As you may already know, there are two types of analyses that are used to analyze the financial market – technical and fundamental. A lot has been said and also written about the principal differences between these two analyses. To give you a general overview, fundamental analysis is the study and observation of macroeconomic indicators, meaning it is used to analyze the reasons of asset price behavior from an economic and political point of view. Technical analysis, on the other hand, does not include macroeconomic indicators. It is the assessment of history asset price movement on a chart with an attempt to find certain patterns for different price behavior.
There are often heated debates between fundamental and technical analysts as to which analysis is better to use. In our opinion, technical analysis is currently “losing” in comparison to fundamental analysis and there are a few reasons for this. One reason is that traders have an illusion of simplicity and because of this they lack trust in technical analysis, but, in fact, when analyzing the market at a more serious level, such as the wave theory or market profile a trader understands that technical analysis is not as easy as it may seem at first.
Secondly, fundamental analysis has a certain distinguished shade of “nobility”. And here, author Greg Michalowski greatly expressed himself in his book called “Attacking Currency Trends”, he said “Can you imagine if CNBC’s Larry Kudlow stopped talking about free market capitalism and instead spoke about how the price broke a Fibonacci level? What if Ben Bernanke went in front of Congress and said how the stock market was oversold on a RSI basis and was due for a correction. Better yet, imagine if you and your spouse were invited to a dinner party with new neighbors. After the host asked you what you though of “the market”, you went into a monologue on how the price moved above the Ichimoku cloud, or how the hammer formation on the candlestick chart points toward a strong rebound – both technical tools. Most dinner hosts would think twice about the next invite.” What Michalowski said perfectly defines the opinion of some fundamental analysts when referring to technical analysis – as a sort of horoscope that most sensible people should not take seriously. We won’t get into the details of all disputes, but we do want to mention that both analyses are rather subjective and reflect the position of a particular trader (or a group of traders).
Thus, the truth remains somewhere in the middle – a balance between the two. This means that ideally both analyses should be considered and used in order to fully understand the situation on the financial markets.
Today, we are going to please fans of fundamental analysis because this will be our main focus, namely how to use this type of analysis on the FOREX market — one of the most aggressive and fast paced markets in the world.
How can fundamental analysis help us on the Forex market?
Indeed, the FOREX market and, for example, the stock market are two different things. Investors that invest their money in shares or bonds of certain companies are primarily concerned about the long-term stability of the companies themselves. So, the analysis of the company’s financial reports and, of course, its corporate policy in this case take center stage. FOREX is an over the counter market and practically nobody uses analyses for long term perspectives. There are too many factors that may influence any given currency, which makes it hard to predict, for example, the future outlook of the American currency against the Euro in five years’ time. According to various assessments, the maximum window for Forex market analysis is about six months.
In our opinion, using fundamental analysis for FOREX trading is possible in the following scenarios:
- Position trading based on fundamental analysis
- “Scalping” on fundamental analysis
- Position trading using fundamental analysis as a supporting auxiliary — (mix of technical and fundamental analyses).
Let’s discuss each of the three options.
Position trading based on fundamental analysis. Advantages and disadvantages
In order to understand how to act based only on fundamental analysis, let’s look at the situation with the British pound. We are not going to go into all the details of the British economy and politics, we are only going to use the example of BREXIT. It’s well known that for quite some time the United Kingdom has not been able to reach an agreement regarding their withdrawal from the European Union. This led to a shift in Brexit deadlines and ultimately to the resignation of UK prime minister Theresa May.
This had a negative impact on the British pound.
Therefore, considering the difficult situation as a factor of pressure on the sterling, we were able to forecast, solely from the above fundamental analysis, that the British pound is in a selling position. Indicating that we should, for example, open SELL (Short) orders for GBP/USD currency pair.
As with the British pound, currencies of other countries can also be analyzed to form a more global conclusion as to what may happen to them in the mid-term.
The advantage of this approach is the assessment of the main, fundamental economic principles that act as the main driving force in any market.
However, if we take a deeper look, the disadvantages of this approach outweigh the advantages.
- Your assessment will be highly subjective. This means that you can underestimate or overestimate the factors you rely on to analyze the market. In addition, unfortunately, you may often not possess all the necessary information and only see the «tip of the iceberg». The availability, or rather lack of availability of important information, leads to the following drawback of this approach.
