Market Analysis

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How does one carry out analysis of the market?

There are two main ways of undertaking market analysis: technical analysis and fundamental analysis, you will learn about both of them in the next lesson.

Technical Analysis

To succeed as a Forex trader, it is essential you undertake a detailed analysis of the market before placing any trades on the trading platform.

Analysis of the market involves forecasting the market behavior to identify the best places to enter and exit trades.

Technical analysis is a strategy of forecasting future market movements by studying historical price patterns and trends in the foreign exchange market. Whereas technical analysts may use various tools and theories in attempting to predict correctly market moves, the most common instrument used by all is the chart.

There are three main principles in technical analysis:

Market action is the king

Followers of technical analysis hold that all the fundamental conditions that could affect the behavior of a currency are already reflected in the price movements.

The market movement follow trends

Technical analysts hold that the rise and fall of currency prices in the foreign exchange market occurs in an orderly manner, which is both systematic and easy to forecast. The three major types of trends are upwards, downwards or sideways.

History tends to repeat itself

The movement of currency prices in the foreign exchange market has been tracked for several years. And, a lot of studies have revealed a number of repetitive patterns that often appear on charts. Therefore, technical analysts believe that patterns that appeared in the past are likely to appear in the future.

The three main schools used in technical analysis in Forex trading are:

Chartism/charting

Forex indicators

Theories

Chartism/charting

Technical analysts usually use Forex charts to predict the movements of currency prices in the future. Basically, a Forex chartist holds that the market movements are not random, but can be predicted through a study of past trends as well as by the use of other tools in technical analysis.

Some of the methods used in charting include trends, support and resistance levels, and channels.

Trends

An important aspect of technical analysis involves identifying tradable trends. A trend for a currency pair consists of sustained directional movement in the pair’s exchange rate. When the exchange rate trend for a currency pair is higher, traders look for a suitable time to buy. And, when the exchange trend is lower, traders look for a good time to sell.

There are three main types of trends: upwards, downwards, or sideways. An upward trend or uptrend is defined as series of consecutive higher peaks and troughs. An upward trend line can be drawn through the rising trough point.

When the currency pair closes above the upward trend line, a buying opportunity may exit. On the other hand, when a currency pair breaks below an uptrend line, it signals a trend reversal to the downside so a selling opportunity may exist.

A downward trend or downtrend is defined as a series of consecutively lower peaks and troughs. A downward trend line can be drawn to link the declining peak points.

When the currency pair rallies to close below the downward trend line, a selling opportunity may exist. On the other hand, when a currency pair breaks above a downtrend line, it signals a trend reversal to the upside so a buying opportunity may exist.

Lastly, a sideways trend is defined as a situation in which the overall direction of the currency pair is see-saw; that is, price is fluctuating without following any definite direction.

Support and resistance

In general, support and resistance are terms used by technical analysts to describe price levels on charts that tend to act as obstacles to thwart market movements towards a certain direction.

Support refers to a certain price level on a chart at which a falling currency pair encounters resistance from the market. This takes place because the number of traders who expect the price to stabilize or rise is greater at this level – so the pair is literally “supported.”

Resistance refers to a certain price level on a chart at which a rising currency pair struggles to increase in value. The number of traders who think that the market will not move above this level is greater, and so the level “resists” further price rises.

It is of essence to note that the concepts of support and resistance are a matter of human psychology. They exist because the traders in the market believe them to exist; and act accordingly – by selling near resistance and buying near support.

Channels

There are three types of channels in Forex charting: ascending channel, descending channel, and horizontal channel. In an ascending channel pattern, the peaks create higher highs and higher lows. In a descending channel pattern, the peaks create lower highs and lower lows. And, in a horizontal channel pattern, the market is ranging.

Forex indicators

In the currency market, indicators are important in portraying the fluctuation of currency prices. Here is a description of some of the major types of indicators used in technical analysis:

Stochastic

The stochastic indicator makes it possible for traders to measure overbought and oversold conditions in the foreign exchange market. The indicator is calibrated from 0 to 100. And, if the stochastic lines go above the 80 mark, then it indicates that the currency pair is overbought. Alternatively, if the stochastic lines go below the 20 mark, then it indicates that the currency pair is oversold.

