BEST METHODS OF ANALYSIS FOR FOREX TRADING

Unless you’re using a sophisticated 100% automated trading algorithm, trading in the foreign exchange or forex market generally requires a certain amount of analysis to be successful. Forex trading also often involves using a combination of analysis methods for the most profitable results.
The Best Methods of Analysis for Forex Trading

Knowledge is power. This phrase has even more meaning to forex traders who need to rely on accurate information regarding market dynamics to make more informed decisions on their trades. Forex market analysis typically includes assessing the level of supply and demand of one currency against another and can also take many other factors into account. 

Successful forex traders usually analyze the market in a number of different ways. They might stick to one particular analysis method or use a combination of several methods to signal that they should initiate or close out their trades. The most common methods for analyzing the forex market consist of technical analysis, fundamental analysis and sentiment analysis.  

Currency traders will also typically choose a type of analysis that complements their trading style. For example, if they scan the forex market for objective trade set-ups that involve certain technical events taking place, then they would generally use technical analysis as their best and principal method for analyzing the market. 

On the other hand, if a trader bases their trades on certain fundamental factors, such as the benchmark interest rate and monetary policy of a country’s central bank, then they will probably find a fundamental analysis approach best suits them.

Some currency traders might analyze the news circulating around a particular currency pair to inform their trading activities while others might position themselves in the forex market using market sentiment indicators. 

You can find listed below some of the best and most popular analysis methods used by forex traders and a brief description of what each analysis method entails:

1. Technical Analysis

Technical analysis is one of the cornerstones of forex market analysis. It uses the basic simplifying assumption that the current market exchange rate discounts all available information available to forex traders. 

Technical analysis has the advantage over the other analysis methods of being able to provide objective buy or sell decisions that can help traders overcome their emotional impulses when trading currency pairs.  

Many technical forex traders use a currency pair’s exchange rate history to measure the levels of supply and demand in the market by identifying levels of support and resistance on exchange rate charts. Others may use technical indicators computed from market observables like the exchange rate, volume and open interest. 

Since the forex market is decentralized, however, observables like volume and open interest are less reliable and mainly come from the limited activity seen on futures exchanges. 

Fundamental analysis focuses on how currencies are affected by socioeconomic and geopolitical factors in real-world situations. Currencies trade in pairs, so a fundamental analyst should examine the underlying fundamental factors for both currencies relative to each other. 

A currency’s valuation can often be affected by the political environment in the issuing nation. For example, if a change of government is imminent in a country, then the incoming administration's policies could significantly affect its currency valuation against other currencies, especially if they seem radically different from the former administration.

Natural disasters are additional fundamental factors that can adversely affect a currency’s relative valuation since they can negatively impact the issuing country’s potential for economic growth. Examples include major events like floods, earthquakes, landslides, epidemics and hurricanes. 

While the forex market’s emphasis can and does change over time, the key economic fundamental factors that presently have the most significant effect on a currency’s relative value include:

• Employment data: A nation’s employment data has a considerable impact on a currency’s valuation. If the country has an increasing level of employment, this would indicate a strong economy and continued economic expansion. Conversely, a decrease in employment levels suggests a lagging economy that may cause the national currency to decline in value relative to other currencies. Perhaps the most closely watched economic data release by forex traders is the U.S. Non-Farm Payrolls number that usually comes out on the first Friday after the end of each month.

• Benchmark interest rates: A country’s central bank determines the nation’s benchmark interest rates according to the economic activity in the country. If a nation’s economy is very active and growing strongly, the central bank might raise interest rates to control inflation. When interest rates rise in one country versus those in other nations, demand for its currency generally rises among international investors. Also, the interest rate differential is paid or charged on a daily basis in the forex market, so it can affect the cost or benefit of holding a currency position overnight. Forex traders closely review central banker statements for hints about benchmark interest rate changes and respond quickly to unexpected rate changes.

• Inflation data: The rising cost of goods and services plays a significant role in a currency’s valuation. Rising prices can indicate that a nation’s central bank is adding too much currency into the economy, that demand is strong or that certain key commodities are experiencing supply shortages that can cause a price rise. Oil prices are one of the most important drivers of inflation since most economic activity depends on oil derivatives to deliver many products.

• Trade deficit/surplus: A nation’s status as a net exporter or net importer can influence the valuation of its currency. If a country exports more than it imports overall, then it has a trade deficit that tends to weaken its currency, while a trade surplus will tend to make its currency stronger. For example, a nation with a trade deficit might depend on other countries to obtain products and services unavailable domestically at competitive prices. Since this cross-border trade probably entails paying for the goods and services in the currency of the exporting country, it will tend to weaken the importer’s currency and strengthen the exporter’s currency.

