Introduction to fundamental analysis
Fundamental analysis can help you understand markets and assist you in making trading decisions. Traditionally, fundamental analysis is used when taking a longer-term outlook. However, it is still highly relevant when trading short-term contracts and can provide valuable insight. Learn about fundamental analysis, how it works, and how to apply it when trading.
What is fundamental analysis?
Fundamental analysis works on the simple premise of supply and demand, and how this will affect the value of stocks, commodities or forex pairs. In a nutshell, it involves trying to break a financial instrument down into its basic components and key economic drivers in order to establish present and future value.
Once traders have carried out their fundamental analysis, they can use this information to make market predictions.
How does fundamental analysis work?
There are two main types of fundamental analysis:
Quantitative fundamental analysis. This type of fundamental analysis is numbers based, examining aspects such as the financial strength of an index and the companies within it. In the case of currencies, you might analyze related hard data, such as the benchmark interest rates for the countries in which they are legal tender. For commodities such as oil, one may look to the weekly inventory numbers as a guide to future direction.
Qualitative fundamental analysis. This is more concerned with quality – in terms of the stock market, it might involve looking into the strength of the brand and whether the company is well known. On a broader scale, you might consider current and future perceptions of economic quality in a particular country. One example of this could be the perceived future implications of Brexit upon the UK. Various estimates have been made as to what the economic impact might be, but so far, there are no actual numbers. Rather, much of the financial impact on the GBP has been due to perceptions of the UK’s potential future economic quality.
In the stock market, traders and investors often look at elements of a company’s balance sheet to establish current value and potential future value. Examples include:
Earnings per share (EPS)
Price-to-earnings ratio (P/E ratio)
With commodities such as oil, traders look to information such as the weekly inventory report or manufacturing index to gauge supply and demand. These types of reports show whether oil, or other commodities, are exceeding or falling below potential future needs.
With currencies, traders may look at the following factors (to name just a few):
Interest rate levels
Expected interest rate levels
Employment indicators, e.g. nonfarm payroll report
Fundamental analysis is generally not used as a standalone method of making market predictions. There are multiple forms of analysis you can use, including technical analysis. This uses very different information, taking the market at face value rather than looking at it in terms of external factors that could have an influence. Yet the two work very well together and there are often crossovers. For example, technical indicators such as Bollinger Bands® or moving averages could be used to confirm a trend that you suspect might be forming after carrying out fundamental analysis.
What to look at with fundamental analysis
The main aim of fundamental analysis is to examine external factors that could affect the value of a given market, be it stock index futures, commodities, or currencies. It's important to note that various asset classes are more interconnected from a global perspective than ever before. Large economic reports, in particular, may have far-reaching implications for all asset classes simultaneously.
Fundamental analysis considers data from major economic reports that can have a lasting effect. It’s important to understand this when trading short term with products such as binary option contracts, as the factors that have been driving markets in a particular direction may not change immediately. However, the release of major economic data can also have an immediate and significant impact on markets. For example, if you are trading the EUR/USD currency pair, it will be important to know precisely when the US Federal Reserve or the European Central Bank release their interest rate decisions or economic outlook. If trading a contract based on a stock index future, such as the US Tech 100, your analysis may be as granular as examining company-specific earnings reports from the major contributors to that index, such as Apple and Amazon. Understanding these factors may better prepare you to follow the trend on a short-term trade.
These are some of the main economic indicators that may influence broader markets:
Any major central bank interest rate decision (Federal Reserve, European Central Bank, Bank of England, Bank of Japan, etc.)
US nonfarm payroll report
Gross domestic product (GDP)
Consumer price index (CPI)
US home sales and building permits
Retail sales figures
ADP employment report
How to trade using fundamental analysis
Fundamental analysis can be used in various trading styles. Here are some of the key examples:
Swing trading using fundamental analysis
A swing trader looking at weekly binary options or knock-outs will want to understand as many of the existing driving forces behind the markets as possible. They'll also want to be aware of upcoming events that may have an impact on the market they're trading.
