Chapter 2-2 Forex Trading Strategies
Forex trading strategies can either be based on technical or fundamental analysis. Technical analysis involves making investment decisions based on the chart of a currencies price action. Fundamental analysis involves interpreting economic and political factors as a means for making investment decisions. Forex strategies can be purely technical, purely fundamental, or a combination of the two. Regardless of the strategy’s style, it is always a good idea to have a general idea of what is going on in the global Forex market before taking on any exposure.
Trading strategies, like most things in the investment world, are not a one-size-fits-all endeavor. Quite to the contrary, the best strategies are often those developed by an individual over time as he or she learns what works out best. Some traders prefer strategies that yield several trades a day whereas others prefer those that might only produce one trade a week. It may be a trader’s goal to look for many small gains instead of one or two “home run” trades. It is important to consider your goals and preferences before making major investments decisions. You should plan on updating and tweaking your trading strategy as you grow and develop as a trader. Adaptability is one of the most important traits that all successful traders share. What works in one market might not work in another. Similarly, what works in the morning might not work in the afternoon. Traders are constantly evolving to keep pace with the ever-changing financial markets.
There are two styles of trading systems- mechanical and discretionary. Mechanical systems have very strict rules that cannot be bent or broken, everything is black or white. There are no decisions to be made, either the conditions for a trade exist or they do not. As a result, mechanical systems take all of the emotion out of trading. Discretionary trading systems put the trader in total control of the trade and rely on experience and knowledge of the markets. For most traders it comes down to discipline. Although discretionary systems give the trader more control, they are almost always based on a set of rules and signals that have been tested and refined. If you are disciplined enough to follow your rules than a discretionary system will probably work out better for you because it can be adapted on a second by second basis. However, if you are trigger-shy and often find yourself taking profits too quickly then perhaps a purely mechanical system may solve these problems for you. Generally speaking it is better to start out with a mechanical system and move towards discretionary trading as you gain experience and learn how to advantageously supplement a mechanical system.
One of the most important aspects of formulating a trading strategy is money management. Traders that develop, and follow, clearly defined money management rules invariably are more successful than those who do not. The cornerstone for most successful money management strategies is the reward to risk ratio. The reward to risk ratio is used to define profit targets in relation to the amount or risk assumed. At bare minimum a trade should carry a 1:1 reward to risk ratio; most Forex traders look for this to be 2:1 or better. For example, if a trader is buying a support level and risking 15 pips, that trader will be looking to take profits at 30 pips or better. Truly disciplined traders will place their exit orders immediately upon entering a position to avoid taking a larger than anticipate loss, and to avoid the temptation of getting greedy if the trade works out. Identifying a core reward to risk ratio will also help put profitable trading into perspective. Consider a 3:1 reward to risk ratio- if managed correctly, a trader would only need a success rate greater than 25% to be profitable as 1 good trade will offset 3 poor trades. Whatever reward to risk ratio you decide on will depend entirely on what your trading goals are, the most important thing is to be consistent. By maintaining a consistent money management policy you can standardize all of your trades regardless of price.
Journaling is one of the most important and widespread characteristics of successful traders. Journaling’s serves two main functions- it creates a record of all of your trades for reference in the future, and it provides a foundation for self analysis and development. History often repeats itself in the financial markets; by keeping a journal of all of your trades you are far more likely to capitalize on a repeat opportunity when it presents itself. By noting actions and emotions, traders are better able to get a feel for a market and the securities that comprise it. Some currencies trade very differently than others; by recording how each trade went you are able to learn which currencies you excel at and which give you trouble. Analyzing past journal entries on a weekly or monthly basis provides a good means for growth and development as a trader. Not every trade works out; the most important thing is to learn from mistakes in order to avoid repeating them.
