While technical analysis is the study of charts, fundamental analysis is the study of different factors that might dictate what the price of a currency “should” do. Technical analysis uses past prices and numerical studies, while fundamental analysis takes into consideration interest rates, economic strengths or weaknesses, politics, etc., etc. of different countries. Behind every chart should be a series of fundamental reasons explaining why the price behaved as it did. What are some of the fundamental factors that can affect the price of a currency?
Interest rates – the level of interest rates between different countries can affect the exchange rates between them. If the United States raises its interest rate, then foreigners might flock to the US dollar-denominated investments because they can get a higher interest on US dollars. This will raise the price of the dollar relative to the foreign currencies. If the US lowers its interest rates, then the opposite effect might take place.
Economy – the strength or weakness of a country’s economy tends to create longer-term trends in the price of its currency relative to others.
Political situation – a country’s political situation can impact the price of its currency. A political crisis can lower the price of a country’s currency as people flock to safer currencies.
Stock market – the state of a country’s stock market can also affect the price of its currency. For example, if the US stock market declines rapidly for a prolonged period of time, foreigners might take their money out of US stocks and put it in other foreign markets. This will lower the value of the US Dollars versus foreign currencies. This was observed since the US stock market began its multi-year decline that started in the year 2000. This factor comes into play if foreign investors have a substantial amount of capital invested in a country’s stock market (e.g., like in the United States).
There are many other fundamental factors other than these that affect the prices of currencies. The difficulty in trading currencies based on fundamentals is that the decision to buy or sell is subjective; in other words, it requires a trader’s logical interpretation of the situation at hand.
With the infinite number of variables that affect a country’s economy, it is very difficult to know which statistic or event will impact a currency the most. Furthermore, when a trader reaches a conclusion that appears very “logical” to him, sometimes it is difficult for that trader to admit he was wrong if the trade does not go in his favor, leading to a substantial loss.
While some traders do make money based on their fundamental interpretation of the currency market, many don’t.
I believe that to day trade currencies, an individual does not have to be an expert in economics or politics. Since fundamental factors will have some effect on the price of a currency and the price of a currency can be plotted on a graph, it can be argued that all fundamentals will, at some point or another, be reflected on the chart. Consequently, I feel that when a trader simply uses the information on the chart to determine when to buy or sell, he is acting on the sum of all the fundamental factors that are influencing the price at that moment in time, regardless whether he knows what each of these factors is and how it “logically” influences a given currency.
Back: Technical Analysis | Next: Advantages