Types of forex analysis

There are many different ways to analyze the FX market. This lesson will explore the three most common forex analysis techniques – fundamental, technical and sentiment – and how they can help in shaping a trading strategy.

Fundamental analysis

Forex fundamentals center mostly around the currency’s interest rate. This is because interest rates have a sizeable effect on the market.

As you might remember from the previous course, other fundamental factors are included, such as gross domestic product, inflation, manufacturing, economic growth activity. However, whether those releases are good or bad is of less importance than how they affect that country’s interest rate.

Investors who are more comfortable with trading risky assets might look to open positions on currencies that offer higher interest rates. But those who are risk-averse might choose safe-haven currencies.

Here’s a look at how economic data can affect currencies based on whether expectations have been met or not:

*Developed nations welcome moderate inflation as it’s a sign of a growing economy. Developing nations view decreasing, or maintained, inflation as a positive statistic as this keeps price levels in check.

Technical analysis

As a quick reminder, technical analysis involves looking at patterns in a market’s price history to try and determine its future movement. This style seeks to find the ideal time and price level at which to enter and exit a trade.

Technical analysis is one of the most widely used types of analysis in forex. Because FX is one of the largest and most liquid financial markets, the movements on a chart from the price action generally gives clues about hidden levels of supply and demand.

Price action simply means changes in a security’s price over a given period. Technical traders rely on interpreting these movements to find trends in the market and establish the ideal price levels at which to open or close a trade.

You can also find other patterned behavior by reviewing a market’s price chart, such as which currencies are trending the strongest. An example of this can be seen below in the GBP/USD chart, where the US dollar is strengthening against the pound sterling.

You can also use indicators to help you find patterns in a chart. Many traders prefer using indicators because the signals are easy to read than if you were to try and map the movements manually.

Some of the more popular indicators are the relative strength index (RSI), moving average convergence/divergence (MACD) and average true range (ATR).

Technical versus fundamental analysis in forex is a widely debated topic. There’s no right answer to the question of which type of analysis is better, and many traders tend to adopt a combination of the two in their analysis.

Key differences between fundamental and technical analysis

Sentiment analysis

Market sentiment is another widely popular form of analysis used in forex trading. When you see sentiment overwhelmingly positioned to one direction (eg many people going long on a currency pair), this means the vast majority of traders are already committed to that position.

Perhaps this can be better explained with an example. Let’s assume that an overwhelming number of traders and investors are bullish on the euro, meaning they think it’s going to appreciate.

The IG Client Sentiment tool gives an indication of the number of people who are long on a market versus those who are short. You can normally view this when you click on a market’s chart data on our website. Here’s an example of what this looks like:

Since we know there’s a large pool of traders who have already bought (went long), then these buyers become a future supply of sellers. That makes the EUR to USD vulnerable to a sharp pull back should these buyers sell to close.

How to apply forex techniques to your trades

You can use a mix of all three types of forex market analysis. This can be done by:

Use fundamentals to assist in identifying a long-term trend

Analyzing a country’s GDP, interest rate and inflation rate gives insight into the strength of that country’s economy and by extension, their currency.

For example, if the US begins an interest rate hiking cycle, the US dollar will look attractive. If enough investors/traders buy US dollars, this will prop up the value of the USD.

Apply sound technical analysis to spot entries into the market

By using multiple timeframe analysis and an indicator like the MACD or Relative Strength Index, you can spot ideal entries into the market.

Consider client sentiment

You can analyze client sentiment either by observing the net number of traders long or short and your position based on your findings. The main takeaway, however, is that retail clients tend to trade against prevailing trends and can therefore make client sentiment a contrarian indicator.