Learning to trade the Forex market takes time and practice. Fortunately, there are ways for traders to practice trading in a real-time environment. Paper trading, or trading with virtual dollars, is an integral part of becoming a successful trader. All traders have paper traded at some point in time in their career, generally for at least a few weeks before putting any real capital to work. The first months as a trader are some of the most difficult as you are completely submerged into a market filled with professionals while you yourself have very little experience. By trading a demo account you are able to gain experience, make mistakes, and learn important lessons without suffering massive financial losses. You should only start trading with real dollars when you are comfortable with your performance paper trading. Some traders continue to paper trade after moving to real dollars as a means of testing out different strategies and practicing new techniques. It is important to note that although paper trading is great practice, the results are not guaranteed to carry over due to liquidity, slippage, and the emotional element that arises when capital actually changes hands. FOREX.com offers one of the best demo account programs around with no risk and no obligation to open an account.
It is very important to consider the time of day when trading Forex. Although it is true that the global Forex market trades around the clock, different market centers have different operating hours. As a result, the Forex market behaves differently depending on what time of the day it is. The following are the Eastern Standard Time market hours for the three main exchanges: London, open at 3 AM, closed at 12 PM; New York, open at 8 AM, closed at 5 PM; Tokyo, open at 7 PM, closed at 4 AM. There are two periods of overlap in which multiple exchanges are open at the same time. From 3 AM to 4 AM both Tokyo and London are open, and from 8 AM to 12 PM both London and New York are open. For obvious reasons, these are the five busiest hours of the day in terms of volume and dollar value exchanged. Due to the multiple overlaps, the London session generally experiences the greatest overall activity.
One of the first things to consider when learning Forex trading is what time frame you intend to operate on. The three main trading time frame styles are day trading, swing trading, and position trading (also known as long-term holding). Day trading involves opening and closing positions on an intraday basis, never holding positions overnight. Some day traders try and make quick plays based on volatility and momentum in a style known as scalping. Others attempt to hold onto their positions for as long as possible in an effort to maximize daily exposure time. Regardless of your trading style it is important that you arm yourself with the correct tools. For example, scalpers are much more concerned with minute by minute price action and often look at 1, 2, and 5 minute charts and only look at higher time frame charts occasionally to get a feel for the overall trend. Day traders dedicate the majority of their time to studying and comparing price action charts while staying up to date with all major news events in the global economy. Day trading is arguably the most involved and time consuming trading style but most traders agree that it provides the most opportunity due to its dynamic nature.
Swing trading is a trading style in which traders hold on to positions for a medium duration, often 2-5 days but can be longer if the trade is working out favorably. Swing trading often considered the middle ground of investing as it involves a combination of day trading and long-term holding strategies in its execution. Swing traders look for direction based on the overall trend, or macro picture, then use intraday charts to time entries to create the most desirable position possible. Daily and weekly charts are used as anchor charts to identify opportunities then intraday charts, most often 5, 15, and 30 minute charts, are used for spotting entries and exits. This trading style requires significant patience and discipline as securities do not always behave the way traders want them to. As a result traders often find themselves making ill advised decisions. Swing traders split up their time between searching for new opportunities, timing entries and exits, and managing positions once they have been established.
Position trading is generally based off of fundamental factors rather than technical indications. However, some traders do consider daily, weekly, monthly, and even yearly charts when making long-term investment decisions. This style of investing often involves establishing a core position then trading around it as it fluctuates in value over the weeks and months. One of the key advantages to longer term trading is that it removes all of the intraday noise that occurs in most securities. This lets investors focus on the overall trend of a security and reduces stress significantly.
One of the most common entry strategies involves trading news driven currency pairs. Economic reports from around the globe often create sharp short-term moves in the market that traders, if prepared, can take advantage of. There are a number of tradable reports scheduled on almost every trading day, so it is easy to see why many traders focus on this aspect of currency trading. Not every report affects the market in the same way so it is important to take the time to learn how the market reacts to each one before attempting to trade it. The most common news reports that move the US markets are: employment growth, interest rate level, trade balance, GDP, retail sales, durable goods orders, and inflation. Each of these reports is scheduled months in advance; it is important to know when they are approaching even if you do not plan on trading it as the release will create volatility regardless.