Let’s use the example of crude oil. The manufacturing and consumer goods data from the previous week was positive, and current geopolitical tensions in an oil producing region all point to the US oil market remaining bullish. For this example, our trader is bullish and decides to buy a knock-out, also known as Touch Bracket™, contract on Monday morning.
Let’s skip to Wednesday morning. So far, the market has moved higher, as expected. The trader knows the weekly oil inventory report is released by the Energy Information Administration every Wednesday morning. This report – one of the most impactful for the price of crude oil – can dramatically shift the market, and turn a previously profitable position into one that’s losing money very quickly.
All signs previously pointed to oil keeping a bullish outlook, but the oil inventory report can be very influential, and the time before its release is uncertain. This gives the trader three options:
Simply close out the position, lock in existing profit and walk away.
Close the existing position for profit and consider entering into a new position with a knock-out contract, looking for one with a much lower defined risk profile.
Keep the position open and see what happens. However, this may be a risky option in times of market uncertainty.
When using fundamental analysis, you will never know all the information in any given market. It is important to process the information you do have, and to remain aware of the next big scheduled announcement.
Short-term trading with fundamental analysis
Traditionally, trading the release of a fundamental announcement was one of the trickiest and riskiest tactics. Surrounding the release, volatility explodes, markets can whipsaw, and no one really knows what might happen.
If trading in a leveraged market, this can be exceptionally dangerous and result in losses greater than the account size. Even in a non-leveraged market, such as typical stock trading, the volatility can have losses mount much faster than expected.
After all, how many times have you seen a company release very strong earnings only to have a monster sell-off in that particular stock?
If trading around fundamental announcements, one strategy traders can implement is called a binary option strangle. As a basic overview, this is a direction neutral strategy, meaning traders have the ability to profit from market movements in either direction. The main thing necessary to make this strategy a success is sufficient market movement.
To implement this strategy, traders may look to daily or intraday binary option contracts, where they can potentially profit on a move in either direction. They take positions in both directions, looking for low risk and high potential reward. Due to the speed of market movement surrounding major report releases, traders will often implement limit orders in an attempt to lock in profit should the market move suddenly.
How to keep up with the markets: making fundamental analysis easier for you
Our team of Nadex experts are here to help you learn about the markets, and we have free learning resources on our website to support you as you become a more confident trader.
Join our webinars – learn how to analyze from the experts.
Explore our education section – read about analysis and find the tools for you.
Now that you understand fundamental analysis and what to look out for, these are some of the ways you can apply it to your trading:
Deciding on market direction. Knowing about newsworthy events can help you form predictions about which way markets will move, so you can decide whether to buy or sell.
Choosing your strike. Depending on how much you think markets will move, you can choose an appropriate strike price. If you think there will be a significant movement or reversal, you might want to buy low and sell high, giving you the opportunity to make a bigger profit. If you think markets are going to remain quite flat, you might play it safe and buy a binary option, knock-out, or call spread contract that is already in-the-money.
Timing your trades. If you know that big news is coming and you think it could influence the markets, you might decide to get into a trade ahead of a new trend forming, so you can capitalize on your fundamental predictions. Equally, if news is slow and markets are flat, you might want to wait for some major news to give you greater opportunity.
Cross-referencing with various analytical methods. Use technical indicators to confirm your predictions and make better trading decisions.
Finding trades that fit in with your plan. Your trading plan will be unique to you and will inform the trades you place. Fundamental analysis can help you seek out these trades and decide whether they are the right opportunities for you.
Carrying out your own fundamental analysis is also a great way to stay engaged in the world of financial markets and to become a well-educated trader. If you live and breathe the markets and take a genuine interest in them, this will keep your enjoyment in trading alive. The more you know, the more you can predict, and the more likely you are to stay engaged with the trading experience.
MORE ON FUNDAMENTAL ANALYSIS