As such, the 20 and the 80 marks are called the “trigger points”. It is important to note that the basic guideline when using stochastic to identify trade opportunities in the market is to enter long (buy) positions when the stochastic lines are below the 20 mark and to enter short (sell) positions when the stochastic lines are above the 80 mark.

For instance, when the indictor has been staggering over the 80 mark for sometime, then it is highly probable that a reversal to the downside is imminent.

Parabolic SAR

Parabolic SAR (Stop And Reversal) indicator is commonly used by technical analysts to spot the ending of market trends. Parabolic SAR places a series of dots either above or below the currency price in order to assist traders identify trade opportunities.

When the indicator places dots below the price of the currency pair, then traders should look for opportunities to place long orders. Conversely, when the indicator places dots above the price of the currency pair, then traders should look for opportunities to place short orders as the market is likely to maintain a downward trend.

Relative Strength Index (RSI)

The Relative Strength Index, commonly referred to as RSI, is more or less similar to the stochastic indicator. This is because it also makes it possible for traders to gauge overbought and oversold conditions in the currency market.

RSI is also marked from 0 to 100. And, when the RSI goes above the 70 mark, it indicates that the price of the currency pair is overbought; thus, a reversal to the downside is bound to take place. Conversely, when the RSI goes below the 30 mark, it indicates that the price of the currency pair is oversold; therefore, traders should anticipate a reversal to the upside.

Moving Average Convergence Divergence (MACD)

The Moving Average Convergence Divergence, normally called MACD, is a well-liked and useful technical analysis tool majorly used as either a trend or a momentum indicator. In general, this indicator exhibits the relationship between two moving averages of prices.

MACD is calculated through getting the difference between the 12 and the 26 exponential moving averages (EMA’s). It is important to note that the former moving average is faster than the latter moving average.

The difference between these two moving averages is what is shown as a single line. And, this is the MACD main line. In most cases, MACD indicators comprise of one extra line that is a simple moving average of the main line and it usually has the default setting of 9 in most of the trading terminals. This single line is important in pointing out potential turning points in the market.

The numbers 12, 26 and 9 are normally the default settings of this indicator; however, other numbers can be employed to reflect the desire of the user.

The cross-over of the fast and the slow moving averages is normally used by traders

as a means of identifying places of entry and exit in the currency market. Since the two moving averages are moving at different speeds, it is definite that the faster one will react to price action much faster than the slow moving one. And, their cross-over give trading signals.

Moving averages

Moving averages is a technique used in smoothing out the price action over a certain time period in the foreign exchange market. These indicators simply reduce the noises and the disarrays in the market and make the charts easier to identify potential trade opportunities. The two main types of moving averages are the simple moving averages (SMA) and the exponential moving averages (EMA).

Simple moving averages are the most widely used type of moving averages. A simple moving average is worked out by adding up the closing price for the definite number of time periods (for instance X) and then dividing this total number by the number of time periods (X).

Traders love simple moving averages because they assist them in measuring the prevailing market sentiment and the big picture and thus ease the process of identifying trade entry and exit areas.

The other type of moving averages is the exponential moving averages. Exponential moving averages are the same as the simple moving averages. Nonetheless, the only distinction is that the exponential moving averages put more emphasis on the recent happenings in the market.

Bollinger bands

Bollinger bands are used by technical analysts to measure the volatility of the Forex market; that is, whether the market is quiet (low activity) or whether it is loud (high activity). Bollinger bands consist of three lines: upper band, lower band and middle band. The middle band is a simple moving average.

The upper and the lower band are used for measuring deviations; they become close together when there is low activity and they spread apart when there is high activity in the marketplace.

