Part 7 - Fundamental Analysis

Throughout the ages, traders, producers and speculators have made use of fundamental analysis to understand and correctly interpret economic developments, and attempted to profit from them. Past or present, there has been no shortage of individuals who have used their understanding of supply and demand in the markets for acquiring great wealth. Until the beginning of the 20th Century, all the speculative wealth generated by speculative activity was created through the guidance of fundamental analysis. Like any theories or trading strategies, fundamental analysis require deep knowledge and understanding of its different components. There is always a risk invloved when trading the currency markets, regardless of the analysis method used. 

Fundamental analysis is the study of the causes of price developments, as determined by the supply and demand dynamics of economic activity. To be sure, markets are independent of underlying economic dynamics in the short term. The speculative enthusiasm of major market actors does not allow short term price developments to reflect the underlying trends of economic activity. On the other hand, since all speculative activity is eventually dependent on the availability of money, and as the availability of money is determined directly by fundamental economic factors, fundamental analysis is the best guide to understanding and predicting market developments in the long term. To give an example, regardless of the immediate reaction of the markets to an interest rate decision, the effects of the decision will be powerful in the course of years, the understanding of which is facilitated by the use of fundamental studies.

The fundamental analyst does not necessarily analyze the price action, although market movements must be inevitably be taken into account when studying economics. Economic events and government authorities do indeed react to market developments, and in many cases these reactions can be of momentous significance for both economic events and price action.

How does the analyst perform his study? There’s no single approach to this matter among traders. The vast majority of traders focuses on the short term market responses to fundamental data releases, and call the buy or sell signals generated by those reactions fundamental analysis. However, this approach is just another form of technical trading, since the interpretation and short term value of each news release is only dependent on the market’s internal dynamics. For instance, if the market reacts to a particular unemployment number by driving the value of a currency pair up, and the trader decides to buy that currency pair on the basis that the release is favorable to that currency pair, he certainly is not basing his decision on fundamental analysis. There’s no justification for the belief that the market’s short-term reaction to a piece of data is a guide to the meaning of that data. In that sense, the trader who completely ignores the purported fundamental causes behind market movements, and bases his actions on the technical aspect of trading alone is far more sensible than one who tries to incorporate fundamental explanations into his short-term trading decisions for the simple reason that there’s no fundamental explanation for short term market movements.

Fundamental analysis is concerned with all aspects of economic activity. Consequently, the statistical releases that shake the markets in the short term are just a small part of the analytical tools which are at the disposal of the fundamental trader. Indeed, it is often the case that news releases, statistical data are just backward-looking indicators with limited predictive value for the long term.

Social and Political Analysis

Under this heading a large number of concepts, including economic regulation, geopolitical tensions, economic habits of a nation, and many other aspects indirectly related to economic functions are analyzed.

Traders with just a little bit of experience will admit readily that the currency rates are strongly responsive to changes in the political environment of a nation. In addition, it is well known that the regulatory structure of a country can be very influential on its economic dynamism, which would be reflected on GDP values, and eventually on currency rates. But beyond these basic concepts, social and political analysis of a nation’s character can be very helpful in predicting the economic reactions of currency to all economic events at the global scale.

In example, many people were expecting the EU economy to perform much better than the American one in the aftermath of the 2008 collapse in economic activity, as the European consumer had a much smaller debt burden, and was affected by the collapse of the real estate bubble to a lesser extent. But those who defended this proposal were neglecting to perform the social analysis on the mentality and habits of the European consumer. Eventually, when the impact of the crisis was felt by Europeans, the reduction in spending was much more severe than initially expected due to the conservative mindset of the European consumer.

There are many cases where a raw analysis of the data, without accounting for the various different characteristics of nations, can lead to mistakes and errors on a grand scale. It is therefore important that we incorporate these characteristics into our analysis of interest rate changes or global shocks. On the other hand, the differences in national characteristics are not a result of genetics, and they are not irreversible; they merely reflect the divergent economic paths taken by nations, the varying regulatory mechanisms, and demographic trends which can all change in time.

Economic Analysis

It is self-evident that fundamental analysis will include economic analysis as per the definition of the term. This is the aspect of fundamental analysis which focuses on indicators, statistical releases and economic news to derive the data that can signal profitable trades to us. There are a very large number of releases that many traders keep track of, and many of those have an important impact on the short-term direction of the markets. But the kind of data that can allow us to make predictions and form conjectures on future price movements is more limited in nature. The GDP data, for instance, is carefully followed by market participants and its release results in volatility and excitement among market participants. However, since it’s backward looking, in many cases its value for understanding future developments is less than the inventory component of the release.

