Long Term Profits with Fundamental Analysis in Forex Trading
Is Fundamental Analysis in Forex Trading Still Effective?
Most people (if not all!) people would agree that when buying and selling currency the goal is to buy low and sell high. In real estate, an adage I find very telling is that you make your money when you buy not when you sell. Loosely translated that means you make a profit if you buy at the right price. Now you can apply this adage to trading forex. But how can you determine the best time to buy (low)? This is where fundamental analysis comes into the picture. Many traders would agree (and I do as well), that over a medium term horizon the best way to make a profit trading forex is through fundamental analysis.
There are two main ways to analyze the forex markets. These are technical analysis and fundamental analysis. Technical analysis uses formulas to spot trends and to determine the optimal time to buy and sell currency. The result of technical analyses is typically a set of charts with different lines, triangles and indicators in general. You then decide if you want to act on those signals or not.
On the other hand fundamental analysis is much more subjective in its approach to identifying trends. Fundamental analysis looks at endogenous factors that cause the value of the currency to go up or down. It considers factors that influence the financial position of the country issuing the currency. For example, if the financial system in that specific nation is in trouble (such as was the case of Iceland not long ago), there will be lower demand for that nation’s currency and hence the exchange rate versus other currencies will decline. Why will there be less demand for the currency if the financial institutions are in trouble? There are many reasons, but the most obvious one is that there will be less investors wanting (and willing) to buy that country’s currency to deposit money with the local banks.
Another major factor in impacting the value of a country’s currency are governments and other legislative bodies such as local authorities. E.g. governments can (and do) pass legislation that facilitate or restricts international trader. This will decrease the flow of goods and services and hence the amount of that country’s currency is bought or sold. For example, if a law that enhance exports is passed there will be more people wanting to buy that nation’s currency to by local goods hence the forex rate will appreciate in that country’s favor. By the same token, instable governments affect unfavorably the value of the currency as there is a lot of uncertainty over what’s going happen in the region. And financial markets don’t like uncertainty.
Another element that plays a key role in fundamental analysis is central bank activity. Central banks can raise or lower interest rates (pretty much) as they wish. Another way of seeing this is that they can decide to raise or lower inflation. Coming back to the bank deposits example, lower interest rates will cause less external investors wanting to deposit money with the local banks and hence less demand for the nation’s currency. This in turn causes the forex rate to depreciate.
In all fairness, fundamental analysis is more subjective because you are guessing on the impact that governments, central banks and other financial conditions will have on the country. One thing you can be sure about though: it’s that they will have an impact.
In forex trading, the best combination is usually a mix of fundamental and technical analysis. Typically fundamental analysis is used for deciding whether you want to buy or sell the currency whereas technical analysis is used for choosing the best timing to open the position.