What Exactly Is a Forex Trading Strategy?
A forex trader uses a forex trading strategy as a method to decide whether to buy or sell a currency pair at any particular moment.
Technical analysis or fundamental, news-based events can serve as the foundation for forex trading methods. The typical component of a trader’s currency trading strategy is the use of trading signals to initiate buy or sell decisions. Forex trading techniques can be found online or created by traders themselves.
Basics of a Forex Trading Strategy
Forex trading techniques can generate trade signals manually or automatically. A trader in a manual system sits in front of a computer screen, searching for trading signals and deciding whether to buy or sell. A trader creates an algorithm that discovers trading signals and performs deals on its own in automated systems. The latter technologies remove human emotion from the equation, perhaps improving performance.
When acquiring off-the-shelf forex trading techniques, traders should take care because it is impossible to evaluate their track record and many effective trading systems are kept hidden.
Long and short trades are the most fundamental types of forex transactions. A long trader is wagering that the currency price will rise and that they will benefit from it. A short trade is a wager that the price of a currency pair will fall. Traders may also fine-tune their trading method by employing technical analysis strategies such as breakout and moving averages.
Trading strategies are classified into four groups based on their duration and number of trades:
- A scalp trade consists of accumulative positions maintained for little more than a few seconds or minutes, and the profit margins are constrained in terms of pip values.
- Short-term transactions known as day trades include holding and liquidating holdings on the same day. A day trade might last for hours or minutes.
- The trader keeps the position in a swing trade for several days or perhaps several weeks, rather than just one day.
- A position trade involves holding the currency for a lengthy time—months or even years—by the trader.
Developing a Forex Trading Strategy
Many forex traders begin with a straightforward trading approach. They may note, for example, that a certain currency pair tends to bounce from a specific support or resistance level. They may then elect to incorporate other components that, over time, increase the accuracy of these trading signals. They may, for example, demand that the price recover from a given support level by a specified percentage or number of pips.
An efficient forex trading strategy has numerous components:
- Choosing a Market – Traders must decide which currency pairings to trade and become specialists at interpreting them.
- Position sizing – Traders must select the size of each position in order to manage the level of risk in each particular trade.
- Entry points – Traders must come up with criteria that specify when to start a long or short position in a certain currency pair.
- Exit points – Traders must establish guidelines that specify when to get out of a winning or losing position, as well as when to quit a long or short position.
- Trading tactics – Using the appropriate execution technology is only one of the guidelines that traders should follow when buying and selling currency pairs.
Trading systems should be created on platforms like MetaTrader, which make automating rule-following simple. These tools also enable users to backtest trading methods to evaluate how well they might have done in the past.
How Currencies Are Traded
Every currency is given a three-letter code, similar to the ticker symbol of a stock. Although there are more than 170 other currencies in the world, the U.S. dollar is used in the great majority of forex trades, thus understanding its code, USD, is very useful. The euro, which is accepted in 19 member states of the European Union, is the second most popular currency on the forex market (sign: EUR).
The British pound (GBP), the Australian dollar (AUD), the Canadian dollar (CAD), the Swiss franc (CHF), and the New Zealand dollar (NZD) round out the list of other significant currencies.
A combination of the two currencies being exchanged is used to represent all forex transactions. Approximately 75% of trading on the forex market is conducted using the following seven currency pairings, referred to as the majors:
- EUR/USD
- USD/JPY
- GBP/USD
- AUD/USD
- USD/CAD
- USD/CHF
- NZD/USD
The exchange rate between the two currencies is shown by each currency pair. Following is an explanation of how to understand that data using EUR/USD, or the euro-to-dollar exchange rate:
- The base currency is the euro, which is shown on the left.
- The quotation currency is represented by the U.S. dollar on the right.
- How much of the quote currency is required to purchase one unit of the base currency is indicated by the exchange rate. As a result, the quotation currency fluctuates depending on the market and how much is required to purchase 1 unit of the base currency. The base currency is always stated as 1 unit.
- If the EUR/USD exchange rate is 1.2, then €1 will be equivalent to $1.20 (or, to put it another way, €1 will be equivalent to $1.20).
- Because one euro will now purchase more U.S. dollars, when the exchange rate increases, it indicates that the base currency’s value has increased relative to the quote currency. In contrast, if the exchange rate decreases, the base currency’s value has decreased.
A brief reminder: Although there is a historical standard for how some currency pairings are represented, currency pairs are typically presented with the base currency first and the quote currency second. For instance, conversions from USD to EUR are reported as EUR/USD but not USD/EUR.
Forex for Hedging
When businesses do business outside of their home markets, they run the risk of losing money owing to volatility in currency values. By establishing a rate at which the transaction will be executed, foreign exchange markets offer a mechanism to mitigate currency risk. A trader can lock in an exchange rate by buying or selling currencies in advance on the forward or swap markets.
Depending on which currency in a pair is stronger or weaker, securing the exchange rate enables them to cut losses or boost gains.
