What is Fundamental Analysis? – Definition & tutorial

The essence of fundamental analysis is to use market news and sentiment to predict the future value of an asset. Why are fundamental analyses of the market so “fundamental” in nature as far as using the news to trade the markets are concerned?

Looking at the global landscape, there are countries that are regarded as major players in world economics and politics. The economies of other countries hinge on the performance of these countries. For instance, the US became a key global player after the 1944 Bretton-Woods conference because other countries who were neck-deep in World War 2 were forced by circumstances to tie their currencies and economies to the value of the US Dollar. Since then, the US dollar has been the standard currency on which international trade is denominated. Many countries of the world depend on US trade and aid to survive. China has also assumed a similar role and its vast industrialization has placed a huge demand on certain assets such as oil. Many countries in Africa are dependent on China for a lot of things. In Europe, Germany has the strongest economy and is basically calling the shots as far as the bailout packages to troubled countries in the Eurozone are concerned.

Now in the marketplace, there are periodically programmed announcements concerning key economic and political events that have an impact on world economics as a result of the interplays we have explained in the previous paragraph. The markets monitor these announcements very closely because they will impact the future of the world economy at any given point in time. Depending on the outcome of the announcement, the markets may either assume a positive sentiment or a negative sentiment on the economy and currency of the country making the announcement. This in turn will have a multiplier effect on the sentiment and outlook of traders in other countries whose economies are tied to the performance of these major players. Once market bias has been formed, traders will trade assets based on the bias and could either buy more of the asset or sell it off and move to safer investments.

This is why the news has such a profound impact on the market. The news tap on human emotions, and when humans get emotional, anything can happen.

News announcements can be classified on the basis of the extent of global impact on the world economy and asset sentiment into low-impact, medium-impact, and high-impact news.

More attention is paid by market participants to high-impact news. It is possible for a low-impact news item to make the transition to high-impact news, depending on the prevailing economic factors. That is why the housing data and the GDP figures of Eurozone economies like Spain, Portugal, Ireland, Greece, and Italy which hardly made an impact on the markets a few years ago, are now major market movers because the economic dynamics have changed and made these data very important in the assessment of the health of the US and Europe.

Traders who watch the news pay attention to the following news items:

  1. Employment Data: Such as jobless claims and the US Non-Farm Payrolls.
  2. Data on manufacturing.
  3. Gross Domestic Product (GDP).
  4. Consumer sentiment and retail sales reports. Anything that measures consumer sentiment is now a key matrix used by the financial markets in sampling the health of an economy.
  5. Some country-specific reports such as ADP Employment change in the US.

Components of Fundamental Analysis

In analyzing a trade fundamentally, traders will look at the following:

  • Consensus/Expected Number: A poll of leading economists will give an average figure which they expect the news to conform to.
  • Actual Number: This is the figure in the news release.
  • Deviation: This is the difference between the consensus figure and the actual figure.

In using the news to trade the markets, these are what the traders look at. The deviation is very important. A market surprise (deviation much higher than expected either to the upside or downside) gives a good, tradable signal. There are ways to measure the deviation to see if a deviation is tradable or not. Generally speaking, the deviation benchmark is attained by comparing the expected figure and the previous number. The difference now serves as the benchmark to the upside and downside, and depending on how far above or below the deviation is from the benchmark, the market will react accordingly.

Using the news to trade the binary options market will depend on how the trader wants to use the information. But one thing is clear: the news moves markets, and this is what produces the greatest trading opportunities.

See other important articles in my glossary.

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