There are two things to consider when trading news events- the macroeconomic and short-term effects that the news report will have. How traders interpret these reports is directly base on the time frame and style of trader that they are. The macroeconomic effect a news report will have on a currency is based on whether or not the data released is positive or negative. Consider GDP growth of 5% year over year. Generally speaking, this is a bullish number and will likely cause the country in question’s currency to appreciate. That is to say that the overall effect over the long term should be appreciation relative to other currencies around the world. The short-term effect a news report will have on a currency is based on whether or not the data released meets, exceeds, or misses expectations. Consider again GDP growth of 5% with an expected growth of 5.5%. This report, although positive in nature, will likely be received negatively by the market because it missed the mark by .5%. Short-term traders will look to short the currency for a quick trade where long-term traders will look to buy the currency at a depreciated price. This divergence between trader’s mindsets is what creates the volatility associated with news reports and can be a very powerful tool in any trader’s arsenal. Generally speaking, the short-term trade only works when the reports beat or miss by a significant margin, if reports are released as expected there is little cause for short-term volatility. It is also important to consider the significance of the news report, a 2% GDP miss in the United States is going to create a lot more action than the same margin of error in durable goods orders in Pakistan.
The carry trade is a very popular Forex strategy that does not involve buying and selling currencies but rather holding on to them to collect interest payments. In the spot market, interest is paid on the long portion of a currency pair and deducted on the short portion. Recall that entering a Forex position involves buying one currency while selling another. The carry trade works by buying pairs that have a disparity in interest rate charges therefore allowing the holder to collect the difference. Interest rates change as the exchange rate changes, thus carry trades work best when prices remain constant. Interest paid and earned is reconciled on a daily basis, thus the cost of “carrying” a position overnight is established. The highly leveraged nature of Forex investing allows investors to earn higher returns than a traditional savings account with a smaller investment.
Consider this example:
- Enter a long CAD/EUR currency pair, $100,000 position, 100:1 leverage.
- Long CAD yields 3.75%
- Short EUR costs .25%
- Profit is 3.5% – the difference between interest received and interest paid, $3500
There are three situations to consider when analyzing the risk and reward of the carry trade: currency appreciation, deprecation, and stagnation. Currency appreciation, an increase in the position’s value, is the best case scenario. In this circumstance, profits will be the $3500 from the carry trade based on interest disparity plus the gains earned on the currency pair. Conversely, currency depreciation, a decrease in the position’s value, represents the worst case scenario. A move to the downside will likely result in margin call, and thus a loss on both the interest earned and the principal invested in the currency pair. Although interest income will offset capital losses, if the depreciation in the paring is great enough the trade will still result in a loss. The risk of currency depreciation is the primary risk of the carry trade and should be carefully considered before investing any money. The third scenario is currency stagnation, or prices remaining constant. Under these circumstances profits are entirely based upon the interest rate disparity as the currency pair has not changed in value. Remember, the main goal of carry trades is to profit off of interest payments so trades should be entered with the expectation of being involved over a long time frame. In general, less volatile currency pairs will have lower interest rate disparity. Some investors seek these pairs despite the lower returns as they carry less risk. Currencies such as the Japanese Yen, which have extremely low interest rates, are very attractive to carry traders as a funding source. On the flip side, the Aussie dollar is known for having a very high interest rate and thus is very attractive as a carry trade income source. Other investors might look to use interest earned from carrying to offset the risk in a more volatile pairing that they have an opinion on the future value of. Regardless, analyzing the synergy between interest rate parity and the trend in price action should be the primary concern of carry traders.
