Analyzing market trends and the factors affecting them is crucial for traders. It provides them with a framework to work with and a solid basis to guide their trades.
There are three primary market analysis techniques: technical analysis, fundamental analysis, and sentiment analysis.
Each one provides investors with data from different perspectives relevant to trading environments and helps formulate better trading strategies.
Despite the importance of these three trading analysis techniques, most people are only familiar with technical analysis and fundamental analysis. Sentiment analysis is still not a widely used technique among traders.
Read below for an in-depth discussion of the three trading analysis techniques and learn which will work best for you.
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Pro Tip: Analyze Before You Trade
For some people, online trading is like gambling. It’s risky, and it can result in huge financial ruin.
However, when you trade, you deliberately do it. You research the potential of the asset, analyze the market, and use strategies and risk management techniques and other measures to ensure your trade is profitable and safe in the inherently risky financial market.
But when someone gambles, they only rely on luck. They analyze nothing and just go with what their gut is telling them.
That sets traders apart from gamblers: they analyze the market. Pro traders do it religiously, it become part of their daily routine.
However, it’s actually easier said than done. Even experienced traders mess up this part of their trading because (honestly) there is a lot to consider.
But here’s food for thought: Does individual trading mean you must do it alone?
At CommuniTrade, you’re connected to hundreds of thousands of online traders worldwide. You can use the community’s knowledge to create your own analysis or simply verify it! As they say, two (or more) heads are always better than one!
What Is Technical Analysis?
Technical analysis is an approach to evaluating market trends and financial assets (e.g., stocks, currencies, and commodities) using past data, primarily volume and price movements.
In contrast to fundamental analysis, which focuses on factors affecting assets and market trends, technical analysis examines the volume and price movements of shares over time.
Analysts use charts and other technical indicators to do this.
Technical Indicators Commonly Used in Technical Analysis
Below are some of the technical indicators traders commonly employ during technical analysis.
Support and Resistance Levels
This technical indicator refers to the lowest and highest price levels traders predict for a given asset, respectively.
The support zone points to a chart level or price zone that shows an area signifying traders’ willingness to buy.
When an asset’s current price reaches this level, demand will often overwhelm supply. This eventually causes price declines to stop and enter a reversal.
Resistance operates oppositely. When demand for a particular asset exceeds supply levels, it causes the asset’s prices to go up.
This process will continue up to a point when selling will eventually overpower traders’ buying motivation for one reason or another.
When supply starts overwhelming demand, an asset’s price will eventually stop moving up and enter a reversal. Similar to support, the resistance zone can also point to a price zone or chart level.
Once traders have identified an asset’s support and resistance levels, they can use these as the basis for their trade entry and exit points.
Moving Averages
A moving average (MA) is another indicator traders often use in technical analysis. Investors often use this indicator in stock market analysis to predict the possible trend direction of a given asset’s price.
Traders determine moving averages by calculating the sum of all the data points in a particular period and then dividing it by the number of time periods. Once figured out, moving averages help technical analysts generate trading signals.
Moving averages have two basic forms: simple moving averages (SMA) and exponential moving averages (EMA).
As the term implies, a simple moving average is a straightforward technical indicator. It is determined using the formula
SMA = (A1 + A2 + … An) / n
Where:
A = average period in n
n = number of periods
As you can see, SMAs rely on past price data over specific periods. Traders commonly use SMA indicators to help them narrow down securities buy and sell signals.
Exponential moving averages are more complex. EMAs place greater importance on the most recent price points and are, therefore, more sensitive to recent price changes than SMAs.
Traders follow three steps when calculating EMAs:
Step 1. Calculate the SMA for a specific period.
Step 2. Determine the multiplier for weighting the EMA, where
Multiplier = [2 / (Selected Period + 1)]
Step 3. Compute for the EMA using the formula.
Current EMA = [Closing Price – EMA (Previous Time Period)] x Multiplier + EMA (Previous Time Period)]
Fibonacci Retracement
A Fibonacci retracement is a trading chart pattern. As the name implies, this chart uses the Fibonacci sequence of natural numbers where each number is derived from adding the previous two (e.g., 0, 1, 1, 2, 3, 5, 8, 13 ...)
These numbers’ unique attributes provide retracement ratios (23.6%, 38.2%, 61.8% …) that traders use to determine retracement in an asset’s value.
Traders use the Fibonacci retracement to gauge trading levels and determine the range at which an asset’s prices will go into reversal. Fibonacci retracement charts use the Fibonacci trading ratio to predict the reversal range.
The Fibonacci retracement is a handy tool for determining bearish and bullish market trends and helping traders place entry orders for profits.
Bollinger Bands
Bollinger Bands are another popular indicator traders use during technical analysis. Developed in the 1980s by John Bollinger, this technical indicator uses a moving average with trading bands both above and below.
These trendlines are the upper, middle, and lower bands.
The trendline in the middle position signifies the moving average, with the trader choosing its parameters. The upper and lower trendlines are positioned above and below the moving average, respectively.
