If you are going to profitably trade forex, you need to focus on the 3 “Ms” of forex: mental, money management, and method. When it comes to method, most of your options fall neatly into three different categories: fundamental analysis, technical analysis and price action. In this article, we are going to introduce you to fundamental analysis.
What is Fundamental Analysis?
Have you ever said to someone something like this?
“I think the price of the Euro is going to drop because of [insert recent news event here].”
Or maybe a friend said something to you like:
“With the current president’s economic policies, it seems inevitable to me that the value of the US dollar will drop.”
These are casual examples of fundamental analysis.
Unlike technical analysis, which has you looking for patterns in the data displayed in your charts, fundamental analysis is about trying to make determinations about what price is doing based directly on economic, social, and political data, reports, and events.
Broadly speaking, at any given time, two things are possible for a country and its currency:
1. A country’s economy is healthy, which attracts investors. As a result, they also buy into the currency, resulting in its value climbing.
2. A country’s economy is not healthy, so investors flee. They unload the country’s currency, and its value drops.
When you conduct fundamental analysis, your goal is to try and figure out how healthy the economy of a country is and whether its currency value is going to rise or fall.
That means you will need to investigate monetary policy, unemployment, GDP, retail sales and additional factors which can impact supply and demand for a country’s currency.
Key Point: Fundamental analysis is the practice of studying economic data directly to try to understand what price is doing.
Why Trade Using Fundamental Analysis?
People who are attracted to fundamental analysis like that are looking at what is taking place in the real world. Economic events are concrete and actual—they may feel more meaningful and reliable than the data on a chart.
Fundamental analysis also can be a powerful tool for spotting trends that might form over months or years, making it a useful approach for some position traders.
Key Point: The concrete nature of fundamental analysis is appealing. It also can be a great choice for long-term trades.
Why Avoid Trading Using Fundamental Analysis?
While fundamental analysis works great for some traders, that does not mean it is suited to every trader.
For one thing, even though it is good for position trading, it may not be as useful if you want to trade on short time frames.
The other issue with fundamental analysis is that understanding the forces of economics and politics is really complicated.
Even someone with an economics degree might struggle to make reliable predictions using fundamental analysis. There are just so many factors at play at any given moment in time.
So, if you are not an economics expert, how much work do you think it will take to become one? You may need to be one if you want to succeed with this type of analysis.
This does not mean that trading profitably with fundamental analysis is impossible—just that you need to know that you are embarking on a challenging journey if you decide to do it.
One more potential drawback of fundamental analysis is that it is hard to keep subjectivity out of it.
In fact, you arguably cannot keep subjectivity out of it. You will always be interpreting the data you study through your own personal framework of economic and political beliefs.
Key Point: Fundamental analysis may not be ideal for short-term traders. It frequently requires significant economic expertise as well. Additionally, it can be difficult not to let your subjective feelings sway you in your analysis.
How Do You Use Fundamental Analysis to Trade Forex?
Now that you know more about what fundamental analysis is and a couple of its pros and cons, let’s talk about how you can put it to work in your trading.
A good starting point is to track economic indicators. Governments publish these indicators in reports. You can use them to assess the well-being of various aspects of their economies. Here are a few examples of indicators and reports worth following:
- Gross Domestic Product (GDP): The GDP is an annual lagging economic indicator that adds together the total market value for a country’s products and services. Prior to the release of the GDP, a government will release reports. If these reports feature unexpected divergences in their data, you can look to the market to react in a volatile way.
- Consumer Price Index (CPI): As its name suggests, this indicator tells you how much consumer products cost.
- Industrial Production: You can find out how productive various industrial facilities are using this report, as well as whether they are operating at peak capacity or not.
- Retail Sales: You can find out what all the receipts from retail stores across a nation add up to in the retail sales report.
- Non-Farm Payroll: A favorite of forex traders is the non-farm payroll report, which you might want to just think of as the “employment report.” This is broadly considered one of the easiest types of economic reports to trade. Indeed, many systems that are popular among novices make use of this report.
News, Events, and Speeches
While you should keep an eye out for economic reports, it is important to remember that they are not the only measures of the health of economies—nor are they the only things that impact currency values.
If a president, prime minister, dictator, or other leader gives a major speech, that may sometimes have an impact on whether currencies rise or fall.
News events concerning wars, plagues, terrorist attacks, famines, and other world events can influence the values of currencies.
Key Point: You can use economic indicators to help you trade using fundamental analysis. You also will need to determine how various news events may impact the markets.
Don’t Just Trade the News – Trade Reactions to the News
There is something else you need to consider when you use fundamental analysis. You are essentially reacting to reactions.
Let’s say, for example, that the non-farm payroll report is coming out soon. Everyone is hoping—and expecting—that unemployment is going to decrease.
When the report comes out, it shows that indeed, unemployment has dropped. That is good news, right? Surely you might expect a rise in the value of the currency that reflects that change.
But sometimes it does not work that way. Comparing the real numbers to the numbers they expected, investors become uneasy—or maybe even panicked. The economy is not recovering at the rate they had predicted.
As a result, you might actually see a decrease in the currency value.
So, when you are going to trade the news, you need to take into account the complex ways in which people may react to what is going on.
If you do not, you might end up trading in the opposite direction you should.
So, you need to not only study economics and learn to predict possible outcomes but also learn how to predict how the market responds to those outcomes based on the difference between reality and expectations.
Key Point: Sometimes, the market reacts in a non-intuitive way to economic events. Your expertise will need to encompass not just the economy, but the ways investors react to the economy.
Should You Account for News and Reports if You Are Not Trading With Fundamental Analysis?
One more question worth addressing with respect to fundamental analysis is this: If you are not using it, should you worry about it?
Imagine, for example, that you are trading using a technical analysis or price action system. Typically, you ignore fundamentals. But what if one of your trades is going to coincidentally fall right when a report is released? Should you hold off?
There are a couple of different views regarding this issue.
Some traders believe that all traders should keep careful track of news reports and events, whether they are using fundamental analysis or not. They feel that you should strongly consider not trading during these events, even if your system gives you a setup.
Why? Because the market can become very volatile during these times, your system may not work the way it normally would.
But other traders believe that you can ignore reports and news events entirely. If your system gives you an entry, you should trade as usual.
Why? Because hypothetically, your system may be designed to work even during these types of conditions, and/or it will naturally steer you around news events.
The only “right” answer here is “it depends on your system.”
Backtest and demo test your strategy to find out what makes sense for you. If, during testing, your method delivers the results you are looking for even while you ignore reports, then you should be able to safely ignore them when you go live.
If, on the other hand, you find your strategy does go awry when reports are released, you probably should keep an eye on the calendar and avoid trading at those times.
Key Point: If you are not trading with fundamental analysis, you might still need to monitor reports and news events, depending on how your strategy works.
Now you have a basic understanding of what fundamental analysis is and how you can use it when you are planning FX trades.
Fundamental analysis is not easy to learn and involves an in-depth study of the economy and politics.
For that reason, it will not be right for every trader. But if you believe you can develop an edge through your economic knowledge and analysis, it might just be the right path for you.