One of the most common and simple trading strategies out there is the breakout trade. Breakouts occur when the price action of a currency pair breaks out of a consolidation area or trading range. Usually consolidation areas occur below major resistance areas or above major support areas. When these support and resistance areas are violated traders on the opposite side of the trade move to cover their positions as many traders place stop loss orders on the other side of major support and resistance levels. This often results in an abnormally large amount of buying or selling in the direction of the breakout which in turn pushes the price higher and higher. Breakouts occur on all time frames, and like other signals become more relevant the higher the time frame. The main risk associated with breakouts is the failed breakout, or head fake. Failed breakouts occur for the same reason that breakouts work- they occur at major support and resistance areas. If momentum is not strong enough when the level is broken the breakout will not have enough steam behind it and will likely fail to make any significant move. Traders often refer to this as a head fake as the price action will make a tiny blip in the direction of the breakout and then immediately fall apart, often moving very violently in the opposite direction as breakout traders scramble to cover their quickly deteriorating positions. Breakouts that occur in conjunction with a major economic news release have the greatest probability of succeeding as the news event will naturally draw more players into the market.
At any given point in time, all currency pairs can be described by one of these three characteristics- up-trends, down-trends, and trend reversals. Spotting up and down trends is relatively simple. Most traders use moving averages to track price action over a predetermined length of time. If the moving averages have a positive slope the trend is up; if the moving averages have a negative slope the trend is down. Traders may also manually draw trend lines as they see fit and once again, the slope of the line defines the trend. Spotting changes in trends is much more difficult as most traders look for trends to continue. Reversals are often counterintuitive, but nothing keeps going up or down in a straight line forever. Fortunately, there are momentum oscillators to help traders spot potential reversals and act accordingly. The most commonly used momentum oscillators is the moving average convergence divergence, or MACD. The MACD follows price action through two moving averages, one slow and one fast, and then plots the difference between the two on a histogram. As momentum increases, the faster moving average pulls away from the slower moving average and the histogram grows in the direction of the difference. A positive histogram reading indicates upward momentum while a negative reading indicates downward momentum. The MACD is very useful to Forex traders for two main reasons- confirmation of trends and spotting trend reversals. MACD confirmation occurs when you enter a position on either side of the market and the MACD histogram begins to grow in your direction. This indicates that momentum is on your side and the trade is likely to work out in your favor. Although it is unwise to make entry and exit decisions purely on the MACD, many traders will not enter trades if the MACD is not on their side, or neutral at the very least. The second use for the MACD is identifying changes in trends. Recall that we have defined an uptrend as a series of higher highs and higher lows. Consider a currency pairing that is moving in an uptrend, putting in higher highs and higher lows, with a positive MACD. One day the pairing makes a higher high but the MACD fails to follow. In fact, the MACD makes a lower low as the pairing is making a higher high. This is known as a divergence, and is a strong signal that a change in trend is about to occur, most often in the form of a double top or double bottom. MACD divergences are leading indicators and therefore a very important tool for most Forex traders as identifiers of both entries and exits.
There are many different trading systems out there, but most seek to accomplish the same two goals- identify trends early enough to make a trade and identify trends relevant enough to avoid getting shaken out. Generally speaking, trading systems based on longer time frames will produce fewer signals that are more relevant while trading systems based on shorter time frames will produce many more signals that might not work as often. Regardless of your trading style it is important to make sure that your trading system is calibrated to meet your needs. After deciding what time frame you intend to operate on you will need to find indicators that identify trends as early as possible. Common trend indicators are moving average crossovers, oscillator centerline crossovers, and short-term consolidation breakouts. Next, you will want to find indicators that will keep you for entering trades that are irrelevant. The most popular confirmation indicators are the moving average convergence divergence (known as MACD), the relative strength index (RSI), and the stochastic momentum oscillator. The next step is to define your risk and design entries and exits. It is important to identify your risk on both a trade-by-trade and overall basis. Furthermore, you must identify your profit targets to ensure consistency across all trades. Once again, it does not matter what type of trader you are as there are many ways to make money trading, the key to success is adaptability and consistency. The final, and ironically most often overlooked, step is to follow your system. Give two traders the exact same system, one a veteran and one a rookie, and the veteran will out earn the rookie 100% of the time for one reason- discipline. So many traders out there spend countless hours developing their systems through and through and then fail to follow their rules when it’s time to execute. Greed is the most common culprit; trying to squeeze a few extra pips out of a trade almost always ends poorly, and in the worst-case scenario turns a winner into a loser. After developing a trading system, and often along the way, you will want to test it against historical data. This can be done by hand, an often tedious task but very useful, or through computer programs that have become readily more available. When back testing it is very important not to overanalyze the results- the numbers don’t lie and you run the risk of optimizing a system to a set of data. Conversely, you should look for a happy medium between number of winners vs. losers and average dollar amount of winners vs. losers. Once you have developed your system, back tested it, and revamped it, it’s time to go live. It is recommended that you paper trade your system for at least a month to make sure that it is performing up to historical standards before trading any real capital.
