What is Fundamental Analysis?

Along your travels, you've undoubtedly come across Gulliver, Frodo, and the topic of fundamental analysis.

Wait a minute...

We've already given you a teaser about fundamental analysis during Kindergarten! Now let's get to the nitty-gritty!

What is it exactly and will I need to use it? Well, fundamental analysis is the study of fundamentals! That was easy, wasn't it? Ha! Gotcha!

There's really more to it than that. Soooo much more.

Whenever you hear people mention fundamentals, they're really talking about the economic fundamentals of a currency's host country or economy.

Economic fundamentals cover a vast collection of information - whether in the form of economic, political or environmental reports, data, announcements or events.

Fundamental analysis is the use and study of these factors to forecast future price movements of currencies.

It is the study of what's going on in the world and around us, economically and financially speaking, and it tends to focus on how macroeconomic elements (such as the growth of the economy, inflation, unemployment) affect whatever we're trading.

Fundamental Data and Its Many Forms

In particular, fundamental analysis provides insight into how price action "should" or may react to a certain economic event.

Fundamental data takes shape in many different forms.

It can appear as a report released by the Fed on U.S. existing home sales. It can also exist in the possibility that the European Central Bank will change its monetary policy.

The release of this data to the public often changes the economic landscape (or better yet, the economic mindset), creating a reaction from investors and speculators.

There are even instances when no specific report has been released, but the anticipation of such a report happening is another example of fundamentals.

Speculations of interest rate hikes can be "priced in" hours or even days before the actual interest rate statement.

In fact, currency pairs have been known to sometimes move 100 pips just moments before major economic news, making for a profitable time to trade for the brave.

That's why many traders are often on their toes prior to certain economic releases and you should be too!

Generally, economic indicators make up a large portion of data used in fundamental analysis. Like a fire alarm sounding when it detects smoke or feels heat, economic indicators provide some insight into how well a country's economy is doing.

While it's important to know the numerical value of an indicator, equally as important is the market's anticipation and prediction of that value.

Understanding the resulting impact of the actual figure in relation to the forecasted figure is the most important part. These factors all need consideration when deciding to trade.

Phew!

Don't worry. It's simpler than it sounds and you won't need to know rocket science to figure it all out.Fundamental analysis is a valuable tool in estimating the future conditions of an economy, but not so much for predicting currency price direction.

This type of analysis has a lot of gray areas because fundamental information in the form of reports releases or monetary policy change announcements is vaguer than actual technical indicators.

Analysis of economic releases and reports of fundamental data usually go something like this:

"An interest rate increase of that percentage MAY cause the euro to go up."

"The U.S. dollar SHOULD go down with an indicator value in that range."

"Consumer confidence dipped 2% since the last report."

Here's an Economic Report, Now What?

The market has a tendency to react based on how people feel. These feelings can be based on their reaction to economic reports, based on their assessment of current market conditions.

And you guessed it - there are tons of people, all with different feelings and ideas.

You're probably thinking "Geez, there's a lot of uncertainty in fundamental analysis!"

You're actually very right.

There's no way of knowing 100% where a currency pair will go because of some new fundamental data.

That's not saying that fundamental analysis should be dismissed.

Not at all.

Because of the sheer volume of fundamental data available, most people simply have a hard time putting it all together.

They understand a specific report, but can't factor it into the broader economic picture. This simply takes time and a deeper understanding of the data.

Also, since most fundamental data are reported only for a single currency, fundamental data for the other currency in the pair would also be needed and would then have to be compared to get an accurate picture.

As we mentioned from the get-go, it's all about pairing a strong currency with a weak one.

At this point, you're probably still waiting for the answer to "Will I ever need to use fundamental analysis to become a successful trader?"

We totally understand that there are purists on both sides.

Technical analysis seems to be the preferred methodology of short-term traders, with price action as their main focus.

Intermediate or medium traders and some long-term traders like to focus on fundamental analysis too because it helps with currency valuation.

We like to be a little crazy by saying you should use BOTH!

Technically-focused strategies are blown to bits when a key fundamental event occurs. In the same respect, pure fundamental traders miss out on the short term opportunities that pattern formations and technical levels bring.

A mix of technical and fundamental analysis covers all angles. You're aware of the scheduled economic releases and events, but you can also identify and use the various technical tools and patterns that market players focus on.

There's your answer!

Happy?!

In this lesson, we'll discuss the major fundamental factors that affect currencies. These are interest rates, monetary policies, and market-moving economic reports.