When it comes to investing, the key is to follow the old cliché that says to buy low and sell high. Determining when an investment is low or high, however, is the difficult part. Two major theories used to help determine the most likely future moves of a company's stock price are fundamental analysis and technical analysis. Comparing the two forms of analysis is a great way to understand both theories and to determine which method of analysis the investor prefers.
Fundamental Analysis Defined
Technical Analysis Defined
2. Technical analysis is the process of using past trading data and stock price movements associated with a particular security, and then comparing those to how other similar investments have historically responded to similar patterns. When a pattern is detected, the investor can predict that the target investment's future pricing will respond similarly to previously observed patterns.
Function
3. Both fundamental analysis and technical analysis are used to select investments whose prices are likely to move in a profitable direction for the investor – up for investors wanting to buy an investment and down for an investor looking to sell, or short, an investment. With fundamental analysis, the trader attempts to find an investment that is incorrectly priced in the market compared to its real value as determined by the investor's analysis. With technical analysis, the trader attempts to find investments whose patterns match previously seen patterns, which, when followed, will result in the price of the investment moving in the desired direction.
Time Frame
4. Both fundamental analysis and technical analysis require that the market at large eventually respond in the way they are "supposed to." However, there is no time limit on how long it may take the markets to do so. A technical analysis pattern can take months to complete, and an incorrectly priced security can take just as long to move toward its more intrinsic value.
Considerations
5. Fundamental analysis makes the assumption that the market is rational and that a security's price will eventually reflect the true value of the investment. By contrast, technical analysis assumes that the marketplace will repeat past trends and that a security's price will eventually move in the same way as other investment prices have moved. As such, both theories potentially turn a blind eye to important external data. A stock that announces big unanticipated news is unlikely to continue to complete a price pattern, or to move directly toward its underlying real value, without being affected.
The Factors & Variables
1. Geo-Political Factors
There are two necessary methods in forecasting the currency market – fundamental analysis and technical analysis. As the technical analysis focuses on the study of price movements, fundamental analysis focuses on the economic, social and political forces that drive supply and demand. Fundamental analysts look at various macroeconomic indicators such as economic growth rates, interest rates, inflation and unemployment. However, there is not single set of beliefs that will guide fundamental analysis. There are several theories as to how currencies should be valued.
2. Financial Factors
Financial factors are extremely vital to fundamental analysis. Any changes in a government's monetary or fiscal policies are bound to generate changes in the economy, and in turn these will be reflected in the exchange rates. Financial factors should be triggered however only by economic factors. When governments focus on different aspects of the economy, or have additional international responsibilities, financial factors may have priority over economic factors. This was painfully true in the case of the European Monetary System (EMS) in the early 1990s. The realities of the marketplace revealed the underlying artificiality of this approach.
3. Political Crises Influence
A political crisis is known to be dangerous for Forex because it can trigger a sharp decrease in trade volumes. Prices under critical conditions dry out quickly, and at times the spreads between bid and offer jump from 5 pips to 100 pips. Unlike predictable political events (parliamentary elections, the conclusion of interstate agreements, etc.), which generally take place in an exact time and give the market the opportunity to adapt, political crises come and strike suddenly. Currency traders have a knack for responding to crises. The traders should react as quickly as possible with risk management to avoid big losses. They do not have a lot of time to make decisions – often mere seconds. Return on the market after a crisis is usually problematic.
4. The Role of Interest Rates
Using the interest rates independently from the real economic environment translates into a very expensive strategy. Because foreign exchange, by definition, consists of simultaneous transactions in two currencies; it follows that the market must focus on the two respective interest rates as well.
This is known as the interest rate differential, which is a basic factor in the markets. Forex traders react when the interest rate differential changes, not simply when the interest rates change. For example, if the G-5 countries decided to lower their interest rates by 0.5 percent simultaneously, the move would be neutral for foreign exchange only, because the interest rate differential would also then be neutral. Most of the time the discount rates are cut unilaterally, a move that can generate changes in both the interest rate differential and the exchange rate. Forex traders approach the interest rates like any other factor, trading on expectations and facts. If rumor says that a discount rate will be cut, the respective currency will be sold before the fact. Once this cut occurs, it is highly likely that the currency will be bought back or vice versa. An unexpected change in interest rates is likely to trigger a sharp currency move. Other factors affecting the trading decision are the time lag between the rumour and the fact, the reasons behind the interest rate change and the perceived importance of the change. The market generally prices in a discount rate change that was delayed. Since it is a fait accompli, it is therefore neutral to the market. If the discount rate was changed for political rather than economic reasons (a common practice in the European Monetary System), the markets are likely to go against the central banks, sticking to the real fundamentals rather than the political ones.