Use of Forex for Speculation
The supply and demand for currencies are influenced by a number of variables, including interest rates, trade flows, tourism, economic strength, and geopolitical risk, which results in daily volatility in the forex markets. This makes it possible to profit from shifts that can elevate or depreciate the value of one currency in relation to another. If one currency is expected to decrease, it is generally assumed that the other currency in the pair would rise.
A trader who anticipates price movement might profit from it by shorting or longing one of the currencies in a pair.
How to Begin Forex Trading
Equity trading and FX trading are comparable. Here are some actions you may do to begin your forex trading experience.
- Learn about forex: Although it is not difficult, trading forex is a task that calls for specific knowledge and a dedication to study.
- Create a brokerage account: To begin trading foreign exchange, you will need a forex trading account with a brokerage.
- Create a trading plan: Although timing and market prediction are not always achievable, having a trading strategy can help you establish broad principles and a road map for trading.
- Keep track of your numbers at all times: After you start trading, check your positions. A daily accounting of trades is already offered by the majority of trading software. Make sure you have enough money in your account to execute future transactions and that there are no open positions that need to be completed.
- Cultivate emotional equilibrium: Beginning forex trading is riddled with emotional roller coasters and unresolved issues. Discipline yourself to close out your positions when required.
A Basic Forex Trading Strategy Example
The majority of profitable forex traders create a strategy and refine it over time. While some choose to concentrate on a single research or calculation, others choose to make their trades using a broad range of data. One straightforward method is based on relative changes in interest rates between two distinct nations.
Consider a trader who anticipates higher interest rates in the US than in Australia at a time when the AUD/USD exchange rate is 0.71 (i.e., it costs $0.71 USD to buy $1.00 AUD). The trader thinks that if demand for USD increases as a result of increasing U.S. interest rates, the AUD/USD exchange rate would decline since it will take fewer, stronger USD to purchase a AUD.
In the event that the trader is right and interest rates increase, the AUD/USD exchange rate will drop to 0.50. Accordingly, $0.50 USD is needed to purchase $1.00 AUD. The investor would have made money from the value move if they had shorted the AUD and gone long the USD.
Graphs for Forex Trading
Forex trading employs three different sorts of charts. As follows:
Line Charts
For a currency, line charts are used to determine broad patterns. They are the most fundamental and typical kind of chart that forex traders utilize. They show the currency’s closing trading price for the time periods that the user has chosen. A line chart’s trend lines may be utilized to create trading strategies. For instance, you may use the data in a trend line to spot breakouts or a shift in the direction of the trend for increasing or falling prices.
A line chart is frequently utilized as the beginning point for additional trading analysis, despite its value.
Bar Charts
Bar charts offer more pricing information than line charts, as they do in other applications. Each bar chart shows the opening, highest, lowest, and closing prices (OHLC) for each deal for a single trading day. The beginning price of the day is shown on the left by a dash, and the closing price is indicated on the right by a similar dash. Sometimes, colors are used to represent price change; green or white are used to represent periods of rising prices, while red or black are used to represent periods of declining prices.
When trading currencies, bar charts may be used to show whether a market is more favorable to buyers or sellers.
Candlestick Charts
Candlestick charts were initially utilized by Japanese rice dealers in the 18th century. Compared to the aforementioned chart kinds, they are easier to read and more aesthetically pleasing. The beginning price and highest price point of a currency are shown in the upper section of a candle, while the closing price and lowest price point are shown in the lower portion. An up candle denotes a time of rising prices and is tinted green or white, whereas a down candle is a period of falling prices and is shaded red or black.
Candlestick charts’ patterns and shapes are used to determine the direction and movement of the market. Hanging man and shooting star are two of the candlestick charts’ most popular shapes.
Risks of Forex Trading
There are more risks associated with forex trading compared with other asset classes since it uses leverage and margin. Because currency prices fluctuate continuously yet in very tiny increments, traders must make huge deals (using leverage) in order to profit.
If a trader places a winning wager, this leverage is fantastic since it may increase winnings. It can, however, potentially increase losses to the point where they exceed the original borrowing amount. Users of leverage expose themselves to margin calls, which might compel them to sell stocks they bought with borrowed money at a loss if a currency depreciates too much. In addition to potential losses, transaction fees can mount up and can reduce the value of a deal that was previously lucrative.
Plus, the Securities and Exchange Commission issues warnings about potential fraud or information that might be perplexing to novice traders. People who trade foreign currencies are like small fish swimming in a pond of expert, professional traders.
Therefore, it may be advantageous that individual investors don’t engage in forex trading as frequently. According to data from DailyForex, just 5.5% of the overall worldwide market is really accounted for by retail trading, often known as trading by non-professionals, and some of the largest online brokers don’t even provide FX trading.
Additionally, the majority of the few store dealers that trade forex find it difficult to make money. According to data from CompareForexBrokers, 71% of retail FX traders lost money on average. This makes forex trading a tactic that is frequently better left to experts.
