If you are just starting out in Forex Trading, then you might have heard the term “fundamental analysis" being mentioned often. If not, then you better start paying close attention. In short, fundamental analysis is the assessment of important data before making a trading decision. In business, this data usually involves a company’s financial statements and health, as well as its competitors and market segment. However, when it comes to the Forex market, the data traders are usually interested in the overall state of the currency country’s economy, and factors such as its interest rates, production, earnings, employment, GDP, manufacturing, and management.
There are two broad approaches that you can take when using fundamental analysis to perform an analysis on stock, futures contract, or fiat currencies – a bottom-up and top-down analysis (not to be confused by other types of investment analysis such as quantitative analysis and technical analysis).
Fundamental analysis in finance involves using historical and present-day data to make financial predictions which usually include:
- Conducting a stock valuation of a company and forecasting its probable price outcome
- Predicting the company potential business performance
- Determining a company’s management style and business decision-making
- Calculating a company’s credit risk.
As you can tell, these are critical considerations that will help determine whether a stock’s current pricing is overvalued or undervalued.
Why Use Fundamental Analysis?
In simple terms, an analysis will greatly help you to decide which financial instruments to buy and at what prices. Having said that, there are two basic methods to achieve this:
- Fundamental analysis is an approach which maintains that markets may incorrectly price a security in the short run, but that this mispricing will always be corrected in the long run. By trading the mispriced security and then waiting for the market to readjust, profits can be made! Fundamental analysis includes economic analysis, industry analysis, and company analysis
- Technical analysis assumes that all information has already been reflected in the stock price. This follows the rule that trends 'are your friends' and sentiment changes dictate trend changes. Therefore, recognizable price chart patterns are a result of investors' emotional reactions to price movements. As such, this approach disregards the 'value' of a stock and assumes that price predictions are only extrapolations from historical price patterns.
However, you don’t have to stick religiously to either method as both can be useful tools for any trader when used properly. In fact, many fundamental traders use technical analysis for deciding entry and exit points, while it isn’t uncommon for technical traders to use fundamentals to limit their universe of possible stock to 'good' companies.
Ultimately, it depends on the investor's individual understanding of the stock market. But regardless of whether you are a fundamental trader or a technical trader, one thing is for certain: it always pays to trade on a proven and trusted platform like Forex4you.
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This article has been updated on 7/12/2021.