The introduction to financial market analysis

The introduction to financial market analysis
Table Content
1. Technical Analysis
The benefits of technical analysis
The three rules of technical analysis
2. Fundamental Analysis
How does fundamental analysis work?
What does fundamental analysis look at?
Gross Domestic Product (GDP)
Trade Balance
Consumer Price Index (CPI) & Inflation
Employment Indicators, like US Non-Farm Payrolls (NFPs)
Interest Rates
3. Sentiment Analysis
Last thoughts

Financial market analysis is key for anyone trying to figure out the value of an asset in the market. And based on a variety of circumstances, you’re gonna want to tailor your strategy to a specific type of market analysis. 

So, today, we’re gonna take a closer look at the three main types of financial market analysis: technical analysis, fundamental analysis, and sentimental analysis. 

1. Technical Analysis

Technical analysis is a way to analyze and predict the future value of financial markets using charts. It can be used for stocks, commodities, or forex, and it’s usually based on how prices have moved in the past. 

The benefits of technical analysis 

Technical analysis offers an estimation, just like any other kind of forecasting. It doesn't give exact price levels for the future. It can help you land on outcomes that're more "likely" to happen than "certain" to happen in the future. And it's done with a variety of charts that show how prices change over time.

Charles Dow, the co-founder of the Dow Jones & Company, came up with the foundation for what developed into modern technical analysis. 

Here are the three rules to keep in mind when using this type of analysis, according to Dow.

The three rules of technical analysis:

1. Price discounts everything

This rule represents strong and semi-strong forms of market efficiencies. Technical analysts say that the current price of any asset or currency reflects all available information about that asset’s/currency’s performance. This means that the current price is a good indicator of fair value and should be used as the starting point for any analysis. 

After all, the market price is affected by what investors, hedge funds, banks, traders, portfolio managers and buy-side analysts think. The price is also affected by what sell-side analysts, market strategists, technical analysts, fundamental analysts, insiders, and almost all other market players think. So, the idea behind technical analysis is that the price of an asset tells people enough about it to let them trade.

2. Prices movements aren’t random

Even though market players typically agree that prices and investors' moods tend to be random, there are also patterns to be found. For example, the markets often tend to move in one direction or get stuck in a price range. 

On top of that, a helpful tidbit is that traders also tend to buy at the same levels at which they've bought in the past and sell at similar prices to which they've sold in the past. These levels should be clearly marked on a chart and can be used to strategize new trades.

3. “What” is more important than “why”
Because the price of a currency takes a lot of economic factors into account, technical analysts and traders believe that it is not necessary for them to know exactly why the price is going up or down. What matters more than why something is happening is what is happening, e.g., whether the market is trending or trading sideways, etc.

2. Fundamental Analysis

Fundamental analysis is a more traditional way to try to figure out what prices in the financial markets will do in the future. In other words, it's a prediction of how the financial markets could react to a certain set of potential global economic events. These could include major economic data releases, political news, company earnings, central bank policy meetings, and major announcements from influential organizations like the IMF and the World Bank, to name a few.

How does fundamental analysis work?

The idea behind fundamental analysis of any market is that if a country or company is doing well financially, a bunch of factors could cause the currency or shares of that country or company to go up, and vice versa. So, because a country's or a company's economic health is a major factor in attracting foreign investment (FDI) and new businesses, it follows that investors and entrepreneurs from abroad will have to purchase local currency before setting up shop.

Say, for example, that, on average, economies in the eurozone are doing well. In that case, the euro (EUR) will get stronger because it will be in higher demand than other currencies. When growth is strong and inflation is high, the central bank usually raises the key interest rate to slow inflation and slow down growth. Higher interest rates tend to attract foreign traders and investors, and as a result, they buy the euro (EUR) to make use of the relatively higher interest rates in the eurozone.

So, what does fundamental analysis look at?

There’s a selection of factors that influence the outcome of fundamental analysis. And, usually, it consists of economic data that drives currency movements, such as:

Gross Domestic Product (GDP)

The Gross Domestic Product is the total market value of all the goods and services that a country's economy produces over a certain time period. It’s one of the most essential factors in measuring how well a country's economy is doing; in fact, GDP reports are released quarterly. 

The US, for example, comes out with a GDP report at 8:30 a.m. EST on the last day of each quarter, and it’s used to show how the economy performed over that last quarter. Traders tend to keep an eye on the GDP growth rate because they use it to compare one country to another.

Trade Balance

The trade balance is the difference between a country's exports and imports of tangible goods and services. If a country exports more goods than it imports, the effect on its currency is positive, while the opposite would typically have a negative impact. 

It’s also great to keep in mind that if a country exports more than it imports, that typically points at a trade surplus. And if it imports more than it exports, that’s a sign of a trade deficit.

Consumer Price Index (CPI) & Inflation

The Consumer Price Index (CPI) is the change in the price of a group of consumer goods and services on a monthly basis. It’s also the most common and trusted way to measure inflation in a country. CPI data is followed closely by market players, and it’s released monthly; the US inflation report comes out around the 15th of every month at 8:30 AM EST. 

The CPI number shows how much inflation has gone up over the past month and year. Reports on inflation are important for a currency because central banks try to control inflation by changing interest rates and the amount of money in circulation.

Employment Indicators, like US Non-Farm Payrolls (NFPs)

Employment indicators are sets of data about the job market. The unemployment rate is considered one of the most important signs of a country's economic health and future inflation pressure. 

What other indicators are good to stay posted on? Well, traders keep an eye on the number of new jobs created and signs of labor market inflation, like average hourly earnings or wage growth.

Interest Rates

The main thing that moves the currency markets is the difference in interest rates between countries, so all market players pay close attention to central banks around the world. 

For example, if the interest rate at bank A is 10% and the interest rate at bank B is 5%, traders are likely to choose bank A over bank B if the only difference between said banks is the interest rates. It's just a better deal—that is if you’re a saver, though, not a borrower.

The same logic applies for trading currencies. Traders will invest in currencies with high yields by borrowing in currencies with low yields. This type of trading strategy is called the “Carry Trade”.

3. Sentiment Analysis

This one’s a little different from the last two. Simply put, market sentiment is what investors think could happen in a financial market that they’ve got an open position in. 

History shows that when the market is moving in a certain direction, small traders tend to buy or sell in the opposite direction. This means that retail traders try to be net-short of the market when the trend is going up. 

Based on past data, analysts have found that retail traders tend to do well when the market stays in a narrow range. This could mean that if the market is locked in a narrow range, the market price is hovering around a major resistance level and traders are becoming net-short, the pair or asset's value will likely move down.

Given what we can gather from well-documented investor behavior, the sentiment indicator is a good way to check if market trends and breaks are for real and should impact how you trade.

Last thoughts

To wrap it up, you’re gonna want to do some market analysis before trading in different financial markets, even if it’s across all three types. It’s helpful to get a sense of where the market’s at and will definitely help you figure out an effective investment strategy. 

There are a bunch of factors that can impact market movements, like the ones we mentioned above. But don’t worry, you don’t have to overload yourself with info from the get-go! Start small, pick a financial market, and slowly build a list of economic data, events and trends to keep an eye on. It’ll become habit.

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