There are three types of Forex analysis that traders use to analyse trends and anticipate the direction of a currency pair. Forex traders may combine different forms of analysis or specialise in one aspect to suit their trading style and personality, becoming experts at measuring price action.
Forex trading is challenging, and there's a 95% failure rate for novice traders. The primary reason for trader failure is a lack of preparation. The Forex market isn't complicated. The price goes up or down, after all. A trader's job is to be on the right side of the trade. Sounds easy? Well, if Forex were easy, we'd all be rich and coasting around on our yachts.
When you start trading Forex with real money, your emotions kick in. It's a natural human response to risk because the brain reacts in survival mode. So, the way to help reduce the emotional reactions is to have a solid plan, and analysis forms part of that plan.
In this post, we'll break down the three common forms of Forex analysis: Technical, fundamental and sentiment analysis. We'll discuss applying them to your trading plan and improve your Forex trading results.
The Three Forms of Forex Analysis
Forex fundamentals are founded on what is happening in the countries of the currency pairs you want to trade, especially interest rates, which have a significant effect on the Forex market.
Why interest rates? Because they are a good indication of the state of a country's economy. The role of a central bank is to protect its economy, so raising or lowering interest rates can influence currency prices.
Other fundamental data that affect currency prices are:
- Gross domestic products
- Employment rates
- Unemployment rates
- Economic growth activity
Novice Forex traders can find it confusing when negative fundamental news releases cause the opposite reaction with currency prices. For instance, when the United States releases non-farm payroll figures on the first Friday of each month, the US dollar price may spike if unemployment rates are higher.
But if you dig deeper, the price reactions may be dependent on anticipated figures. For example, if pre-release data suggested a 5% increase in unemployment and actual data is only 3%, that's a positive result against expectation.
When reviewing fundamental data or releases, consider how future movement of interest rates may be affected. When investors want to minimise risk, they move their money to safe-haven currencies to protect their investments. When interest rates are high, investors follow the money, although it may be a higher risk.
It's also worth checking commodities. For instance, oil prices influence the Canadian dollar.
Novice Forex traders often shy away from fundamental analysis. It may seem like a lot of work, but evaluating fundamentals can stop you from entering trades blindly. More experienced and professional Forex traders often incorporate fundamentals into their analysis as confirmation before entering a new trade.
Check Out: Forex Analysis Fundamentals
Technical analysis is the most popular form of analysis for the majority of Forex traders. It involves studying the Forex charts, looking for past and current price patterns to measure the probability of future price movement. Technical analysis helps a Forex trader to determine the best time to enter and exit a trade.
Forex is a highly liquid market with $6.6 trillion traded 24-hours, five days a week. Price action leaves clues about possible levels of supply and demand. For example, following a bullish rally in a trending market, the price may consolidate in a range.
It could take days, weeks or months before the price breaks out of the range.
Then, typically, the price will make a false breakout, indicating the direction of price.
Retail traders often get caught in these false moves because, quite often, the price bounces back into the range and then continues in the original direction. Institutional traders make significant profits from these moves. But, once a trader becomes aware of these patterns, they learn to watch and wait and follow the price action of the 'big boys.'
CAD/JPY daily chart showing a bullish market with consolidation and breakout
The image above shows a bullish, trending market. Inside the green box (consolidation area), many retail traders would have lost trades for several reasons:
- The price action shows an M pattern – most traders assume it means the price is reversing bearish
- The second top of the M pattern is lower than the first – novice traders analyse this as price rejection
- The final low is lower than the previous low – again, most retail traders assume the price is weakening.
Professional Forex traders wait until the retest of the range after a breakout, and then they take the trade.
If you want to improve your technical analysis skills, study the charts and identify multiple examples of this type of price action.
Technical traders may also use indicators as further confirmation of price direction. Though most technical indicators are lagging, they can assist in determining an optimum time to enter and exit a trade.
Sentiment analysis is another popular form of Forex analysis, but novice traders often misunderstand it.
When you see significant momentum on the charts, sentiment is driving the price action, which means that the vast majority of Forex traders have an open position.
It's easy to spot sentiment in areas of support and resistance. Traders across the globe have earmarked these zones, waiting for the price action. For instance, assuming significant numbers of traders are bullish on EUR/USD, they believe the Euro price will rise, stronger than the US dollar. The price reaches a historical zone where perhaps the price has reversed multiple times in the past, which is visible by checking the charts.