• Gross domestic product (GDP): A nation with high GDP growth will typically reflect a strong economy, which will in turn tend to attract foreign money. This key indicator of economic strength would be one of the main contributors to an increase in the value of the country’s currency. Conversely, the currency of a country with weak GDP growth would attract less foreign investment and would therefore tend to fall in value versus the currencies of countries showing better growth prospects.   

• Commodity prices: The price of certain key commodities can play an important role in the valuation of certain currencies when their issuing nations either have a significant trade surplus or deficit in that commodity. For example, the currency of a country with an economy that is largely dependent on its oil exports can be vulnerable to an unexpected drop in oil prices. Furthermore, if the price of oil increases, then that nation’s currency would probably appreciate relative to the currencies of oil-importing nations.

Sentiment analysis is probably the least used method of analysis by currency traders since the forex market is sufficiently decentralized that no single indicator can reflect the sentiment of all market participants. 

Some forex traders might use the Commitments of Traders (COT) report issued periodically by the Commodity Futures Trading Commission (CFTC) that reflects activity in the Chicago Mercantile Exchange (CME) currency futures market as a sentiment indicator. Nevertheless, this U.S.-based exchange-traded market is relatively tiny in comparison to the huge decentralized global forex market. 

Traders can also look at client positioning data released by some online forex brokers to gauge market sentiment. While this information only reflects a small amount of overall forex market activity, it can be useful to indicate market sentiment for currency pairs without a CME-listed futures contract.

Why Do Forex Traders Analyze the Markets?

Forex traders generally use one or more market analysis methods as virtually indispensable tools to help them better understand and respond appropriately to current market conditions before making a trading decision. 

They will also typically include details about their analysis methods in their trading plan as a skillful means to suggest whether buying, selling or holding a position in particular currency pair makes sense.

Forex traders who use fundamental analysis also need to keep in mind that analyzing a particular currency pair requires taking into account the economic and geopolitical situation underlying the valuation of each currency relative to the other. They have to understand that present and future market exchange rates result from developments in a variety of fundamental factors.

These factors make monitoring and analyzing the current technical, fundamental and sentiment situation in a currency pair very important for a forex trader.  Some market analysis tips for the factors that forex traders might need to review when trading a currency pair appear below. 

Tip #1: Watch fundamental developments: Forex traders might need to monitor and analyze any new and unexpected fundamental development to determine the causes that brought about the change seen in an economic indicator or geopolitical event. 

Tip #2: Monitor market conditions: Forex traders generally need to keep in touch with market conditions. This means knowing whether they are trading in a trending, ranging or correcting market, as well as whether it is an orderly or highly-volatile market. Technical indicators like the ADX can show if a currency pair’s market is trending or ranging, while indicators like historical volatility can highlight riskier currency pairs that exhibit sharp exchange rate movements. 

Tip #3: Know the direction of the underlying trend: Since the trend is your friend, forex traders should have a good sense of whether the underlying trend in a currency pair is up, down or neutral. They should also determine if the trend seems ripe for a correction. Technical indicators like moving averages can filter out market noise to show the direction of the trend while indicators like the Relative Strength Index can help identify markets that seem ready to reverse direction.

Tip #4: Review sentiment:  Even though the forex market lacks a comprehensive market sentiment indicator, it may make sense for a forex trader to keep an eye on the COT report for a currency pair, if available. This lets them identify notable positioning situations that may have substantial implications for its future exchange rate. 

Should Every Currency Pair Undergo the Same Analysis?

One of the interesting things about the forex market is that different currency pairs can display very different market conditions at the same time. This makes the most effective form of technical analysis to use on any given currency pair a more tailored and complicated decision that can depend significantly on the way that particular currency pair is presently trading.

From a fundamental analysis perspective, some currencies have a more complex fundamental picture with multiple economic indicators to consider by an analyst compared to other currencies. This seems especially true of those currencies issued by highly developed nations like the U.S, Japan and the U.K.

When considering the fundamentals of a less well-developed nation, however, other key fundamental factors may come into account. Such factors can potentially include political instability, very high inflation levels and long- or short-term currency devaluations.

Regarding market sentiment analysis, key sentiment indicators like the COT report are only available for a relatively small subset of major currency pairs that the CME hosts futures trading on. Those trading in currency pairs without a listed futures contract have to forgo sentiment analysis or resort to using other less reliable sentiment information, such as client positioning data from a retail forex broker, for example.