According to the Cambridge dictionary, analysis is the “act of studying or examining something in detail to discover more about it.” It appears as though the world masters at Cambridge have given us a rather broad definition.
However, that’s precisely what we do when we trade forex — we study the market to learn about tendencies, patterns, and opportunities.
There are two basic types of study in the financial markets: fundamental and technical analysis. Read on to learn more about fundamental analysis and how you can integrate it into your approach to the foreign exchange markets.
In the financial markets, fundamental analysis is the study of how external factors impact an asset’s valuation. As it pertains to forex, fundamental analysis investigates how assorted market drivers influence the pricing of currency pairs.
At this point, you may be asking what a fundamental market driver is? A market driver, or underpinning, is any information that may impact a given asset’s valuation model. Market drivers come in many shapes and sizes, varying by asset class.
To illustrate the market driver concept, assume that Erin, the equities trader, is interested in buying a chunk of Apple (AAPL) stock. Before buying, Erin is well-advised to scrutinize AAPL’s specific fundamentals, such as the corporate balance sheet and income statement.
Also, it may be a good idea for Erin to look at broader fundamentals, such as the current economic cycle, stock market trends, etc.
Remember, the whole point of fundamental analysis is to identify opportunities in the marketplace. These opportunities may arise due to pricing disequilibrium or through spotting an asset’s intrinsic value. The topic of intrinsic value is pretty involved; for now, let’s say that something’s intrinsic value is its true worth, not necessarily its market price.
If your fundamental analysis says that an asset’s price doesn’t reflect its actual value, then an opportunity may be afoot! Should this be the case, you may be able to make money by implementing bullish, bearish, or neutral trading strategies. And, with a bit of luck, collect a stack of green pips in the process!
The forex features a collection of unique market drivers that are best factored into your fundamental analysis. Among the most important are breaking news items, economic indicators, and the monetary policies of central banks.
Perhaps the most important thing to understand about market drivers is that they can quickly prompt enhanced forex participation and severe exchange rate volatility.
As a general rule, news comes in two forms: planned and breaking. Planned news events are pre-scheduled, such as official press conferences or the annual G-7 Summit.
On the other hand, breaking news items come as a complete surprise. Examples include terror attacks, election results, or a pandemic’s onset.
If you’ve ever spent a week in front of a forex trading screen, then you know how any country’s currency can react to breaking news and how news trading is used by many forex traders. That’s why most forex traders ensure that they have access to a live news feed.
Perhaps the most important aspect of forex fundamental analysis to be aware of are official economic data releases published on an economic calendar. A financial data release is a report that discloses both macroeconomic and microeconomic information. These releases are conducted by central banks, governmental bureaus, and independent research firms.
The primary function of an economic data release is to keep the public updated on financial affairs. To do so, a variety of economic indicators are used. A few of the most important to forex traders are gross domestic product (GDP), the consumer price index (CPI), and Non-Farm Payrolls (NFP).
Economic data is a vital element of the fundamental analysis pertaining to currency trading. By studying a country’s economic performance, active traders can determine which way a country’s currency may be poised to move. And, although economic indicators such as CPI and NFP are fallible, they give us invaluable insights into a nation’s actual financial state.
Monetary policy is central banks’ toolset for fostering pricing stability, maximum employment, and economic growth. Central banks such as the Bank of Japan (BoJ), Bank of England (BoE), and the U.S. Federal Reserve (Fed) use monetary policy to control their country’s domestic money supply.
Among all forex market fundamentals, monetary policy is the most important. Take it from us — when central banks talk, it pays to listen! Raising/lowering interest rates, enhancing/restricting credit, or adopting emergency measures can rapidly send any foreign exchange currency surging or retreating.
In the live market, fundamental and technical analysis are powerful tools for crafting trading decisions. However, there are several stark differences between the two. Keep reading to learn more about three areas where forex fundamentals and technicals diverge.
Ultimately, fundamental and technical analysis differ in one primary way: fundamental analysis addresses evolving topics that may impact the markets, while technical analysis studies past price action.
Thus, fundamental analysis is predictive in nature, while technical analysis is reactive. What exactly does that mean? Well, the scrutiny of fundamentals is centered around what will be or what is driving the market, not what price did in the past.
In this fashion, fundamental market drivers are ever-evolving and in the now — not stories of ancient history!
By nature, technical analysis focuses on the details of price action. Subsequently, many technical forex traders get lost in the minutiae of currency pricing and ignore the bigger picture. That’s why it’s important not to completely forget about fundamental analysis; it gives us insights into why price is moving, not that it already has.
It’s important to understand that intermediate and long-term (macro) trends don’t happen by accident. In reality, there’s a good reason behind every sustained move in price. Beit news, economic data, or policy moves, there’s always a collection of underpinnings at work driving a bullish or bearish trend.
Implied volatility is the measurement of forthcoming movements in asset pricing. The concept of implied volatility is frequently applied to derivatives regulated by the US National Futures Association (NFA). However, it can also be related to forex pairs and CFD products.
One area where fundamental analysis excels is in addressing implied volatility. By identifying when key market drivers are to occur, one can accurately project periods of pricing volatility in advance.
For instance, we know that when the US Federal Reserve makes its interest rates announcement, forex volatility is assured. And, Fed announcements are scheduled well in advance. So, through examining Fed fundamentals, we can gain an understanding of precisely when the implied volatility facing the forex majors is likely to increase.
Technical analysis does not account for implied volatility; it is focused solely on price action. This can pose a significant risk to leveraged trading strategies that discount fundamentals in favor of technicals.
Fundamental analysis is a powerful tool for understanding which market drivers are actively influencing price action. Three of the most important market drivers are news, economic data, and the monetary policies of central banks.
When you’re trading your favorite forex pair, be sure to keep an eye on the key market drivers. Even if you favor technical forex trading, it’s imperative that you stay in tune with the fundamentals!
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