Currency correlation represents the strength in the relationship between two currency pairs over a predetermined length of time. Correlations range from -1 to 1 with 0 being the centerline. A correlation of 1 is known as a perfect positive correlation and represents a relationship in which two currencies behave in the exact same way- their charts would be identical. A correlation of -1 is known as a perfect negative correlation and represents an inverse relationship in which two currencies are exact opposites- their charts would be mirror images of one another. A correlation of 0 is known as no correlation and represents no relationship at all- charts would be completely random with no measureable relationship between the two pairs. In practice, correlations are rarely perfect, but often lie somewhere in between the centerline and the two extremities. There are a few key points when considering correlation. A positive number indicates that the two pairs move together while a negative number indicates that they move in opposite directions. A correlation between -.5 and .5 is generally considered non-correlated, and one should not expect the two pairs to follow one another. Correlations greater than .75 and less than -.75 are considered strong enough to be actionable and it is reasonable to expect the two pairs to follow one another or, in the case of negative correlation, operate in a predictably inverted fashion. Consider the following chart examples of how correlation works between various currencies:
The following chart shows the Aussie (AUD/USD) in blue and the Kiwi (NZD/USD) in red. As you can see, these two currencies demonstrate strong positive correlation- they move virtually in lock step with one another. A trend change in one of these currencies is likely to be followed by the other.
The following chart shows the Euro (EUR/USD) in blue and the Yen (USD/JPY) in red. As you can see, these two currencies demonstrate strong negative correlation- they move in an inverse relationship. As one rises the other falls, and vice versa.
- Let’s say the Japanese Ministry of Finance announces a restructuring in Japan’s trade policy that will effectively double the demand for Japanese products.
- As a result, global demand for the Japanese Yen will increase as foreign importers will have to convert their currencies into the Yen to purchase these Japanese goods.
- Trader A purchases the USD/JPY because the United States is Japan’s main trading partner.
- Trader B purchases the USD/JPY, GBP/JPY, EUR/JPY, CAD/JPY, and AUD/JPY.
After the announcement:
- The USD/JPY blips up 15 pips momentarily then settles back to its original value as the Japanese government takes actions to stabilize the Yen against the dollar.
- The EUR/JPY and GBP/JPY currencies behave similarly, although end up appreciating 10 pips each when all is said and done.
- The AUD/JPY skyrockets 50 pips as investors look to reposition themselves within the Asia–Pacific market space.
- The CAD/JPY depreciates slightly as most investors choose to focus on Japan’s bigger trade partners.
Trader A sees an immediate increase in his positions’ values reflected on his Profit/Loss statement. Assuming this will continue he does not cover any of his positions and lets his position ride without stop-exits in place. Minutes later the USD/JPY is back at his entry price and Trader A, for all intents and purposes, has missed out on any chance of making a profit based on the news.
Trader B sees his basket of currencies fluctuating in value both positively and negatively. He notices that the AUD/JPY is leading the pack and adds to the position. The CAD/JPY is depreciating while the others are up, flat at the worst, so he cuts the losing position. As the USD/JPY settles back to its original resting place he aggressively takes profits in the AUD, GBP, and EUR positions. He places break-even stop-exits on his remaining positions, if they run higher he will look to take profits, but he is walking away with a profit regardless. Given that this was a news driven event, Trader B moves his attention to other areas of the market, and congratulates himself on a job well done.
