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Fundamental Analysis – What is it, and How Is It Used?

fundamental analysisA financial product moves based on differences between supply and demand. As a rule of thumb, when there are more buyers than sellers, the price moves to the upside, and when sellers dominate a market, the price moves 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 taking place on a daily basis that there is no entity to influence prices. What moves a currency pair, though? It is said that for a currency pair to move, there has to be a reason, and that reason is some fundamental factor. The fundamental analysis therefore represents 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 all aspects of them completely into consideration, as economic events can be monitored and predicted, but natural events, for example, can come as a total surprise.

What Does Fundamental Analysis Entail?

Fundamental analysis is carried out based on all of 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, such as all the economic data used to analyse an economy in order to compare it with another one; but they can also be also political and geopolitical events 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 it: the economic calendar. This is free information grouped in the form of economic news from major economies, and offers traders a chance of knowing when news is going to be released, what its impact may be on a currency, and an indication of 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 time it is offered by Forex brokers as well. In view of the above, a trader has no excuse for not knowing when a high-impact economic news item will hit the wires. All the economic news that makes up the economic calendar is grouped based on its importance, with high-impact news marked with the colour red, medium-impact news marked with orange, and low-impact items marked with yellow. The market does not move much when yellow or orange news hits the wires, but it 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 about them in advance, as otherwise trading is only guessing, and will resemble gambling. If the actual release is going to be different from the forecasted one, the market will move, and this is what fundamental analysis is based on overall: events (in this case an economic one) that, at least for a while, change 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 buy or sell currency pairs based on the outcome of a news release when compared with the forecasted value.

Political and Geopolitical Events

Another important part of the fundamental analysis consists of 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 offers us the perfect example of a political event that changes the way currencies are valued. The Brexit vote for the United Kingdom to leave the European Union had a tremendous impact on the British Pound, such that it lost in value virtually overnight. It is not only the GBP currency pairs that 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  based solely on them. It doesn’t really matter if the news item 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 US dollar, the world’s reserve currency. In addition the JPY was bought for the same reasons, as well as the CHF. It is therefore clear that a political event, in this case a referendum, had a major 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.

Natural Phenomena

These are some things that are impossible to predict, but they are part of the fundamental analysis as well. These kind of phenomena, such as natural cataclysms, are so powerful that they disrupt the economic activity of a country/region. Examples of such events are floods, earthquakes, tsunamis, volcanos eruptions, etc., which happen unexpectedly and disturb the way an economy functions. All these have the potential to bring about large moves on the currency market.

These last two categories that are 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 catastrophe happens, then a gap will form at the Monday’s opening. If the gap is big enough, there is no stop loss to help Forex traders, as brokers only fill an order  if there’s a market. All of the factors above are show why fundamental analysis is critical to trading, and why keeping an eye on all these events is vital for correct money management technique.

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