11.1 Learn How to Use Fundamental Analysis

Additional reading about why is risk important

What is fundamental analysis? - text version

Fundamental analysis is the use of economic data, known as “fundamentals”, in making a forecast of future prices of an asset. It is completely different to technical analysis, which is similar, but takes historic price data as the subject of analysis. It is important to know that the two techniques can be used together if so desired, and we will talk about that later at the end of this course.

So, what are the economic data making up the “fundamentals”? Well, if you have bought stocks in a company or read about it, you probably heard about a company’s “fundamentals”, meaning its earnings, revenue, cashflow -the actual metrics of its business. These numbers can be analyzed to tell you whether a stock looks like a good buy at its current price, or if it’s overvalued. You can also look at data relating to the wider economy, with the idea being that if an economy or economic sector is growing strongly, its relevant stocks will be supported by these fundamentals, and are therefore likely to rise in value. You can do the same thing in Forex by looking at economic data from a currency’s country, and you can even compare it to the global economy or other economies to get an idea whether the fundamental data suggest that a particular currency should be strong or weak.

A lot of traders find the idea of fundamental analysis intimidating and prefer to rely on technical analysis only. After all, if prize winning economists cannot agree on where an economy is heading, what is the use in trying to make the same guess? Well, the truth is, collecting and interpreting fundamental data is much easier than you might think, especially in Forex where you are looking at broad metrics from national economies, such as interest rates, inflation, and gross domestic product. You don’t need to be anything close to 100% accurate. All you really have to do is collect the data, determine whether it is getting better or worse, and see how the actual numbers compared to the relevant consensus forecasts – what the market thought the data would be before release.

While there is nothing wrong in not using fundamental analysis, an understanding of economic fundamentals can increase the profitability of your trading. Be aware that fundamental analysis must be used in conjunction with technical analysis, otherwise you will be likely to enter trades either too early or too late. For example, imagine that the United States is in a deep economic recession. The latest gross domestic product number is released, showing the rate of change of the total output of the economy. For the first time in over a year, the change is positive instead of negative. If this is a surprise to the market, you can expect it to be a very positive fundamental development for the U.S. economy. However, if you go and buy the U.S. Dollar right away and sit tight waiting for it to go up, you may be too early, even though this bullish change seems obvious to you. This is why it is hard to profit in Forex using fundamental analysis alone – timing is as important as being right.

In the next lesson, we will look at the key economic data releases: what they are, what do they mean, where can you find them, and how to interpret them. Along with central bank monetary policy, economic data releases are at the heart of fundamental analysis.