Fundamental Analysis – What is it and How to Use It
A financial product is moving based on differences between supply and demand. As a rule of thumb, when there are more buyers than sellers, the price is moving to the upside, and when sellers dominate a market, the price is moving to the downside. The same is valid for the Forex market as well, only that here it is very difficult to assess the overall supply and demand level due to the fact that on this market there are so many transactions that are taking place on a daily basis that is no entity to influence prices. What moves a currency pair, though? It is being said that for a currency pair to move, there’s a need for a reason and that reason is being given by a fundamental factor. The fundamental analysis represents, therefore, the multitude of external factors that influence the two currencies that form a currency pair. These factors can be geopolitical, economic or even natural events. They are critical to trading and one cannot take them into consideration completely as economic events can be monitored and predicted, but natural events, for example, come as a total surprise.
What Makes Fundamental Analysis
Fundamental analysis is being made out of all the external factors that can influence a currency or a currency pair, and can change the supply and demand balance. Fundamental factors are mostly economic factors, like all the economic data used to analyze an economy in order to compare it with another one, but also natural events, political and geopolitical ones, as well as natural phenomena.
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Economic Events That Influence the Forex Market
This is by far the most important and the most influential part of the fundamental analysis and it takes one thing to master: the economic calendar. This is free information grouped in the form of economic news out of major economies and offer traders a chance to know when news is going to be released, what the impact may be on a currency, and, more or less, a chance to know when the market is expected to make its next move.The economic calendar can be found for free with a simple Internet search and most of the times it is being offered by the forex broker as well. Having said that, a trader has no excuse for not knowing when a high-impact economic news will hit the wires. All the economic news that make up the economic calendar is being grouped based on its importance, with high-impact news (marked with the color red), medium-impact news (marked with orange) and low-impact ones (marked with yellow). The market is not moving much when yellow or orange news hits the wires but travels aggressively on the rest. It goes without saying that the red events are critical and on the economic calendar one will always have the previous value of an economic release and the forecasted value for the new one. A trader must prepare for these releases and must know them in advance as otherwise trading is only guessing and will resemble gambling. If the actual release is going to be different than the forecasted one, the market will move and this is what the overall fundamental analysis means: an event (in this case an economic one) that, at least for a while, changes the balance between the supply and demand levels on a currency pair. The high-frequency trading industry is strongly involved in news trading as trading algorithms are buying or selling a currency pair based on the outcome of a news when compared with the forecasted value.
Political and Geopolitical Events
Another important part of the fundamental analysis is being made by political and geopolitical events that surround a currency pair. These events can change the balance between two currencies so aggressively that it is worth keeping an eye on what their impact might be. The recent referendum in the United Kingdom is offering us the perfect example of a political event that changes the way currencies are being valued. The Brexit vote for the United Kingdom to leave the European Union had a tremendous impact on the Great Britain pound that has lost in value virtually overnight. Not only the GBP currency pairs moved, though, as correlations influenced trading as well. As mentioned in another article here on our Forex Trading Academy, correlations are very important as some markets will move only based on them. It doesn’t really matter if the news refers to these currency pairs or not. As a consequence, the EUR/USD moved to the downside as well as traders looked for refuge in the safety of the U.S. dollar, the world’s reserve currency. Moreover, JPY has been bought for the same reasons as well as the CHF. Therefore, we can say that a political event, in this case, a referendum, had a big impact on the overall currency market as the GBP rebalancing influenced the value of all currency pairs. Other events in the same category are general elections in major economies, as well as war strategies and war-related events.
These are things impossible to predict but they are part of the fundamental analysis as well. This kind of phenomena as natural cataclysms that are so powerful that disrupt an economic activity of a country/region. We can talk about floods, earthquakes, tsunamis, volcanos eruptions, etc., that happen and disturb the way an economy function. All these have the potential to bring large moves on the currency market.These last two categories that are being part of the fundamental analysis are the reason why the Forex market is not actually considered to be closed over the weekend. In principle, it is closed, but if elections happen over the weekend and the result is a surprising one or a natural cataclysm is happening, then a gap will form at the Monday’s opening. If the gap is big enough, there’s no stop loss to help Forex traders, as brokers are filling an order only if there’s a market. All of the factors above are showing why fundamental analysis is critical to trading and why keeping an eye on all these events is vital for correct money management techniques.
Other educational materials
- Technical Analysis – What to Consider
- Moving Averages – Find Support and Resistance Areas
- How to Use Parabolic SAR to Buy Dips or Sell Spikes
- Leverage and Margin Requirements
- Forex Trading Platforms – Metatrader 4 and 5
- What is a Margin Call?
Recommended further readings
- “Fundamental analysis, future earnings, and stock prices.” Abarbanell, Jeffrey S., and Brian J. Bushee. Journal of Accounting Research 35, no. 1 (1997): 1-24.
- Short-sellers, fundamental analysis, and stock returns. Dechow, P.M., Hutton, A.P., Meulbroek, L. and Sloan, R.G., 2001. Journal of Financial Economics, 61(1), pp.77-106.