There are two types of market analysis that you need to know: fundamental and technical analysis. To succeed in trading, it is important to understand both types of analysis. This will help you find your own trading style.
Both fundamental and technical analysis provide their own unique advantages and disadvantages. Today we will discuss the pros and cons of each of these approaches.
This guide is intended to teach traders the basics of fundamental analysis, as well as provide more detailed instructions and ideas for more advanced traders. I will also explain the difference between qualitative and quantitative analysis.
By reading the reference materials below, you will have a basic understanding of how to conduct fundamental analysis using different approaches to data analysis, historical fundamentals, market research, and economic factors.
What is fundamental analysis?
Fundamental analysis examines and analyzes economic data. Economic news often has a big impact on the price. These can be: inflation, trade balance, GDP , unemployment and changes in interest rates by central banks .
In the foreign exchange market, the activities of the central bank are closely monitored by fundamental analysts. Upcoming interest rate decisions, meetings and speeches by senior central bank officials are extremely important for the fundamental trader.
Fundamental analysts will attempt to gauge general market conditions using various economic reports. That being said, they may be short-term traders trying to catch price swings during periods of potentially high volatility, such as the US nonfarm payrolls report. Or they may be traders with a long-term macro position who are more interested in multi-month or multi-year trends.
Fundamental traders seek answers about why economic conditions are the way they are and try to justify their predictions based on analysis of economic data. The technical trader, on the other hand, cares much less about causes and much more focused on price action itself.
There are many ways to define fundamental analysis, but when broken down into as simple terms as possible, it is the study of the underlying value of financial assets using a variety of data, both qualitative and quantitative.
The definition of fundamental analysis may vary slightly for each trader depending on the strategies they use. It is also very important whether an investor or trader is considering a stock, cryptocurrency, forex or other financial asset.
Whether it's diving into economics, reviewing quarterly earnings reports, or reviewing a product line, there are an infinite number of factors that affect an asset's price, all of which can be foreseen through detailed and in-depth research through fundamental analysis.
Fundamental analysis uses economic data to predict movements in currency pairs. By interpreting economic data, you can evaluate the strength of the economy for the countries whose currencies you trade. For example, if there is strong economic data in the Eurozone and weak economic data in the US, you can consider that the euro will rise against the dollar and go long on the EUR/USD pair.
Typically, traders who trade fundamental analysis will hold their trades for weeks or even months. Economic factors usually do not cause immediate spikes in the value of currencies.
One of the most important economic indicators of fundamental analysis is interest rates. Countries with high interest rates attract more foreign investment. If you had to choose between an interest rate of 0.5% or 5%, you would obviously choose 5% to invest your money.
When a particular country's interest rate is higher compared to other countries with similar economic conditions, foreign investment and capital will flow into the country at a relatively higher interest rate. Investors are always looking for higher returns and therefore a higher interest rate will tend to attract more capital from global markets.
Over longer periods of time, high interest rates affect the value of a currency. So if the US has an interest rate of 2.25% and Europe has an interest rate of 0%, the US dollar could appreciate against the euro. This means that fundamental traders will mainly consider short positions in the EUR/USD pair.
Some fundamental traders often use the foreign exchange market to simultaneously buy high yielding currencies against those offering lower yields. This strategy, called the carry trade , is quite popular among long-term fundamental traders and global investment funds.
Quantitative and qualitative analysis
Quantitative analysis is carried out using actual statistics, measurements, financial ratios and other forms of quantitative research.
The practice of quantitative analysis allows you to evaluate anything from product sales figures, profit margins, operating expenses, return on assets and much more.
Quantitative analysis includes mathematics and numerical analysis, including stochastic calculus, linear algebra, statistics, probabilities, and econometrics.
Quantitative analysis can be used to develop algorithmic trading strategies, portfolio optimization, liability valuation, risk management, credit analysis, and more.
Qualitative analysis requires critical thinking. Each trader has his own type of analysis.
For example, does the company you are considering shares have a corporate culture? Do you expect the industry to take off soon? Do you like the product the company makes?