An essential characteristic of Bollinger bands is that price often tend to go back to the middle of the bands; therefore, price normally touches the upper and lower band and retrace to the middle of the band. Also, when the upper and the lower bands constrict towards one another, then it often indicates that a breakout of price either to the upside or downside is about to take place.

Fundamental Analysis

Fundamental analysis is a type of market analysis that involves examining the economic, social and political factors and their influence on the value of currencies. Traders using fundamental analysis as the basis for making informed decisions on when and how to trade currencies believe that the value of a currency in the Forex market is reflected by its macroeconomic condition. This means that a currency of a country with a strong economy will have a higher value than a currency of a country of with a weak economy.

It is important to mention that economic news as well as important political events have the power to trigger big movements in the Forex market. As such, by analyzing them, you can better understand how the market is likely to move in the future.

When examining economic data on an Economic Calendar, you should study the previous results and forecast results, and then compare them with the actual results. Movements in the market happen when there is a difference between market expectations – based on the previous and forecast results – and the actual result.

Here is a description of some of the key economic data that often cause movements in the Forex market

i) Interest rates

Interest rates are regarded as possibly the most significant mover of currency prices in the foreign exchange market. It is of essence to note that each currency has a daily interest rate determined by the nation’s central bank.

Lower interest rates can cause the value of a nation’s currency to weaken and higher interest rates can cause the value of the currency to strengthen. If a central bank of a country makes its interest rates to be high, this would increase the yield of holding the currency; therefore, the currency would become more attractive to hold as weighed against its counterparts. As a result, its value would rise.

Conversely, if a central bank of a country decreases the interest rates of a country, then this would make the currency less attractive to hold. As a result, its value would come down.

ii) Growth indicators

Growth indicators exhibit the status of the economy of a country. If the indicators are positive or increasing, it usually suggests good overall economic condition of the country. Naturally, this would attract foreign investors and make the value of its currency to appreciate.

Some of the growth indicators closely monitored by currency traders include Gross Domestic Product (GDP), Gross National Product (GNP), Consumer Price Index (CPI), construction indexes, capital expenditure, and government spending.

iii) Inflation rates

Inflation alludes to the general increase in the prices of goods and services within a certain territory over a specific time period. Inflation indicators like PPI (Producer Price Index) in a country are usually employed as a means of measuring its underlying economic growth. As such, central banks normally have checks and balances to ensure inflation rates do not go out of control.

A country with a high rate of inflation has a low purchasing power and thus a poorly performing currency. To increase the strength of such a currency, the government may decide to raise the country’s interest rates

iv) Employment indicators

Employment reports provide a sign of how the economy of a country is performing. If the number of individuals getting jobs in a country is increasing on a regular basis, then it means that the economy is expanding. Conversely, if there is no remarkable growth in a country’s employment rate, then it indicates that its economy is not performing as expected and can cause its currency to also weaken.

For instance, the Non-Farm Payrolls report, which is an employment report released on a monthly basis from the U.S., plays a vital role in determining the strength of currencies in the foreign exchange market

v) Balance of trade reports

Balance of Trade (BOT) means the difference between the imports and the exports of a country. If a country has more exports than imports, then this usually translates to it having a strong currency. The opposite is also true.

How does one trade news and events?

Trading the markets based on important news events is a popular fundamental trading strategy that is practiced by several traders around the world. News traders attempt to anticipate how the market will react to events and time the biggest movements.

Fundamental traders watch for surprising news that differs from the market expectations and can result in substantial price changes. It is of essence to note that news results can have a surprising impact on the market, so fundamental traders need to beware of this.

Worth mentioning, key economic news releases from the world’s largest economies often trigger price movements in the currency market. And, following the most important news releases with the greatest market impact is one fundamental strategy for trading the Forex market.

Therefore, you should learn which releases to look out for, when they are due out, and how to trade based on the observed results.

This trading style requires considerable research, but allows well-informed traders to reap significant rewards. It is important to remember that market movements based on news events can only last for a few minutes, so watching news as it occurs is crucial to this strategy’s success. And, you should beware of a contrary market impact when trading key events in the marketplace.

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