Fundamental Analysis

Fundamental Analysis

Fundamental Analysis

Fundamental analysis  is a form of evaluating and forecasting movements in currency exchange rates, as well as for the prices of securities, commodities or any other publicly traded asset or financial derivative. The basic skill involved in fundamental analysis in Forex trading requires an analyst or a trader to determine how a currency will react to macro-economic events, central bank monetary policy shifts, political and social news from the currency’s nation of origin when compared to the other currency in a currency pair.However fundamental analysis involves two type of analysis which eventually determines the type of trader one may be.  Fundamental analysis has traditionally been better suited for traders who operate on a longer time frame.  The method involves analyzing a nation’s overall economic strength, its interest rates, central bank policies, money supply, trade and current account balances, as well as the country’s overall political stability,  they need to look at several data releases in order to form a clear picture of the performance of the currency before they can commit themselves in any trading activity and the move can last for months or years. Other type of trading fundamentals is called News release trading. These type of trading is concerned with trading shorter movements that last from anything between hours to as long as two to three weeks, they use short term news trading strategies that generally operate right after the release of a major economic number, central bank rate decision or news of a major geopolitical event, such as a war or natural disaster. 

News and economic data are the main drivers of market developments, however the markets’ reaction to any type of data is unpredictable. This is not only the case when the news release is in line with analyst expectations, as published by news channels and financial news providers, but also when the release surprised significantly. Sometimes it’s not even possible to predict how volatile the markets reaction will be to the news release. Sometimes the market will move within a range of fifty or more pips in response to data released. Sometimes a 100 pip movements in the span of one or two minutes and can be completely reversed immediately and  negated by the price action during the rest of the day. Conversely, while news releases are usually the most volatile periods of a typical trading day, a very unusual release may be welcomed with relative calm if the market decides to do so. 

Central Banks

All developed nations have a central bank, and the actions of the central bank directly influences the price movements of the country’s currency. This is why central banks are so important to watch for all forex traders. Everything they do, impacts the trades they take and how they navigate the markets. Whether you are a long term fundamental trader or short term (News Release) it is important to understand central banks action. Central Banks are government agencies that regulate their national currencies in order to maintain a healthy economic environment, balance exports and imports, prevent inflation, and stimulate growth within their economies.  The role of central banks extends to setting monetary policy for their particular country. Monetary Policy is defined as the actions taken by a central bank to regulate the supply of its currency. However the central bank does not just take actions, but they are guided by economic indicators that inform them as to what type of action is needed in order to ensure that the economy of their country is healthy. 

As traders, it is important to know what the central bank is thinking, what they are happy with and what they are not happy with, because we can use that piece of information to our advantage to try and predict what they might do next as these actions that they take usually move the price of the respective currency. So looking at the same thing that the central banks is looking at when deciding whether they are happy or concerned about the current state of the economy would put us at a place of advantage regardless of whether you are long term or short term trader.

The picture above shows us two sections, the upper and lower. 

The upper section is the economic data or economic indicators that the central bank looks at when deciding whether the economy is healthy or not. The lower part of indicates the type of action that the central bank will take based on the state of the economy of the country as the economic indicators unfolds. The picture also represents the distinction between long term fundamental traders and short term fundamental traders. Long term fundamental traders will look at several releases of the economic indicators, meaning they wont trade as each economic data is released but will collect all the data to build a picture about the health of the economy,after collecting these data they wait for the central bank to take action or indicate a significant concern or satisfaction before they take their trades these actions are the ones indicated at the bottom half of the picture which is the monetary policy of the banks. Short term traders will take their trades as each major economic release take place. These means short term traders target smaller pips and small trends while long term target Main trends in bigger time frames. 


Fundamental Analysis Tools

The most useful tools for fundamental analysis consist of the economic calendar, the financial news media, and historic fundamental data.In order to be able to make sense of all the economic data as discussed in the previous section and also to understand exactly when how it impacts the market, these tools are very important and will become bread and butter of any fundamental trader.

