Fundamental analysis is the carrying out of research into tradeable assets to establish if current prices are fair value, or not. It can involve analyzing a firm’s business reports, a particular sector or market, or in terms of forex, an entire economy. The aim is to establish a trading opportunity based on current price being incorrect and there being a catalyst to bring about a correction.
Top-Down analysis, as the name suggests, involves analyzing macro scale indicators such as inflation, forex, unemployment or political structuring, and using increased knowledge to filter down into what are seen as potentially mispriced assets groups, and then particular instruments within that group.
Bottom-up analysis works in the other direction. Here investors start their research by considering a tradeable instrument and work to consider the range of higher-level features that might bring about a change in price. Of course the probability of those changes coming about, and indeed when, also form part of the analysis.
Fundamental analysis can involve a lot of work. It might be studying financial reports to a granular level or carrying out site visits to retailers to ascertain the health of a business. Some trading strategies might require in-depth analysis of several different factors: for example, a company’s year-end financial statements, the currency markets of its major markets and growth projections of its major rivals.
Once this many variables start being included the chances of one part of the sequence breaking down increases and the chances of the trade working decrease.
Some of the most successful trading in this area therefore focuses on one particular trigger point. It’s much easier to do this than to try and know everything about everything.
The timescales involved are particularly important. You could say that interest rates at current levels are unsustainable and trade a pending hike in rates. But trading that theory would involve getting the timing correct as much as it would involve getting the direction right.