Many traders are familiar with fundamental analysis when trading stocks, but fundamental analysis can also be applied to the pricing of futures contracts.
Stock analysts will use the financial information of a company to help determine its health. Most of the analysis will center around accounting ratios, an analysis of how the company is performing compared to their peers, and how the sector is performing in general. The resulting price models are compared to the current market price and the decision to invest or not is made based on those numbers.
Futures contracts represent a market, not just one company; when analyzing the fundamentals of an entire market, the trader will adjust their methodology, substituting economic variables for accounting ratios, and look at the factors influencing supply and demand. Fundamental analysis is the process of determining the model price of a futures contract, now and in the future using factors like micro economic data, macro-economic data and industry financial conditions. The analyst is looking to determine where supply and demand will move, price at a later date and whether the contract is priced fairly today.
Did you know? - Stock fundamentals are typically calculated using accounting ratios to determine potential for future growth. In the futures market, fundamental analysis will look at factors that could impact supply and demand.
For example, a trader who is looking to analyze crude oil may want to research the factors that drive supply, such as OPEC production limits, disruptions in the supply chain and natural disasters.
They might also want to look at factors that affect demand, such as economic expansion and more cars on the road, to determine an assessment of how they think supply and demand will increase or decrease in the future.
One trader might see that OPEC production has increased, creating downward pressure on the price of Crude. While another trader could also see that due to population growth and economic prosperity that demand for Crude is going to increase and will look for price to increase in the future.
Macroeconomic factors are variables influenced by the economy, which can lead to price movement of a futures contract. These factors affect many, or all, sectors at once, and are typically the highest-level factors that affect the financial health of a country’s economy.
Macro-economic factors such as GDP, inflation and interest rates, create upward and downward pressure on the prices of key sectors and commodities.
For example, if GDP is increasing and the economy is growing and driving an increase in construction, commodities, such as copper that are used in construction could see increased demand and as a result increasing prices.
In another scenario, what happens if interest rates are increased domestically? For example, if the U.S. increases rates and we see no economic changes in the European Union, then the EUR/USD (6E) contract should decrease in price given that the U.S. dollar has strengthened in relation to the Euro.
Microeconomics is the study of supply and demand for a commodity. These factors are specific to the commodity and sector being analyzed. Factors that might impact supply and demand are consumer preferences, technological advancements and substitute and complementary goods.
Improvements in technology could make it more efficient to produce goods, thus increasing supply while changing the products that consumers are interested in, decreasing demand.
As consumers change their preferences or as trends change and consumers no longer want a particular item, demand dynamics are changed.
Demand for products can also change as substitutes come on to the market. In the futures market, this relationship occurs between different contracts. For example, corn and soy meal are both used to feed livestock and both are represented by futures contracts. At certain price levels, there may be farmers who will move from using corn to using soy meal and vice versa, resulting in the price change of one commodity affecting demand in both commodities.
When an increase in the price of one good impacts the demand of another, they are called complementary goods. For example, the price of feed can affect the price of livestock. These markets move together and demand in one market can affect the other market.
Industry or sector analysis also factors into the decision-making process. The trader will look at the industry and see whether the industry is growing or contracting and if there are any factors that might impact growth in the future.
For example, a trader might see the demand for crude oil declining in the future with price possibly moving lower. However, if there are factors within the crude oil industry that are leading to production issues, supply might decrease and, even though demand is lower, the reduction in supply means that even the new lower levels of demand cannot be met and price might increase.
Traders are looking to understand what is ultimately driving price and if the current market price of the futures contract is higher or lower than the model price.
If the model price is higher than the current market price, then the trader believes that the market is undervalued and would want to buy contracts of the undervalued contract.
If the model price is lower than the current market price, then the trader would want to sell contracts of the overvalued futures contract.
The relationship of supply and demand is complex, global and everchanging. Fundamental analysis can involve tracking and understanding multiple variables. Each variable can have a small or large effect on any another variable in the pricing model.
Traders who are using fundamental analysis should always be looking for signals in the market that could impact the balance of supply and demand. And they should also recognize there can be influences, outside of their analysis, that could move the price of the market they are trading.