The economic calendar as seen on the picture above informs the trader on the scheduled time and date of the release of major and minor economic data that can have an effect on the nation’s currency. The picture used above comes from a website called ForexFactory.com which shows all the economic release and Governor Speeches and meetings. Each release is color coded according to the importance of each announcement. The Red announcements or releases are the most important and have the ability to move the market strongly, the orange announcement are important but not as much as the red ones and finally the yellow ones a the least important and hardly move the market although important for the overall analysis of the currency. There a lot of calender's out there, we just prefare ForexFactory and each calendar comes with its own indication of the most important and least important news.

Trading news broadcasts from the financial news media like Bloomberg, Dukascopy and Bloomberg keeps the market informed of any major economic or geopolitical developments that could directly or indirectly affect the market. So some traders prefare listening from this media on any changes in order to manage their positions or initiate new ones.

Historical fundamental data can be useful to determine trends in fundamental indicators, as well as to analyze how a currency might react to a specific economic release after examining its behavior in the wake of a previous release or central bank rate decision. The key thing for traders to remember is that the actual data that comes out is only relevant based on whether it hits, misses or exceeds consensus. Consensus is an important word for the markets. Usually economic data calendars include the market’s expectation of the data release. The expected number is the mean of estimates from a number of economists who have been polled prior to the event and asked to give their views on what the number will be. Reuters and Bloomberg are some of the most popular data providers that measure the street’s expectations prior to major data releases. As a general rule, a data miss (the figures released are worse than the forecasts) can be currency negative, a number around expectations usually has a negligible effect, and if the reading exceeds expectations this tends to be currency positive.



Economic Indicators

In these section we going to be looking at the key economic indicators that every forex trader should look at, they are as follows:

Employment Reports(Employment) – The employment report is the most important and widely watched indicator on the economic calendar including the unemployment rate, the number of claims or jobless individuals applying for services, Non-farm payroll, average hourly earnings ,and other job related data.

Trade Balance(Production) – the difference between a country’s imports and exports which has a direct effect on the demand for that nation’s currency. A deficit would mean the country is importing more than exporting, while a surplus would indicate more exports than imports. a higher number if the country is an exporting country would signal strength in that nations economy.

Current Account(Growth) – one of two components of a nation’s balance of payments, the current account is the balance of trade and net cash transfers for a country. A surplus would indicate the value of a country’s foreign assets were higher than its debt, while a deficit would indicate the reverse

GDP(Growth) – changes in a nation’s Gross Domestic Product can have notable effects on that country’s currency. A sharp increase in GDP indicates strength in the economy that could stimulate appreciation in its currency, especially if the market anticipates a possible interest rate hike while a lower GDP would signal weakness in that countries overall economy.

CPI(inflation) – the Consumer Price Index shows the level of prices of products on a consumer level and is a key inflation indicator. Controlling inflation is one of the first mandates of most major central banks so CPI changes can directly influence monetary policy. An increase in inflation could indicate an interest rate rise, while lower consumer prices would indicate lower benchmark interest rates.

PPI(inflation) – the Producer Price Index gauges what manufacturers are paying for their material before making a finished product. This number affects a nation’s currency because a higher PPI number suggests higher future consumer inflation, while a lower number indicates the opposite.

 PMI (Production) – The Purchasing Managers’ Index surveys the activity of purchasing managers and can be a leading economic indicator. Purchasing managers generally are the first to know of increases or decreases in future production that can indicate strength or weakness in the manufacturing sector.


Monetary Policy

The central bank controls the supply of money in country. They are able to achieve these by using different tools which will be covered in these section. They these  money in circulation to achieve economic objectives and affect monetary policy. These is usually where the longterm traders like to enter their trades, because when central banks uses these tools, the move of the currencies turns to be sustained and for a very long period of time, therefore bigger trends are usually formed after these decisisons.These are the tools they use to achieve their objectives:

Policymaker and Central Bank Official’s Speeches - the content of a speech by the president, governor or other official of a major central bank can sometimes give indications of the bank’s future monetary policy, which will often affect that country’s currency. Other key policymakers include the voting members of the central bank’s monetary policy committee, and while their speeches may not carry the weight of a central bank governor, they could also have an effect on the country’s currency depending on the content of the speech.

