There are three types of market analysis:
- Technical Analysis
- Fundamental Analysis
- Sentiment Analysis
There has always been a constant debate as to which analysis is better, but in fact, all of them need to be known. It’s kind of like standing on a three-legged stool.
What is Technical Analysis?
Technical analysis is the framework in which 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.
Someone who uses technical analysis is called a technical analyst. Traders who use technical analysis are known as technical traders.
The main evidence for using technical analysis is that, theoretically, all current market information is reflected in the price.
Technical traders generally ascribe to the belief that “It’s all in the charts!”
This simply means that all known fundamental information is priced into the current market price.
If price reflects all the information that is out there, then price action is all one would really need to make a trade.
Technical analysis looks at the rhythm, flow, and trends in price action.
A prophase ‘History tends to repeat itself’ is basically what technical analysis is all about!
If a certain price held as a major support or resistance level in the past, forex 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 could possibly act the same way that it did before.
Technical analysis is NOT so much about prediction as it is about PROBABILITY.
Technical analysis is the study of historical price action in order to identify patterns and determine probabilities of the future direction of price.
In the world of 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!
Technical analysts live, eat, and breathe charts which is why they are often called chartists.
The past data can help traders to observe the spot trends and patterns which could help to 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.
What is Fundamental Analysis?
Whereas technical analysis involves poring over charts to identify patterns or trends, fundamental analysis involves poring over economic data reports and news headlines. (And even random tweets from a certain world leader before he was banned.)
Fundamental analysis is a way of looking at the forex market by analyzing economic, social, and political forces that may affect currency prices.
It is supply and demand that determines price, or in the foreign exchange 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.
Traders have to understand the reasons why and how certain events like an increase in the unemployment rate affect 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, its 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.
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 U.S. dollars first. This increases demand for the currency.
As a result, the value of the U.S. dollar will likely increase against other currencies with lesser demand. Since currencies are always paired, their performance is determined relative to that of another currency.
What is Sentiment Analysis?
Sentiment analysis is used to gauge how other traders feel, whether it’s about the overall currency market or about a particular currency pair.
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, 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 retail traders feel about a certain trade, the forex markets can’t move in their favor. As a trader, all of them have to be taken into consideration. Sentiment analysis need to be performed.
Sentiment analysis is often used as a contrarian indicator. There are a couple of ideas why this is:
One idea behind this is if EVERYONE (or almost everyone) shares the SAME sentiment, then it’s time to go hipster and trade against the popular sentiment.
For example, if everyone and their mamas are bullish EUR/USD, then it might be time to go short.