Before you think of trading in the currency of another country or even that of your own country, you have to have a basic understanding of what affects the exchange rates of these currencies and how you will be able to identify when is a good time to trade. One of the most important methodologies is that of fundamental analysis.
As the name suggests, fundamental analysis studies the most important factors that influence the economy and hence of entities like stocks or currencies. The main factors that affect an economy are the main economic indicators, government policies and of course, many other factors that play a role within a business cycle.
By looking at these factors, fundamental analysis hopes to be able to understand how the economy is functioning and thereby predict what the movement in prices is going to be and what trends can be expected.
Of course, you also have another method of analyzing the market and that is through technical analysis, which we will be coming to in the next chapter. When you read any book or reference on Forex, you may have the distinct feeling that these two methods of analysis are mutually exclusive and either you can go in for a fundamental analysis of the market or a technical one. This is far from true and in fact, most smart traders use a bit of both to make well informed trade decisions.
Most fundamental analysts have their theories confirmed by quickly glancing at charts and trendlines while technical analysts verify their trends by considering all the economic data and major political decisions.
How to Use Fundamental Analysis
Fundamental analysis takes into account current socio-economic factors and tries to predict what the upcoming economic conditions will be like. However, it is difficult to make predictions about the currency prices merely through fundamental analysis. When one studies a country’s GDP forecasts or export figures, it is very easy to understand what the state of the country’s economy is and what forces are playing a role in it.
However, this understanding now has to be converted into a model that will help one understand how this affects price movements and what may be good times to trade in the foreign exchange market. This model called a trader model uses the current market data, compares it with historically available data and tries to predict what future prices may be. This can then be used in making trade decisions.
To begin with, one has to know what exactly are the fundamentals that one needs to study. The fundamentals of the economy are those that have a significant impact on the country and its currency. These could range from GDP forecasts and interest rates to bank policies. Events such as elections or natural disasters could also affect the country.
However, not all such events will have the same amount of significance with some having more of an impact on the country’s currency than others.
Of course, fundamental analysis is finally an art of forecasting and can be approached and carried out in many different ways. Not all conclusions will match, only adding to the trader’s confusion. At this point, it may help to take the help of technical analysis, which will support or refute any forecasting predictions that you may have made so far.
Before we begin by understanding how exactly to use fundamental analysis to predict currency prices, we need to know the important contributors that will play a role in its variations.