 Print More Money-As no economy is pegged to a gold standard, central banks can increase the amount of money in circulation by simply printing it. They can print as much money as they want, though there are consequences for doing so. Merely printing more money doesn’t affect the output or production levels, so the money itself becomes less valuable. Since this can cause inflation, simply printing more money isn't the first choice of central banks.

Interest Rate Decisions - the amount of interest charged by a central bank is extremely important to the valuation of a nation’s currency. If a country’s central bank sets a high interest rate  barring other factors, such as political instability for example  that nation’s currency tends to attract foreign assets from countries with a lower interest rate.

Central Bank Rate Statements-Most central banks issue a statement after a rate release describing their monetary policy committee’s voting and the reasons the rate was changed or left unchanged. The statement could affect the market if the policymakers voting was unexpected or if the central bank has a more hawkish or dovish demeanor for future rate decisions.

 Engage in Open Market Operations-Central banks affect the quantity of money in circulation by buying or selling government securities through the process known as open market operations (OMO). When a central bank is looking to increase the quantity of money in circulation, it purchases government securities from commercial banks and institutions. This frees up bank assets they now have more cash to loan. This is a part of an expansionary or easing monetary policy which brings down the interest rate in the economy. The opposite is done in a case where money needs to taken out from the system.

 Introduce a Quantitative Easing Program-In dire economic times, central banks can take open market operations a step further and institute a program of quantitative easing. Under quantitative easing, central banks create money and use it to buy up assets and securities such as government bonds. This money enters into the banking system as it is received as payment for the assets purchased by the central bank. The bank reserves swell up by that amount, which encourages banks to give out more loans, it further helps to lower long-term interest rates and encourage investment. 


Quiz

  • The basic skill involved in fundamental analysis in forex trading requires an analyst to determine how a currency will react to macro-economic events, central bank monetary policy shifts, and political and social news from the currency’s nation of origin when compared to the other currency in a currency pair
  • the amount of money a central bank uses to purchase debt securities and other assets to support a weak economy. Increases or decreases in the amount of stimulus measures can have a significant effect on a nation’s currency because changes in asset purchases can indicate a change in the interest rate and money supply
  • Some fundamental traders use economic news and data releases to initiate and liquidate short term trades based on the results of the release.
  • Fundamental analysis focus solely on past price action
  • Monetary policy is the process by which the monetary authority of a country, typically the central bank or currency board, controls either the cost of very short-term borrowing or the monetary base.
  • Central banks are able to borrow money from commercial banks in order to purchase assets from their country by implementing the QE program.

Different ways to trade the market using fundamental analysis

As mentioned before that we have long term and short term news traders, long term traders take trades and follow news that will impact the market for a very long time while short term traders take advantage of the volatility caused by the release as they happen. To trade news on a short term basis, the trader must have a clear criterion on what kind of news will justify a trade. Many news traders seek at least a 50 percent surprise in the data to consider the release traderble. 

We will look into different ways of trading the news:

1. Straddling Both Sides of the Market: 

Some traders position themselves on both sides of the market before a significant release using a hedged position.They wait for the number to come out and then proceed to trade out of the position. For example, they might take a loss on one side during a post number correction, after having hopefully taken a larger profit on the winning side of the trade.This straddle or hedge strategy consists of going both long and short in the same currency pair before the release of the economic number. Action is not taken until after the number is released. Once the number comes out, the trader must decide how to go out of the two opened position. Generally this involves taking both a profit and a loss. A variation on this technique involves placing a stop loss immediately on the losing position and waiting for the stop loss to be hit. Once the stop loss has been filled, the winning side of the position can be held for additional profits or liquidated immediately.

2. Trade the Spike:

 We wait for the news release to come out. Based on the release number we enter the market immediately either with a Long or a Short position. We try to catch the initial spike move, or part of the move.We will put our Stop/Loss >15 pips from the pre-release price and our Take/Profit at the maximum expected range based on the report and its historical data.This type of trading requires that you react fast enough to the release and use a broker that gives you good fill during news releases. 

