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Fundamental Analysis

Fundamental Analysis – A Step by Step System to Trading Financial Markets

Traders in financial instruments deploy fundamental analysis or technical analysis tools to determine positions. Traders using fundamental analysis study macroeconomic indicator releases such as NAPM, non-farm payrolls, CPI, PCE price index and their effect on financial instrument prices to take positions in order to profit.

Our objective is to teach you these strategies in depth – both fundamentals as well as technicals.

One of the most popular quotes that stress the importance of trading on fundamental analysis is

“Market Analysis can be approached from either direction (Technicals or Fundamentals). While I believe that technical factors do lead the known fundamentals, I also believe that any important market move must be caused by underlying fundamental factors. Therefore, it simply makes sense for a technician to have some awareness of the fundamental condition of a market.

John J. Murphy, Technical Analysis of the Futures Market

 

What does Trading using Fundamental Analysis Mean?

We see economic data such as the Consumer Price Index, the Quarterly GDP Report, Retail Sales, Durable Goods Orders and many others being released on a daily basis. Recently, one of the largest historic crashes of the DJIA was attributed to a very strong employment and wages data. This relationship appears to be paradoxical to those who haven’t learned to make the connections between economic indicators, financial asset prices, and the central bank’s monetary policy.

Traders and investors who use fundamental analysis for trading strategies understand the relationships between asset prices, economic indicators and the central bank’s monetary policy.

Trading financial markets using fundamental analysis is studying the effect of these economic indicators on asset prices in order to create trading strategies that generate profits.

Macroeconomic indicators are statistics released by government agencies and the private sector that provide us with information on the state of the country’s economy. These indicators are generally classified as leading, lagging or coincident indicators depending on their ability to predict the economic state.  An example of a macroeconomic indicator is the Quarterly GDP report released by the Bureau of Economic Analysis.

The First Step to Trading on Fundamentals

As a first step to making the connections between financial asset prices, economic indicators and the central bank’s monetary policy, you must understand an asset’s price determinant. An asset’s price determinant is the factor that determines the price of that asset. For example, the price determinant of a fixed income asset is interest rates. There is an inverse relationship between bond prices and interest rates. Similarly, the price determinant of foreign exchange rates are interest rate differential and the price determinant of stock prices are expected earnings.

The Second Step to Trading on Fundamentals

The next step after understanding an asset’s price determinants is to study macroeconomic indicators. We will achieve this with the use of an economic map.

To begin with the basics we first understand how the economic growth of a country is measured by the Gross Domestic Product. We will take an example of a simple hypothetical country and building on the model to emulate the real world. Next, we will look at the historical context of growth in the US and the components of the Gross Domestic Product. Each macroeconomic indicator tells us a story on either growth or inflation, the agencies that release these indicators, and their release dates.

Fundamental Analysis - Economic Indicators Classification

Fundamental Analysis – Economic Indicators Classification

For each macroeconomic indicator, we see what impact that indicator has on the determinants of financial instruments, and what the central bank’s reaction to each indicator is. We will make all these connections between economic entities, factors, markets and central bank policies through the use of our “Economic Map”. The economic map helps us to understand how each small sub-component aggregates to the larger components, which in turn aggregate to the Gross Domestic Product thus giving us a wider perspective of how entities interrelate with one another.

Fundamental Analysis - Economic Map - GDP

Fundamental Analysis – Economic Map – GDP

Step Three – Determine the Impact of each Indicator on the Financial Asset’s Price

For each economic indicator, you need to determine the impact of the economic indicator data release on the asset’s price. Every country’s economic indicator is released on specific dates or periods. This economic calendar can be found on various websites such as Forex Factory.

Traders conduct an impact analysis for each indicator. This impact analysis is determining the effect of the data release on prices before and after the release taking into account the deviation of the release from the expected value and previous value.

Step Four – Setup your Trading Strategies Based on your Impact Data

Once you have compiled historical data on the impact analysis you can use that to create your trading strategy. For example, if the USD CPI data is due today, based on the impact analysis spreadsheet you could take a long or short USDJPY position pre or post the data release.

 

 

 

 

For a full course on the steps involved to trade fundamental analysis, you could take the InvestopediaPro’s course – Tradeonomics. Check out our Courses page for full details.

Alternatively, continue to browse this site for more topics on Fundamental Analysis.

Related Topics

Price Determinants of Financial Instruments

Economic Indicators

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