Throughout the years, participants of the investing world have developed all sorts of tools and techniques to better identify and predict future market directions. After all, if one can successfully find or create a tool that accurately predicts future price action, then it’s safe to say he/she can make a lot of money trading the market. Unfortunately, we do not live in such a world where a Holy Grail-like system exists. What traders do have is fundamental analysis, which many say is the closest means to accurately predicting the markets, particularly the billion-dollar-per-day foreign exchange.
What is Fundamental Analysis?
In general, fundamental analysis pertains to the underlying forces that move economies. Traders and analysts examine these forces with the end goal of deriving a forecast of future market direction. Since currencies are highly sensitive to what happens to its underlying economies, forex traders will do best to use fundamental analysis to look for actionable opportunities. Fundamental analysis, however, can be expanded to encompass other financial markets. Stock traders, for example, analyze company and sector fundamentals to gauge market sentiment and future stock valuation.
Importance of Fundamental Analysis
Fundamental analysis provides another side of the coin instead of being limited to look at technical factors, which at times will make no sense. Fundamental analysis, when supplemented with other types of analysis, can provide a more complete view of the currency pair and, more importantly, the currency market. With it, you can have an idea of future bank policies, interest rates, and economic reforms underway that could move a particular currency pair. Wouldn’t you buy the New Zealand Kiwi if you knew they were planning to increase the currency’s interest rates to 25 or 50 basis points in the next rate announcement?
Using Fundamental Analysis
In theory, fundamental analysis is easy to grasp. Applying it, however, is where the challenge lies and where most traders fail. Fundamental analysis isn’t merely about buying a currency you think is about to skyrocket because of outward central bank influences or sell a currency because of geopolitical turmoil that’s currently on the limelight. If you do implement fundamental analysis in this manner, you’ll find nothing but disappointment and financial losses to show for your effort.
Instead, use fundamental analysis to formulate ideas and biases on currency pairs. For example, if a currency pair is soaring high but the fundamentals on the overbought currency is weak and unsupported by actual numbers or final decisions, you should either sit on the sidelines and wait for clearer signals or trade a short position with the expectation the currency will drop sharply over the next few days or weeks as the market corrects itself.
Using fundamental analysis can also involve identifying price levels, particularly support and resistance levels that price can bounce or deflect from. While most traders would argue that price levels are more related to technical analysis, most support and resistance levels are formed as a result of economic reports.
Augmenting Fundamental Analysis
Fundamental analysis as a standalone tool is not nearly as effective as when it is coupled with other tools like proper risk management and technical analysis. Risk management is an important factor to the success of a trader. It ensures financial losses are minimized while also helping maintain a positive net cash flow. Simple risk management principles to follow include lowering your position size to at most 10 percent of your total capital size, trading only during certain times of the day, and trading only major currency pairs that are less volatile and more liquid.
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