What Is Forex Analysis?
Forex analysis examines the changes in currency pair prices, and attempts to isolate which direction prices are going and where they may go in the future. In the forex market, traders buy and sell currencies with the goal of making a profit. The foreign exchange market, the largest market in the world, handles over $5 trillion in daily trading.
Banks, commercial companies, investment management firms, hedge funds, and traders use forex analysis to determine the best trade for a currency pair at any given time. Some forex analysis is manual, some is performed by computers with software which analyzes historical data. Some traders use a combination of manual analysis and computer-driven analysis.
- Forex analysis is the study of determining whether to buy, sell, or wait on trading a currency pair.
- Currencies trade in pairs, with the exchange rates based on the price of one currency relative to the other.
- Major types of analysis include technical and fundamental, with sentiment and statistical analysis potentially being used by both technical and fundamental analysts/traders.
- Most forex trading occurs in pairs involving a handful of currencies.
Understanding Forex Analysis
The forex market is open 24 hours a day, five days a week, and currencies are traded worldwide among the major financial centers including London, New York, Tokyo, and Australia. There is always a major global market open somewhere, which means there are always buyers and sellers for currencies at any time during the week.
There are many different currencies, and currencies always trade in pairs. A pair is one currency traded relative to another. When one currency in a pair is purchased, the other is sold. If a currency is sold, the other in the pair is bought. Think of going to the bank to exchange US dollars for euros because you are going on a trip. The currency pair, in this case, is the EUR/USD. US dollars are being sold and euros are being bought.
Forex analysis is attempting to predict or profit from currency pair movements. Traders use forex analysis to determine which currency within a pair is likely to be stronger. They will buy that currency and sell the weaker currency.
For example, if the EUR is expected to rise against the British pound (GBP), then a trader would buy the EUR/GBP. If they thought the EUR was going to weaken against the GBP, then they would sell the EUR/GBP. The first currency listed in a pair is the directional currency. If the first currency rises relative to the second the exchange rate is increasing. If the first currency falls relative to the second, the exchange rate is decreasing.
There are more than 150 global currencies, although most currency trading happens in only a handful. The euro (EUR), British pound (GBP), Japanese yen (JPY), Swiss franc (CHF), Australian dollar (AUD), New Zealand dollar (NZD), and Canadian dollar (CAD) are the most heavily traded in the world. Currency pairs which involve these currencies tend to have higher daily volume. The EUR/USD is the most heavily traded pair in the world. It tends to have the tighest spread between the bid and ask prices.
Currency pairs that involve currencies outside those listed above tend to have lower volume. The smaller the economy and demand for a currency, the less trading volume that currency will tend to have. This means fewer buyers and sellers, less volume, and the potential for more erratic price movements.
All currency pairs are subject to massive and swift price moves, since the currency markets are very susceptible to economic news such as gross domestic product (GDP) reports, employment data, interest rate announcements, inflation figures, or central bank statements.
Some traders attempt to analyze the fundamentals of a country to predict how the market is likely to react to upcoming economic data. Other traders base their trading decisions on how currency pair prices actually move.
Types of Forex Analysis
Forex analysis is highly dependent on the business or individual doing the trading and may be technical or fundamental in nature. Fundamental analysts are more concerned with the economic situation of a currency (and its country or zone), and how that may affect the value of the currency relative to others. Technical analysts are more concerned with how prices act, and will attempt to find patterns in the price.
Sentiment and statistical analysis are also forms of analysis that may fall under both fundamental or technical analysis. Statistical analysis may include finding patterns or tendencies within fundamental or technical data. Sentiment analysis looks at how traders are positioned, or what they expect, in order to determine when a price trend is healthy or when it may have become too lopsided and is likely to reverse.
- Technical analysis relies on past price movement data to predict a currency pair's future value. Traders focus on charts of price movement and various analytical tools to evaluate a currency pair's strength or weakness. In technical analysis, a trader examines the prices of specified currencies over time. In most cases, they will recognize repeated patterns, which they then use to predict the movement of the market. With automated technical analysis, computer software analyzes the history of the currencies’ price movement.
- Fundamental analysis relies on quantifying current factors, or predicting future factors, that are affecting a country's economy. In fundamental analysis, traders examine factors such as a country’s inflation rate, interest rates, GDP, and other economic indicators. Traders consider interest rates particularly important when making decisions. A higher interest rate will attract more investors, which, over time, will increase the value of that country’s currency. Yet if interest rates are too high, that means inflation may be a problem. Inflation will erode a currency's value.
- Sentiment analysis is based on how many people are buying or selling a particular currency, or their thoughts about which direction a currency will go. It is the feeling or tone of a market, also referred to as crowd psychology. When a trader uses sentiment to analyze the forex market they look for a particularly large amount of investment in a particular currency in one direction. With a large number of investors purchasing a given currency, the number of future sellers of that currency expands and the number of available buyers shrinks. This creates the potential for a price reversal, as eventually, all those buyers will need to sell.
Example of How a Currency Pair Could be Analyzed
Consider the USD/CAD, a heavily traded currency pair as it involves two of the world's most heavily traded currencies. The two countries are close trading partners and physical neighbors which means a high amount of business, government, and speculative trading, as well as cash exchanges for travel, in the currency pair.
Fundamental analysts will look at the interest and inflation outlook for both currencies. They will also look at factors such as employment, which may provide insight into future interest rate trends. A strong economy will tend to push interest rates up, attracting more investors into that currency and into that market to benefit from the higher interest rates.
The Canadian dollar also tends to move with the price oil, as oil is one of the country's main exports. The economy is dependant on the price of oil, therefore, both fundamental and technical analysts may also analyze the price of oil. if they can analyze oil correctly, they can likely make a more informed decision about the direction of the CAD, and thus the USD/CAD.
Technical analysts will look for trends and ranges within the price history of the USD/CAD. A trend will provide the overall direction the currency pair is moving. Ranges may indicate areas of support or resistance the price is approaching. They may also use technical indicators in an attempt to find a rhythm or pattern in the price movements. Charts patterns can be used to anticipate how the price will move within the pattern, and once it breaks out.
Sentiment may also be used. If the vast majority, 90% for example, of current positions are long, that means there isn't much room for people to become even more bullish. It also means the big money, the 10% in this case, is on the opposite side of the 90%. Big money tends to be right more often than small money, which is how it got and stays big. Therefore, the sentiment trader may consider this a warning sign that the price may fall once the 90% start exiting their positions.