Different Types of Trading Analysis
If you're new to forex trading, you've probably read debates between people who advocate “technical analysis” as opposed to “fundamental analysis”. If so, you may wonder what these terms mean and which form of analysis is the best.
The truth is there are many tools a forex trader can use to make reasonable bets on the direction of a currency's price. And a good trader will not rule out any of them.
So here's an explanation of the different kinds of forex analysis. And here's how to combine them to have the most success.
The most basic form of analysis for any asset, including currencies, is fundamental analysis. Fundamental analysis tries to determine the direction of a currency's price based on supply and demand.
If the supply of a currency goes up while demand stays the same, you can expect the price will fall. Conversely, if demand for the currency goes up while supply stays the same, you can expect the price will rise.
So how do we know what the supply or demand for currency will be in the future?
Here's a few factors that fundamental analysis pays attention to.
Central Bank Policy
Every national currency is produced by a central bank. These central banks create currency through “open market operations”, which is a fancy term that just means “buying and selling government bonds”.
When the central bank thinks that there's too much demand for the currency and not enough supply, it creates money and uses it to buy government bonds. This increases the supply of currency and pushes down its price.
When it thinks that the supply of currency is too high and demand is too low, it sells the government bonds and destroys the money that it gets from the sale. This shrinks the supply of currency and pushes up its price.
The financial media calls this creation and destruction of currency “lowering interest rates” or “raising interest rates”.
This is because a higher supply of currency leads to lower borrowing costs and a lower supply of currency leads to higher borrowing costs.
But from the perspective of fundamental analysis, the important thing to understand is that supply and demand drives the price of currencies. And central banks determine the supply of currencies.
So what determines the demand for currencies? This is where the other factors in fundamental analysis come in.
In the early days of forex trading, analysts used to pay a lot of attention to the “balance of trade” report for each country.
If a country increased its exports and decreased its imports, traders expected that the currency from that country would increase in value. This is because the demand for the currency would increase as people bought products from that country.
In recent years, more and more investors have sought to buy assets from countries other than their own, and these “investment flows” have been more important than trade flows.
But the trade report is still important for countries that are very export-driven. And even countries with consumption-based economies can't completely ignore it.
If a country has rising unemployment, it means that consumers don't have much money to buy products. In such a case, businesses are not going to do very well. This means that foreign investors are not going to want to buy stocks from that country.
Tax revenue will also fall. This means that foreign investors will not want to buy the government's bonds. As a result, demand for the currency will fall.
In addition, the central bank is likely to cut interest rates to try to help businesses get out of debt and create new enterprises to hire people again. This will make foreign investment demand fall even more because investors don't like to be paid low interest rates.
Because of this, fundamental analysts pay a lot of attention to unemployment reports. If unemployment goes down, this is a sign that the currency may go up. If unemployment goes up, this is a sign that the currency may go down.
If a country has rising prices, it's a sign that the supply of that country's currency is outstripping demand. This can lead forex traders to believe that the central bank will raise interest rates (reduce supply). So this can cause the currency to go up in value.
On the other hand, if traders believe that the central bank is not taking the inflation seriously enough, it can cause a vicious cycle in which the currency sells off...causing inflation...causing a further selloff...causing more inflation..rinse, repeat.
Regardless of how it is ultimately interpreted by the markets, paying attention to inflation reports is an important part of fundamental analysis.
Fundamental analysis seeks to understand the direction of a currency's price based on supply and demand. It is an important part of a trader's arsenal of tools.
While fundamental analysis can give you a “big-picture” view of the direction of a currency, it isn't good enough by itself.
This is because the conclusions reached by fundamental analysis may take months or years to come to fruition.
So you need some means of deciding where a currency will head in the short-term, which may or may not be the same direction as the long-term.
So how do you know where the price of a currency will go in the short term?
Well, you just read the minds of Forex traders all over the world. Once you know what they're thinking, you know when they will buy or sell.
Oh wait...you're not psychic?
Don't worry, you don't really have to have telepathic powers to understand the minds of traders. All you have to do is look at the behavior of the price in the past. The hopes, dreams, and fears of every forex trader in the world is right there.