This is the type of solution that all the calculations and computer data in the world cannot provide. This category includes data that cannot be quantified in any meaningful way.
During a recession, it may be more profitable to trade gold or oil, since the volatility of these assets increases, when the economy is on the rise, trading in stocks and cryptocurrencies can be more profitable.
Fundamental analysis tools
There are many tools and methods of fundamental analysis that allow you to more accurately determine the underlying value of a stock or other asset.
Earnings per share
This tool analyzes the earnings allocated to each individual share of a company and is calculated by dividing the total earnings of a company by the total number of shares in a company.
Earnings per share = Net income after taxes / Number of company shares
Value for Money
This is what the market will willingly pay for one dollar of company profits.
Price to earnings ratio = market price of each share / company earnings per share
Book value
Shows how much investors are paying per dollar in an asset and is often referred to as equity. This measure compares a company's book value with its current market share.
Price to book value ratio = share price / book value per share
Price to sales ratio
This tool compares the value of a company's shares to its revenue figures to get a clear picture of the overall health of the company and evaluate asset performance.
Price to Sales Ratio = Market Cap / Total Revenue
Top-down or bottom-up analysis
Top down investing is an analytical approach that looks at the overall macroeconomic background and then looks at the finer details.
In a bottom-up analysis, investors first look at the smallest details of an asset and then analyze the economy in more detail to appreciate the bigger picture.
Why do we need fundamental analysis?
Travelers don't go blind without a road map, and doctors don't perform surgeries without years of experience and training. Why would a trader or investor just randomly buy an asset and then expect it to perform and provide a profit? Consumers even test cars before buying them - don't you want to know the data behind an automaker's financial statements before you buy their stock?
Anyone who wants to make money knows that they must first spend time learning what they are investing in or what assets they want to trade. This can mean the difference between buying a worthless product or buying a company like Amazon or Apple.
These assets made the early investors rich. Of course, some people are probably just lucky, but the vast majority of investors or traders have learned about long-term assets that have brought them profit through fundamental analysis.
Fundamental analysis is most often associated with investing, but it is no less important for traders.
Knowing which markets are volatile and using the latest news, data, quarterly financial statements to open positions can lead to significant profits.
For example, if a company publishes an income statement that does not meet the expectations of investors with large enough margins, it can cause the stock price to drop as investors overestimate the company's earnings after failing to make the expected earnings.
Fundamental analysis of the stock market
When considering individual stocks, any of the most common methods of fundamental analysis are valid and can be used depending on the preferences of the investor or trader.
These include price-to-earnings ratio, earnings per share, or return on equity to perform basic quantitative analysis. Qualitative analysis may include a review of the company's board of directors or an examination of a particular company's product line.
Fundamental analysis of stock indices can include jobless claims, debt, interest rates, and more.
Forex fundamental analysis
Such an analysis of unemployment claims, debt and other factors can significantly affect the prices of forex currencies and their price activity.
A more qualitative analysis might include looking at government leadership, positioning in global trade, the military, manufacturing, and more.
Fundamental analysis of commodities
Here, supply and demand indicators, as well as data related to the environment, geolocation and weather, are of paramount importance.
The production and consumption of any commodity greatly affects the intrinsic value of an asset.
For example, due to travel restrictions, the demand for oil has fallen. However, when production was cut, oil prices rose sharply. In such situations, quantitative and qualitative fundamental analysis can help.
Fundamental analysis of cryptocurrency
Cryptocurrencies are difficult to perform fundamental analysis due to their speculative nature and the lack of a use case or, in many cases, companies that back them.
Let's take Bitcoin for example. It is a decentralized blockchain network. Since nothing like this has ever existed in the past, it can be very difficult to set a fair price, which leads to wild volatility.
What is technical analysis?
Technical analysis is the analysis of price movements in the past in order to predict future price changes. This is a very efficient method of analysis. In financial markets, the price movement is periodically repeated and obeys certain patterns. This is because the price movement depends on the actions of people, and people always act according to certain patterns.
