Fundamental Analysis for Forex Trading
HOW TO USE FUNDAMENTAL ANALYSIS FOR FOREX TRADING
There are two types of analysis that traders use extensively for forex trading: fundamental and technical analysis. These two types of analysis create two types of forex traders: fundamental traders and technical traders.
The big difference is fundamental analysis looks at the big picture, whether it’s the economy, an industry or a company. Technical analysis focuses on historic price movements and uses charts to identify patterns that provide clues for potential exit and entry points.
In this article, we review what fundamental analysis involves and how it can be used for trading. Look for the next article on technical analysis to compare the two.
What is fundamental analysis?
Fundamental analysis involves looking at the big picture for a country, industry or company and how it impacts on the intrinsic value of currency pairs. This differs from technical analysis that focuses on patterns in currency prices.
Fundamental analysis doesn’t track currency price movements. Instead, it allows traders to use data points to ascertain the strength or weakness of a particular currency at a particular time.
Economic indicators monitored as part of fundamental analysis include:
- Consumer Price Inflation (CPI)
- Gross Domestic Product (GDP)
- Trade balance
- Employment Cost Index (ECI)
- Housing statistics
- Central Bank’s benchmark rate
- Moody’s rating
- Michigan Consumer Confidence Survey
- Medium and long-term economic data
- ISM Manufacturing Index
- ISM Producer Price Index (PPI)
- Purchasing Managers Index (PMI)
- Durable goods report
What is a fundamental trader?
Fundamental traders essentially trade the news. They monitor economic data releases and typically hold longer positions while being careful to accommodate volatility spikes that follow immediately after an important news release.
Fundamental traders focus on country-, industry- or company-specific events that point to forex trading opportunities and allow them to speculate on when to open and close positions. Fundamental traders tend to adopt a buy-and-hold strategy associated with long positions as opposed to short positions for short-term trading.
A buy-and-hold approach is a passive trading strategy where traders hold onto a position for a longer and they don’t concern themselves with short-term price movements. They hope to make profit over an extended period of time and hold out for long-term gains.
In terms of company-specific events, fundamental traders analyse the following for buy and sell clues:
- actual and anticipated earnings reports
- stock splits
- company reorganisations
- company acquisitions
How fundamental analysis differs from technical analysis
In contrast to the big picture of fundamental analysis, technical analysis focuses on micro points in different time frames on price charts. Basically, it involves forecasting currency price movements by looking for historic patterns in price charts. These include price action charts and short-, medium- and long-term chart analysis.
A technical trader will look for price patterns indicated by triangles, flags and double bottoms. Depending on what the pattern presents, technical traders decide on entry and exit points. They are not concerned with why a currency price is moving, only the signals that show in which direction it is moving.
Best forex trading tools for fundamental analysis
One of the most important and widely-used tools for fundamental analysis is an economic calendar. It keeps forex traders up to date with the latest data releases that are posted multiple times a day.
An economic calendar alerts fundamental traders to key global events that could subtly shift or substantially stir up the financial markets. Available on the popular MetaTrader 5 trading platform, an electronic calendar helps fundamental traders to plan trades and portfolio reallocations.
Fundamental traders rely heavily on the economic calendar on their trading platform. They will carefully time entry and exit points based on trading opportunities that correspond with an announcement of a global, industry or company event. Heavy trading volume usually precedes a scheduled announcement.
Economic calendars are also valuable for forex traders who favour taking short positions. They use the information to speculate on price movements and can quickly open and close positions having been forewarned of likely price movement caused by a global event.
Examples of events that are listed on an economic calendar include:
- weekly jobless claims
- reports of new home starts
- scheduled changes in the interest rate
- economic sentiment surveys
- government and central bank releases
- commodity sector releases (gold, crude oil, natural gas, coffee, grains, beef etc.)
How to use an economic calendar for fundamental analysis
Events on an economic calendar are graded low, medium and high importance. The grading depends on their likely degree to impact the financial market.
It’s important to know how to read a forex economic calendar so you can maximise your trading prior to or following important releases. Economic calendars are available for free on the major forex trading platforms. More experienced fundamental forex traders tend to customise their economic calendar on filters that are relevant to them.
By default, an economic calendar automatically alerts you to scheduled event releases but you should get into the habit of checking your economic calendar every morning to stay up-to-date on global events.
If you’re suffering from information overload, click on buttons that show the most recent scheduled announcements. Click on ‘Today, Tomorrow and Next Seven Days’, a little bit like you would if you were looking at a weather report.
It’s recommended you change the time zone to one that you’re most comfortable with; do this by clicking on the button ‘Time Zone’.
Click the ‘Currencies’ and ‘Importance’ buttons to narrow down events that are most relevant to you. In other words, if you’re interested in trading EUR/USD; you’d select EUR and USD separately and then you should only see news announcements from the Eurozone and United States. This would be your ‘High Importance’ filter.
OCA Orders is a software plugin that forex traders use for fundamental analysis. It’s available on MetaTrader 4 which is the mostly widely-used forex trading platform in the world.
OCA stands for ‘One Cancels Another’.
Basically, an OCA Order allows forex traders to set two orders; one buy-limit order and one sell-limit order. When the first order is executed, the second order is automatically cancelled.
Fundamental traders find OCA Orders very useful if they are looking for breakouts. The software helps traders execute their fundamental analysis more efficiently to maximise profits and limit losses.
Fundamental versus technical analysis: which is better?
One is not better than the other but rather more relevant to different trading styles.
Fundamental analysis is used by forex traders who focus on the quality of long-term investments across a wide range of securities and derivatives. It considers the intrinsic value of a security or derivative by evaluating all aspects of the market.
Fundamental analysis produces an intrinsic value of a particular security or derivative. In the case of forex trading, this would be the value of a country’s currency. When that value is determined, forex traders decide whether to buy or sell based on whether they think the currency pairing is undervalued or overvalued.
Technical analysis is used by forex traders who are more focused on short-term CFDs or forex trading in active trading markets. It uses data in shorter time frames to identify patterns in historic price movements. This helps forex traders speculate on price movements in the future and entry and exit points.
Technical analysis is often used to determine the quality of short-term trades and usually complements fundamental analysis. While you get fundamental and technical traders, both types of forex analysis have a role to play in forex trading.
FOREX TRADING AFRICA DISCLAIMER
Trading foreign exchange on margin carries a high level of risk and may not be suitable for all investors. Forex trading involves a high degree of leverage which increases the risk associated with forex trading.