The Forex industry is flooded with all sorts of Technical trading systems. When it comes to Fundamental Analysis the picture is very different.
The bulk of trading information available is based on Technical Analysis alone. Usually without any mention of the Fundamentals.
We believe that every great trading strategy should start with Fundamental Analysis. That should be your starting point before entering any trades.
In this post, we’ll discuss the basic concepts of the Fundamentals. We’ll also provide a few simple steps on how you can incorporate it in your own trading.
Here are a few of the points we’ll discuss in this article:
- What is Fundamental Analysis at a basic level
- Why are the Fundamentals important?
- Why don’t more traders use the Fundamentals?
- Fundamental currency drivers
- How can you get started with the Fundamentals?
What Is Fundamental Analysis At A Basic Level
According to the CFI, it’s the process of analysing the intrinsic value of a security. It involves analysing both quantitative and qualitative factors that influence currency values.
The goal of Fundamental Analysis is finding the underlying reasons why prices move. Apart from current moves it also tries to evaluate future currency directions.
For this reason, Fundamental Analysis can be used in the short, medium or long-term.
This type of analysis incorporates various factors which can affect currency values. For this reason, the Fundamentals are considered by many as being difficult.
However, that simply is not the case. The Fundamentals can be simple if you know what to look for.
Why Are The Fundamentals Important?
Investopedia calls Fundamental Analysis a ‘central pillar of investing’ with good reason. Most serious investors in the Finance game take fundamental analysis seriously.
The bulk of institutional traders use it as the foundation of their strategies. Why should it be different for us as retail traders?
We know from basic economics that prices are driven by supply and demand. Fundamental Analysis studies the factors that influence the supply and demand for currencies.
As a result, it can give traders a unique advantage in the markets. Especially if they can front-run other participants who only focus on the charts.
So, how exactly is this possible?
When there is a demand for a currency its price will appreciate. Contrastingly, if there is a strong supply of a currency it will depreciate.
Correct Fundamentals reveal when the supply and demand dynamics of currencies are changing. Thus, it allows traders to take trades which pure chart chasers would probably miss.
The other big advantage of the Fundamentals is with emotional management. Knowing the reasons why prices are moving helps you know whether moves will continue or now.
That will help your emotions stay calm when the price goes against your trade.
If the Fundamentals have not changed, it gives you confidence in your trade. Especially when the price is not moving the way you expect it to.
Why Don’t More Traders Use The Fundamentals
The first reason is that lots of retail traders think the Fundamentals are worthless. They feel this way because that’s the way they were taught.
Majority of Forex educators try hard to keep students away from the Fundamentals.
A popular claim made by many educators is that all events are priced into the charts. This is a popular misconception about the markets known as Dow Theory.
It teaches that the charts reflect the ‘sum knowledge of all investors’. Advocates of Dow Theory believe the charts reflect all the underlying economics.
As such, they think the only way to trade the markets are with price charts.
However, these claims cannot be further from the truth.
Have you ever seen how prices can move with certain economic news events? If you’ve ever traded the NFP news release, you’ll know exactly what we mean.
If everything was priced in the markets would not react this way to real-time news. It just doesn’t make any sense if you think about it logically.
The second reason why traders dismiss the Fundamentals is due to clever marketing. It’s much easier to sell fully automatic trading systems.
People want to believe that trading is easy. They want to believe they will get rich quick.
Beginners love the idea of having a Technical system that does all the work for them. It’s just clever marketing.
Sadly, most of these systems and strategies will never work in the long run.
The third reason why Fundamentals are avoided is that traders think it’s too complicated. They think you need to have some sort of background in economics,
However, after reading this article you’ll see it’s a lot simpler than you might think.
The Top Five Fundamental Drivers Of Currencies
There are lots of things that drive currency values. For this article, we’ll briefly mention the top five drivers.
1. Central Bank Decisions
So, what exactly are central banks? They are the organizations that manage a country’s monetary system and policy.
They are in control of a country’s money supply. Every central bank has specific mandates under which they operate.
Stable inflation is a common mandate applicable to the majority of central banks. Interest rates are a crucial tool used by them to reach their mandates.
Changes in interest rates have a tremendous impact on the Forex markets. Rate decisions from central banks can cause lots of volatility.
They’re also great opportunities for banking pips if you know what to look for. For this reason, interest rates should be something all Forex traders monitor.
As a beginner in the Fundamentals, this should be your starting point.
2. Economic News Releases
So, what exactly are economic news events?
