CO07 - What is fundamental analysis?

"Fundamental analysis is a form of studying the financial markets. As the name suggests, fundamental analysis deals with the underlying reasons behind the price of the security being analysis. Depending on what markets you are trading, fundamental analysis can vary. In forex, fundamental analysis is simply the study of the economy for the currency in question. By studying the economy, traders are able to understand the implications it will have on the country’s interest rate. The interest rate in turn tends to make a currency more or less preferable. To be good at fundamental analysis you need to have some knowledge about the economies and the markets. It might seem a bit difficult at first, but with practice you can use fundamental analysis to determine whether the price is really reflecting all the news or if there is some anomaly in the markets. Fundamental analysis is important if you want to trade with the trend and want to trade from the medium to long term basis."

Fundamental analysis is a field of study in the financial markets which is based on the study of the fundamentals that determine the price of the stock. Using fundamental analysis, traders are able to judge whether the price of the security is correctly priced or valued.

Fundamental analysis simply answers the question of the reasons why the price of a security is behaving the way it is. Based on fundamental analysis, traders or analysts are able to judge the fair value of a security. Based on this analysis, they can then ascertain if the price is trading at a premium or a discount.

In forex, fundamental analysis is slightly different compared to stocks. Using fundamental analysis such as studying the GDP, inflation or the unemployment rate, traders are able to understand whether the price of the security is trading accordingly.

Therefore, to be good at fundamental analysis, traders need to have some basic knowledge about the economy and economics. The forex markets and the financial markets in general discount all the news there is. This is known as the efficient market hypothesis.

Price starts to react only to new incoming data or news events.

In the forex markets, these news can range from business surveys which give a glimpse into how the economy could perform to central bank monetary policies.

At the core of the forex markets, interest rates are what drives prices of the currencies in question. When the interest rate for a currency is higher, investors flock to such currencies in order to get higher yield or return.

Conversely, when a currency’s interest rate is lower, investors prefer to sell these currencies in favor of higher interest bearing currencies.

As you can see, there is a close relationship between the fundamentals (economic releases) and the central bank monetary policy which in turn affects the general market preference for the currency pairs in question.

What are the most important fundamentals to follow in forex?

There are a number of economic news releases or fundamentals that come out on a day to day basis. But these are mostly categorized into the two types outlined below:

Leading indicators: Leading economic news are mostly business surveys and central banker speeches. These reflect the near term outlook for the economy. Business surveys are done on a monthly basis. They are mostly surveys conducted by private institutions or universities. They typically show how the businesses and consumers feel about the economy. This can play a big role in understanding how the economy is performing and whether or not to expect growth or a slowdown in activity.

Lagging indicators: Lagging economic news releases are those which are backward looking. Due to the nature of these economic indicators, they are reported for the previous month or the previous quarter. Some examples of the lagging economic news events include GDP report, the monthly unemployment report, inflation data and so on.

Among the above two, the most important indicators or fundamental events fall into the second category. These are:

GDP reports: The GDP reports are released once a month or once a quarter, depending on the time period that the report covers. This gives the trader an idea of whether the economy is growing or stalling (or even falling into recession).

Unemployment reports: The unemployment reports give you a basic idea of how the economy’s labor market is doing. This is an important indicator because it also tells you the wage growth for the economy. Wages after all impact everything, from inflation to spending and saving.

Inflation: The inflation data tells you how much the cost of goods or services are. They are compared to a baseline and often reported in a month over month or quarterly or annualized terms. Inflation tells you whether the price of goods or services are increasing or decreasing.

Monetary policy meetings: The central bank monetary policy meetings are held just about every month. But major policy changes are usually made around the quarterly meetings. This is where the central bank’s monetary policy committee discusses whether interest rates should be increased or cut.

Traders read and try to understand the implication of the above reports on interest rates. As a result, fundamental analysis is a great way to understand the reasons behind the price movements.

Typically, fundamental analysis is done in isolation. However, if you combine fundamental analysis with technical analysis you are able to get a full picture of the market that you are trading.

You will understand the reasons behind the price movements and also predict what price can do in the near term by applying these two schools of study.

Read 894 times Last modified on Thursday, 04 July 2019 11:04