What is fundamental analysis?
To form an investment strategy, customers use fundamental and technical market analysis. Unlike technical analysis, which looks at historical price changes and related trends to help determine when prices can rise or fall, fundamental analysts look at all available data to determine market conditions. They then look for discrepancies between the current market price and their own valuation in order to identify trading opportunities for profit. For example, they may want to take a long position (buy) USD on Forex if you think that valuation is higher than the current share price.
Imagine that you want to buy a car. The one you like costs $ 10,000, but you don’t know if the price is fair. Thus, you will conduct research on the Internet, ask other people questions, compare its cost with other car dealership offers, etc. to assess whether the price is “fair” and whether the car is worth the money.
What you do in this scenario is fundamental analysis. You take into account all the key factors in making a decision about the fair value of an asset.
Fundamental analysts use the wealth of data available, including corporate earnings reports, geopolitical developments, central bank policies, environmental factors, and more to help them analyze them. They are looking for clues to determine the future direction of the forex trading .
Such tips can often be found in macroeconomic data, so knowing when important data is released (Economic Calendar) is so important for customers. Markets tend to respond to changes in important macroeconomic indicators. Here are some examples of macroeconomic data and how they can affect financial markets:
Inflation is an indicator of growth in the general level of prices for goods and services. Central banks are trying to limit inflation and avoid deflation in order to ensure the country's economic development. They do this by changing interest rates. As an example: When central banks announce a rate hike, this can lead to an appreciation in the respective currency and vice versa.
Unemployment. Labor market data, such as US non-farm payrolls in the US, can have a big impact on financial markets. An employment report is published on the first Friday of every month and represents the total number of US workers in any business. The market is very sensitive to this type of data because of its importance in determining the rate of economic growth and inflation.
As an example: if US non-farm payrolls are growing, this can be interpreted as an indication that the economy is growing. If the increase is fast, this may indicate that inflation may rise. If US non-farm payrolls are declining, then customers can potentially sell US dollars in anticipation of a weakening currency.
GDP - gross domestic product - is an indicator of the value of all goods and services produced for a certain period. Central banks and investors are looking at GDP growth to see changes in the country's economy. As the economy grows, companies earn higher profits and people earn more, which could potentially lead to an increase in the stock market and a stronger currency.
The impact that macroeconomic releases can have on the market is highly dependent on market expectations. Simply put, the greater the difference between expectation and reality, the greater the reaction may be. If the market expects the central bank to raise interest rates and the bank does so, the reaction can be “evaluated”, and this is common. However, when a release takes the market by surprise, it is then that there is a lot of volatility.
You can receive information on all fundamental data releases using our Economic Calendar. Each event of the Economic Calendar is accompanied by a mark “High”, “Medium” or “Low” in terms of its potential impact on the market.
Impact on the Central Banks Market
As mentioned earlier, one of the most important factors of fundamental analysis is the monetary policy pursued by central banks. Interest rates, open market operations and central bank interventions affect market conditions and are closely monitored by financial analysts. The most influential central banks include the Federal Reserve (USA), Bank of England (UK), European Central Bank (EU) and Bank of Japan (Japan).
Consider an example. The US economy grew by 3% in the first quarter of 2017, and inflation rose to 2.5% compared to last year. The Fed has decided to raise interest rates. Interest rates increased, so customers decided to put their money in US dollars, as this could lead to higher profits. Such a step can lead to an increase in demand for the US dollar, which leads to higher prices. Bear in mind that there are many factors that can affect market prices, and this example is for educational purposes only.
The influence of other factors.
Fundamental analysis also takes into account external influences that may affect the value of the instrument or price movement. Natural disasters, such as floods or earthquakes, can also have a significant impact on the value of an asset. For example, an explosion in a critical pipeline can lead to a rapid increase in oil prices, as it becomes more difficult to transport and buy goods. In such a situation, you could open a long Oil position using CFDs.
Different point of view
Unlike technical analysis, which focuses on price changes and trends, fundamental analysis uses all available data to determine the value of the instrument. Although technical analysts believe that all the necessary information is contained in a price change chart, fundamental analysis considers other aspects, including political, social and economic factors, as well as macroeconomic releases and corporate earnings.
Fundamental and technical analysis should not be used separately; indeed, some of the most successful clients claim that a combination of both types of analysis is required.