Introduction to Fundamental Analysis

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Takeaway: Many of the most profitable trades ever made in forex are based on fundamental analysis.

Introduction to Fundamental Analysis
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Currency trading is usually seen as a technical art in that the majority of the trading volume is assumed to be the result of market participants buying and selling based on technical analysis. This may be true in terms of the number of trades, but many of the most profitable trades ever made in forex are based on fundamental analysis. In this article, we’ll take a brief look at how fundamental analysis works in forex and some indicators would-be fundamental traders should watch out for.

What Is Fundamental Analysis?

When a trader is using fundamental analysis, he or she is attempting to identify long-term trends in a currency pair’s price action that is due to factors affecting the economies of the nations issuing the currencies. Simply put, fundamental analysis tries to predict the future direction of a currency pair based on how the economies underlying the currency are doing. For example, if the U.S. is in a recession with high unemployment and inflation - a situation known as stagflation - and Japan is seeing strong year-over-year GDP growth and shrinking debts, then a fundamental trader might short the dollar against the yen using the USD/JPY currency pair.

That said, the data is rarely so simple or so clear. In practice, the economic performances of Japan and the U.S. often move together due to the nature of international trade and finance, so a fundamental trader must follow many fundamental indicators in order to decide which economy and currency is comparatively stronger in a given period of time. So it isn’t as simple as fundamental traders sometimes make it sound - which begs the question of why you should put in the effort.

The Benefits of Fundamental Analysis in Currency Trades

The most profitable forex trade ever made - George Soros’s $1 billion profit breaking the Bank of England - was a fundamental trade at its heart. Using what he knew about the economic situation in Europe (specifically Germany and England), Soros shorted the pound heavily. He was betting on a sharp downwards correction that would more accurately represent the pound’s fundamental value. He was right.

This is the advantage of fundamental analysis. It allows a trader to bet on a longer, primary trend for a potentially larger overall profit than short-term trading can yield. Day traders seek small, regular profits, whereas fundamental traders seek larger profits on fewer trades. This makes fundamental analysis ideal for a currency trader with a keen sense of economics and the ability to recognize cause and effect in the forex market.

What Tools do Fundamental Traders Use?

Perhaps the biggest difference between fundamental and technical traders is the tools they use. Although both use indicators, technical indicators are mathematical and constantly changing as data pours in. Fundamental indicators, by contrast, are released on a regular schedule and are essentially static once they are released.

Three of the most basic fundamental analysis indicators are:
  • Interest rates as set by central banks - these rates set the tone for lending in an economy and can heavily influence the rate of inflation.
  • Unemployment rates - an economy is at its best when more people are working and creating the economic value that ultimately props up the value of a currency.
  • Gross domestic product (GDP) - GDP is basically a very rough measure of the economic activity of a nation and allows for a quick comparison to past GDP figures in order to show if a nation is doing better or worse.
In order to effectively track these economic releases for the currencies they wish to trade, fundamental traders follow economic calendars. Many also use news alerts to gather any information that can offer a good guess as to what the release figures will be. Once they have a notion of which way the primary trend is going, they can jump on for the long haul.

The Technical Fundamental Trader and Other Gray Areas

This is a quick and dirty intro to fundamental analysis. However, even if you have only been trading forex in a demo account, you probably are aware that the gray area between fundamental and technical trading is huge. Many fundamental traders also use technical signals to enter and exit trades, just as many technical traders watch fundamental indicators to target currency pairs approaching volatility. This mixture is part of what makes forex so challenging and attractive. You can get by being absolutely fundamental or absolutely technical, but there is also a wide range in-between that can be explored to fit your particular personality. (For further reading, check out The Top 10 Mistakes That First Time Forex Traders Make.)

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About Andrew Beattie
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Andrew Beattie has spent most of his career writing, editing and managing financial content as well as more general web site material in all its many forms. He is especially interested in the future of search and the application of analytics to the business world. He has been a long-time contributor to Investopedia.com and is currently venturing forth on ForexDictionary.
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