions, fiscal policies, and global events that could impact the stocks and indices.
- Estimate how the Fed’s decision might affect corporate earnings, borrowing costs, and consumer spending, which in turn can impact the S&P 500.
- Based on your analysis, form a conclusion about whether you believe the S&P 500 will rise or fall in response to the Fed’s interest rate decision.
In this example, findings from the fundamental analysis can also be combined with an analysis of market sentiment by monitoring news sentiment, investor sentiment surveys, and social media discussions related to the Fed’s decision.
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 forecast future market trends (remember that no forecast is 100% accurate) 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 (say, the US Dollar) or a currency pair (such as EUR/GBP). It is the crowd psychology of a currency market, its tone or 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 your 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 a currency.
Example: Sentimental Analysis of Google’s Stock
Here’s an example of using sentimental analysis when trying to gauge how the stock price of a company might move. Remember that this is not trading advice and should be seen as an example only.
Moreover, not all the tools you need for this kind of analysis can be easily available – bear this in mind when charting your approach to understanding market sentiment.
- Collect textual data from various sources such as news articles, social media posts, earnings reports, and financial forums related to Google’s stock.
- Natural language processing tools can help you clean and preprocess text data by removing stop words and punctuation and converting text to lowercase.
- Sentiment analysis tools or libraries can assign sentiment scores (positive, negative, or neutral) to each piece of text.
- Calculate aggregate sentiment scores for Google’s stock by summing or averaging the sentiment scores of all collected data.
- Analyse sentiment trends over time to see how public perception of Google’s stock has been changing.
- Consider the context of major news events or corporate developments that may have influenced sentiment.
- Interpret the sentiment analysis results to understand how positive or negative sentiment might impact Google’s stock price.
In this case too, stronger inferences can be made by combining sentiment analysis results with other forms of analysis for a comprehensive view of Google’s stock.
Which Type of Analysis is Best for Forex Trading?
Some traders are purists and may prefer to just use one type of analysis. For instance, they may concentrate on technical analysis, looking only at the charts to make trading decisions.
Other traders may prefer to focus on market fundamentals to make trading decisions. And some others rely heavily on market sentiment.
Traders can also 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.
Take time to explore these types of analyses and educate yourself about them. This will enable you to find an approach that best resonates with your trading style.
Good luck with your analysis and trading!