Fundamental Analysis Explained

The truth about forex trading is that all of us are “fundamentalists.” We are all trading the news and the underlying economics of currencies, especially supply and demand. Although there is an acknowledged schism between fundamental traders and those that rely on technical analysis, the difference relates more to how each type of analysis is employed, and not the foundations. Technical analysts believe-without any sense of irony-that fundamentals are already included in the price as well as reflected by indicators.

Fundamental Analysis Explained

Fundamental analysts have a different focus than that of technical traders. In truth, they both have their advantages, as well as their blind spots. The endless debate about which is better, is beside the point. Neither is incorrect, and both are complimentary with each other. In his book “The Disciplined Trader,” Mark Douglas made a telling reference to the methodology of unsuccessful traders whom he said were, “Focusing on price and the monetary value of a trade, instead of the potential for the market to move based on its behavior and structure.” This is the sine qua non of fundamental analysis. The fundamental analyst asks not only what the price of something is, but what the intrinsic value is. Some other aspects of this analysis are: 

Fundamentals drive markets

You may have to use “enhanced interrogation techniques” to get technical traders to admit it, but if technical indicators are a proxy for fundamentals, then one can draw the obvious conclusion; prices are the fundamentals. Currencies are reflections of the nations-or groups of nations in the case of the EUR-that issue them. Economic events, trade, growth, inflation,  employment, interest rates, investment, fiscal policies, national debt, as well as overall prosperity and political conditions, determine the basis for fundamentals. So can wars and natural disasters as the latest U.S. GDP figure for the fourth quarter of 2012 may have indicated. Fundamental analysis seeks to measure and quantify these, to come up with probable values of currencies related to other instruments. Unlike technical analysis, it does not seek exact levels or precise measurements, only sentiment and direction. It is more of a “big picture” impression rather than a microscopic measurement.

Valuation, not prices

Most fundamental analysts talk about price levels or areas rather than specific prices. They factor in market noise, liquidity as well as the irrationality of the market over the short term, with the belief that the market corrects itself over longer periods. Their trading matches this, and they give wide berth to price movement with entries and exits based more upon confluences in the environment mirrored by convergence and divergence. Many fundamental traders are contrarians by nature as well as habit. Examples include George Soros and Jim Rogers whom  have made careers of defying expectations, bucking common assumptions and predictions. Their main abilities were not only in economic forecasting based upon fundamental analysis, but in devising strategies for a wide variety of economic conditions.

Technicals are snapshots of fundamentals

Fundamental analysts get a fair amount of good natured ribbing from the technical analysts. The major point of contention seems to be that fundamental analysis is imprecise and subjective and not especially useful for certain types of trading. Fundamental analysts and traders retort that technical traders are promoting science where there is none, and at best, technical indicators give traders a temporary picture amidst the fluidity of the marketplace. Most traders fall somewhere in between and use technicals to help with entries and exits, and fundamentals to decide whether those entries and exits are right to begin with. The technical traders are correct about one thing though: fundamentals are reflected in the prices at some point. However, it can take long periods of “irrational markets” and extended volatility before prices accurately reflect those fundamentals. The best traders want to be in the market BEFORE everyone else realizes this, and out of trades when they do. This is akin to selling into strength and buying into weakness.

Forecasting and Reviews

While technical traders will rely on historical patterns vis-à-vischarts, fundamental analysts will put more stock in comparisons of economic data and historical outcomes. The fundamental trader is seeking to grasp the undercurrent of the market as defined by trends, which tend to last longer than many traders realize. This is the edge of the fundamental trader whom is not psyched out of the market by temporary swings or price spikes.

Long Term traders

Fundamental analysts tend to be long term traders as real trends take longer to form after periods of consolidation. This can be a disadvantage for those that prefer to trade shorter time frames which are more conducive to technical indicators such as support and resistance.

Key indicators versus secondary indicators

Inflation and interest rates. These are the crucial components of value due to their reflection of supply and demand.  They can be reflected in both currency values as well as sovereign bond prices. GDP is another key fundamental indicator since it reflects housing, industrial production, consumer activity and trade. Secondary indicators would be bank deposit rates and equity indexes.   

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