What’s it gonna be? The red pill, the green pill, or the blue pill?
3 Types of Forex Market Analysis
By now you’ve learned some history about the forex, how it works, what affects the prices, blah blah blah.
This is all obviously super important, but know that you’re now thinking…
Well say no more friends because here is where your journey as a forex trader begins…
This is your last chance to turn back…
Take the red pill, forget everything, and we’ll take you back to where you were before.
You can go back to living your average life in your 9-5 job and work for someone else for the rest of your life…
You can take the green pill, which is fully loaded with the dollar extract, and learn how you can make money for yourself in the most active market in the world, simply by using a little brain power.
Just remember, your education will never stop. Even after you graduate from the School of Pipsology, you must constantly pursue as much knowledge as you can, so that you can become a true FOREX MASTER!
The learning never ends!
Are you ready to make that commitment?
Now pop that green pill in, wash it down with some delicious chocolate milk, and grab your lunchbox… the School of Pipsology is now in session!
Three Types of Forex Market Analysis
To begin, let’s look at three ways on how you would analyze and develop ideas to trade the market. There are three basic types of forex market analysis:
- Technical Analysis
- Fundamental Analysis
- Sentiment Analysis
There has always been a constant debate as to which analysis is better, but to tell you the truth, you need to know all three.
It’s kind of like standing on a three-legged stool.
If one of the legs is weak, the stool will break under your weight and you’ll fall flat on your face.
The same holds true in trading.
If your analysis on any of the three types of trading is weak and you ignore it, there’s a good chance that it will cause you to lose out on your trade!
Technical analysis is the framework in which forex traders study price movement.
The theory is that a person can look at historical price movements and determine the current trading conditions and potential price movement. The main evidence for using technical analysis is that, theoretically, all current market information is reflected in price.
If price reflects all the information that is out there, then price action is all one would really need to make a trade.
Now, have you ever heard the old adage, “History tends to repeat itself“?
Well, that’s basically what technical analysis is all about! If a price level held as a key support or resistance in the past, traders will keep an eye out for it and base their trades around that historical price level.
Technical analysts look for similar patterns that have formed in the past, and will form trade ideas believing that price will act the same way that it did before.
In the world of currency trading, when someone says technical analysis, the first thing that comes to mind is a chart. Technical analysts use charts because they are the easiest way to visualize historical data!
You can look at past data to help you spot trends and patterns which could help you find some great trading opportunities.
What’s more is that with all the traders who rely on technical analysis out there, these price patterns and indicator signals tend to become self-fulfilling.
As more and more forex traders look for certain price levels and chart patterns, the more likely that these patterns will manifest themselves in the markets.
You should know though that technical analysis is VERY subjective.
Just because Ralph and Joseph are looking at the exact same currency chart setup or indicators doesn’t mean that they will come up with the same idea of where price may be headed.
The important thing is that you understand the concepts under technical analysis so you won’t get nosebleeds whenever somebody starts talking about Fibonacci, Bollinger bands, or pivot points.
Now we know you’re thinking to yourself, “Geez, these guys are smart. They use crazy words like ‘Fibonacci’ and ‘Bollinger’. I can never learn this stuff!”
Don’t worry yourself too much. After you’re done with the School of Pipsology, you too will be just as… uhmmm… “smart” as us.
Fundamental analysis is a way of looking at the forex market by analyzing economic, social, and political forces that may affect the supply and demand of an asset.
If you think about it, this makes a whole lot of sense! Just like in your Economics 101 class, it is supply and demand that determines price, or in our case, the currency exchange rate. Using supply and demand as an indicator of where price could be headed is easy. The hard part is analyzing all of the factors that affect supply and demand.
In other words, you have to look at different factors to determine whose economy is rockin’ like a Taylor Swift song, and whose economy sucks.
You have to understand the reasons of why and how certain events like an increase in the unemployment rate affects a country’s economy and monetary policy which ultimately, affects the level of demand for its currency.
The idea behind this type of analysis is that if a country’s current or future economic outlook is good, their currency should strengthen.
The better shape a country’s economy is, the more foreign businesses and investors will invest in that country. This results in the need to purchase that country’s currency to obtain those assets.
In a nutshell, this is what fundamental analysis is:
For example, let’s say that the U.S. dollar has been gaining strength because the U.S. economy is improving. As the economy gets better, raising interest rates may be needed to control growth and inflation.
Higher interest rates make dollar-denominated financial assets more attractive.
In order to get their hands on these lovely assets, traders and investors have to buy some greenbacks first. As a result, the value of the dollar will likely increase.
Later on in the course, you will learn which economic data points tends to drive currency prices, and why they do so.
You will know who the Fed Chairman is and how retail sales data reflects the economy. You’ll be spitting out global interest rates like baseball statistics.
But for now, just know that fundamental analysis is a way of analyzing the potential moves of a currency through the strength or weakness of that country’s economic outlook. It’s going to be awesome, we promise!
Earlier, we said that price action should theoretically reflect all available market information. Unfortunately for us forex traders, it isn’t that simple.
The forex markets do not simply reflect all of the information out there because traders will all just act the same way. Of course, that isn’t how things work.
