Fundamental analysis examines how external factors impact an asset’s price and help the trader find its’ fair value. Opposed to technical analysis, which looks only at the price action to forecast the future, fundamentals help to construct a holistic view of an asset’s performance. For example, in the context of forex trading, it explores how various market drivers affect the pricing of currency pairs. The primary goal is to discern which external factors might influence currency values and in which direction they are likely to push these prices. This approach to understanding the market has its place in the bag of tools successful prop traders use in their journey to growing their accounts.

A market driver is any piece of information that can impact an asset’s valuation. These drivers can vary widely depending on the asset class.

Take the COVID-19 pandemic, for example. As nations implemented lockdowns, economic activities slowed significantly, causing the value of many currency pairs to drop. This is because the strength of a currency is closely tied to the economic health of its country.

Purpose of Fundamental Analysis

The main aim of fundamental analysis is to identify trading opportunities by examining external factors which are likely to have a significant bearing on the price. Traders break down these factors to predict upward or downward movements in the price of the asset. This approach can be applied to single stocks, currency pairs, entire market sectors, asset classes, indices, commodities etc.

Here is a simple example – if the US unemployment rate spikes, it generally signals a weakening US economy, which in turn could lead to a depreciation of the US dollar. For a pair like EUR/USD, where the dollar is the quote currency, this would mean buying EUR in anticipation of a weaker USD. Conversely, for a pair like USD/JPY, where the dollar is the base currency, the strategy would involve selling USD in expectation of a lower value of the pair price.

Finding Fair Value

Fundamental analysis assumes that every asset has a fair value, which determines how much it is actually worth. At times however the assets do not trade at their fair value, rather they are either underpriced or overpriced and traders try to find these opportunities to enter the market, hoping that the market will eventually return to its fair price. 

Let’s say you analyse a company and come to believe that it is actually not worth its current share price. In this case you can enter a short sell position and then buy it back once its price drops to where you think it must be. Conversely, if you think a stock is trading below its real value, you can buy its stock in a long position and sell once the price catches up with your expected fair value.

There is a wide range of factors you could be looking at in your analysis for the fair value of a company. To name a few, you could analyse its earnings reports to predict whether profits may rise in the future, check how its competitors are doing or you could look at various local and geopolitical factors that may have an impact on its supply and bottom line.

Key Factors in Fundamental Analysis

In fundamental trading, a wide array of sources provides valuable insights. Among these, several factors stand out for their significant impact on the markets:

• Central Bank Announcements – Central banks are pivotal in driving volatility across various asset classes. Their most influential actions include adjusting interest rates, which can significantly impact currencies, stocks, indices, and more. Beyond rate changes, fundamental analysts monitor new monetary policies, potential shifts in the central bank’s stance, asset purchases, currency revaluations, and changes in key personnel;
  
• Company Earnings – Publicly traded companies are required to release periodic earnings reports that detail their revenue, profit, costs, and other financial metrics. For stock traders, these updates are crucial as they provide insights into a company’s current performance and future prospects;
  
• Economic Data – The overall health of an economy influences almost every asset class, making economic data a cornerstone of fundamental analysis. Indicators of economic growth, such as gross domestic product (GDP), employment statistics, and production reports, are essential for assessing whether an economy is expanding or contracting;
  
• Inflation – Inflation measures the rate at which the purchasing power of a currency is decreasing. Central banks are tasked with managing inflation to avoid both excessive inflation and deflation. Inflation affects not only forex markets but also bonds, commodities, equities, and indices, all of which experience volatility in response to inflationary pressures;
  
• Politics – Political developments within a country or region can significantly influence financial markets. A new leader, for instance, may introduce policies that impact businesses or increase infrastructure spending. Geopolitical events, such as conflicts in resource-rich regions, can also have substantial market effects. For example, increased conflict in the Middle East can disrupt oil supplies, raising prices and impacting companies dependent on oil;
  
• Natural Disasters and Seasonality – While seemingly unrelated to financial markets, natural disasters and seasonal weather patterns can cause significant volatility. Natural disasters can disrupt business operations and economic stability, while seasonal weather can affect the supply and demand of various commodities.

Forex Market Drivers

All the factors above that may influence a single company can be applied to the country’s economy as a whole, which will impact the strength of its national currency. In turn, this affects its exchange rate against other currencies and may cause significant moves in the FX market. This is the reason forex traders who apply fundamental analysis to their market approach, keep a close eye on economic calendars for major news releases, either regular or breaking, related to the state of the economy, monetary policy and geopolitics. The most important ones to follow are:

• Gross Domestic Product (GDP) –  the total value of all goods and services produced by a country. It provides insight into the overall economic health and growth;
• Interest Rates – set by a country’s central bank, interest rates influence borrowing costs and, consequently, spending and investment;
• Employment Reports – data on unemployment rates, job creation, and wage growth reflect the labor market’s health, which, in turn, impacts consumer spending;
• Inflation Rates – the rate at which the general level of prices for goods and services rises, influencing consumer purchasing power;
• Consumer Price Index (CPI) – measures changes in the prices paid by consumers for a basket of goods and services, serving as an indicator of inflation;
• Trade Balance – the difference between a country’s exports and imports, affecting the currency’s value;
• Monetary Policy – statements and decisions by central banks regarding monetary policy, interest rates, and economic outlook have a significant impact on pretty much every aspect of economic activity;
• Retail Sales – data on retail spending provides insights into consumer behavior and economic activity;
• Housing Market Indicators – including data on home sales, construction, and prices, these reflect consumer confidence and financial health.
• Business Confidence Surveys – these surveys gauge the sentiment of businesses regarding economic conditions, providing insights into future economic activity.
• Government Debt – the level of a country’s debt relative to its GDP influences economic stability and investor confidence.
  

Conclusion

Fundamental analysis can be time-consuming, requiring analysts to examine various economic aspects and data comprehensively. This process can be daunting and may not suit short-term traders who seek to capitalize on minor market movements. They might opt for technical analysis tools for their trades.

However, fundamental analysis provides traders with essential information and updates necessary for making informed trading decisions. It is particularly beneficial for long-term traders, as it helps predict prices and fair value over extended periods.

For further reading you can visit our FPT Trading Academy​.