5. Monetary Operations by Central Banks
All central banks, including the US Federal Reserve System (FRS), affect the foreign exchange markets’ changing discount rates and perform the monetary operations like currency and interventions.
For foreign exchange operations, most significant are repurchase agreements in order to sell the same security back at the same price at a pre-determined future date and at a specific interest rate. This arrangement amounts to a temporary injection of reserves into the banking system. The impact on the foreign exchange market is that the national currency should weaken. The repurchase agreements are usually customer system or customer repos.
Matched sale-purchase agreements are just the opposite of repurchase agreements. When executing a matched sale-purchase agreement, a bank or the FRS sells a security for immediate delivery to a dealer or a foreign central bank, with the agreement to buy back the same security at the same price at a pre-determined time. This arrangement amounts to a temporary drain of reserves. The impact on the foreign exchange market will cause the currency to strengthen.
Intervention in the United States foreign exchange markets by the US Treasury and the FRS is geared toward restoring orderly conditions in the market or influencing the exchange rates. It is not geared toward affecting the reserves. There are two major types of foreign exchange interventions – naked intervention and sterilized intervention.
Naked intervention refers to the sole foreign exchange activity. Only thing taking place is the intervention itself, in which the Federal Reserve will either buy or sell US dollars against a foreign currency. If the money supply is impacted, then consequent adjustments must be made in interest rates and in prices. Therefore, a naked foreign exchange intervention has long-term effects.
Sterilized intervention neutralizes its impact on the money supply. There are rather few central banks that want the impact of their intervention in the foreign exchange markets which would affect all corners of their economy, sterilized interventions have commonly been the tool of choice. This holds true for the FRS as well. The sterilized intervention involves an additional step to the original currency transaction. This step is the financing of a sale of government securities that offsets the reserve addition that occurs due to the intervention. It's easier to visualize if you think of it as the central bank financing the sale of a currency through the sale of a number of government securities. Because a sterilized intervention only generates an impact on the supply and demand of a particular currency, its impact will therefore tend to have a short- to medium-term effect.
6. Board of Governors of the Federal Reserve System
- European Central Bank
- Bank of Japan
- Reserve Bank of Australia
- Swiss National Bank
7. Economic Indicators
An economic indicator is a statistic about the economy. Economic indicators allow the analysis of economic performance and predictions of future performance predictions.
Economic indicators can be leading, lagging or coincident; which indicates the timing of their changes relative to how the economy as a whole changes.
8. Leading: Leading economic indicators are indicators that change before the economy changes. Stock market returns are a leading indicator, as the stock market usually begins to decline before the economy declines, and they improve before the economy begins to pull out of a recession. Leading economic indicators are the most important type for investors, as they assist in predicting economic future.
9. Lagged: A lagged economic indicator is one that does not change direction until a few quarters after the economy does. The unemployment rate is a lagged economic indicator, as unemployment tends to increase for 2 or 3 quarters after the economy starts to improve.
10. Coincident: A coincident economic indicator is one that simply moves at the same time as the economy does. The Gross Domestic Product is a coincident indicator.
Please find more about regional economic indicators in our economic calendar: Economic Calendar (picture of calendar)
11. Economic Calendar / Financial Announcements
Economic Calendar is a type of calendar that is intended to inform financiers and traders about the scheduled major economic numbers (like consumer price index, PMI, Jobless Claims), government reports and speeches of the most influential persons of the financial world.
The Economic Calendar is used by investors to interpret current and/or future investment possibilities, and to judge the health of an economy. An economic indicator is only useful if interpreted correctly. Determining whether a specific company will grow its earnings based on one indicator is nearly impossible. Indicators give us signs along the road, but the best investors will utilize many economic indicators, looking for patterns and verifications within different sets of data. Most economic indicators have a specific schedule for release, enabling investors to prepare for and plan on seeing certain information at certain times of the month and year.
12. Forex Trading Is Driven By Five Top Economic Indicators
There are many factors that affect Forex trading. It is critical to understand the various factors that cause the fluctuations from day to day. The foreign exchange market will change depending on the economic factors that play a major role in the movement of currency.
Economic factors and indicators are released by the government or by private organizations that take an in depth look at economic performances. These indicators can be used to analyze economic performances from any country. The economic reports measure a country's economic health.
For the most part, reputable brokers can look at economic indicators and know which trades will be best at that time. Reports on these indicators are released at scheduled times and can tell if a certain country is experiencing improvement and economic state.
