- Case Study: Real World Fundamental Trades Playing Out - February 7, 2020
- How To Trade Forex With A Full-Time Job - January 31, 2020
- How To Get Started With Fundamental Analysis - January 24, 2020
Fundamentals Drive Currency Prices And Investor Sentiment
We will explain what fundamental analysis is and how to get started with fundamental analysis and get to grips with it in your trading.
We will also include a step by step guide that will help you begin to interpret news and analysis into clear trading opportunities.
To illustrate how fundamental analysis applies to the trading routine of most professionals we can use the example of driving a car.
80% of driving is done by looking through the windows and reading the signs to tell us where we are heading and how to drive. 20% is about using the mirrors at important times to avoid accidents.
Imagine the result if you tried to drive your car using the rear view mirrors 100% of the time … This is effectively what you are doing when trying to trade solely off a price chart.
Fundamental Trading Myths
If you want to know how to get started with fundamental analysis, then we had first better debunk some certain myths.
In the world of retail trading education there are many myths concerning fundamental analysis and trading of news.
For example, many people believe that fundamental analysis is complicated or reserved only for those that have specialist degrees in finance.
Other people believe that trading around news events is highly unpredictable and dangerous. And some people are told that all information is perfectly priced into the markets at any given time.
These are all retail trading myths and one of the best ways to see how this is the case is to simply watch the price of major currencies as a major economic event is released.
You will often notice that the price moves almost instantly in reaction.
These moves are the direct result of professional traders waiting for these releases and taking action immediately.
They do not hide or avoid these events, in fact they are often the highlight of the week for most professional trading floors.
If this is how professional traders operate then it gives us a clue to the importance of fundamental news and analysis.
Later in this course we will also demonstrate how news and fundamentals very often take months and even years to be fully priced in.
This is very easy to prove and we will use a real-life example on a major currency.
After you see for yourself how simple and effective the fundamentals can be you will then be ready to understand exactly how you can start using them to vastly improve your trading.
So how can you begin conducting some basic fundamental analysis now and what do you need to be watching out for?
Central Banks - A Key Fundamental Driving Influence
When trading currencies, everything revolves around the central bank of the relative country. A central bank is responsible for the economic stability of each nation.
Famous examples of central banks you may have heard of include the Bank of England and the Federal Reserve in the US.
Each central bank has a mandate. This is just a selection of targets for the overall economy.
These targets generally revolve around how many people are employed, how fast the economy is growing and how quickly prices are rising for normal everyday people doing their shopping.
To help them make sure that the economy is working in a way that will keep to their targets they monitor the economic data that is released on a regular basis and then try and use that data to spot trends in the economy.
When they see a trend forming that they don’t like the look of, they will use some of the special tools at their disposal to fix it.
The process of the central bank is fairly simple: They set their targets. They monitor the economic data. They implement their tools when they see the need to.
So how does this help you as a trader?
It is the use of those tools that causes currency prices to move.
Central Bank Economic "Tools"
The most common tool used by central banks around the world is that of interest rate adjustments.
Once way in which they can adjust interest rates to improve the economy is when people start saving their money instead of spending it.
When this happens the economy starts to slow as fewer people are buying and selling. As the economy slows down more people stop spending and it gets harder and harder to make money.
The worry of not being able to make money then leads more people to cautiously save the money they do have. Thus growing the problem.
To nip this in the bud quickly the central bank will lower its interest rate. This is the rate used by all commercial banks as a guide from which to pay its savers and charge is borrowers.
By suddenly having a lower rate, it makes saving money much less attractive because people get no reward.
It also encourages people to take more risk and borrow money which they then use to buy houses or start up new businesses.
This gets the money flowing and people become confident that they will be able to make money again. This confidence leads to further spending which gets the overall economy back on track.
Each time the bank implement their tools in this way it has a powerful effect on the value of their currency.
The example we just looked at, of lowering interest rates, would also reduce the value of the related currency, sending the price plummeting.
The reason is that investors would suddenly have no benefit of saving or investing their money in that country.
The interest they were previously being paid is now gone. Instead they cash out and move their funds to another country where interest rates are more attractive and they will get a better return.
Part of this process involves changing that money from the local currency into the currency of the new country. They are in effect selling the local currency to buy the new one.
This selling of the currency causes the price to drop.
Imagine the advantage you would have if you knew how all of this worked and began selling that currency just before the rest of the market and the larger investors had a chance to do all of this?
This is where understanding and trading the fundamentals will make you money.
Let’s look in a little more detail how all of this works and how you can start learning and applying it today to improve your trading results!
As we know it all starts with that economic data.
But instead of being mysterious numbers that have a totally random impact on the markets they can in fact be followed, interpreted and even predicted in the right circumstances.
So what are these economic data points and what do they tell the central bank and us about the economy?
The main ones can be broken down between Production indicators which show what the country is making, Employment which show how the workforce is performing, growth, which show how fast and at what rate the economy is expanding or shrinking, inflation which show the rate at which prices of every day goods and services are rising or falling and finally geopolitical which isn’t directly related to the economy but can potentially have a huge impact, for example if a country goes to war or if an anti-business government is elected then this can cause problems that the central bank might have to contend with.
When these indicators point to action being needed from the central bank then this will move currency prices as traders try and get into position to ride the moves for as much as they can.
