Basics of Fundamental Analysis
Fundamental analysis considers the two economies that represent the currencies in a currency pair. However, fundamental factors are not only economic ones; political events, such as elections, are part of the fundamental analysis as well. Usually, anything that is not technically related is considered as a fundamental reason why markets are moving, such as wars, etc. Predicting such events is a hard thing to do, if not impossible. Even though the outcome of some elections may be interpreted ahead of their release due to other factors, the way to treat fundamental analysis is to know where to take your information from, and to be aware of which information will move the market in the period ahead. In other words, being proactive rather than reactive works all the time. This in conjunction with technical analysis is the recipe for successful trading.
What Constitutes Fundamental Analysis?
The biggest part of fundamental analysis is based on the economic news that is released on a constant and scheduled basis. The economic calendar is a must for every trader, as this news is the bread and butter of Forex trading. It is said that technical analysis gives the direction the market is going to go in, while fundamental analysis offers the reason why such a move happens. This is 100% true. Let me give you an example. The first Friday of each trading month, the jobs data in the United States, the Non-Farm Payrolls (NFP) indicator, is released. This makes it extremely unlikely for the overall dollar pairs to move during that week until the NFP numbers are released. Therefore, if you’re looking for a big move to come based on your technical analysis, and you’re in the NFP week, chances are the move won’t start until Friday. In that way, fundamental analysis plays an important role in the way markets move and the way profits are made, if any, on a trading account.
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The economic calendar shows the news and high-impact events that will have a say in how the market will move. They are organised based on the currencies that are being impacted, and traders will know where the risk of the market making wild moves is. As a rule of thumb, there is nothing more important in currency trading than correctly positioning for the next move of the central bank. This is all that matters for traders: what the central bank is going to do with the interest rate, and with the overall monetary policy the next time its members meet. Everyone wants to own a currency that pays a higher interest rate, and this is the main driver in the Forex market. Any other economic releases that come out between two central bank meetings are only viewed with regard to how they will influence the future decision regarding interest rates. You should therefore look for central bank meetings for the currencies you are interested in trading, as well as member’s speeches and other news that may influence future monetary policy. You’ll find that the market will move aggressively when these events are happening. As a brief mention, in the order of their importance, the economic news part of the economic calendar is central bank meetings and interest rate decisions, inflation data, jobs data, PMIs (Purchasing Managers Index), GDP (Gross Domestic Product), Retail Sales, etc.
Political events exert a lot of influence in the way markets move, especially when these are happening in countries that have economies ranked as the biggest in the world. 2016 brought two such events that are worth mentioning here: the UK’s referendum vote and the United States Presidential election. Due to the uncertainty that surrounded both events, markets didn’t really move until the outcome was known. Then after that, based on the outcome, violent moves hit. The reason for that is that traders are always looking ahead, trying to interpret what the impact of an event on an economy and on its currency will be. For example, as soon as it was obvious that Mr Trump was going to win the presidential election, the dollar started to appreciate across the board. The reason for that was that traders looked closer at Trump’s agenda and at the promises he made during the election campaign, and interpreted the possible implications for the US dollar. This, together with the classical supply and demand balance, made the dollar move across the Forex dashboard. The same was true in the case of the Brexit vote, when the United Kingdom decided to leave the European Union.
Who Trades Mostly on Fundamental Reasons?
Big institutional players such as hedge funds and other investment vehicles mostly use fundamental analysis for their trades. This is to be viewed as the main reason for being in a trade, as the actual execution is based on technical factors. Let me give you an example. Such a position is built over time, rather than being a “one time pushing the button” thing. In this case, fundamental analysis is part of the so-called macro-decision to invest in a financial product. It may be that these investment managers are bearish on an economy, or on the way monetary policy is applied in an economy, and they therefore want to take a bearish bet on that economy’s currency. To do that, they will sell the currency. The next thing to do is to work out the perfect currency to sell it against. To do that, a suitable currency pair is identified. This is fundamental analysis to the extreme, and the macro-global picture is key here. However, as mentioned earlier, the actual execution is technical. What these traders are doing is called scaling into a position. No one goes and makes a big short bet on a currency pair, or on a currency in general, by throwing the whole amount into the market at one time. The scaling process calls for adding to a position multiple times to build the right and proper average. Trend indicators are used, along with divergences and other local fundamental factors (such as changes in monetary policy, etc.), and much more. Now that we’ve described the basis of both technical and fundamental analysis, it is worth mentioning here that technical analysis mostly appeals to retail traders, while fundamental analysis is for the big players. Rarely do retail traders understand the fundamental factors that drive prices in an economy, and this is a big handicap. On the other hand, if one looks at the size of retail trading in Forex market transactions overall (less than 5% of all daily transactions are made by retail traders), then the conclusion must be that fundamental analysis is more important than the technical picture. Again, this is true to some extent. The correct way is to look at what may move markets, and then to act technically. This is what big players are doing as well, only on a bigger scale.
Recommended Further Readings
- Financial Products to Trade
– Different categories of financial products that a Forex Broker offers for retail clients, starting with the classical currency pairs, and moving on to commodities, CFDs, indexes, etc.
- Forex Trading Sessions and Their Importance
– Explaining the differences between the three types of Forex trading sessions, and their importance, ranking, etc.
- Forex Brokers Types – ECN or STP?
– What ECN and STP are; how brokers deal with clients’ orders; and advantages and disadvantages of the two types.
- What Makes a Good Forex Broker?
– Things to consider when deciding which broker to trade with, and the factors that carry most weight in the decision-making process.
- Financial Products to Trade
Other Educational Materials
- “Neural network techniques for financial performance prediction: integrating fundamental and technical analysis.” Lam, Monica. Decision support systems 37, no. 4 (2004): 567-581.
- “Stock trading using RSPOP: A novel rough set-based neuro-fuzzy approach.” Ang, Kai Keng, and Chai Quek. IEEE Transactions on Neural Networks 17, no. 5 (2006): 1301