This indicator shows a security’s relative peaks and troughs compared to previous trades. Because of the unique data Bollinger Bands can provide, traders have developed a variety of uses for them, including:
- Determining overbought and oversold securities
- Deciding trading entry and exit points
- Monitoring breakouts
- Following trends
The simplicity of Bollinger Bands makes them a favored technical analysis tool among professional and casual traders. However, relying solely on Bollinger Bands when trading can be risky, as they only focus on prices and volatility.
Chart Patterns Used in Technical Analysis
Aside from these technical indicators, investors also use chart patterns to help predict the future movement of markets or assets.
There are two primary types of chart patterns traders can rely on: continuation and reversal chart patterns.
Continuation Chart Patterns
As the term implies, continuation patterns might indicate the tendency of a prevailing trend to continue after the pattern’s conclusion.
However, it’s important to note that a continuation pattern does not always mean a trend will continue. On the contrary, a continuation pattern might even indicate an incoming reversal.
When using continuation patterns in technical analysis, analysts often look at the trend’s strength relative to the continuation pattern’s size.
Typically, prices strongly moving upward and forming a small triangle pattern, then breaking above the triangle before moving higher again, is more reliable and indicates a trend’s continuation.
However, continuation patterns almost the same size as the upward price movements signify volatility. In such cases, the pattern is more of a warning sign than a green light.
There are many types of continuation patterns analysts can use in technical analysis. Commonly used patterns include:
Triangles
Triangle patterns form when price actions become more compressed.
There are three types of triangle patterns, namely, ascending, descending, and symmetrical. Whether a triangle pattern will become one of these three depends on swing highs and lows.
Ascending triangle. In ascending triangle patterns, rising swing lows form an ascending line while swing highs remain constant, creating a horizontal trendline. These two lines result in an ascending triangle pattern when they connect.
Descending triangle. In a descending triangle pattern, the swing highs form a downward trendline when connected, while the swing lows remain at similar positions.
Symmetrical triangle. Declining swing highs and rising swing lows create ascending and descending trendlines, which form a symmetrical triangle once connected.
Pennants
Pennants are smaller versions of triangles. This type of pattern usually forms following strong upward or downward movements.
Pennants often resemble a consolidation gradually decreasing in size. Once the consolidation ends, the preceding trend resumes in the same direction.
Trading volumes commonly decline during a pennant pattern’s formation before substantially increasing following a breakout.
Flags
Like pennants, flag continuation patterns form at the end of a flagpole or a strong movement in securities.
Unlike pennants, the moving points of a flag follow parallel lines in an ascending, descending, or sideways direction instead of converging at one point.
Reversal Chart Patterns
Reversal chart patterns are the opposite of continuation patterns. These indicators help analysts determine whether a bullish or bearish market trend is beginning to lose momentum and enter a reversal.
Examples of reversal chart patterns traders commonly use are the head and shoulders, double top and bottom, and gap reversal patterns.
Head and Shoulders
The head and shoulders reversal pattern can form at either market tops or bottoms.
It is easily recognizable because of the three peaks or troughs that constitute the pattern’s “head” and “shoulders.” When this pattern appears at market bottoms, it is called an inverse head and shoulders.
In this pattern, a strong movement in one direction is followed by a movement in the opposite direction that brings the price back to its starting point.
Double Top/Double Bottom
Double tops and double bottoms are easily recognizable by the “M” and “W” patterns they form, respectively.
The consecutive peaks and troughs of these patterns often occur at around the same level. However, it isn’t necessary for these points to be at the same point for a pattern to be classified as a double top or bottom.
A double top occurs following an uptrend and signifies a possible reversal. In this pattern, two peaks occur at roughly the same level.
Conversely, downtrends create double bottoms and can signal a potential reversal.
In a double bottom pattern, the troughs of two consecutive downward movements start reversing at around the same point.
Example of Technical Analysis in Forex
To better understand how technical analysis works in real-life scenarios, consider the example below.
John wants to open a long position in the EUR/USD currency pair. He has observed the pair for several weeks and noted that its price has been experiencing a constant uptrend. He decides to use technical analysis to determine the best entry and exit points for trading.
- Trend Analysis: John observes that the EUR/USD pair’s price shows consistently higher highs and higher lows, indicating an uptrend.
- Identifying Support and Resistance: John identifies the trend’s key support and resistance levels. He noticed strong support levels around 1.1500.
- Indicator Confirmation: John wants to confirm his observation. He uses a momentum indicator, the Relative Strength Index (RSI), showing that the market is not yet overbought and the uptrend may continue.
- Chart Pattern Recognition: John also noticed a bullish flag pattern, confirming his initial observation of the uptrend’s continuation.
- Entry and Exit Strategy: Following his technical analysis, John opened a long position near the 1.1500 support level and set up stop-loss and take-profit orders accordingly.
What Is Fundamental Analysis?
While technical analysis relies on technical indicators, such as graphs and patterns, fundamental analysis uses economic ones.