This race to catch the next big move is generally what is moving currency prices on a daily basis as professional traders constantly analyse the economic data and try to predict when the central banks will act next.
Very often the moves caused by the speculators creates opportunity in itself.
If you learn to recognize things that the market might be paying attention to or something that has historically caused traders to buy and sell then this is an opportunity to take advantage of just like the anticipated moves caused by the larger investors moving their capital in and out of the country over the longer term.
This is why news is never fully priced in instantly. Sometimes it just takes a while to move huge amounts of money around, and this drags out the time it takes for things to ever be fully priced in.
This brings us to the tools themselves that the central banks use.
The main tools used are interest rates as we have already looked at.
The banks also use price caps which is when they will decide to keep the value of their currency at a specific price level against another currency.
An example of this is on the EURCHF currency pair in between 2013 and 2015 when the central bank of Switzerland, the SNB, decided to hold the value of the Swiss Franc against the Euro at 1.20.
Even though the market wanted to sell that pair lower, it couldn’t because the bank would literally print money to absorb all of the sellers.
This was one battle that the market knew it couldn’t win.
This was a powerful tool and traders knew that when the price hit that 1.20 level there would be renewed buying from the bank and that it would rise back from it.
The power of the banks floor was demonstrated when they removed it in 2015.
The price fell over 10,000 pips in a matter of minutes as the markets scrambled to take advantage of the removal of this tool.
Another tool used by central banks is that of language.
This simply involves trying to convince the market that they will do something if needed in the hope that the markets believe them and start trading as if that action had been taken.
For example, if a bank would like the value of the currency to be lower but doesn’t want to actually lower interest rates, then it could tell the market that it will act unless the price falls.
If the market believes the bank then very often it will oblige and sell the currency, thus giving the bank its desired effect without them having to actually do anything.
These messages are delivered through regularly scheduled statements that the banks all host. It is not hard to figure out what the banks are thinking because they go to great lengths to actually tell us.
There are many other tools that banks can use but these are the most common, and in the years after the financial crisis they also started using a new tool called quantitative easing.
This is where they print money and flood the economy with that new money. The goal is to reduce the value of the currency while also stimulating the economy.
So traders are constantly looking for any signs that a central bank may be about to use one of these tools and then they will try and trade that ahead of everyone else.
The earlier they can enter the more of the ensuing move they will catch and profit from.
Your job as a trader is be aware of what is going on and then figure out what the central bank is likely to do next with its monetary policy.
If it is likely to take action that will devalue its currency then we would be looking to sell it.
If it is taking action to increase demand and therefore the value of its currency, then of course we would be looking to buy it instead.
This constant cycle of economic data and the central banks reactions is never ending and is what provides unlimited opportunities for currency traders all over the world that understand what is going on.
There is no need to try and follow every analyst or be watching every single movement of all of the currency prices.
The only thing you need to be aware of is what each major central bank is doing and how the market is expecting that to impact the currency.
Once you become proficient at this process you will start to see many opportunities to make money from your ongoing analysis, across the major currency pairs.
You can get started with this right away and see for yourself just how connected the economic news is with the movement seen in currency prices.
To do this you can follow a simple 4 step guide that we will walk you through now:
A Step-by-step Fundamental Guide
Before you can apply the 4 steps, and how to get started with fundamental analysis, you need to know where to find the necessary news and information.
There are many freely available resources that you can start using right away. These will help you start using fundamental analysis even if you have no experience in it until now.
The following 4 step guide can be applied on any news analysis sites. One of the best out there (not being biased here!) is the very site you’re on. I’ve provide the link for you This Week’s Economic Calendar, where you will find extremely in depth market analysis. But there are others out there. Explore them all and see what you think.
Here is a link to Google with the search query pre-defined for you.
When reading the articles that you find there, if you cannot apply each and every step to the information that you are reading, then you should abandon that particular piece of information and find one that does contain each of the 4 steps.
Step 1: Which currency is it talking about?
When reading a piece of fundamental news or analysis the first thing you need to find is which particular currency it’s talking about. This will usually be in the headline or first few lines of the text.
Step 2: Which direction is the currency moving in?
Now you know which currency the news is moving your next step is to find out which way it is expected to move next. This should again should be in either the headline or the first few lines of text.
Step 3: What are the reasons behind this latest move?
This step is very important and is perhaps where most retail traders go wrong when trying to find trades. The reason behind why the price is moving is absolutely crucial to understand and will really help you to figure out what to do next.
You will discover the reason behind the move by reading the main article itself.
Step 4: What are the analyst expectations from here?
This will be where you start to understand how to interpret the news. As a beginner the best path is to simply follow along with what the expert analysts and traders are thinking.
Each article should contain a specific expectation that you can use to base your own trading on.
For example, do they expect the moves to continue or do they think it is merely a pullback against the main fundamental trend. This will tell you whether to buy or sell.
They will also very often give you specific price targets for that specific currency pair. These targets are only general guides but can give you a nice idea about how much of a move can be expected.
Even if you’re a complete beginner to fundamentals, you can start practicing this process by following the 4 steps that we have outlined here.
After a few days you will start to see just how directly the fundamentals move currency prices every day.
This is your key to becoming a consistently profitable FX trader