- Since for the most part your assessment is based on information that is available to the general public, means that the conclusion you reach may already be «embedded» in the currency price and in the medium to long term the price may simply not change, which may lead to additional commission expenses instead of profit.
- Unfortunately, with this approach, focused solely on fundamental analysis, it is impossible to determine exact entry points, therefore an exact entry point is often not considered and the buying and selling is conducted at current prices. But that’s not the half of it. You also need to have an exit point and an understanding of where fundamental factors have ended their impact or are simply limited and not causing movement for the currency.
- And lastly, is its complexity. In order to be able to decipher the details of fundamental analysis, such as different readings and reports, one needs to possess a certain level of corresponding competence, that only comes after a prolonged period of practice.
“Scalping” on fundamental analysis
The main idea of the approach when using fundamental analysis and «scalping» on the FOREX market is rather simple. Short-term profit (scalping) is made by selecting and analyzing «strong» macroeconomic indicators with the purpose of determining the deviation between the forecast and actual (fact) report. In other words, the work is carried out on the basic principle of fundamental analysis — «Buy by rumor, sell by fact». There are two options for this approach — preliminary analysis and position taking before the news release or preliminary analysis and position taking right at the moment of news release (trader joins the «majority»).
Let’s take a look at an example of GDP news release from Japan for the 1st quarter of 2018. Actual GDP of Japan for the first quarter was published on May 16th. The data was negative and was released at -0.2%. However, the forecast value, that was published before the news release was 0%. Analyzing the situation with retail sales (consumption) in Japan in the first quarter (which makes up a large part of GDP), experienced traders did not have difficulty noticing that the actual deviation from the forecast value should be negative due to reduced consumption in the first three months of the new year — 2018.
Thus, assuming a decline in price movement relative to the forecast, it is possible to take a position on currency pairs such as EUR/JPY or USD/JPY — against the Japanese currency, i.e. to increase («buy by rumor»). At the moment of news release and market movement in favorable direction there is a fixation of profit and an exit («sell by fact»).
The complexity of this approach, as in the case of trading based solely on technical analysis, is that it is necessary to have a very good understanding of macroeconomics in order to be able to find the interrelationship and compare your data with the predicted value. In addition, market movements caused by news can be very limited. For example, in the case of the Japanese yen, the market movement was only a few points and could only be successful with a large leverage (multiplier).
The second approach is opening a position right at the moment of the news release. This approach looks more promising, because in this case the trader can try to join the majority, «attacking» the current short-term trend right at the moment of the release. Losses can be limited with the help of the “Stop-loss” instrument.
Joining the majority, the trader as if «jumps» in the sled of the desired trend, which is quickly «sliding» towards profit. The question is the moment of taking this very profit. Here, as we believe, we can focus on the dynamics of the market itself («fading» of a trend indicates its end).
Position trading using fundamental analysis as a supporting auxiliary (mix of technical and fundamental analyses)
The most interesting approach, from our point of view, is the merging of fundamental and technical analyses. Namely the confirmation we obtain when we combine our technical analysis with the market perspective from a macroeconomic point of view.
For a trader it looks like this. Let’s assume that we get a technical signal to sell the U.S. dollar and buy the Russian ruble, but, as we already know from the example above, there are certain risk factors that will put pressure on the Russian currency. In this case, it is quite possible that it is better to refrain from buying at this particular moment in time.
As another example, let’s say we have a technical picture that signals us to buy the European currency and sell the U.S. dollar. Moreover, the technical picture was formed in the first week of the new month, right before the release of non-farm payrolls. Having analyzed the situation with macroeconomic indicators, a trader may come to the conclusion that the data report may come out weak, which supports the arguments obtained from technical analysis, which is — the possibility of buying. In this case, the trader will feel more confident when opening a position and, quite possibly, will increase its size if necessary.
In order to have a more complete picture of the markets, we believe it is necessary to use fundamental analysis. The complexity of fundamental analysis lies in the need for a better understanding of the processes that take place in the economy and the various interrelationships. Despite the complexity, this task is quite feasible if you set you mind to it. The reward is well worth it – a more accurate understanding for your trading approach and, quite possibly a higher financial result.