These economic determinants include a country’s inflation data, employment rate, GDP, and central bank policies, to name a few.
Traders using fundamental analysis are trying to predict potential forex market trends based on a country or region’s overall economic health.
Events tied to a country or region’s economic health (e.g., political turmoil and natural disasters) often impact the concerned country’s currency value.
Factors Commonly Involved in Fundamental Analysis
Many components affect a country’s economic health. Each of these attributes contributes to the strength of a country’s economy.
Thus, analysts often include all or most of them when conducting fundamental market analysis.
Below are some of the most common factors analysts use in fundamental analysis.
Central Bank Events
Central banks play a crucial part in the financial markets. These banks often act as the monetary and fiscal authority of the countries they represent.
These financial institutions are responsible for setting the interest rates of their countries. As central banks dictate their countries’ monetary policies, they can effectively control the relative value of their currencies.
Economic Data
A country’s economic data include its GDP growth, inflation, interest rates, and employment rates. These factors help market analysts assess a country’s economic health and outlook.
Market Sentiment
News, surveys, and official reports affect how traders “feel” a market’s trend will go. The collective sentiment of traders can influence market prices as they buy or sell assets, depending on how they feel the market will react to specific events.
Geopolitical Events
Geopolitical events can also affect the value of a country’s currency. For instance, the Russian ruble’s value dropped substantially following the country’s invasion of Ukraine.
Another example is England’s departure from the European Union. Brexit took a heavy toll on the British pound, causing it to lose by as much as 19% against the USD in 2016.
Example of Fundamental Analysis of Currency Pairs
To better understand how fundamental analysis can help you make sound market decisions, read the scenario below.
Wanda is considering opening a long position in the USD/JPY currency pair. She decides to use fundamental analysis to determine the pair’s potential future price movement.
- Central Bank Events: Wanda closely monitors the policy announcements of the US Federal Reserve and the Bank of Japan (BOJ). She sees the US Fed shifting to a more hawkish stance, as the BOJ hints at possible policy changes.
Wanda notes these as potential indicators of upcoming market volatility.
- Economic Data: Wanda also examines the US’ and Japan’s economic reports. She sees an unexpected slowdown in the US GDP growth and higher-than-usual inflation. Looking at Japan’s economic data, Wanda sees an increase in the country’s exports and a rebound in industrial production.
Wanda interprets the two countries’ contrasting reports as signs that the USD is weakening against the yen.
- Geopolitical Events: Wanda is aware of US involvement in foreign conflicts, particularly in Europe. At the same time, she notes the relative stability in the Asia-Pacific region.
She notes how other investors are flocking towards the Japanese yen, a safe-haven currency.
- Market Sentiment: Although the present market trend swings in favor of the USD, Wanda notices the pervading market sentiment shifting to a cautious stance.
Wanda knows that conditions like these call for more prudent positions.
- Conclusion: After considering the various economic factors affecting the USD/JPY pair, Wanda decides that it would be better for her to open a short position in the pair instead.
What Is Sentiment Analysis?
Sentiment analysis is another market analysis method.
However, many investors and analysts don’t consider sentiment analysis as a separate approach to analyzing markets. Instead, they classify it as a subset of fundamental analysis.
This market analysis technique focuses on how the overall mood of traders may affect a particular currency, or even the entire market.
This is where the line between fundamental and sentiment analysis blurs. Investor “mood” can be swayed by news and reports, which fall under fundamental analysis.
However, market sentiment analysis fills one niche more effectively than when using fundamental analysis. This is when it comes to short-term trades, such as intraday and scalp trading.
As short-term trades are more vulnerable to fluctuations and volatility, using sentiment analysis allows traders to be more dynamic.
Technical Analysis vs. Fundamental Analysis
Technical and fundamental analysis are both methods of determining how market prices could behave in the future. But the two methods’ similarities end here.
The table below shows some of the key differences between the two forex analysis techniques.
| Technical Analysis | Fundamental Analysis | |
|---|---|---|
| Data sources | Relies on historical price data Trade volume Chart patterns | Evaluates the intrinsic value of assets through economic, financial, and qualitative factors |
| Tools | Technical indicators Volume analysis Relative strength Charts and patterns Support and resistance | Financial statements Economic indicators Interest rates News and events Qualitative information |
| Decision-making process | More systematic | Involves a more comprehensive assessment of various economic factors |
| Risk management | Uses technical indicators, stop-loss orders, etc. | Considers risk factors (e.g., financial stability, industry trends, etc.) |
Technical Analysis or Fundamental Analysis: Which Suits Your Trading Style?
Deciding which market analysis technique will work best for you depends on your trading style and goal.
Fundamental analysis emphasizes the use of economic data and company financial statements. These factors play well for traders with long-term goals.
Technical analysis uses price movements and trends to identify potential trading opportunities. This makes it a better method for short-term traders.
However, many traders find that using a blend of the two gives the best results.
Interested in learning more about market analysis and how to use it to your advantage? Join the CommuniTrade and gain access to our various trading courses and educational resources!
