A Comprehensive Guide to Conducting Fundamental Analysis in Forex Trading
Introduction
Fundamental analysis plays a crucial role in trading markets, whether it be currencies, equities, commodities, or fixed income.
As traders, our goal is not to become economists but to use economic information to make informed trading decisions.
This article will guide you through the process of conducting fundamental analysis in Forex trading, emphasizing the importance of understanding market value to profit from undervalued or overvalued prices.
Why Fundamental Analysis Matters
Fundamental analysis is essential because it helps traders determine whether an asset is relatively cheap or expensive. By identifying undervalued or overvalued prices, traders can make profitable decisions.
It’s crucial to remember that we engage in fundamental analysis not to gain theoretical knowledge of economics but to leverage that information to buy low and sell high.
Fundamental analysis is versatile and can be applied to any asset class. Markets are interconnected, creating correlations that can serve as effective trading tools across different asset classes.
Key Fundamental Factors in Forex Trading
When conducting fundamental analysis for currencies, focus on the following key drivers:
- Economic Performance
- Fiscal Policy
- Geopolitics
- Intermarket Analysis
- Monetary Policy
These factors help determine whether a currency is undervalued or overvalued. Central bank actions and monetary policy are always the primary drivers of currency value, with the first four factors evaluated in relation to their impact on monetary policy.
Economic Performance
Assessing the overall state of the economy is the starting point for fundamental analysis. Key indicators include:
- Growth (GDP): Determines if the economy is expanding or contracting. A growing GDP indicates economic health and often leads to stronger currency values, while a shrinking GDP can signal economic troubles and a weaker currency.
- Inflation (CPI): Indicates if prices are stable, rising, or falling. Moderate inflation is typically a sign of a healthy economy, whereas high inflation may lead to increased interest rates to cool down the economy. Conversely, deflation can be a sign of economic weakness and may prompt central banks to lower interest rates.
- Labor Market (Employment): Reflects the health of the job market. High employment rates generally lead to stronger consumer spending and economic growth, positively influencing currency value. Conversely, high unemployment can signal economic problems and a potential decline in currency value.
While growth is important, inflation often takes center stage. A healthy economy typically sees moderate inflation and low unemployment, the sweet spot for central banks.
However, too rapid growth can lead to high inflation, risking a recession. Conversely, low growth can lead to deflation, also risking a recession.
If you are interested in trading economic data points click here.
Fiscal Policy
Fiscal policy, influenced by economic health, involves government spending and taxation. A weaker economy may lead to increased spending and tax cuts, while a booming economy might see higher taxes and reduced spending. Understanding fiscal policy is crucial as it impacts monetary policy.
- Elections: Election outcomes can drastically impact economic policies. A pro-business candidate might implement policies leading to tighter monetary policy, while a candidate favoring increased social spending might result in looser monetary policy.
- Global Events: Events like pandemics, wars, and trade disputes can disrupt economic stability, affecting currency values. For example, a trade war can reduce export revenues, weakening a currency.
Intermarket Analysis
Intermarket analysis involves examining the relationships between different markets. For commodity-dependent countries, the prices of key commodities (e.g., oil for Canada, iron ore for Australia) significantly impact their currencies. Understanding these relationships helps predict central bank actions.
- Commodity Prices: The value of commodities like oil, gold, and agricultural products can affect currency values. For example, rising oil prices can strengthen the Canadian dollar due to Canada's significant oil exports.
- Bond Markets: Interest rate differentials between countries can influence currency flows. Higher yields in one country compared to another can attract investment, strengthening the currency.
Monetary Policy
Monetary policy remains the most critical factor in fundamental analysis. Central banks adjust interest rates and conduct quantitative easing or tightening based on economic indicators. Traders should focus on whether a central bank is likely to tighten or loosen monetary policy, the timing of these adjustments, and the expected aggressiveness of the changes.
- Interest Rates: Changes in interest rates directly impact currency values. Higher rates attract foreign investment, boosting the currency, while lower rates can weaken it.
- Quantitative Easing/Tightening: Central banks may buy or sell government bonds to influence money supply and economic activity. QE typically weakens the currency by increasing money supply, while QT can strengthen it by reducing money supply.
What a simple way to get started trading the fundamentals?
