What Is a Forex Trading Strategy?

A forex trading strategy is a technique used by a forex trader to determine whether to buy or sell a currency pair at any given time.

Forex trading strategies can be based on technical analysis or fundamental, news-based events. The trader’s currency trading strategy is usually made up of trading signals that trigger buy or sell decisions. Forex trading strategies are available on the internet or may be developed by traders themselves.

Key Takeaways

  • The forex market is the largest market in the world with a daily volume of around $6.6 trillion.
  • Forex trading strategies are the use of specific trading techniques to generate profits from the purchase and sale of currency pairs in the forex market.
  • Manual or automated tools are used to generate trading signals in forex trading strategies.
  • Traders working on their own trading systems should backtest their strategies and paper trade them to ensure that they perform well before committing capital.
  • One way to learn to trade forex is to open up a demo account and try it out.
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Forex Market Basics

Basics of a Forex Trading Strategy

Forex trading strategies can be either manual or automated methods for generating trading signals. Manual systems involve a trader sitting in front of a computer screen, looking for trading signals and interpreting whether to buy or sell. Automated systems involve a trader developing an algorithm that finds trading signals and executes trades on its own. The latter systems take human emotion out of the equation and may improve performance.

Traders should exercise caution when purchasing off-the-shelf forex trading strategies since it is difficult to verify their track record and many successful trading systems are kept secret.

 One way to learn to trade forex is to open up a demo account and try it out.

Creating a Forex Trading Strategy

Many forex traders start with a simple trading strategy. For example, they may notice that a specific currency pair tends to rebound from a particular support or resistance level. They may then decide to add other elements that improve the accuracy of these trading signals over time. For instance, they may require that the price rebound from a specific support level by a certain percentage or number of pips.

There are several different components to an effective forex trading strategy:

  1. Selecting the market: Traders must determine what currency pairs they trade and become experts at reading those currency pairs.
  2. Position sizing: Traders must determine how large each position is to control for the amount of risk taken in each individual trade.
  3. Entry points: Traders must develop rules governing when to enter a long or short position in a given currency pair.
  4. Exit points: Traders must develop rules telling them when to exit a long or short position, as well as when to get out of a losing position.
  5. Trading tactics: Traders should have set rules for how to buy and sell currency pairs, including selecting the right execution technologies.

Traders should consider developing trading systems in programs like MetaTrader that make it easy to automate rule-following. In addition, these applications let traders backtest trading strategies to see how they would have performed in the past.

Leverage

If you have limited capital, you can see if your broker offers high leverage through a margin account. If capital is not a problem, any broker with a wide variety of leverage options should do. A variety of options lets you vary the amount of risk you are willing to take. For example, less leverage (and thus less risk) may be preferable for certain individuals.

When Is It Time to Change Strategies?

A forex trading strategy works really well when traders follow the rules. But just like anything else, one particular strategy may not always be a one-size-fits-all approach, so what works today may not necessarily work tomorrow. If a strategy isn't proving to be profitable and isn't producing the desired results, traders may consider the following before changing a game plan: 

  1. Matching risk management with trading style: If the risk vs. reward ratio isn't suitable, it may be time to change strategies. 
  2. Market conditions evolve: A trading strategy may depend on specific market trends, so if those change, a particular strategy may become obsolete. That could signal the need to make tweaks or modifications.
  3. Comprehension: If a trader doesn't quite understand the strategy, there's a good chance it won't work. If a problem comes up or a trader doesn't know the rules, the effectiveness of the strategy is lost.

Although change can be good, changing a forex trading strategy too often can be costly. If you modify your strategy too often, you could lose out.

Example of a Basic Forex Trading Strategy

Most successful forex traders develop a strategy and perfect it over time. Some focus on one particular study or calculation, while others use broad-spectrum analysis to determine their trades. One simple strategy is based on relative interest rate changes between two different countries.

Imagine a trader who expects interest rates to rise in the U.S. compared to Australia while the exchange rate between the two currencies (AUD/USD) is 0.71 (i.e., it takes $0.71 USD to buy $1.00 AUD). The trader believes higher interest rates in the U.S. will increase demand for USD, and the AUD/USD exchange rate will thus fall because it will require fewer, stronger USD to buy an AUD.

Assume that the trader is correct and interest rates rise, which decreases the AUD/USD exchange rate to 0.50. This means that it requires $0.50 USD to buy $1.00 AUD. If the investor had shorted the AUD and went long the USD, they would have profited from the change in value.

Frequently Asked Questions

Where can I trade currencies on the forex market?

There are many online forex brokers to choose from, just as in any other market. Look for platforms that feature low fees and tight spreads. Make sure your broker is covered by a regulatory body and has a solid reputation. For more advanced traders, a platform with charting tools and algorithmic trading is also a plus.

What is a "pip" in forex?

Pip is an acronym for "percentage in point" or "price interest point." A pip is the smallest price move that an exchange rate can make based on forex market convention. Most currency pairs are priced out to four decimal places and the pip change is the last (fourth) decimal point. A pip is thus equivalent to 1/100 of 1% or one basis point.

What is the easiest trade in forex?

Like all financial markets, there is no free money in forex trading. However, the simplest strategy from a mechanics perspective is simply speculating that one currency will rise or fall in value relative to another. Of course, if you gauge the direction of the bet wrong, you could lose money.

What is the carry trade in forex?

A currency carry trade is a popular strategy that involves borrowing from a low-interest rate currency and to fund purchasing a currency that provides a higher rate of interest. A trader using the carry trade attempts to capture the difference between the two interest rates, which can be substantial depending on the amount of leverage used.

What is trade size in forex?

Depending on your level of expertise and amount of capital, there are several standard trading (lot) sizes for forex accounts. Standard forex accounts require order lots of 100,000 base units, Mini accounts are standardized at 10% of that, or 10,000 lot trades. Meanwhile, the even smaller micro accounts allow 1,000 base unit trades and nano accounts just 100 (although nano accounts aren't always available). What this means is that standard accounts must enter orders in multiples of 100,000, whereas mini account holders place trades in multiples of 10,000, and so on.