Now that you know what forex trading is, and you know how to choose the best broker, you may be tempted to indulge directly in demo trading. But we advise you to learn the types of forex trading analysis first. This will help you as you demo-trade appropriately. Remember that your ability to analyze the market and make appropriate decisions will be determined from your demo trading. If you cannot make good analysis while demo trading, what makes you think you can trade with actual money when stakes and emotions are high? The three approaches of forex trading analysis are: technical, fundamental, and sentiment analysis.
Technical Analysis
The technical analysis approach is where you critically observe the movements of prices in the market.
In finance and economics theory, historical prices of a product determine current trading behaviors. Investors often use historical price movements to make judgments on possible future movements of prices in the forex market.
In theory, it is also said that the market conditions are reflected in prices. For example, if the price of USD is rising, it is theoretically presumed that the market conditions in the U.S. are positive. This is only in theory, and can be proved through fundamental analysis.
They say history determines the present and the future. Thus, historical prices of currencies affect current trading behaviors and decisions. They also guide future plans of investors. Past prices of a product help in planning and forecasting the future movements of prices.
In technical analysis, traders base their trades on the historical prices of currency pairs.
You mostly use charts or graphs, which are abundantly available in your broker’s trading platform. These graphs show historical prices of currency pairs. They usually cover a specific period such as the last one hour, 1 day, 1 week, 1 month, etc.
In technical analysis, savvy forex traders look at these graphs to identify past patterns as a basis for making forex trade decisions in the present. In this case, you buy or sell a currency pair based on historical movements of prices, hoping that the price will behave in a similar manner as before. If for instance, the price was historically rising, you buy the pair, hoping that it will continue rising.
The advantage of technical analysis in forex trading is that there are so many people relying on it. If many traders use technical analysis, price movements and market signals will always be self-fulfilling. As traders look for price patterns, these patterns will most likely be reflected in market prices. This reduces volatility in the market prices.
The greatest disadvantage of technical analysis in forex trading is that it is highly subjective. Different people could have different ideas of how prices will change based on the same chart patterns and signals.
Fundamental Analysis
This is a more objective approach to forex trading analysis. Fundamental analysis in forex trading refers to the process of analyzing the economic, political and social factors that could affect price movements in the forex market.
There are various factors in the political economy of a country that often shape the demand and supply of that country’s currency. In Microeconomic Theory course ECON100, you learned about the factors that affect the demand and supply of a product. If you did not attend an economics class, there is no need to panic. Just know that the forces of demand and supply affect currency exchange rates in the forex market.
It is easy to forecast prices using demand and supply. For instance, unemployment rate is an economic factor that affects the demand and prices of a product. For instance, when unemployment rate increases, the economy is likely to decline. This weakens the country’s currency relative to the country whose currency it is paired with.
If you have EUR/USD pair, and the unemployment rate in the U.S. increases, the U.S. dollar will be weak compared to the Euro. In this case, you will sell the dollar and buy the Euro, expecting the Euro to become stronger.
As the economy becomes stronger, central banks raise interest rates to control inflation and growth. Higher interest rates make assets in the country or region more attractive, leading to increased value of the said currency in the country or region.
Other economic issues to look at in fundamental analysis include: GDP, interest rates, fiscal and monetary policies, Federal Reserve or Central Bank decisions, etc.
In a nutshell, the fundamental analysis in forex trading involves looking for opportunities in the forex market based on the economic outlook of a country.
Sentiment Analysis
Sentiment analysis basically involves the use of opinions and gut feelings to make a trade. This is the most subjective of all three methods of forex trading analysis.
Based on the fundamental analysis approach, price should theoretically reflect the market conditions. However, each participant in the forex market has their own perspective on why the market behaves in a specific manner.
The maxim behind sentimental analysis is that the forex trade market combines the feelings of multiple investors about the market. You, Warren Buffet, George Soros, Michael Marcus, Joe Lewis and your neighbor converge in the forex market. Each individual has their views and attitudes about the market.
The thoughts and attitudes of each individual in the forex market are reflected in how they trade – whether they go long or short; take profit and accept loss; or do nothing at all. All these behaviors combined form the sentiment of the market.
Considering that there is an extremely large number of traders, your sentiment alone cannot move the market; whether you are right or wrong about the market conditions. In this regard, you will be obliged to follow the market sentiment to succeed.
Even if you are confident that the U.S. Dollar is losing value, and you are right about it, but all other investors believe that the dollar is gaining, you will do nothing to make the dollar to move in your favor. So, you will follow the market sentiment and execute a buy order.
The world is not always fair; so isn’t the world of forex trading. You can decide to follow your “right” sentiment at your own peril. Don’t come here crying when your trade tumbles, you have been warned.
Which Type of Forex Trading Analysis is the Best?
None but ALL.
Every human being always has a position that they support. In forex trading, various investors favor one of the methods of analysis over the other. Each forex trader, as a human being, has a unique way of looking at things, including the forex market.
Fundamental factors in the market influence individual sentiments of investors, which collectively form the market sentiment. The technical analysis provides a visual summation of the market sentiment.
Thus, all the three types of analysis in forex trading is part of the whole continuum, and none works perfectly without the others. It is upon you as a trader to find a strategy that is most comfortable to you. Most often, the most successful forex trading strategies combine the three types of analysis.
However, one of the three types of analysis in forex trading can take preference over the others.
If you choose the technical analysis for example, you will examine the historical prices of your preferred currency pair from the charts. You then determine whether the price is going to rise or fall.
Before trading, though, consult the fundamentalists and the sentimentalists. For example, if your technical analysis shows that the price of a dollar is likely to rise, you decide to buy. But before buying, you look at the fundamental factors in the market. Perhaps there was a terrorist attack on White House a few minutes ago, and that will most likely affect the U.S. economy negatively. If you ignore this fundamental factor, my fellow investor, prepare for a downside loss.
As a trader, my strategy always starts with the technical analysis; but yours does not need to. In the end, we must all analyze the sentimental, fundamental and historical factors in the forex market if we need to survive in this business.
