You are probably aware that fundamental analysis is not as formal as technical one. It is evident through the methods of its application that largely depend on individual traits of traders and their manner of work but not formulae and precise calculations. Still, here are a few classical areas of its application.
1. Comparative method
The essence of this method is that we compare an asset under scrutiny with another asset whose fair value has been already determined through fundamental analysis. By comparing structural similarities or differences between the two assets, we can predict trading opportunities of the asset under scrutiny. For example, we can assess a potential value of a currency by comparing economic metrics of its country with the ones of another country about which we have enough information.
Let’s assume we have discovered considerable structural correlation between indicators of the two economies and we are certain that no other non-economic factors will violate this correlation. Thus, we assume that the fair value of the national currency of our interest will have roughly the same value as the value of the second one.
In other words, market values of two currencies are correlated to a certain degree. Analysts apply a special index known as the correlation index that can vary in the range of -1 to 1. If a correlation index of two currencies is measured at 1, their values change in the same direction. If the index is calculated as -1, these two currencies have opposite trajectories. If the index is zero, the odds are that two currencies are not somehow connected.
2. Seasonal factors
We have explained to you that currency values can grow or fall depending on economic, natural, political, and other driving forces. Sometimes, trends in assets are sensitive to seasonal factors.
For example, a country increases gas purchases to pump up its gas reserves to provide enough heating in winter. This could first and foremost influence the fair value of its currency and even make the currency volatile.
However, seasonal factors are not as visible in currency fluctuations as, for example, in stock fluctuations.
3. Methods of logical analysis
Despite mass computing in processing vast amounts of information and other tools for simplifying analytical work, the main tool remains the same. Deduction and induction are the methods of logical analysis that have been used for centuries.
In the case of induction, we can move in our research from various single or occasional moments, for example, an array of economic indicators, and try to find certain patterns in them that would indicate to us the potential value of each of the currencies based on the economic factors in their countries. This would allow us to predict the value of this currency pair.
In the case of deduction, the direction of the search is, on the contrary, the extension of the features of some known to us A to some B (or a whole set of elements) based on the recognition of cause-and-effect relationships between A and B.
For example, we know that the exchange rate of one currency impacts on a certain economic indicator of another country. In turn, the national currency also depends on it. Hence, under certain conditions, we assume that an increase in the exchange rate of the first currency triggers volatility of the second national currency.
One way or another, the inductive approach is preferable for rookie traders. Indeed, unlike the deductive one, the accuracy of its conclusions is based on the analysis of a variety of data, but not on the accuracy of the conclusion that identifies the relationship between A and B. In the latter case, it is more likely to make a mistake, missing an important factor.
Disadvantage of fundamental Analysis
To conclude this chapter, let’s figure out the main disadvantages of fundamental analysis. It has its drawbacks, even though it requires thorough and well-rounded market analysis giving an insight into the whole picture and breakdown. Like any trading strategy, fundamental analysis alone is not a sure-fire recipe of success. Fundamental factors may signal that a currency is undervalued, but it does not guarantee that the currency will appreciate to its fair value in the near time. Things are not as simple. In reality, a dynamic of a current price is sensitive to plenty of factors. So, it might happen that forecasts of fundamental analysis will never come true.
First, it is hardly possible to allow for all factors that will matter a lot to the assessment of an asset’s current value for the simple reason that a trader might not always have all available information on the market. Besides, the information at his disposal is also available to all market players. Thus, a trader does not have the upper hand over others.
Second, even though an analyst has enough information, it does not guarantee a successful forecast because any data could be deciphered in different ways.
Third, there is no guarantee that a forex rate of an undervalued or overvalued currency will ever reach its fair value.
Fourth, fundamental analysis is a painstaking and time-consuming activity. That is why this strategy is inefficient for short-term trading.
With all pros and cons in mind, traders and investors prefer to complement fundamental analysis with technical one. This way, they offset the disadvantages of both approaches against their advantages, thus improving trading results.
1. Comparative method
The essence of this method is that we compare an asset under scrutiny with another asset whose fair value has been already determined through fundamental analysis. By comparing structural similarities or differences between the two assets, we can predict trading opportunities of the asset under scrutiny. For example, we can assess a potential value of a currency by comparing economic metrics of its country with the ones of another country about which we have enough information.
Let’s assume we have discovered considerable structural correlation between indicators of the two economies and we are certain that no other non-economic factors will violate this correlation. Thus, we assume that the fair value of the national currency of our interest will have roughly the same value as the value of the second one.
In other words, market values of two currencies are correlated to a certain degree. Analysts apply a special index known as the correlation index that can vary in the range of -1 to 1. If a correlation index of two currencies is measured at 1, their values change in the same direction. If the index is calculated as -1, these two currencies have opposite trajectories. If the index is zero, the odds are that two currencies are not somehow connected.
2. Seasonal factors
We have explained to you that currency values can grow or fall depending on economic, natural, political, and other driving forces. Sometimes, trends in assets are sensitive to seasonal factors.
For example, a country increases gas purchases to pump up its gas reserves to provide enough heating in winter. This could first and foremost influence the fair value of its currency and even make the currency volatile.
However, seasonal factors are not as visible in currency fluctuations as, for example, in stock fluctuations.
3. Methods of logical analysis
Despite mass computing in processing vast amounts of information and other tools for simplifying analytical work, the main tool remains the same. Deduction and induction are the methods of logical analysis that have been used for centuries.
In the case of induction, we can move in our research from various single or occasional moments, for example, an array of economic indicators, and try to find certain patterns in them that would indicate to us the potential value of each of the currencies based on the economic factors in their countries. This would allow us to predict the value of this currency pair.
In the case of deduction, the direction of the search is, on the contrary, the extension of the features of some known to us A to some B (or a whole set of elements) based on the recognition of cause-and-effect relationships between A and B.
For example, we know that the exchange rate of one currency impacts on a certain economic indicator of another country. In turn, the national currency also depends on it. Hence, under certain conditions, we assume that an increase in the exchange rate of the first currency triggers volatility of the second national currency.
One way or another, the inductive approach is preferable for rookie traders. Indeed, unlike the deductive one, the accuracy of its conclusions is based on the analysis of a variety of data, but not on the accuracy of the conclusion that identifies the relationship between A and B. In the latter case, it is more likely to make a mistake, missing an important factor.
Disadvantage of fundamental Analysis
To conclude this chapter, let’s figure out the main disadvantages of fundamental analysis. It has its drawbacks, even though it requires thorough and well-rounded market analysis giving an insight into the whole picture and breakdown. Like any trading strategy, fundamental analysis alone is not a sure-fire recipe of success. Fundamental factors may signal that a currency is undervalued, but it does not guarantee that the currency will appreciate to its fair value in the near time. Things are not as simple. In reality, a dynamic of a current price is sensitive to plenty of factors. So, it might happen that forecasts of fundamental analysis will never come true.
First, it is hardly possible to allow for all factors that will matter a lot to the assessment of an asset’s current value for the simple reason that a trader might not always have all available information on the market. Besides, the information at his disposal is also available to all market players. Thus, a trader does not have the upper hand over others.
Second, even though an analyst has enough information, it does not guarantee a successful forecast because any data could be deciphered in different ways.
Third, there is no guarantee that a forex rate of an undervalued or overvalued currency will ever reach its fair value.
Fourth, fundamental analysis is a painstaking and time-consuming activity. That is why this strategy is inefficient for short-term trading.
With all pros and cons in mind, traders and investors prefer to complement fundamental analysis with technical one. This way, they offset the disadvantages of both approaches against their advantages, thus improving trading results.
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