When looking at the market, Forex traders use the same two basic forms of analysis that they use for the stock market: technical analysis and fundamental analysis. While technical analysis advocates state that all you need to know about an asset is reflected in the price trends, fundamental analysis focuses on the intrinsic value of an investment.
Fundamental analysts look at everything but the price. Instead, this method implies that you can take rational conclusions and determine an asset’s fair market value by looking at the factors that influence it.
Performing this type of analysis can sound a bit complicated – after all, a country is not like a company, where you can pull out the balance sheet and draw conclusions from it. However, certain factors, such as the state of the economy, the unemployment rate, or political changes, can influence the country’s monetary policy and that is reflected in the evolution of the currency.
The main premise behind fundamental analysis is that the value of an asset isn’t always reflected in the price and that, by performing this analysis, they can discover the fair market value of an asset and identify trading opportunities. Thus, if an asset’s fair market value is higher than the cost, that asset is undervalued and it should be bought.
Fundamental Forex analysts believe in four basic principles:
Fundamental analysis is generally perceived as more theoretical because it implies understanding the underlying factors that influence the value of a security, which is why it’s mostly advanced traders who tend to use it. When establishing a currency’s intrinsic value, fundamental analysts take into consideration the following factors:
By interpreting economic data, fundamental analysts are able to foresee some shifts in the economic situation of a certain country and therefore its currency. This economic data includes:
Apart from following these main indicators, fundamental analysts keep economic calendars where they monitor other important events, such as:
In very simple terms, if a country has a good economy, its currency will likely have a higher value, but if the economy shows signs of regression, that will be reflected in the lower currency value.
A country’s political climate has a major influence on the exchange rate, which is why fundamental analysts keep an eye out for important events like:
In general, when investors believe that the policies of an elected leader will encourage economic growth, the currency value will rise. And the other way around, when a leader is expected to cause political instability, the currency value will drop. For example, when Silvio Berlusconi announced he was running again for prime minister in Italy, the market quickly reacted and the euro weakened.
These factors do not intervene with currency value very often, but when they do, they have a major impact. Typically, it’s easier to work with social circumstances, which are somewhat easier to predict, such as strikes, revolutions, or even coup d’états, because if you monitor a region carefully you will notice signs of unrest. Natural disasters, however, are much more problematic. Even if the weather forecast gives traders some insights about higher risks of flooding, droughts, or hurricanes, earthquakes are impossible to predict and they can destabilize the currency. For example, when Japan was hit by a major level 9 earthquake in March 2011 (the largest in modern history), it cost the country 5% of its GDP. For the first time since 2000, all G7 nations had to carry out coordinated efforts to stabilize the yen.
Another idea behind fundamental analysis is that the market reacts to news, which breaks previously formed patterns. For example, if a reputable authority issues a report on employment data in the United States, that report could be an indicator of the country’s economic health. Traders who rely on fundamental analysis use the news to adapt their strategy, but they don’t just consider the impact of the news on the dollar, but also on the other currency in the pair.
As important as the news may be for traders, reacting quickly isn’t always wise. For example, if a head of state makes a seemingly controversial statement that goes against their usual political and economic beliefs, traders should first wait and see what happens. Many times, that statement was misunderstood or may be clarified. The same goes for reports because the numbers can be revised soon after they were issued. When it comes to news and data, there’s usually a lot of commotion before it’s released, as the market sentiment tends to lean in one direction. Then, it’s more a matter of meeting expectations than the data itself.
Should your trading strategy be based on fundamental analysis? Following the Forex economic calendar and watching for important global events that could shift financial markets is a great way to boost your trading education and make informed decisions. If you look at the numbers and understand what they mean, you will also be able to manage risk substantially. And, even though technical and fundamental analysis may be on opposing sides, you don’t have to choose just one. You can always combine the two.