The main tool for technical analysis is price data. Regardless of the time period chosen, price is the most important factor. A trader makes trading decisions by studying the current price movement and constantly comparing it with history.
Technical analysis can be applied to many different markets, including the stock market, forex, commodities, and cryptocurrencies. As long as the market has sufficient liquidity and is not subject to strong external influences, technical analysis can be applied in the most effective way.
One example where technical analysis may not be as effective due to lack of liquidity and exposure to external influences is the market for so-called penny or junk stocks.
Three basic principles of technical analysis:
- The price takes everything into account.
- Price movement is subject to trends.
- History repeats itself.
The price takes everything into account . Technical analysts believe that the current price reflects all known information available to market participants. And any new information that comes out is already reflected in current prices.
Price movement is subject to trends . There are trends in the price movement in the market and these trends do not move randomly. Trends appear after a period of consolidation. Then, when the trend reaches its peak, it eventually returns to a consolidation phase before a new trend phase re-emerges in the market.
History repeats itself . Financial markets exhibit a repetitive, recursive nature in their price data. Although no two patterns in price history look the same, there may be similarities in them that cannot be explained by price noise or randomness. These repetitive patterns are constantly seen on charts in the form of candlestick patterns, price momentum, volume, and other forms of price data.
Let's look at the chart below.
You can see that whenever the price approaches the 1.0626 level, it bounces back sharply from it. This means that you may consider selling USD/CAD the next time the price hits 1.0626.
Technical analysis is the most common way to trade in the financial markets. It works like a self-fulfilling prophecy. If hundreds of thousands of traders use the same type of market analysis, they will trade the same way. The fact that all traders trade the same way makes the price move in the same direction.
Twice in a row, the price direction in the USD/CAD currency pair changed sharply at the level of 1.0626. The next time the price hits 1.0626, thousands of traders will bounce off the level because they expect a reversal.
This type of analysis takes into account:
- Current state of the market: trend or consolidation .
- Support and resistance levels .
- Technical indicators .
- Price action patterns .
You should know that technical analysis is not as easy as it seems. Your predictions will not always be correct. Teaching technical analysis will take time and constant practice.
Sometimes you may hear that technical analysis is more of an art than a science. This is because when we try to predict future price movements through technical analysis, there can be many nuances that can sometimes lead to different conclusions.
Technical analysis is the study of candles, chart patterns, indicators, oscillators, trading volume and much more.
Technical analysis is not at all similar to fundamental analysis, but both together give investors and traders a complete set of analytical tools necessary for maximum profitability. It is recommended that all traders considering fundamental analysis also consider studying technical analysis.
For example, finding the right asset and doing all the research in the world will not be profitable if the asset has recently reached an all-time high or is showing severe overbought conditions on a technical analysis indicator such as RSI. Combined with buying at the bottom of a downtrend or when the RSI enters an oversold area, this can minimize risk and maximize overall profit.
Market sentiment analysis
Market sentiment analysis is another kind of analysis that shows how traders will react to certain news. For example, when important events happen, such as Brexit or the US elections, they have a huge impact on the market. However, not on their own, but because traders will trade based on how they think these events will affect the market.
Benefits of technical analysis
Let's look at some of the benefits of technical analysis:
Can be used on any timeframe
Whether you are a short, medium or long term trader, you can apply technical analysis tools to your decision making process on any time frame.
Trend analysis
There are many different techniques that a technical analyst can use to analyze current market trends. They include moving averages , trendlines , trend channels , swing highs and lows, as well as support and resistance levels , and more.
Opportunities to find the optimal entry point to the market
The main task of a trader is to find the best trading opportunities and then the optimal entry point into the market to make a trade. Technical analysis tools help traders enter the market, manage their positions and exit the market in the most efficient way.
Ideas can be programmed
Many concepts within technical analysis can be programmed into algorithmic trading systems. These types of automated systems help reduce the negative emotions associated with trading. Once you have the algorithm programmed, you can let your trading advisor trade without you.