This is why sentiment analysis is important. Each trader has his or her own opinion of why the market is acting the way it does and whether to trade in the same direction of the market or against it. The market is just like Facebook – it’s a complex network made up of individuals who want to spam our news feeds.
Kidding aside, the market basically represents what all traders – you, Warren Buffet or Celine from the donut shop – feel about the market.
Each trader’s thoughts and opinions, which are expressed through whatever position they take, helps form the overall sentiment of the market regardless of what information is out there.
The problem is that as retail traders, no matter how strongly you feel about a certain trade, you can’t move the forex markets in your favor. Even if you truly believe that the dollar is going to go up, but everyone else is bearish on it, there’s nothing much you can do about it (unless you’re one of the GSs – George Soros or Goldman Sachs!).
As a trader, you have to take all this into consideration. You need to perform sentiment analysis.
It’s up to you to gauge how the market is feeling, whether it is bullish or bearish.
Then you have to decide how you want to incorporate your perception of market sentiment into your trading strategy.
If you choose to simply ignore market sentiment, that’s your choice. But hey, we’re telling you now, it’s your loss!
Being able to gauge market sentiment aka sentiment analysis can be an important tool in your toolbox.
Later on in school, we’ll teach you how to analyze currency market sentiment and use it to your advantage, like Jedi mind tricks.
Which Type of Analysis for Forex Trading is Best?
Ahhhh, the million dollar question….
Throughout your journey as an aspiring forex trader you will find strong advocates for each type of analysis. Do not be fooled by these one-sided extremists! One is not better than the other…they are all just different ways to look at the market.
At the end of the day, you should trade based on the type of forex analysis you are most comfortable and profitable with.
To recap, technical analysis is the study of currency price movement on the charts while fundamental analysis takes a look at how the country’s economy is doing.
Market sentiment analysis determines whether the market is bullish or bearish on the current or future fundamental outlook.
Fundamental factors shape sentiment, while technical analysis helps us visualize that sentiment and apply a framework to create our trade plans. Those three work hand-in-hand-in-hand to help you come up with good forex trade ideas.
All the historical price action and economic figures are there – all you have to do is put on your thinking cap and put those analytical skills to the test!
Let me pull out that three-legged stool again just to emphasize the importance of all three types of analysis.
Take out one or two legs of the stool and it’s going to be shaky, right?!
In order to become a true forex trader, you will need to know how to effectively use these three types of forex market analysis.
Don’t believe us?
Let us give you an example of how focusing on only one type of analysis can turn into a disaster.
- Let’s say that you’re looking at your charts and you find a good trading opportunity.You get all excited thinking about the money that’s going to be raining down from the sky.You say to yourself, “Man, I’ve never seen a more perfect trading opportunity in GBP/USD. I love my charts. Mwah. Now show me the money!”
- You then proceed to buy GBP/USD with a big fat smile on your face (the kind where all your teeth are showing).
- But wait! All of a sudden the trade makes a 100 pip move in the OTHER DIRECTION! Little did you know, one of the major banks in London filed for bankruptcy! Suddenly, everyone’s sentiment towards Britain’s market turns sour and everyone trades in the opposite direction!
- Your big fat smile turns into mush and you start getting angry at your charts. You throw your computer on the ground and begin to pulverize it. You just lost a bunch of money, and now your computer is broken into a billion pieces.And it’s all because you completely ignored fundamental analysis and sentimental analysis.
(Note: This was not based on a real story. This did not happen to us. We were never this naive. We were always smart forex traders…. From the overused sarcasm, we think you get the picture.)
Ok, ok, so the story was a little over-dramatized, but you get the point.
Remember how your mother used to tell you as a kid that too much of anything is never good?
Well you might’ve thought that was just hogwash back then but in forex, the same applies when deciding which type of analysis to use.
Don’t rely on just one.
Instead, you must learn to balance the use of all of them. It is only then that you can really get the most out of your trading.
Where do we go from here?
Now that you’re done with Kindergarten and learned a little bit about each type of analysis, it’s time to delve much deeper! Here’s what’s in store for the next few years of your life…
We’re kidding, we’re kidding! We’re talking about the next few school years in the School of Pipsology.
Elementary school will be all about basic technical analysis tools.
You’ll learn all about the dynamics behind price action, such as support and resistance levels, candlestick formations, and common chart patterns.
You’ll experiment with leading and lagging indicators and discover how to use them in coming up with trade ideas. Sounds pretty exciting, doesn’t it?
The remaining years of Middle School and High School are devoted to studying more technical analysis tools.
We’ll take a look at the more advanced forex tools also such as pivot points, divergences, Elliott Wave Theory, and Gartley patterns.
Sounds fancy? It’s because they are! Bet you can’t wait to get started on those!
College will be a bit more complicated since you’ll be tackling both fundamental and market sentiment analysis at the same time.
Talk about hitting two birds with one stone! You’re the stone and the birds are… well, you get the point.
A couple of reasons why we’re putting fundamental and market sentiment analysis together:
- By the time you reach college, you’ll be so hooked on learning more about forex that one lesson simply won’t be enough.
- It is hard to draw the line between fundamental analysis and market sentiment analysis, but you’ll get there with deliberate practice.
As we mentioned earlier, fundamental factors are mostly responsible for shaping forex market sentiment.