When you trade the forex markets, you want to make sure that you use all the available tools to make the most informed decision. There are several different types of analysis that you can use to help you in forex trading. Two of the more popular types of analysis include fundamental analysis and sentiment analysis. Both of these types of analyses help you determine if new information will move the exchange rate of a currency pair. You can use fundamental and sentiment analysis on their own, as well as in conjunction with each other to help you make the most informed trading decisions.
What is Fundamental Analysis
Fundamental analysis is the process of examining economic and financial factors that could impact the value of a currency pair. Fundamental analysts can derive the value of a currency based on interest rate levels, which are usually driven by the strength or weakness of a country. The goal is to arrive at an exchange rate and compare that level to the current level to see whether the currency pair is undervalued or overvalued.
There are several key metrics that you can use to determine the future value of an exchange rate. The first premise that you should start with is that all the available information is priced into the value of an exchange rate. When new information becomes available, the exchange rate will move to a new equilibrium level.
The two most important metrics are interest rate differentials and capital flows. The interest rate differential is the difference in the borrowing rates of each countries currency that make up the current pair. Generally, investors will want to each income while they hold a security. To achieve this scenario when you own a currency pair you will need to purchase the higher-yielding currency. You can find this out by looking at the difference between each countries borrowing rate.
You can see that the long-term borrowing yield differential can move significantly. When the chart is rising, US yields are becoming more attractive relative to German yields. This makes the dollar more attractive. When the chart line declines, German yields are becoming more attractive, making the Euro more appealing.
Capital Flows are also another key metric that you can use to determine currencies strength. Capital flows refer to the movement of money for investment or business operations. When investors invest money in purchasing assets in a country, capital flows will come into that country. For an investor to buy an asset in a country, they will need to convert their currency to the currency of the country.
Sentiment analysis attempts to evaluate the polarity of a topic. As sentiment is rising toward an asset, it generally gains strength. As sentiment weakens, the value of an assets will decline. When sentiment becomes too strong, it will push an assets to the point where most buyers are in the market, and the price of an asset has no where to go but lower.
There are several ways to measure sentiment. For example, you can look at the volume of trades in a currency pair. The Chicago Mercantile Exchange, CME, provides a report called the Commitment of Traders report. The report categories the volume and open interest of several currency pairs including all of the major currency pairs. You can see if hedge funds are buying or selling and if the open interest of hedge funds is long, short, or neutral. This will provide you with a gauge of sentiment.
The Bottom Line
By using fundamental analysis and sentiment analysis, you can gauge the future direction of a currency pair. Fundamental analysis provides you with information regarding interest rates and capital flows. It will tell you if there is a reason whether a currency pair is overvalued or undervalued. Sentiment analysis tells you how others are potentially betting. If you use the combination of the two types of analysis, you will provide yourself with the best tools to make an informed trading decision.