Let’s review a few of the major indicators used by the forex trader for generating signals.

GDP

The gross domestic product of a nation is the data that provides us the clearest and most straightforward snapshot of the economic situation of a nation. The GDP number includes everything that is produced inside the borders of a nation, and as such, it is the best indicator of overall economic activity in a county. One drawback associated with this data is the fact that it is backward looking. All the information contained in it relates to a previous quarter, and the number itself is usually calculated on the basis of information that is already available to the market. Many analysts use the available data to create their own estimates of the GDP number, and the market evaluates the actual release based on how much it diverges from the analyst consensus as surveyed by news channels and other media sources.

Interest Rates

Interest rate decisions of central banks have long been the most important drivers of currency trends. In general, when central banks are moving in one or the other direction decisively, markets react in a similarly strong fashion and establish strong trends in currency pairs. Conversely, when central banks and government authorities are unclear about the future, and their own policies, volatility rises, and sometimes it is even possible that directionality in the markets disappears.

Interest rates are important because they define the cost of the cheapest borrowing available to anyone in an economy. As the Central Bank is the sole authority controlling the money supply at the lowest level, traders are very attentive to the decisions and declarations of these institutions. And the importance of interest rates is not limited to money supply either. In a healthy economy where money demand is in tune with growth, stimulatory or contractionary policies of central banks have great importance for determining unemployment, industrial production, trade deficits, and many other statistics.

Finally, since interest rates determine the attractiveness of a currency for speculators and investors all over the world, interest rates are powerful determinants of currency flows to a nation, which, by virtue of supply and demand dynamics, determines the value of a currency against its peers.

PPI

The PPI (the producer price index) measures the pipeline price pressures at the producer level. Producers increase or reduce prices in response to many dynamics including import and labor costs, but consumer demands are less relevant to their pricing choices, unless there’s a general slack in demand. Thus there’s often a large gap between the PPI and the CPI, depending on the overall economic conditions of a nation.

The release of the PPI is rarely a market moving event unless the numbers are too surprising and unexpected. Otherwise, most traders focus on the close relative of this statistic, the CPI, and only use the PPI data as a kind of preliminary release of the consumer price index. Nonetheless, especially the gap between the CPI and the PPI can be very useful for analyzing economic trends.

CPI

The consumer price index is one of the most important fundamental indicators, measuring price pressures at the consumer level. Since consumers are the end users of all products and services in an economy, price pressures on consumer goods must eventually be reflected on wages which leads to inflation. Central Banks are very attentive to the CPI and base their interest rate decisions on the changes in the underlying CPI trend. For some central banks, the CPI is the single most important indicator for determining policy rates.

As the importance of interest rates in determining the value of currencies against one another is well-known, the CPI is one of the most closely watched indicators in the currency market. An unexpected number has the potential to change market perceptions about a currency’s future value drastically. Nonetheless, CPI is just the snapshot of price pressures as of the day it is released, and it is predictive power is limited.

COT Report

The commitment of traders (COT) report is released by the Chicago Board of Trade each week reflecting the commitment of various small and large speculators in the US commodity futures market. The report categorizes traders according to their purpose: non-commercial traders are financial firms and speculators whose main purpose is to profit from price swings, with no real interest in buying or using the underlying commodity. Commercial firms are those that use the commodity bought for purposes other than speculation.

The COT report’s main use for currency traders is as a volume indicator. Since there’s no central authority for the currency exchange market, traders turn to the COT report for gauging the depth of the market with respect to any currency pair. There are many other uses of the COT report including for predicting market reversals, but those lie beyond the scope of this introductory article.

Summary

The information contained in these statistical releases is not very helpful when it is used by itself alone. Since the purpose is to gain an understanding of economic developments, and to establish a framework within which we can evaluate price trends, we must combine the data with our own insight. Without that additional angle provided by study and analysis, raw data has very little use for explaining the economic facts behind price developments.

If you choose to use the data for short-term trading, fundamental news releases must still be coupled with some kind of secondary information in order to allow the successful implementation of a trading strategy. It is well known that immediate market responses to fundamental releases are erratic and unpredictable. As a result, unless the news release is very surprising, it is not a good idea to formulate short term strategies purely on the basis of news releases. Indeed, fundamental analysis is perhaps the worst tool for trading markets in the short term.