3. Pre-News Trading:

We enter the market 5 minutes before the news release. We base our entry on market sentiment and fundamental trend of the currency pair. We will always trade the direction of the Technical Trend. If the news release goes our way, we can make the entire move. If the news release goes against us, we might have to endure the initial drawdown, but usually after the impact is over, technical trend will resume its course and give us an exit to break even or 10~15 pips of loss.

Different types of reactions

Before applying your trading style of choice during news releases, these is the reaction that is expected from traders to avoid being caught up in wrong direction and also to ensure traders trade safely all the time. So lets look at them closely so that we can help you with decision making at the time:

1. Follow the Deviation-You need to first Make sure that the market is showing proper first reaction, meaning if the deviation for BUY is indeed moving the market up or deviation of SELL is moving market down. If you are waiting for Retracement, wait for retracement based on dual support and resistance levels, one from the daily range and one from the Movement, then find where the support and resistance levels intersect for stronger reversal levels, usually the first significant level.

2. Wait for Market to move to a range and take a reversal trade (Reversal)- It is always important to know the long-term market bias of a currency pair and the expected movement from a news release. If the news release is expected to move 50 pips and it did move 50 pips, then probably there aren’t any more momentum for it to move further, especially when it is going against its long-term trend. So, we will wait for it to stall (support/resistance levels), and then we will enter a reverse trade based on the stall.It is important to pay attention to the sentiment of “BUY on rumour & SELL on news”.

3.  Do Nothing

 When we have a conflict in the news releases, such as Employment Changes better but Unemployment Rate higher, then it is always better to stay out of the market and do nothing. Also if we are expecting the market to SELL USD on a worse than expected news from U.S., but instead the market start to BUY USD, then stay out of the market until you figure out why it is happening. Remember, when in doubt, stay out

Criterion used to enter trades

As traders we all need a road map to all the numbers as they are released to say which 1 is important and which one is not. The table below will show you exactly how you can decide precisely how to act and what type of Targets you can choose. Please be warned that this criterion is for short trading (News Release) . This table is designed from deviations that arise during announcements.



 

US Reports

Tradable Deviations

Movement Range

Core CPI m/m

0.20%

50 pips

Core Retail Sales m/m

0.50%

50 pips

Interest Rate

0.25%

70 pips

Non-Farm Payroll (NFP)

70k

70 pips

ADP NFP Changes

50k

40 pips

ISM Manufacturing PMI

2.5

50 pips

ISM Non-Manufacturing PMI

3

50 pips

New Home Sales

70k

50 pips

Existing Home Sales

300k

50 pips

GDP q/q

0.30%

70 pips

 

 

 

 

Bank of Canada Reports

Tradable Deviations

Movement Range

Core CPI m/m

0.30%

50 pips

Interest Rate

0.25%

70 pips

Employment Change

30k

60 pips

IVEY PMI

3.0

50 pips

GDP m/m

0.30%

50 pips

Core Retail Sales m/m

0.50%

50 pips

 

   United Kingdom Reports

Tradable Deviations

Movement Range

CPI y/y

0.30%

50 pips

Interest Rate

0.25%

70 pips

Manufacturing PMI

2.0

50 pips

Services PMI

2.5

50 pips

Retail Sales

0.50%

60 pips

MPC Vote (Minutes)

2 votes

50 pips

GDP q/q

0.30%

50 pips

 

 New Zealand Reports

Tradable Deviations

Movement Range

CPI q/q

0.30%

50 pips

Interest Rate

0.25%

70 pips

Retail Sales

0.50%

40 pips

GDP q/q

0.30%

40 pips

 

Australia Reports

Tradable Deviations

Movement Range

Interest Rate

0.25%

70 pips

Employment Changes

30k

60 pips

GDP q/q

0.30%

50 pips

Retail Sales

0.50%

50 pips

CPI q/q

0.30%

50 pips