The Simplest Fundamental Trading Strategy:
There are so many ways to trade using the fundamentals – but let’s use one simple (highly profitable) example around monetary policy.
If a central bank hikes or cuts rates – that directly affects the fundamental value of the currency – weakening it or strengthening it.
Central banks often base whether they will hike or cut on very specific pieces of economic data like employment and inflation.
This is why there is an entire group of people who trade only risk events. So below is a trading strategy for major economic data points – which are one element of fundamental analysis.
Trading Strategy for Nonfarm Payroll (NFP)
Step 1: Analyze Federal Reserve Priorities
Understanding the Federal Reserve’s current economic data focus is crucial. If the Fed is emphasising employment data, those releases will likely cause significant market volatility.
Our Professional Economic Calendar includes a fundamental guide to help you stay updated on the Fed’s focus.
Remember if the Central bank is focused on the data point – it’s because they are using that data point to make a decision on rates. This is the reason data points are focused on cause volatility.
In addition, sometimes the central bank is focused on a data point inside a data point. Like the Federal Reserve has often called out average hourly earnings as the key thing they are looking for inside the Non-farm payroll report.
Step 2: Use High-Low Expectation Forecasts
Professional traders rely on high-low forecasts to gauge market expectations accurately. Here’s why these forecasts are crucial:
- Institutional Forecasts: Our economic calendar includes high and low estimates from top institutions, offering a comprehensive picture of potential outcomes.
- Market Shocks: Reports that exceed the high estimate or fall below the low estimate can shock the markets, resulting in sharp movements. Our "Lightning Bolt" feature signals these deviations instantly, allowing you to act quickly.
Economic forecasts are derived from surveys of credible institutions, each providing their best estimate on upcoming data points. Retail calendars typically present the median of these estimates, which can be misleading.
A professional calendar includes both high and low estimates, revealing the full range of expectations and indicating how surprising an actual data release is compared to the extremes.
Step 3: Choosing the Instrument to Trade
Professional traders also use institutional reports to judge which paid will be the most volatile to jump into. For example, if USD/JPY is particularly sensitive to economic data, as outlined by the City Economic Surprise Index, and NFP shows a significant deviation, this pair could be an ideal target for trading.
- City Economic Surprise Index: Identifies currency pairs that react strongly to economic surprises, helping you focus on the most responsive markets.
- Risk-Reversal Report: Reveals market positioning, showing a buildup of call or put options on certain currency pairs. Understanding these positions helps you choose pairs that may have orders susceptible to liquidation upon an economic data release.
- CFTC Report: Details hedge funds' positions. If many big players are long EUR/USD but data favours the USD, some funds might have to unwind their positions, leading to an outsized move. This insight ensures you pick the right pairs, avoiding less responsive ones like GBP/USD.
Trade Execution Steps
- Confirm Fed Focus: Ensure the Federal Reserve is emphasizing employment data. If so, the NFP report is more likely to move the market.
- Check Forecast Ranges: Review high and low forecasts before the data release. Trade only if the actual data significantly exceeds or falls below these estimates, acting on genuinely surprising data.
- Monitor Revisions: Check for conflicting revisions that might alter the initial market reaction. Ensure the primary release and revisions align to support your trade.
- Enter Trade Promptly: Once you confirm the deviation, act quickly. Speed is crucial as market reactions to significant data surprises happen rapidly.
- Set Stop and Take Profit: Place your stop-loss below the low of the initial spike candle to protect against adverse movements. Aim for 15-30 pips for tier 2 events like NFP, adjusting based on market conditions and volatility.
Managing the Trade
- After the Initial Run: Look for a shallow pullback around a 23% Fibonacci retracement or near support/resistance levels. This initial pullback can provide an opportunity to enter the trade with a better risk-reward ratio.
- Break Even: Move your stop-loss to break even as soon as possible to protect your gains. This step minimizes risk and ensures you lock in profits if the market continues in your favor.
- Reentries: If your initial position is stopped out, consider reentering at deeper retracements, such as the 38% or 50% Fibonacci levels. Use nearby support and resistance levels to guide your reentry points.
Conclusion
If you don’t have access to some of the tools above and would like to level the playing field, check out our professional economic calendar.