Part 8 - Trading Psychology: The Four Demons of Trading Psychology

We’ll conclude the basic lessons of our school with a brief study of trading psychology and its effect on the profits or losses of forex traders.

It is rare to see a brilliant academic do very well in trading. While there are many scholars with degrees and honors from the most prestigious universities of the nation, there are not that many of them who have achieved exceptional success in trading forex. Suffice it to say at this point that the board of directors of LTCM included Myron Scholes and Robert C. Merton, two Nobel Prize winners, whose contributions to economic theory are among the most valuable in the past century. Nonetheless, even their analytical skills were not enough to save that firm from a spectacular collapse, as greed and euphoria overrode the dictates of reason, and leverage amplified the impact of false calculations.

It is clear that a lack of knowledge or expertise wasn’t the cause of LTCM’s demise. Instead, too much confidence, enthusiasm, a lax attitude to risk controls were the main culprits behind the firm’s demise, and it is possible to tie these factors to emotional faults with ease. To understand these emotional problems, and trader psychology, we’ll introduce you to the four forex demons in this text whose lies and deception ruin the careers of many beginners. The harm done by them is far greater than anything caused by faulty analysis or neglect of important information. While the results of one simple mistake can be readily corrected in time, the damage done by these beings is chronicle.

But let us remind you that the rewards of a successful battle with these troublesome beings can be unlimited. The trader who masters the psychological aspect of trading has walked two thirds of the way to riches, and all the rest is just a matter of patience and study, before the inevitable outcome of wealth and prosperity is attained.

Greed

The greed demon is the number one enemy of forex traders. This demon has a long and spiky tongue which constantly whispers to our ears that the opportunities in the market are going away unless we act quickly to profit from them. Its feet are on fire: it screams “faster, faster” to the trader, stressing him, causing him to lose focus. It has an empty belly, is emaciated, weak and hungry, because none of his exhortations for speed and greed lead to the slightest profit in the end.

It is perhaps natural that the vast majority of forex traders are money-oriented, profit seeking individuals who attach great importance to financial success. It is also true that without a strong drive for making money, no trader will be able to withstand the pressures of trading the forex market. In moderate amounts the drive to achieve monetary gain, and focus on financial success are healthy and necessary. But these healthy impulses become unhealthy when they direct our trading decisions: the greed demon needs to know his place, and he must not interfere in trading practices which must be formulated by logic alone.

How to avoid the wrong choices forced on us by greed? The first step for conquering greed is ensuring a disciplined approach to trading which minimizes the role of impulse in our trading decisions. By formulating a trading strategy in the beginning, and remaining loyal to this throughout the course of a trade, we can ensure that greed has nothing to do but bow down in silence as we study the markets and make our decisions based on reason and analysis alone.

Success can be achieved by a refined trading method, and its disciplined application. Emotions thrive where uncertainty and fear are rampant. To avoid such a situation, we’ll ensure that our responses to market developments are calculated and based on the principles established by our diligent study of them. Since our motivation alone, or desire for profits will not ensure that we actually acquire those profits, there’s nothing to be gained from listening to the teachings of the greed demon.

Fear

This fiend has a fearsome sight, and a sharp voice, bellowing, growling all the time, trying to intimidate us into indecision in everything that we do.

Fear has the opposite role of greed in our trading decisions. Instead of inspiring us to trade like a machine gun, opening and closing positions with the speed of lightning, fear convinces us that nothing that we do will be profitable in the long term, regardless of the power of our analysis, and the amount of study and consideration gone into perfecting our method. In this case, a fearful trader will be unable to wait for the realization of a profitable position, and he will be unwilling to act on the basis of rational expectations. In addition, the fearful trader will be unable to realize losses that result from mistaken assumptions, and the red ink in his account will keep spreading everywhere as a result. The result is usually ruin: as fear leads to more and more irrational decisions, and few trades are profitable, a few long-held losing trades will eventually wipe out the account.

It is necessary to distinguish between conservatism and fearfulness. Being conservative in our trading decisions is surely a healthy and sensible practice. A conservative trader is skeptical about everything he hears, but is still willing and able to act when his study confirms a profitable risk/reward prospect for a particular scenario. The fearful trader, on the other hand, is incredulous of not only the opinions of others, but everything that his analysis tells him too. He doesn’t know what to do, where to look, which trade to take and which to avoid, because all are the same to him. As he doesn’t trust his own logic, he has no tools with which he can understand or evaluate market developments. The end result is something akin to panicky gambling, with deleterious results being the inevitable outcome.

