Forex was once a marketplace available only to governments, central banks, commercial and investment banks and other institutional investors like hedge funds. Today, however, there are many venues where just about anyone can trade currencies. These include currency futures, options on futures, PHLX-listed foreign currency options and the largely unregulated over-the-counter (OTC) forex market. Once the forex trader has decided which venue(s) and instrument(s) he or she will trade, it's time to develop a well-conceived trading strategy before putting any trading capital at risk. Successful traders must also predetermine their exit strategies and other risk-management tactics, which will be used if the trade goes against them. Here we look at how to develop a trading strategy for the currency markets based on directional trading.(To review some of the concepts in this piece, check out Basic Concepts For The Forex Market and Common Questions About Currency Trading.)
Develop a Trading Strategy
One way to organize the multitude of potential strategies is to group them into directional and non-directional approaches. Directional trading strategies take net long or short positions in a market, as opposed to nondirectional (market-neutral) strategies. Most investors are familiar with the directional approach; for example, millions of people participate in some form of retirement program, which is basically a long-term portfolio of equity and/or debt securities held long by the investor. Net long strategies are profitable in rising markets, while net short investors should profit in falling markets. Directional strategies can be loosely grouped into the following subcategories:
- Trend-following strategies
- Moving average crossover systems
- Breakout systems
- Pattern-recognition strategies
This list is not all-inclusive, as there are many other approaches to trading forex. (For more, read Trading Double Tops And Double Bottoms and Identifying Trending & Range-Bound Currencies.)
Trend-following systems create signals for traders to initiate positions once a specific price move has occurred. These systems are based on the technical premise that once a trend has been established, it is more likely to continue rather than reverse. (Read more about trends in the forex market in Trading Trend Or Range?)
Moving-Average (MA) Crossover
The moving average (MA) crossover trading system is one of the most common directional systems in use today. This system uses two MAs. Buy signals are generated when the shorter-term, faster-moving MA crosses over the longer average. This indicates that the near-term price action is accelerating to the upside.
These systems are susceptible to false signals, or "whipsaws". As such, traders should experiment with different time periods and conduct other backtesting before trading.
This crossover system posted a buy signal when the five-day crossed over the 20-day to the upside in March 2008. The position is closed once either a downside crossover occurs (as posted in May, right side of chart), or the trade reaches a predetermined price objective.
Breakout systems are extremely easy to develop. They are basically a set of predefined trading rules based on the simple premise that a price move to a new high or low is an indication of a continuing trend. Therefore, the system triggers an action to open a position in the direction of the new high/low.
For example, a breakout system may state that the trader should close all shorts and open a long position if the day's closing price exceeds the high price for the past X days. Part two of the same breakout system will state that the trader must close longs and open a short position if the day's close is below the X day's low print. The secret is to determine the length of the period you'd like to trade. Shorter time periods (faster systems) will detect trending markets faster than slower systems. The drawback is that more whipsaws will occur with faster systems.
A thorough discussion of every pattern used by forex traders is obviously beyond the scope of this article. As such, we will look at a few popular continuation patterns used by traders. (For more on charts patterns, read Price Patterns - Part 1.)
Triangles can signal trend reversals, but most often they are continuation patterns (meaning that the resolution of the triangle will result in the resumption of the prior trend). There are several different types of triangles, each possessing its own unique characteristics and forecasting implications.
Traders should open positions once the price action breaks out beyond the converging boundaries of the triangle. In this case, the trader will buy the British pound once the price breaks out above the upper boundary near 1.99.
One way to forecast the extent of the resulting move is to measure the distance of the triangle base and add that distance to the level where the breakout occurred (~.04 to ~.05 + 1.99 = 2.04)
Figure 2: Symmetrical pattern at the midpoint of a bullish move
Flags are continuation or consolidation patterns that usually display a period of back-and-forth action sloped against the primary trend. Pennants have shown to be extremely reliable. They almost always consolidate the prevailing trend and very rarely signifying a trend reversal. As with triangles, traders should open positions upon a breach of the boundary. Like other continuation patterns, flags often occur near the midpoint of a primary move.
|Figure 3: Textbook bullish flag, sloped against the direction of the primary trend|
There are a number of ways traders can reduce risk and avoid the catastrophic losses that will wipe out trading capital. Traders can set arbitrary points at which they must exit losing positions. They can also place stop orders. Another popular way to trade is to design mechanical trading systems or so-called black-box systems that use an overriding preprogrammed logic to make all trading decisions.
There are several perceived benefits to using mechanical trading systems. One is that the core danger emotions of fear and greed are eliminated from the bulk of your trading. These systems help traders avoid common mistakes such as excessive trading and closing positions prematurely. Another benefit is consistency. All signals are followed because the market conditions required to trigger a signal are detected by the system. Mechanical systems naturally force traders to control losses, since a reversal will arbitrarily trigger a new signal, reversing or closing the open position. (Read more about the effects of excessive trading on your portfolio in Tips For Avoiding Excessive Trading.)
Mechanical systems are only as good as the input data and backtesting conducted before beginning the trading campaign. The simple reality is that there is no perfect way to simulate real market conditions. Eventually, the trader must enter the markets and put real money at risk. You can paper-trade and backtest all you want, but the true test is when you go live.
Traders must always review and evaluate the efficacy of their strategies. Market conditions are constantly changing, and traders must adapt their systems to whatever market conditions they find themselves in.
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