Fundamental Analysis: What is it? Why do you need it?
For traders, there are several tools or resources that can help with the decision-making process. Knowing the right time to buy and the right time to sell is what makes a telling difference to the success of your trades. Technical Analysis is one of arguably two main methods used by a lot of investors to work out what position to take. The other is Fundamental Analysis.
You can combine both as part of your wider trading plan too. But, first, it's essential to understand just what Fundamental Analysis is. After all, making sense of what it tells you could make or break the next position you choose to take. And it could even give you a head start on future price movements if it shows you something not yet reflected in the market.
What is Fundamental Analysis?
The whole point of Fundamental Analysis is to uncover the 'real value' of an asset – from shares in the world's biggest companies to the latest forex prices. As such, that value won't necessarily match what the open market is pricing it at. Instead, this form of analysis seeks to determine if the value of an asset is actually too high or too low.
To do this, Fundamental Analysis looks at factors that could have an impact on the value of that asset. Some of these could be broader, macroeconomic triggers. Others, meanwhile, can be the microeconomic factors that are unique to a specific currency or listed company. Think of it as an in-depth, impartial consideration of an asset and the things that can hold sway over it.
The factors that analysts will look at are where this form of analysis takes its name. Put simply, these are the factors that are considered to be 'fundamental' to the intrinsic value of the asset.
Why Fundamental Analysis is important
As you plot your next trading moves, you want to be sure of the decisions you're taking. When you expect the price of an asset to take a tumble, you'll go short with that expectation. If your opinion is that an asset will rise in value, you'll take the opposite position. Either way, you'll be making that decision – usually – on the back of some robust intelligence.
But when an asset is over or undervalued, there's a genuine risk that your positions could be compromised. If the market wakes up to this reality, the price movement could catch you out and leave positions exposed. Fundamental Analysis can also be important in helping you get ahead of the market; either buying at a lower price or selling at a higher one than most others.
There's one more reason why it can be such a key part of a trading plan. By getting to grips with the "fundamentals" of an asset, you can improve your risk management. Your knowledge will put you in a position to know how well the asset will stand up to less favourable conditions – be they economic, political or market-based.
How does it differ to Technical Analysis?
Fundamental Analysis looks to find the 'real value' of an asset. Technical Analysis, however, is different in that it considers past and present price movements. As such, it can lean on supply and demand as a more accurate representation of what an asset is worth.
So, traders who use Technical Analysis more so than Fundamental Analysis will look at what's gone before – such as price changes or trading volumes. This data and information will shape their expectations for how an asset's price will move in future. For some, there might even be the belief that trading patterns will repeat themselves time and again.
Like Fundamental Analysis, you can use Technical Analysis to evaluate the movement in commodity and currency prices. You can also use them together to achieve the best results.
How to do Fundamental Analysis
Your first introduction to Fundamental Analysis may seem like it could be overwhelming. That doesn't have to be the case, however. It's all about getting stuck into the detail of the chosen asset. If it's a stock, for example, you'll want to consider how the company is managed – plus its financial statements, current debt levels, and how it performs versus its competitors.
The same sentiment can be applied to other assets too – such as forex.
In essence, there are two main types of stocks or forex Fundamental Analysis you can choose:
In this form of Fundamental Analysis, a trader uses data points and numerical metrics to draw conclusions. This is something that's perhaps most overt when looking at trading shares in a specific business. After all, companies – listed or otherwise – release financial statements on a periodical basis. In these documents, you'll have important numerical insights.
You can assess a company's current profitability and future prospects using these statements. Cash flow reports, income statements and broader balance sheets can all be important in this respect. The data obtained from these statements can then be translated into ratios that offer logical conclusions about a company's true value.
It's worth bearing in mind this "bottom-up" analysis can be applied to other securities too.
Unlike quantitative data, qualitative Fundamental Analysis looks at the less tangible factors that can affect an asset's value. In other words, it's not based on data or numbers. Instead, it aims to factor in fundamentals like a company's reputation or market sentiment towards a currency.
One recent example can be said to be the dramatic fall in the value of the British Pound (GBP). In September 2022, its value dropped to new lows after the government announced tax cuts in its "mini-budget". But fears over how those cuts would be funded drained investor confidence.
In terms of qualitative analysis, traders can take two main approaches. The first is a top-down option – looking at wider factors that could affect an asset's price. The second is to go bottom-up, which can include abstract factors like reputation, brand awareness or USPs.
Traders can also consider the following:
- Porter's Five Forces: A look at five main competitive 'forces' that are common to all industries and that could, therefore, affect an asset's value over the long term.
- SWOT Analysis: Many people are familiar with a SWOT analysis. In this context, it's applying the strengths, weaknesses, opportunities and threats to a specific asset.
- Economic Moats: This is a phrase associated with famed investor Warren Buffett. It considers the competitive advantage(s) unique to a specific asset. For a competing asset, this is hard to imitate and creates a moat that acts as a barrier to entry.
Advantages of Fundamental Analysis
One of the main upsides is the use of material data and information when making decisions. It therefore takes personal bias and emotion out of the process. After all, it's not unusual for two technical analysts to come to different verdicts when looking at a trading chart.
It can also be said there is genuine value in understanding the 'real' value of an asset; not just where the market is pricing it. For traders who perform this type of analysis to reach that point, there are opportunities to open positions in early anticipation of a correction.
Fundamental Analysis does tend to have a long-term focus to it. But it doesn't mean it excludes day traders. A long-term view can still be applied when CFD trading. Having a future-based focus can prepare you for short-term opportunities that emerge on a daily basis.
Drawbacks of Fundamental Analysis
For its strengths, this type of analysis also has some potential pitfalls to be aware of. The most important thing to consider is that an asset may never reach its 'real' value as the numbers or sentiment may suggest. That can be for any number of reasons too.
Some assets may retain a 'false' value for much longer than seems realistic. Take a company in a period of fast-paced growth. The share price could be inflated above what the underlying data suggests. In the forex market, a currency's value may stay strong even when all its economic indicators would cause you to think otherwise.
And this type of analysis is exposed to the effects of a shock event that disrupts logical thinking. An oil company, for example, may be expected to benefit from growing demand for its products (and the strength of the Brent Crude price). But investor confidence could be dented if there's a change in senior leadership or a negative news event.
It can also be a risk to have so much data at your fingertips. It can perhaps encourage overconfidence in a mindset. Nor can it accurately predict short-term price movements – or offer clear buy and sell signals. As such, risk management is still needed with this type of analysis.
Trade with FXCM and use Fundamental Analysis
At FXCM, we provide investors with access to many of the world's leading financial markets. No matter what your preference, our award-winning platform puts the power in your hands. It also brings with it countless chances to make use of Fundamental Analysis to your potential benefit.
It may seem as if this type of analysis is best suited to trading stocks and shares. But, in truth, it's an approach you can use when trading whatever securities appeal to you most. Be it the global forex market or diverse commodities market, fundamentals can unlock opportunities.
As part of a mature trading plan, this type of analysis could add a whole new dimension to your trading experience. So, what are you waiting for? Sign up for an FXCM account today and put your detailed analysis into practice as you build a trading plan and portfolio that's right for you.
FXCM Research Team
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