To avoid the disastrous effects of fear, we must train ourselves to understand that there’s nothing random about a successful trading career. We must be convinced that we are in control of our choices; we must have a clear plan to which we adhere with iron will, impervious to the illogical emotional extremes of the crowd. All that is only possible by a logical, calm approach to trading, which can only be gained by patient study. Another good way of avoiding fearful trading decisions is ensuring that we do not over leverage our account, and risking only so much that when the account is wiped out, we can laugh at the outcome, and go on and seek our fortunes in another aspect of life.

Euphoria

The queen of forex demons, Euphoria, is a creature that promises unlimited wealth, and delivers unlimited misery and destitution. Euphoria works hard to ensure that wherever we look, we see nothing but wonderful prospects for limitless profits. It is as if the trader has somehow been blessed with the Midas Touch, with success being the natural consequence of his routine behavior.

Under normal circumstances, euphoria has little relevance for most traders, because most are aware that success in forex trading is not child’s play. While magnificent profits in a short time are sometimes possible, such gains are usually the result of a period of study and practice during which the false promises of euphoria are proven repeatedly to be meaningless. In the case of the beginner, who doesn’t possess this background of hard work and study, euphoria may result from a string of profitable trades, as the trader comes gradually to believe that his understanding of the markets is impeccable, his analysis, flawless.

The key here is the knowledge that the first condition for performing a flawless analysis is beginning with the assumption that no analysis is flawless. Consequently, the successful analyst or trader is always skeptical about the value of his explanations, although he doesn’t hesitate to act on them because he bases his work on logic alone. The profit potential of the next trade taken is independent of how profitable the previous one was. Consequently, there’s no sense in getting excited about a string of profits: the next trade may or may not be profitable, depending on how diligent our study of the market was.

Thus, the best way of avoiding euphoria is by understanding that a string of wins or losses does not impact the outcome of the next trade that we will make. The success or failure of the next trade is only dependant on how capable we are of excluding emotions from our study of the markets, and in that knowledge lies the alpha and omega of a successful trading strategy.

Panic

Panic is the opposite of euphoria. In a panicky situation, the trader sees nothing but losses in the market, with no possibility of concluding a profitable trade. This is an exceptionally strange way of thinking in the forex market, since by definition; the loss of someone must be another person’s gain. When a trader is losing large sums on a long currency trade, another trader is possibly making large profits on a short trade on the same pair. This fact by itself should have helped traders to be more realistic in response to bouts of panic in the forex market, but experience shows that this is not the case.

So what are the causes of the panic that leads a forex trader to wrong choices? Obviously, periods of market volatility are the most common catalysts of a panic response. As price fluctuations increase in depth and frequency, the value of predictions diminishes greatly. This results in a loss of confidence in our trading choices, and if the period lasts long enough, the inevitable emotional outcome is panic in most cases.

A panicking trader will commit all kinds of errors. He will close a profitable position in expectation that it will reverse quickly, and will register losses soon. He will be unable to perform a logical analysis of his situation, and will instead become the victim of mental illusions on “potential” scenarios. The ultimate arbiter of a trade’s success or failure is of course the market, but for the panicky trader, all kinds of imaginary benchmarks, unreal expectations constitute the major criteria for the advisability, and ultimate profitability of a trade.

The impact of panic is greatly amplified by leverage, and the damage caused by it is intensified by tight stops.

Conclusion

To deal with the problems associated with trading psychology, we must minimize the role of emotions in our trade decisions. To minimize the role of emotions, we must understand that success or failure are not related to luck, but are the logical consequences of our own choices. We discussed before that it is almost impossible to have an unleveraged account wiped out as the consequence of a single trade. If the trader succeeds in realizing an empty account as a result of a string of losing trades, it’s hard to speak of luck or chance as being the causes of the disaster. Leverage is entirely in the control of the account owner; he can set it at any value provided that he can live with the consequences. Leverage amplifies the profit/loss potential of a trade, but it also intensifies the emotional aspect of trading too. Eventually, this intensification of emotional pressures may prove to be the most dangerous and negative impact of leverage.

The best way of dealing with emotional problems is acquiring a logical approach to trading. The best way of acquiring that attitude is understanding the market mechanisms, and the forces that direct economic activity. In this website, we have attempted to give you a basic understanding of those factors upon which you can build your own edifice of knowledge to improve your own potential for success in the forex market.

Next, part 9 >> Choosing the Right Broker >>

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