By trading the news event with a basket of currencies Trader B significantly increased his chance for success when compared to Trader A. This works because although there is a precedent for how the market will react to most events; the actual price action is never known until it has occurred. Trader A is not wrong for choosing only the USD, however he is limiting his success to one currency behaving exactly how he expects it to. He did not lose any money on the trade, but he also did not make much, if any at all. Trader B experienced a loss on his CAD/JPY position, but by following money management rules he kept the loss small. By trading a basket of currencies, he was able to offset the loss entirely with the profits he made on either the GBP or EUR positions. The USD position ended up flat just like Trader A. Where Trader B really comes out on top is through his AUD position, by including this in his basket Trader B significantly outperformed Trader A.
It is important to note that when basket trading you should place an equal valuation on each position and avoid “picking favorites”. Basket trading also should inherently involve smaller positions. If you normally trade in $100,000 lots your basket total should equal $100,000, not each individual position. In the previous example this would be 5 positions of $20,000 as opposed to 5 positions of $100,000. The point of basket trading is to reduce risk by diversifying. Consider the case where every position in your basket is a loser- the loss should be equivalent to the loss on one normal position, not 5 times larger.
Another commonly used strategy is the midnight trade. The midnight Forex trade is an advanced trading strategy based entirely on technical analysis. The theory behind the trade is that although currency pairs exhibit an average trading range (ATR) based on recent highs and lows, the size and shapes of these days as demonstrated through their candlesticks will almost always be different. This makes sense because it is virtually impossible for a currency to open at 1.93 and close at 1.96 one day, and then open back down at 1.93 only to close back up at 1.96 the following day. This is the case because Forex trades 24 hrs a day and thus overnight gaps themselves are a rarity.
The strategy is executed by monitoring price action as midnight approaches as placing orders slightly after the new day begins. At this point, you might be wondering what is so special about midnight, which is certainly a valid question. The significance of the midnight hour is that this is the hour when a new candle will be formed on a daily chart and thus the earliest moment a trade can be made based on the previous day’s high and low. In essence, this strategy is designed to give you the “first mover advantage” on a breakout or break down of the previous day’s range with the advantage of knowing where the momentum is heading based on the previous day’s close.
There are two ways to execute this strategy and trades, in either case trades are generated on both the long and short side. The first of these is to place entries based on the opening or closing price of the previous day. This price is represented by the top and bottom of the body on a candle, respectively. Placing entries based on the previous day’s open or close will result in more trades triggered but is a weaker signal. These trades may be subject to a higher whipsaw rate and tighter stops should be used accordingly.
The second way to execute this strategy is to place entries based on the highest or lowest price of the previous day. This price is represented by the top and bottom of the wick on a candle, respectively. Placing entries based on the previous day’s high or low will result in fewer trades triggered but is a stronger signal than those based on the open and close. These trades may take longer to develop and thus slightly wider stops should be used. Generally speaking, the opening or closing price will be closer to the price action at midnight than the high or low, as such, these trades are likely to occur earlier on in the day.
Consider the following graphic that illustrates common characteristics of the two trades:
The following examples will illustrate how this trade works in a number of ways:
In this first example, the GBP/USD is shorted below the open of the previous day’s candle:
- You notice that the GBP/USD is having difficulty breaking through 1.5850
- On December 13 GBP/USD finally closes above this level, but pulls back hard off the high of the day
- Slightly after midnight on the 14th you place a short sell order below the previous days open (bottom of the body) at 1.5795
- You are executed (also referred to as filled) at 8:00 on the 14th and the GBP/USD never looks back
- The trade runs all the way down to 1.53 for a nearly 500 pip profit
This can be shown graphically:
In this second example, the GBP/USD is bought above the high of the previous day’s candle:
- On January 10th you notice that the GBP/USD has been very strong lately, about to close up 2 days in a row for the first time since December 23rd/24th
- Slightly after midnight on the 11th you place a buy order above the previous day’s high (top of the wick) at 1.56
- You are executed (filled) at 10:00 on the 11th. 1.56 acts as support for roughly 24 hours before GBP/USD gains traction and takes off
- The trade runs all the way up to 1.60 for a 400 pip profit
This can be shown graphically: