Fundamental analysis encompasses a lot. While technical analysts follow the concept that the historical performance of markets can indicate future performance, fundamental analysis is based on the theory that the price of a commodity at any given time is the equilibrium between supply and demand. This equilibrium in a commodity is found by adding what is left over from last year (carryout) to this years production (supply) and subtracting this years usage (demand).

Technical analysis is a method of evaluating a market by analyzing statistics generated by market activity, such as prices and volume. Technical analysts do not attempt to measure a markets intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity. Fundamental analysts look at a plethora of news and reports including data on supply and demand, seasonal trends and trade agreements.

A focus on the fundamentals has certain advantages, says Paul Kim, president and managing member of Chicago-based LaSalle Asset Management. A fundamental trader will have an idea of the direction the markets will go and an idea of what factors can change the direction. Hell also have an idea of how high or how low certain news will take the market. If he anticipates certain news will make a big move, he will put on a big position, Kim says. The disadvantage is that sometimes the market will ignore the fundamentals and a fundamental trader will not know what to do. Sometimes the market doesnt think certain news is important enough to move the market; and the fundamental trader will lose a lot of money because he believes in his position and will stay in it, he says.

Also, the theory is the market has already figured certain news into its price. A fundamental trader needs to know this and paying attention to prices and be familiar with where a price should be based on the news. In fact, it is a myth technical traders do not believe in fundamentals; they believe that at any given time the market price already reflects those fundamentals.

Kim says a technical trader is looking at chart patterns and will theoretically never sit through a big loser because if a trade is not working he will get out. They have certain risk exposure where they wont lose more than 2% to 3% on any one trade, Kim says. And technical traders can flip a position right away. They are flexible that way. But on the downside, they dont really know where the market is going so their position size tends to be the same. They wont know when to be big in one trade and small in another trade like the fundamental trader.

Knowing what to look for and what to focus on when using fundamentals will help you get the most out of fundamental indicators.

SUPPLY AND DEMAND

Supply and demand is the fundamental concept behind a market economy and the basis for fundamental trading. Most fundamental traders always have some idea of what the supply and demand is and which factors can impact supply and demand for the market they are trading. There are people who update their fundamental balance sheets every week, Kim says.

When goods are traded in a market at a price where consumers demand more goods than firms are prepared to supply, this shortage (or excess demand) will tend to lead to increases in the price of the goods. Those consumers who are prepared to pay more will bid up the market price. Conversely, prices will tend to fall when the quantity supplied exceeds the quantity demanded.

In the commodity markets, the price of a commodity rises if there is a shortage, bad weather or bad news, and the price goes down if there is an oversupply. Supply and demand affect the markets everyday. Crude oil provides a current example. When news was released in August that petroleum giant BP PLC would shut down its Prudhoe Bay facilities in Alaska for weeks or months due to damage that will require it to replace 73% of a pipeline from the field, causing a removal of about 8% of daily U.S. crude production, oil and gasoline prices shot sharply higher. Light September crude oil rose as much as $1.79 a barrel to above $76.00 in electronic trading on the New York Mercantile Exchange (see Crude reacts, below).

While the BP example provides a simple cause and effect scenario, the oil market has shown how supply/demand basics dont always act as explained in Economics 101. Crude oil has seen reserves grow throughout this long bull market, leading many people to claim manipulation by fund managers. Those supply figures may be misleading because as demand exploded particularly from China those reserves as a percentage of global demand have gone down. And some fundamental drivers are not easily measured, such as the effect of the Iraqi war. There are numerous geopolitical factors that have the market worried that current production could decrease dramatically.

The grain markets lend themselves well to fundamental factors: supply

and demand, seasonal cycles and government reports.

One example is shown in Wheat runs up, (below). December 2006 Chicago Board of Trade wheat rallied in September due to a 35% cut in the size of the Australian crop combined with a heat damaged crop in Europe this summer and a poor crop in the United States due to drought.

SEASONALS

There are many repeat patterns, or seasonals, in the futures markets. For many traditional commodities, such as grains, one critical variable affecting prices is the weather, or weather seasons. The obvious relationship between seasons and commodity prices has been tracked throughout history. However, non-agricultural markets such as the financial and currency markets, which are obviously not directly affected by the weather, also have historical patterns.

The cyclical commodities like most grains, but especially corn, coffee, cotton and copper lend themselves well to fundamental analysis, says Kim, adding those that dont work as well are gold and silver because they have a human emotion thats attached to them: with gold its the fear that the value of the dollar will increase or decrease.

Joe Ross, CEO of Trading Educators, combines fundamental seasonal indicators and technicals to identify the 1-2-3 formation and his own Ross Hook.

A 1-2-3 formation is a common chart pattern consisting of three definable points that appear regularly across most liquid markets. Unlike some chart patterns, such as a triangle or head-and- shoulders that are subjective in nature, a 1-2-3 formation can be accurately defined by an objective set of rules. Following a trend, a 1-2-3 high or low is confirmed if the trendline is penetrated; if there is a lower high in an up trend, or a higher low in a down trend; or if there is a break below the previous low in an up trend, or above the previous high in a down trend.

The Ross Hook is a price bar following a series of higher highs or lower lows that is preceded by a bar that fails to make a new high in an uptrend or a new low in a downtrend. Points to look for to confirm a Ross Hook are: the first correction following the breakout of a 1-2-3 high or low, or the first correction following the breakout of a range.

In an up-trending market, after the breakout of a 1-2-3 low, the first instance of the failure of a price bar to make a new high creates a Ross Hook (a double high/double top also creates a Ross Hook). In a down-trending market, after the breakout of a 1-2-3 high, the first instance of the failure of a price bar to make a new low creates a Ross Hook (a double low/double bottom also equals a Ross Hook). Ross uses the seasonal research of Moore Research Center Inc. at www.MRCI.com.

Ross says there was a seasonal trade in gold calling prices to go up from Sept. 9 through about Oct. 1. This seasonal move has worked 14 out of the last 15 years. I wait for it to make a 1-2-3 formation, which it did, and I go long, Ross says (see As easy as 1-2-3, below).

Ross says seasonal trades in the energies are not currently working. Usually natural gas and crude oil rise in September. Seasonal trades for the January contacts for crude oil and natural gas have worked 13 of the last 15 (years), but are failing this season, Ross says. We have a lot of natural gas in storage right now. Theres no storage, so prices are falling like a rock, he says, adding crude prices are falling too. So theres no guarantee a seasonal trade will work.

REPORTS

There are multiple reports for commodity markets measuring supply, planting intentions and yield, both in the United States and globally. So lets focus on a popular commodity: wheat. A few reports you can start with are found at www.uswheat.org. Those include harvest reports, which show the condition of Americas wheat crop beginning when the harvest starts in June; crop quality reports, which break down the quality of crops and compiles weekly prices from exporters of all classes of wheat from all coasts and thats just to start. You also have to take into consideration The Commercial Sales report according to Joe Sowers, market analyst at U.S. Wheat Associates.

Theres also the USDA Economics Research Service at www.ers.usda.gov, which covers trade and international markets from the North American Free Trade Agreement (Nafta), the World Trade Organization (WTO), U.S. agricultural trade, briefings on China, Mexico, Brazil and other countries, publications on world agricultural supply and demand estimates, and the latest U.S. agricultural trade data. Sowers says the ERS site is very helpful. You can look at data by crops or by country; and there are articles written by ERS people that will build your knowledge, Sowers says.

Another one is the National Agricultural Statistics Service (NASS) at www.nass.usda.gov, which publishes a report calendar with the dates production reports are due. The big supply and demand report is World Agricultural Supply and Demand Estimates, which is another monthly USDA released report. And for grains specifically, the Production Estimates and Crop Assessment Division, which uses satellite imagery to produce reliable production forecasts for crops.

Sowers breaks down the fundamentals but also watches the technicals. You have to be aware the technicals are out there and you have to use them both together. You have to know it all. The traders I know who are successful have a very good knowledge of the fundamentals but they know about the technicals too, he says. Kim agrees, The fundamental side takes a long time to learn, though, and the technical side is a little easier to learn. But the best trader [uses] a blend: a trader who is fundamental based with an understanding of the technicals.