Takes into account the mood of the market
By studying price action and analyzing charts, you can better understand the mood of most market participants. You will be ready to identify the mood of the big players and market makers during both ups and downs.
In addition, you will be able to get an idea of where the true level of supply and demand is, so you can position yourself on the right side of the market rather than trading with the crowd.
Technical analysis is much easier and takes less time
Fundamental analysis often involves many variables and factors that constantly need to be analyzed and taken into account: interest rates, inflation, consumer sentiment, money supply, etc. This can lead to overly complex models that only PhDs in economics can understand .
On the other hand, technical analysis models tend to be much simpler and easier to create and implement because you only need to consider the price action on the chart.
Disadvantages of technical analysis
Here are some disadvantages of technical analysis:
mixed signals
There will be times when your technical analysis tools will give mixed or conflicting signals. For example, based on your analysis of support and resistance levels, you may get a buy signal, but your MACD indicator may indicate a sell.
Too Much Analysis
A condition in which traders overanalyze the market so thoroughly that it becomes difficult for them to make the right decision. This usually happens when the trader is trying to match all the factors, which rarely happens in live trading. In trading, we deal with probabilities, not certainties.
We must act on incomplete information
With the sheer number of technical tools available to traders, some fall into the trap of over-analyzing and failing to make a trading decision. The best solution to this problem is to try to simplify things.
Other factors may influence our market analysis
While technical analysts rely on price as their primary tool of analysis, some biases can influence how they perceive the information they collect from charts. For example, if you have a bullish bias in the EURUSD pair, you will subconsciously look for and test buying opportunities while ignoring signals that indicate a weakening EURUSD. Therefore, it is extremely important to try to analyze charts in a truly open-minded way.
Interpretations may vary
As I have written before, technical analysis is more of an art than a science. Two technicians may be looking at the same price chart, and sometimes they may come up with two opposing interpretations. This is not uncommon, and one of the culprits for this is our internal biases. Also, chart patterns that seem clear in hindsight can be quite subjective in real time.
Advantages of fundamental analysis
Let's look at some of the benefits of using fundamental analysis:
Helps explain price action
Major economic news and reports can quickly move market prices in one direction or another. This is especially true when the economic emission data is unexpected or significantly different from the expected data.
Provides insight into global markets
Using a fundamental approach to analysis helps the analyst better understand what is happening in the economy of a particular country and in other countries of the world. This provides a deep understanding of global markets.
Measures fair value
Each financial instrument or asset has a fair value associated with it. The trader's job is to find assets where there may be a discrepancy between the asset's true value and the market price.
Fundamental analysis can help the currency analyst in this regard by examining interest rates, inflation, consumer sentiment, industrial production, and other indicators.
Analysis of long-term trends
The true power of fundamental analysis is to help a trader develop a long-term view of a particular currency pair or asset. Most of the data in economic reports is usually compared and analyzed on a relative basis.
For example, when asking the question, what are the unemployment rates today compared to last month, last quarter, and last year? This will help to know the current trend in unemployment, and then we can use this information, along with other economic data, to predict the potential impact on the currency pair in the long term.
Disadvantages of Fundamental Analysis
Here are some disadvantages of fundamental analysis:
Information overload
Fundamental analysis is a very broad and deep subject. There is so much information available to traders and investors that it can take an incredible amount of time to analyze it. This can sometimes lead to confusion and conflicting conclusions.
Not very suitable for the short term
Even though economic data and reports are published regularly throughout the month, news trading on a short-term basis is very problematic, as there is always the danger of unpredictable bursts of volatility. Therefore, fundamental traders tend to focus mainly on the longer horizon.
No entry point
Fundamental analysis can give us a broader view of the market, but it cannot provide us with an objective and reliable method for determining our entry and exit points. And in trading, this is the most important thing.
You may be right in your long-term analysis, but if you get the timing wrong on when to enter the market, your trade will most likely end up in a loss. As such, fundamental analysts generally must rely on technical or other methods of analysis to find the optimal entry point.