Some trading platforms show the trading volume, and others don't. You can also use a currency strength meter, which highlights weak/strong currency pairs. If prices are gathering momentum, you know the money is flowing with the sentiment.
How to use sentiment for analysis
You're aware that there are a lot of buyers for EUR/USD, and you may think you've missed the trade. But wait, these buyers have exit points. Look at the charts for the next resistance price level and watch and wait. What is likely to happen is EUR/USD will have a sharp pullback as sellers exit the market, presenting you with an opportunity to buy EUR/USD at a better price.
Forex pro trading tip:
Analyse institutional sentiment levels because it may give you a more accurate assessment of price direction. Among retail traders, remember the 95% failure rate. Most novice traders place trigger trades without proper analysis.
Institutions often trade for clients and take a more professional approach to Forex, waiting for the optimum time to enter the market.
Use the Commitment of Traders (CoT) report to analyse the institutional market and use the results to wait for the right moment to take the trade.
How To Choose The Best Form Of Forex Analysis
Quite often, new Forex traders use one form of analysis, such as technical. It's easy to learn, and with experience, you can quickly spot patterns on the charts that signal an opportunity to enter the market.
As you develop your trading skills, you will realise how to improve your results by combining fundamental, technical and sentiment analysis.
- Find a trending market – use fundamental analysis to find a strong currency, ideally paired with a weaker currency. Check interest rates or any other noteworthy economic data.
- Identify the best entry points – use technical analysis and any preferred technical indicators.
- Assess market sentiment – focus on analysing institutional sentiment because they can place significant amounts of money into the market to influence prices.
Read Also: Basic Types Of Orders In Forex Trading
Recap Of What Are The Best Forms Of Forex Analysis
There's an ongoing debate between traders regarding which form of Forex analysis is the best. Technical traders may disregard fundamentals and sentiment.
Fundamental traders won't rely on technical analysis. But no one way is best because nothing can guarantee 100% success for your Forex trades.
Technical analysis may appear logical. When you see a trendline break, a head and shoulders pattern, a double top or a double bottom, it may look like the price is rejecting a zone. But, as you progress as a Forex trader, you will learn that you cannot rely on patterns alone. It takes much more to increase probabilities, and that's what Forex trading is about, finding the highest probability trades instead of guesswork or hope.
Introduce fundamentals, assess sentiment and use technical indicators or currency strength meters. The secret to Forex success is to never rely on one thing. Always, always have a trading plan that incorporates several confirmation steps before placing a trade.
You may think that combining all three forms of Forex analysis is time-consuming, but ultimately, it could be your quickest route to consistent profits.
Please note that the above information is not providing advice on tax, investment, or financial services. We provide the above information without consideration for risk tolerance and a specific investor's financial circumstances.
Trading or investing in financial instruments such as Forex may not be suitable for all investors. It does involve risk and the possibility of a loss of capital. There are no guarantees for profiting from trading Forex, and it's advisable only to risk what you can comfortably afford to lose.
What is the best method of analysis for Forex beginners?
Most new traders find that learning technical analysis is the easiest to learn first. It doesn't take long to spot chart patterns. The best education for this is to study historical data by scrolling back through charts and identifying ideal entry and exit points. It is easier to spot perfect trades in hindsight, but it's a valuable way to become familiar with technical analysis.
How many currency pairs should I trade?
If you want to become efficient at Forex analysis, it is better to focus on two or three currency pairs. The ideal pairs to trade are the majors, the USD pairs like EUR/USD, USD/CHF, USD/CAD. Because the dollar is transparent and traded globally, applying all three forms of Forex analysis across currencies paired with the US dollar is easier.
How many Forex trades should I take every day?
Focus on quality rather than quantity, even if you are scalping Forex. Think of analysis as a way of discounting potential trades, stopping you from taking excessive risks. Most novice traders overtrade and end up losing money. With careful and systematic analysis, one or two trades a day will produce better results than twenty random trades.
What is the best timeframe to trade Forex?
It depends on your trading style and strategies. Analysing the daily chart gives a more accurate representation of a trending market. You can weigh up the fundamentals, assess the technical price action and measure sentiment by comparing the charts with your data. You can move to the 4-hour chart or 1-hour chart to look for an optimum entry and exit point when all that's done.
eToro – Best Social Trading Platform
67% of retail investor accounts lose money when trading CFDs with this provider