All you have to do is know how to see it.
For example, take this long-term chart of XAU/USD. This is gold priced in US Dollars.
Even though it's not produced by a central bank, gold's history of use as money has led many forex traders to consider it a “currency” of sorts. And most forex brokers allow their clients to trade it alongside other currencies.
Anyway, here's the chart.
See the descending diagonal red line that stretches from 2011 to the present? Since 2011, every time the price has hit this line it has gone into a downtrend.
The first time was in 2011. Then it hit this line again in 2012 and fell. In 2016, it once again tried several times to break above this line. But ultimately, it failed and crashed again.
You can see a similar circumstance with the ascending diagonal red line below the price.
In this case, the line represents a series of points below which the price seems unable to fall. The price tried to go below this line in December, 2015 and December, 2016. Both times it failed and went into an uptrend.
What accounts for this spooky behavior?
The answer is actually quite simple. Many traders have adopted the belief that gold will always fall anytime it gets to the descending red line. So when the price gets to this line, they sell and the price falls.
Meanwhile, another group of traders have adopted the belief that gold will always rise when it hits the ascending red line on the chart. So anytime the price gets to this level, they buy. This pushes up the price.
So if you see that these trend-lines exist, a good trading strategy is to buy every time the price hits the uptrend line and sell every time the price hits the downtrend line.
Of course, this analysis isn't perfect. Maybe the next time the price gets to the downtrend line, it breaks straight through it and keeps going up. Or maybe it crashes through the uptrend line and keeps falling.
And maybe this is because traders have changed their beliefs or because new people have started trading that have different beliefs.
But at least it gives you an increased chance of success as compared to someone who doesn't know this information.
There are many different indicators or tools that you can use for technical analysis: bollinger bands, trendlines, support & resistance, RSI, MACD, etc.
But they all have in common the fact that they use past price action to predict the behavior of buyers and sellers in the future.
Technical analysis can't 100% predict the price. But combined with fundamental analysis, it can give a trader a much better chance of success than would be possible otherwise.
Like technical analysis, sentiment analysis is another way to “get into the heads” of forex traders to determine what their behavior will be in the future.
But instead of looking for places where they might buy or sell, a sentiment analyst tries to determine where traders might operate in a kind of collective delusion where they believe something to be true that isn't.
For example, let's say that the economy of the tiny country of Tuvalu starts doing really well. And all of the sudden, a small group of currency traders start buying up all of the Tuvaluan Dollars they can possibly get their hands on.
At some point, other currency traders start seeing that the price is rising, so they start buying Tuvaluan Dollars too. This continues until nearly everyone wants to buy Tuvaluan Dollars and almost no one wants to sell.
From a sentiment analysis perspective, there is one big problem with this predicament: once everyone who wants Tuvaluan Dollars has bought, where are the new buyers going to come from that are needed to keep pushing up the price?
As you can probably guess, these kinds of situations end badly for the traders involved in them.
But if you are the one trader who sees ahead of time that this happening, it can mean enormous profits for you.
So how do you know if there is a mania brewing and it's time to short what everyone else is buying?
The best way of doing this is to take a look at the Commitment of Traders Report published by the Commodity and Futures Trading Commission, found here. The CFTC publishes the CoT report every Friday. It contains info from the week ending the Tuesday before the publication date.
So it must be kept in mind that it does not contain information about trades entered into in the last three days of the current trading week.
The report shows how many open contracts exist from speculators who are long a particular currency and how many have open short trades. If you watch this report every week, you can get a feel for what is a “normal” ratio of shorts/longs.
If the number of longs goes to an extremely high level as compared to the average, there's a good chance the price will soon crash.
On the other hand, if the number of shorts is far beyond it's average level, there's a good chance the price will soon rally.
Of course, just like every other kind of analysis, sentiment analysis is not 100% accurate.
Sometimes manias continue for a very long time and you would have been better joining the mania (with a stop, of course!) then waiting around hoping for a chance to profit from a crash.
But still, combined with other forms of analysis, sentiment analysis can be a valuable tool for a trader to use.
Now that you know these three kinds of analysis, let's delve deeper into technical analysis by discussing how to interpret charts.