Current events and economic state in any nation is a top economic indicator used when analyzing foreign exchange. Factors such as unemployment, housing, and the current state of the government can all affect changes in the Forex. When a country is feeling optimistic about the current state of affairs in their country, prices of the Forex may reflect this. When a nation experiences political unrest, high unemployment and inflation, the rate of the currency will be likewise affected. This indicator is an important gauge in foreign exchange fluctuations but is often overlooked.
The GDP is another economic indicator used when looking at the foreign exchange market. The GDP is considered the widest and broadest measure economy in a country. The gross domestic product represents the total market value of all goods and services produced within any given country. This is usually measured in the time frame of a year, using a larger time period provides statistics on the products and services that are produced. This indicator is not used alone when forecasting the foreign exchange. The GDP is considered a lagging indicator, meaning that is a measurable factor that can change after the economy has already begun to follow a particular trend.
Retail sales reports are the third economic factor that is used in analyzing the Forex. This is the total receipt of all retail stores in any country. This is considered a very reliable and important economic indicator because of the consumer spending patterns that are expected throughout the year. This factor is often more important than lagging indicators, and gives a clear picture of the current state of the economy in any country.
Another reliable economic indicator in the foreign exchange market is the industrial production report. This shows the fluctuation in productions in industries such as factories, and utilities. The report looks at actual production in relation to what the production capacity potential is over a certain period of time. If a country is producing at a maximum capacity, it will positively affect the foreign exchange and is considered ideal conditions for traders.
The consumer price index, or the CPI, is the last critical economic indicator in analyzing the Forex. The CPI is the measure of the change in the prices of consumer goods in 200 categories. This report can tell whether or not a country is making or losing money on their products and services. A country’s exports are very important when looking at this indicator because the volume of exports can reflect a currency's weakness or its strength.
The Forex is affected by many factors. These factors usually follow a certain trend, so it is important to understand how each factor works in forecasting the Forex. Some are good indicators alone while others should be used together for accurate Forex predications.
What Is Technical Analysis?
Technical analysis is a method of evaluating securities by analyzing the statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security's intrinsic value, but instead use charts and additional tools to locate and identify patterns that can suggest future activity.
Just as there are many investment styles on the fundamental side, there are also different types of technical traders. Some rely on chart patterns, others use technical indicators and oscillators, and many use some combination of the two. In any case, technical analysts' exclusive use of historical price and volume data is what separates them from their fundamental counterparts. Unlike fundamental analysts, technical analysts don't care whether a stock is undervalued - the main concern is a security's past trading data and the information this data can provide in terms of where the security might move in the future.
The field of technical analysis is based on three assumptions:
1. The market discounts everything.
2. Price moves in trends.
3. History tends to repeat itself.
1. The Market Price Reflects Everything
A major criticism of technical analysis is that it only considers price movement, ignoring the fundamental factors of the company. However, technical analysis assumes that, at any given time, a stock's price reflects everything that has or could affect the company - including fundamental factors. Technical analysts believe that the company's fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately. This only leaves the analysis of price movement, which technical theory views as a product of the supply and demand for a particular stock in the market.
2. Price Moves in Trends
In technical analysis, price movements are believed to follow trends. This means that after a trend has been established, the future price movement is more likely to move in the same direction as the trend than to be against it. The majority of technical trading strategies are based on this assumption.
3. History Tends To Repeat Itself
Another important aspect in technical analysis is that history tends to repeat itself, primarily in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand trends. Although many of these charts have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.
Not Just for Stocks
Technical analysis can be used on any security with historical trading data. This includes stocks, futures and commodities, fixed-income securities, Forex, etc. In this tutorial, we'll usually analyze stocks in our examples, but keep in mind that these concepts can be applied to any type of security. In fact, technical analysis is more frequently associated with commodities and Forex, where the participants are predominantly traders.
Fundamental Analysis
Fundamental analysis is about using real data to evaluate a security's value. Although most analysts use fundamental analysis to value stocks, this method of valuation can be used for just about any type of security.
For example, an investor can perform fundamental analysis on a bond's value by looking at economic factors, including interest rates and the overall state of the economy, and information about the bond issuer, such as potential changes in credit ratings. For assessing stocks, this method uses revenues, earnings, future growth, return on equity, profit margins and other data to determine a company's underlying value and potential for future growth. In terms of stocks, fundamental analysis focuses on the financial statements of the company being evaluated.
To read about Global Market Factors, click here.
