When you’re investing in the financial markets, it’s not possible to accurately predict what will happen in the future. Instead, investors rely on technical and fundamental analysis to make informed decisions.
Fundamental analysis involves looking at the economic and financial data, then using this information to estimate what will happen in the future. Technical analysis, on the other hand, relies on mathematical calculations to help the traders estimate how the price will move. This article will compare the two types of analysis.
A good way to explain fundamental analysis in forex is to give an example of two countries. Country A has a thriving economy with falling unemployment, increased productivity, and an improved manufacturing sector. Country B, however, is not doing well. Its unemployment rate is rising and the economy is slowing. If you choose to invest in either of these two countries, you would probably prefer Country A. And if you invest there, the demand for its currency will go up, which will make its value rise.
In fundamental analysis, traders receive different types of economic information, and their role is to interpret how the it might affect the market. Examples of economic data that moves the market are employment numbers, manufacturing activities, inflation, and interest rates. Political news like an election or a change in key government ministers can also move markets.
This type of analysis relies on indicators that are derived from mathematical calculations. There are three main types of indicators. First, trend indicators are used to show the formation of a trend, or when a reversal is about to happen. Examples are moving averages, parabolic SAR, and Average Directional Index. Second, oscillators are used to identify the extremes of asset prices. Examples are the Relative Strength Index, Stochastics, and Relative Vigor Index. Third, volume indicators are used to measure the activity of the market. Examples are On Balance Volume, and Accumulation & Distribution. While these indicators are derived from complex mathematics, it is not necessary for a trader to understand the mathematics behind them.
Applying the Two
There are traders who believe in combining the two types of analysis and traders who prefer to use them separately. For example, Warren Buffet believes in using fundamental concepts when investing. His method is to buy good quality undervalued companies and hold them for a long time. He does not apply technical analysis. On the other hand, fund manager James Simmons, who manages more than $30 billion of assets, believes in technical analysis. The same is true with many other quantitative-focused traders.
Technical analysis is ideal for traders who are focused on the price and profiting for the short-term. Their goal is not to understand the fundamental details of the assets; instead, the technical analysis of the price. If the technical indicators show that an asset will move up, they buy and then exit once that goal is reached. However, even for them, it is important to have a brief understanding of what is going on in the wider market.
Fundamental analysis is also ideal for day traders, swing traders, and long-term traders. For example, a day trader can use the economic calendar to make a trading decision when the US Federal Reserve is releasing interest rates decision or when a company is releasing its earnings. Long-term traders on the other hand can use the economic data to determine whether a currency pair or asset will continue doing well.
It is important to understand these two types of analysis. Even if you just focused on price, understanding the fundamentals will help you avoid making simple trading mistakes. For example, it will help you avoid initiating a trade when a major data is about to be released. For long-term traders, having a good understanding of technical factors can be an asset, too.