Fundamental analysis - Meaning, Tools, Methods
Fundamental analysis in forex is a method of analysing and predicting the behaviour of the foreign exchange market and other financial markets by considering fundamental factors. It is usually used for planning long-term investments.
There are four categories of fundamental factors:
- Political: election of the head of state or parliament, change of government, form of government, polity
- Psychological factors: rumours and expectations
- Force majeure: natural disasters, natural calamities, warfare, etc
- Economic: financial indicators and events in the life of a particular company, publication of macroeconomic statistics, speeches of heads of central banks and so on.
What is a fundamental analysis based on?
Unlike technical analysis, fundamental analysis studies the underlying causes of fluctuations in asset values. Practising traders know that any strong movements in financial markets start with news releases. The news acts as a catalyst for change. One of the most famous traders who based their forecasts on fundamental analysis is Warren Buffet.
The main tenets of fundamental analysis are as follows:
- Prices never just change, the change always has a reason.
- The influence of certain factors on price movement can be predicted
- Correct estimation of the dynamics of fundamental factors allows making a reliable judgment about further behaviour of prices
- Force majeure events have a significant impact on prices, but are difficult to predict
Fundamental analysis is based on the following proposition: currency prices in the Forex market are reflections of supply and demand that are in turn influenced by economic fundamentals.
Fundamental analysis proceeds from the assumption that each asset has a certain fair price, and that sooner or later it will return to this fair price.
What you need to keep in mind when doing fundamental analysis:
- Even the most likely scenario may not work out
- Economic education is not a guarantee of success, you should not forget about special literature
It is important to follow money management rules and place Stop Loss orders.
A combination of fundamental and technical analysis will increase your chances of success.
Tools for fundamental analysis
The main tools of fundamental analysis are economic calendar, financial news and analytical forecasts. The economic calendar shows the day when the event is going to take place, how much it is going to influence the volatility, and what are the market participants´ expectations. The tool is convenient because all important publications are collected in one place and grouped by country. The calendar also keeps historical data, which allows forecasting the long-term dynamics of currency pairs
The calendar allows you to filter out unnecessary events. If a trader works exclusively on USD/JPY, he or she can hide statistics from EU countries at any time.
The publication or broadcast of financial news informs traders of important events that can directly or indirectly affect the market. Qualitative analytics from financial experts allows evaluating the accuracy of a trader's forecast.
Events in the US are often the main catalyst for changes in the financial markets: the most popular currency pairs have the US dollar in their composition, and the country's economy is still the strongest in the world. Every first Friday of the month the most important US macroeconomic indicator - Nonfarm Payrolls (a report on new non-farm payrolls) - is released and traditionally drives the market in a strong move.
Fundamental analysis methods
There are about a dozen of different methods of fundamental analysis, but not all of them are relevant to the Forex market. For a trader on the currency market the main methods are as follows:
- Grouping and generalization;
- Deduction and induction.
The comparison method is used to track critical indicators at the country level that can affect price movements. For example, traders are always waiting for the central bank's decision on the interest rate for the national currency of the leading countries.
The correlation method is based on long-term observation of the behaviour of assets. Correlation coefficients allowing predicting which way the price will go and how strong it will be were derived on the basis of the received data. For the forex market, it is first of all determination of the mutual correlation of currency pairs. In correlated pairs, the price change charts will be interdependent.
The method of examining seasonality is also very important because seasonality matters in all markets without exception. It affects the value of food, agriculture, commodities and more. The currency market does not exist in isolation from the commodity market, so a trader should understand the currencies of what countries and to what extent are subject to this factor. This should also include the market behaviour before and after weekends and holidays.
The grouping and generalization method is an offshoot of the correlation method. The essence is that assets are grouped into certain categories, and an index is calculated for each category. For instance, the well-known S&P 500 index is an indicator of US economic conditions.
The deduction method is used to analyse the cause-and-effect relationship between market events in order to predict the price movements of related currency pairs on this basis. That is, the analysis is carried out from the general to the particular. For example, when the oil price goes down and Asian markets fall at the same time, the currency pair AUD/USD is likely to react with a fall.
In contrast to the deduction method, the induction method is based on an analysis from the particular to the general. We take several major assets (e.g. three commodity currencies) and use the analysis of their charts to draw conclusions about the commodity market as a whole. This method is best used for trend trading.
Disadvantages of the fundamental analysis method
It is difficult to find patterns: one and the same fundamental factor can have very different effects on the market at different moments
Delay in getting the data: private traders are outperformed by algorithmic trading systems and insiders, who process the information before the news is published.
Manipulation of data by news agencies.
There is a lot of news, and it is difficult to interpret and compare the data correctly. Also, the fundamental analysis does not always indicate the direction of the trend and the best points to enter or close a position.
You have to take into account fundamental factors, of course, but it is risky to rely only on them when making decisions about the deal. Practice shows that strategies combining elements of the technical and fundamental analysis show the best results.