Here is some of the most common economic news events that you might have heard of:
- GDP (Gross Domestic Product)
- CPI (Consumer Price Index)
- Employment Data (Things like average earnings, NFP and unemployment Rate)
Various economic events can have a huge impact on exchange rates. The reason for this is due to expectations.
Market participants always have expectations and forecasts about economic data. When the actual differs greatly from their expectations the markets react.
These reactions can be very volatile at times. As such, traders need to keep track of these events and their outcome.
3. Geopolitical Events
Politicians can be a big driver of currency values. Just think how exchange rates change when there is political unrest in a country.
Think about it from an investor point of view. They prefer to invest in countries with strong economies and stable politics.
When political tension gets investor worried it can impact the related currencies.
Another thing that is important with political events is Fiscal Policy. Fiscal policy would include things like government spending or tax cuts.
Large scale tax cuts can create a lot of economic expansion in an economy. A recent example of this was the 2017 corporate tax cuts for companies in the US.
This gave the US economy a massive boost and made it attractive to foreign investors. All these types of changes can have an impact on related currency values.
4. Natural Disasters
Any type of large scale natural disasters can also impact the markets. Things like earthquakes or tsunamis can negatively affect a country’s economy.
What if a country loses production in important sectors of their economy? This would not bode well with investors and the financial markets.
Thus, they are important for traders to be aware of. More importantly, traders need to know what the expected economic impact will be.
5. Intermarket Movements
The Forex market is not the only financial asset class in the world. There are also things like Equities, Bonds and Commodities.
All asset classes are connected and can have an impact on each other. Large moves in any asset class can drive prices in other asset class as well.
A good example of this is safe-haven inflows and outflows. The markets are very sensitive when it comes to risk.
If something occurs that cause panic in the markets it usually sends Equities lower. When this happens, it usually supports inflows into safe-haven assets.
Popular safe-havens are government bonds as well as the Japanese Yen and Swiss Franc.
The opposite moves can also be seen when something boosts investor confidence. Then markets usually see inflows into riskier assets like Equities.
These type of moves are better known in the market as risk-on and risk-off market sentiment.
How Can You Get Started With The Fundamentals?
So, now that we know the fundamental drivers of currencies what is the next step? How do we get stuck into conducting our Fundamental Analysis?
1. The first step is staying up to date with upcoming events
This is where an economic calendar comes in very handy. These calendars help traders plan potential trades in advance.
The calendars are also helpful as it shows what markets are expecting from data events. Knowing what markets are expecting to happen are very important.
Some of the biggest moves occur when actual numbers and expectations differ substantially.
So, our first step is to find out when important economic events are taking place. Then we should find out what markets are expecting from the events.
Read up on investment bank analysis to see what they are expecting and why.
2. Proper research and analysis is the next step
Research is a very integral part of proper Fundamental Analysis. You need to get used to tuning in to market data and analysis.
Whenever important economic events take place read what analysts are saying about it. How are they interpreting the events?
What are market participants saying about the events and the related currencies. How are they positioned on the currency and why?
These are all important questions you should ask when conducting your research. Don’t forget the central banks.
Make sure to get to know the central banks. Who are they and what are their current monetary policy stance?
This will help you prepare for rate decisions and central bank statements.
3. Investigate big moves in the markets
When you notice big moves happen in the market try to find out why it happened.
Ask yourself these three questions:
- What caused the most recent moves to occur?
- Are the same drivers currently still driving the market?
- Will the impact of the event have a sustainable reaction or not?
When we understand why moves have occurred it gives us confidence to trade them. As rational being we function better by knowing why things happen.
Think about it in terms of your personal life. We’re always searching for the reasons why certain things have happened.
As traders we can give our confidence a big boost by knowing why things occurred the way they did. This doesn’t mean that the Fundamentals will always perfectly explain every market move.
But it can explain majority of the moves that occur.
In this article we looked at some of the basic of Fundamental Analysis. We trust that the info we shared has helped you discover more about this important topic.
We also explained where most of the confusion about the Fundamentals come from. And why traders should take the time to incorporate it in their own trading.
For some, learning the Fundamentals might seem daunting. However, just like riding a bike it does become much easier as time goes by.
This is why it’s important for new traders to start with it as soon as possible.
It will take time to develop your Fundamental Analysis skills. However, once you get there it will all be worth the effort.
We wish you all the best with your analysis and your trading.
If you have any questions or comments, feel free to let us know in the comment box below.