Welcome to forex trading – a global market that runs on a 24/7 basis, offering enormous opportunities for the traders ready to take the plunge.
This article discusses the guidelines and outline to build a trading model for forex or currency trading. Also discussed are the relevant points about how forex trading is different than equity trading, as well as specific points to be considered for building the forex trading model.
The great advantage with markets is that it accommodates all sorts of theories (fundamental, technical, price action, etc.), allowing market participants enormous opportunities, who follow varied patterns and principals to trade. It’s a matter of time - one is either losing or winning at any particular moment. When carefully done, building a trading model based on a clearly conceptualized strategy allows reducing the losing trades and improving on the number of winning trades, thereby enabling a systematic approach to profit.
As a general thought and process flow, building a trading strategy can be captured within the following steps, as demonstrated in this figure:
However, a few specific inputs may be needed for forex specific trading, which are discussed below.
How forex trading is different
Theoretically, forex rates are said to move due to two fundamental concepts – interest rate parity and purchasing power parity. Significant differences between forex trading and stock trading are that forex market is global in nature, moves on 24/7 basis and regulation remains limited. This leads to highly sensitive, unpredictable and susceptible variations in forex price movements. Primary drivers of forex rates include news items e.g. issued statements from government officials, geo-political developments, inflation and other macro-economic figures, etc.
How To Build A Forex Trading Model
Let's discuss the steps to build a forex trading model.
Identify/conceptualize a trading strategy:
Building a trading model requires identifying suitable opportunities, which in turn involves choosing any defined strategies, or conceptualizing new ones as variants of standard ones. Trading strategy remains the heart of any trading model, as it clearly dictates the rules to be followed, entry/exit points, profit potential, duration of trade, risk management criteria, etc. For e.g., here are two popular forex trading strategies:
- News Fade: Irrational forex market often moves due to news following release of official numbers like (GDP numbers, employment figures, non-farm payroll data release, etc.). An effect commonly observed immediately after news release is a high level of volatility leading to significant price fluctuations. However, around 15 minutes after the news break, prices are often observed to move back to earlier levels, which were maintained just prior to news release. Models can be built to capitalize around these opportunities.
- Inside day breakout: Inside day pattern applies to candlesticks, where today's high and low range is within high-low range of the previous day, indicating reduced volatility. There can be multiple inside day patterns day after day, indicating continuous reduction in volatility and hence significantly increasing the possibility of a breakout. Forex traders build models and strategies based on this concept.
Identify the forex security to trade:
Forex trading specific strategies require a careful selection of the following:
- Assets – will the trade involve simply trading currency notes, or trading forex futures, forex options or more advanced forex exotics derivatives (like barrier options)?
- Currency pair(s) worth trading as per the identified strategy (like EURUSD, JPYAUD, etc.)
- Which forex currency group - major, minor and exotic currencies – do the selected forex pair belong to, as these categories demonstrate specific characteristics
Plug-in the forex specific parameters:
Post trade strategy and tradable security identification, the next step for building a forex trading model is to introduce forex strategy specific parameters which may include:
- News dependency: Unless one is a very long term investor, no forex trader can afford to ignore associated news specific to geo-political developments, state of the economy, announcement of associated macros economic figures, etc. The trading model should have consideration for inclusion of news impact - wholly or partially, manually or automated – to the extent of fitting into the forex trading model.
- Timing the trade: The forex trading model should account for timing dependencies, if there are any, like follows:
- take a position just before macroeconomic figures are announced
- trading a forex currency pair which has more volatility during off hours – like an Australian trader trading on EURUSD currency pair during Australia night time
- exotic currency trading, which takes place only during business hours at designated banks and OTC markets
- Technical tools, fundamental factors and monitoring requirements: If the selected strategy requires constant monitoring of DMA charts or Bollinger bands ®, or calculations based on fundamental/macroeconomic figures, the forex trading model should be equipped to include all necessary tools for these requirements.
Set Trading objectives:
This step primarily concentrates upon incorporating the following basic features into the trading model, with varying values to find the best fit:
- Profit Levels (like pips movement)
- Stop Loss Levels
- Money Management: How much money to bet on each trade, in which style (fix amount per trade or variable amounts with progressive changes)
- Risk Management and scenarios analysis consideration, as applicable
One may start with a few assumptions, and fine-tune those as more iterative tests are conducted to find the best profitable fit.
Back-testing the model:
Any trading model which is developed by an individual reflects the characteristics, thought process, temperament and experience of the trader who builds it. Often constrained by knowledge or even personal challenges of ego or blind belief in self developed models, important aspects are occasionally overlooked by the traders. It hence becomes important to test the model on historical data, to identify the errors and avoid such losses in real world trading. Backtesting also allows required customization within the set objectives (profit targets, stop-losses, etc.) to further fine tune the developed model and strategies, ensuring practical realization of maximum profit potential.
Iterative analysis for trading model:
Developing a trading model requires patient analysis, which includes numerous iterations by repetitive changes to mathematical parameters, as well as variations in underlying theoretical concepts. During this cycle, it helps to record the failure and success cases, so as to keep a record of what works and what’s not, which are useful over the long years of trading career.
Using computers for trade automation and model building:
Today, it's trendy to attempt to automate everything. But remember - "The program is as efficient as the underlying concepts and the practical implementation built in it."
Computers can be used to search for patterns in historical data which can form the basis of developing new models. Back testing can also be aided by computer programs being run against historical data.
One can either use the available applications on trial or purchase basis, or build new ones on their own for their requirements based on their familiarity with computer programming. Be sure to use the computer programs with a full understanding and applicability to your own selected strategies, to avoid any pitfalls later with real money trading.
The Bottom Line:
One major advantage of using trading models is that it takes away the emotional attachments and mental roadblocks while trading, which are known to be the major reasons for trade failures and losses. While it’s always exciting to trade through established models in a defined and systematic way, wise traders always keep looking for possibility of failures and continuous customization for further success, based on market developments. A pragmatic approach, with continuous monitoring and improvements can help profitable opportunities through trading models.