Bank finance articles and tips

What Is Fundamental Analysis?

Fundamental analysis studies the core underlying elements that influence the price of a particular entity, like a stock or currency. It attempts to predict price action and trends by analysing economic indicators, government policy, societal and other factors within a business cycle framework.

The economic, political, governmental, financial, technological and other relevant factors of the country are taken into consideration to predict the future valuation of the country's currency in the forex market. It tends to focus on how macroeconomic elements (such as the growth of the economy, inflation, unemployment) affect whatever we're trading.

Traders that use fundamental analysis will know that changes in these two factors will also cause currency prices to change so many traders that are using the fundamental analysis will look through various news sources (TV, radio, news feeds on the internet etc...).

Important and major political and economic indicators:

Unemployment in any country
Political conditions of the country
Annual GDP
Growth rate
Inflation rate
Foreign investments
Balance of payments
Interest rates
Government policies

In particular, fundamental analysis provides insight into how price action "should" or may react to a certain economic event. Economic and political conditions of any country are the basic variables or factors that affect the country's currency. So forex traders, forex market analysts and fundamental analysts of the forex market keep a close eye on each intended country's economic and political conditions. Fundamental analysts have to keep looking for speeches, statements and press conferences of important political individuals and parties, as their statements becomes policies and then affects the country's overall balance of payments.

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. 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. If you think of the markets as a big clock, fundamentals are the gears and springs that move the hands around the face. Anyone can tell you what time it is now, but the fundamentalist knows about the inner workings that move the clock's hands towards times (or prices) in the future.

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. In fact, most smart traders favour a blended approach versus being a purist of either type. Fundamentalists need to keep an eye on signals derived from price charts, while few technicians can afford to completely ignore impending economic data, critical political decisions or pressing societal issues that influence price action.

Forecasting economic conditions using models

Fundamental analysis is very effective at forecasting economic conditions, but not necessarily exact market prices. Studying GDP forecasts or employment reports can give you a fairly clear picture of an economy's health and the forces at work behind it. But you still need a method to translate that into specific trade entry and exit points.

The bridge between fundamental data and a specific trading strategy usually comes from a trader model. These models use current and historical empirical data to estimate future prices and translate those into specific trades.

Beware of "analysis paralysis"

Forecasting models are both art and science, with so many different approaches that traders can get overloaded. It can be tough to decide when you know enough to pull the trigger on a trade with confidence.

Many traders switch to technical analysis at this point to test their hunches and see when price patterns suggest an entry.

Look for fundamental drivers first

The fundamentals include everything that makes a country and its currency tick. From interest rates and central bank policy to natural disasters, the fundamentals are a dynamic mix of distinct plans, erratic behaviors and unforeseen events.

That said, not every development will move a country's currency. Try to start by identifying the most influential contributors to this mix versus following every fundamental out there.

Forex Market Drivers

The Forex market is driven by a number of fundamentals, including interest rates and the prices of commodities such as gold and oil.

Rising interest rates strengthen that country's currency

A common way to think about interest rates is how much it's going to cost to borrow money, whether how much we pay for our or how much we earn on our bond and money market investments. Interest rate policy is a key driver of currency prices and is a popular trading strategy for new currency traders.

Interest rates affect the market in different ways. For example if the interest rate becomes high many investors will sell at this point whilst foreign currencies will get attracted to it. The economy can be negatively affected when traders start selling because a high number of traders selling can cause a downturn in the market. Either way if the interest rates go up or down then there will always be an effect on the market.

Fundamentally, if a country raises its interest rates, its currency prices will strengthen because the higher interest rates attract more foreign investors.

For example, higher rates in the Eurozone may prompt U.S. investors to sell U.S. dollars and buy bonds in Euros. Similarly, if interest rates increase in Switzerland, those investors may decide to sell their Euro-bonds and move into bonds in Swiss francs (CHF), driving Euros down and Swiss francs up.

International Trade

Another factor that affects the currency is trade deficit (international trade), this is when more items are imported than exported which is not good. This is because there is more money being put into buying foreign goods than money entering which causes a negative effect on the currency. The only time that this affects a currency is when the deficit of the trade is higher than expected.

When gold goes up, the USD goes down (and vice versa)

Historically, gold is a "safe haven", a country-neutral investment and an alternative to the world's other reserve currency, the U.S. dollar. That means gold prices have an inverse relationship to the USD, offering several ways for currency traders to take advantage of that relationship.

Gold,oil and forex markets are intimately connected. As a forex trader, keeping an eye on the gold and oil markets can help you forecast price changes. Gold and oil prices are considered to be leading indicators in forex trading. The three markets, gold, oil and forex tend to move based on the same fundamentals.

For example, if gold breaks an important price level, you'd expect gold to move higher. With this in mind, you might sell dollars and buy Euros, for example, as a proxy for higher gold prices.

Rising gold prices help major gold producers

Australia is the world's third largest exporter of gold, and Canada is the third largest producer worldwide. These two major currencies tend to strengthen as gold prices rise. You might consider going long these currencies when gold is increasing in value, or trade your GBP or JPY for these currencies when gold is on the rise.

Oil-dependent countries weaken as oil prices rise

Just as airlines and other oil-dependent industries are hurt by rising oil prices, so are the currencies of oil-dependent countries like the U.S. or Japan, both of which are massively dependent on foreign oil.Now, almost all the currencies are somewhat correlated with gold and oil prices.

Oil is the commodity that drives the global economy so you can well understand the effect of rising oil prices on the global economy. However, there are four currencies that show quite strong correlation with gold and oil and are therefore popularly called commodity currencies. These four currencies are Canadian Dollar (CAD), Swiss Franc (CBF), Australian Dollar (AUD) and New Zealand Dollar (NZD). AUD and NZD were hot favorites with the carry traders a few years back. CAD is correlated with oil however, it's correlation is not that strong as compared to AUD, NZD and CHF with gold.

CAD is the only currency pair in the commodity currencies that is somewhat correlated with oil prices. Oil drives the global economy. Rising oil prices produce inflation and slows down the global economy. Now, Canada is one of the biggest exporter of oil to US. Canadian economy is heavily dependent on heating oil as the winters are long and people use heating oil extensively during the winters.

If you believe oil prices will continue to rise, you can consider buying commodity-based economies like Australia or Canada or selling oil-dependent currencies.

Learn the fundamentals of Forex trading for free at http://www.tradingforexadvisor.com. Learn Forex Trading from A to Z with complete tutorials, forex education resources, and forex training tools. You can also download some of the and strategies completely free of charge.

By Olajide Hospidales
Article Source: http://EzineArticles.com/?expert=Olajide_Hospidales