Unlike technical analysis, which looks at price action and trends to help pinpoint where prices may head to next, fundamental analysts considers all available data to help them to determine the relative value of a market. They then look for discrepancies between the current market price and their own valuation to spot trading opportunities. For example, they may want to go long or buy Apple shares if their own valuation of Apple is higher than its current share price.
In this lesson, we look at:
The two most common types of analysis when it comes to the financial markets are technical and fundamental analysis.
During this lesson, we look at fundamental analysis in more detail.
Unlike technical analysis, which focuses predominantly on price action, trends and patterns to help pinpoint where prices may head to next, fundamental analysts consider all available data to help them to determine the relative value of a market. They then look for discrepancies between the current market price and their own valuation to spot trading opportunities.
Let’s imagine you want to buy a car. You’ve seen one you like for $10,000, but you don’t know whether this is a fair price. So you’ll research around on the internet, ask other people their opinion, compare it to prices offered at various car dealerships, and do general background research to assess whether the price is ‘fair’ and whether the car is worth the money.
What you’d be doing in this scenario is essentially fundamental analysis - you take into account all the fundamental factors in play to decide if the price reflects the real value of the asset.
Searching for clues
Fundamental analysts use an array of available data including corporate earnings reports, geopolitical events, central bank policy, environmental factors and more to help them with their analysis. They search for clues as to the market’s direction in the future.
Such clues can often be found in macroeconomic data, which is why knowing when important data is released is so important to fundamental traders. The markets tend to focus on potentially crucial macroeconomic readings that could affect the market and provide volatility.
Here are some examples of macroeconomic data releases and why they can have an impact on financial markets:
The way in which macroeconomic releases can affect the market depends strongly on the market’s expectations. Generally speaking, the bigger difference between expectation and reality, the bigger the reaction could be. If a market expects a central bank to hike interest rates and the bank does so, the reaction could be ‘priced in’ and it’s business as usual. When a release takes the market by surprise however, that’s when major volatility can be sparked.
You can keep informed of all fundamental data releases with our comprehensive economic calendar. The effect on the market highly depends on the comparison between the actual reading of a macroeconomic reading and the market expectations, where the bigger the difference, the bigger the effect on the market. You can keep informed of fundamental data releases with our comprehensive economic calendar. Each announcement is categorised as either High, Medium, or Low, in terms of its impact and potential to spark market volatility.
Central banks run the world
As previously touched upon, one of the most important factors in fundamental analysis is the monetary policy carried out by central banks. Interest rates, open market operations and central bank interventions influence market conditions and are closely monitored by financial analysts and traders. Some of the most influential central banks include the Federal Reserve (US), the Bank of England (UK), the European Central Bank (EU) and the Bank of Japan (Japan).
Let’s take a look at an example. The US economy rose 3% in Q1 of 2017, while inflation inched to 2.5% on a year-to-year basis. The Fed elected to raise interest rates. Interest rates increased, higher, so traders decided to put their money in the USD as it could generate a higher return. Such a move can lead to a higher demand for the US dollar, which drives prices higher. Please bear in mind that there are multiple factors that can affect market prices, and the previous is just an example for educational purposes.
Not just bankers and data
Fundamental analysis also considers outside influences that could affect an instrument’s value or price movement. Natural disasters, such as flooding or earthquakes, can also have a major impact on the fundamental strength of an asset. For example, an explosion of a crucial pipeline may lead to a rapid increase in oil prices as the commodity becomes more difficult to transport and to buy. In such a situation, you could go long on Oil using CFDs.
A different point of view
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