Subjectivity
While the fundamental data is fairly clear, the assumptions that can be drawn from such data can vary widely among different economists and analysts.
For example, one analyst might give many different reasons why they believe that raising interest rates would be good for the economy, while another analyst might give as many different reasons why they think raising interest rates would be bad for the economy. .
Technical analysis tools
Technical indicators
A favorite among technical traders. There are many different technical tools. For example, momentum indicators such as MACD or RSI . Trend indicators such as moving averages . Volatility indicators such as Bollinger Bands and Keltner Channels .
Price action
Price is the most important tool in technical analysis. The current price reflects the motivation of all market participants and shows the balance of supply and demand at any given time. Many technical traders rely solely on price action, combining support and resistance levels with candlestick patterns to gauge potential future price action.
Analysis of figures on the chart
Some traditional patterns include head and shoulders , double top and double bottom patterns , and cup and handle formations . There are also harmonic patterns such as Gartley, Bat or Butterfly.
Traders have a natural tendency to recognize patterns and this translates into our desire to find patterns on charts.
Fundamental analysis tools
Economic calendar
The economic calendar is one of the key tools for a fundamental trader. Short-term news traders try to make intraday profits during important news events, while macro traders rely on it to help them build a long-term forecast for a particular currency pair or country.
Analytical sites
Some professional traders rely on financial news feeds such as Reuters, Bloomberg, Dow Jones Newswires or the Financial Times to analyze the news they need. Many well-known financial news feeds, such as these, offer real-time streaming news, and provide coverage through hundreds, if not thousands, of publications and sources from around the world.
Analyst reports
Fundamental traders should be aware of the latest economic releases and news events of the day. While the economic calendar and financial news feeds are important tools to help shape the market, reading articles and analyst reports can also be very helpful.
What to choose: fundamental or technical analysis?
Once you have mastered fundamental analysis and learn how to apply a top-down or bottom-up approach to research, as well as the differences between qualitative and quantitative analysis, you can begin to consider what assets you are interested in.
Now you have an idea about both types of analysis. The natural question is: which one works better? None of them!
Each of these types of analysis has its strengths and weaknesses. Ignoring fundamental analysis often results in news events drastically changing price movements when you don't expect them to. Without the use of technical analysis, you will not be able to find the best entry points on the charts and mark the levels at which there is the most activity of traders and the price often reverses. Therefore, you need to find a balance between the two types of market analysis.
The use of fundamental analysis can lead to the creation of a diverse portfolio that is not subject to risk and has a high performance.
Fundamental analysis is useful for both long-term investors and short-term traders, whether they are new to the world of finance or seasoned professionals. This is a necessary step before making any investments or transactions.
The combination of sound fundamental analysis with advanced technical analysis techniques and the right risk management strategies can lead to consistently profitable trades and minimal losses.
Technical analysis provides additional security if, for some reason, circumstances suddenly change or initial research does not lead to a successful selection.
For example, the stock market recently hit an all-time high and the economy has been doing well. Then the coronavirus caused a major sell-off and the economy hit a recession. Things can change quickly and stop losses placed at key levels could have prevented serious losses.
In the past, for a long period of time, fundamental analysis was the only method of market analysis. But then this situation changed, as the advent of computers made it possible to simplify calculations, and technical analysis began to become more and more popular for most traders. Many large investment funds use computer simulations to determine entry and exit points. An increasing part of transactions in the financial markets is carried out with the help of automated trading systems.
This means that many of the largest players in the market make their trading decisions based on computer algorithms. In fact, according to some estimates, computerized trading represents up to 70% of the volume on all exchanges today. Whether you like it or not, the price movement is now driven mainly by technical factors and only partly by fundamental ones. Markets are constantly changing and you need to change your trading strategies to match them.
Personally, I prefer to use technical analysis in my trading as it provides a complete framework for analysis, finding entry points, managing positions, and exiting the market.
There is no right or wrong answer here. You should try both approaches and see what works best for you.