Forex trading is just one of many ways to invest your money and can be done from anywhere in the world. However, trading forex is nothing like trading stocks. It's important to understand forex trading strategies before you begin.
Many look at the allure and glamour that forex offers and jump right in without properly preparing themselves. And they end up losing money. The truth is there is no one best forex strategy. If there was, everyone would use it. So the question remains, what forex trading strategies are there? And which is the best forex trading strategy for you?
What Is a Forex Trading Strategy?
Theoretically everyone knows how you should make money in forex. Buy low and sell high. Or short sell at a high price and close at a low price. Beginners take the advice, deposit money into an account and log on. They do all this and still find themselves completely overwhelmed with timeframes, charts, forex pairs and much more.
While there is no golden ticket to riches, there are general rules to follow in order to maximize your odds to profit. At the end of the day, forex is a game of probabilities. It's up to you to maximize how much you win when you win, and to minimize how much you lose when you lose.
There are classic rules that traders have been advising for decades now:
Beyond that there are approaches that successful traders use that mesh well with their personalities. Many forget that beyond all the technology, technical analysis, tools, etc., trading is a psychological game. If you choose a strategy that doesn't suit you psychologically, you are destined to fail.
The biggest mistake beginners make when choosing forex trading strategies is to choose a strategy that seems logical enough to work and maybe it is — for someone with a different psychological makeup. They end up losing money and are unable to stick with the trade. So they give up after having lost a sizable chunk of capital in the process.
We want you to avoid becoming another statistic. So read on to figure out what you need to do to craft a strategy that works for you.
How to Create a Strategy That Works for You
We're going to go over some of the most popular strategies, give a brief overview of each, explain how it works and who it is suited for. Hopefully after reading, you will have a much clearer picture of what trading strategy to use.
Price Action Trading
The first strategy we are going to look at is perhaps the simplest of all and the one that is most easily transportable across timeframes and forex pairs.
The price action strategy does not rely on the main technical indicators. Instead it looks exclusively at what prices are doing and whether there is a trend in prices. For this strategy, most traders rely on candlestick charts — so called because they look like a candle with a wick.
Price action has one big advantage over most technical indicators. Most indicators lag behind, making use of old data. But price action is as up-to-date as possible. So traders who use this strategy believe that they get the fastest representation of the market.
The size of a candlestick says a lot about the underlying pair. For example, when you see a bar three to four times as large as the average candlestick, it is clear that there is a breakout happening.
Likewise, some traders look at specific shapes and patterns that the candlesticks form on the chart. Some of the well-known patterns — such as “head and shoulders” — signal a possible trend reversal. Many traders around the world watch these patterns. And this wide following often reinforces the pattern itself as more and more people follow and act on these patterns.
Another major component of price action trading is using lines. The most common are “trendlines.” Traders use trendlines when a forex pair is trending up or down, in order to extrapolate into the future where prices will be at a certain point in time. This is done by drawing lines at the top and bottom of the current range, at the approximate angle of the trend.
Drawbacks of Price Action Trading
One big drawback is that if the currency isn't trending, then you won't have many trendlines to draw. However, many traders also draw horizontal lines around major price points. This can be a recent peak or a recent low (a price that the currency has gravitated to a number of times) or even large, round numbers, which many traders see as important.
Prices have a habit of retesting these levels of support (the bottom price) and resistance (the top price). And these levels often act as intelligent price points at which to take profit or set a stop loss.
Price action trading is great for beginners because of its simplicity. It is also a strategy that can be easily combined with other strategies for higher accuracy. There is a reason that this is possibly the oldest trading strategy out there and is still in use.
Range Trading Strategy
Trading a range bound market is one of two strategies that are much more personality driven than price action trading. With this type of market, your currency trades in a range of prices, going up and then back down. These can be a very tight, narrow range. And that usually signals an explosive move to either the upside or downside.
Or the range can be very wide. Look at a long enough timeframe and you're likely to see the currency pair actually is in very wide trading range.
But we are going to focus on the short- and intermediate-term range trading strategies.
In a range bound market, prices keep bouncing off of the same support and resistance. To use this strategy, buy the currency near the bottom of the range or short sell near the top of the range. Then set a stop loss in case the currency breaks out of its range.
Risks of the Range Trading Strategy
The main risk here is that you never can be sure when the range is going to break and the currency begins trending.
An additional risk depends on how wide the range is. Sometimes the currency price starts toward the opposite end of the range but halts in the middle and comes back to where you entered.
To decrease risk, look at price action to see if there is a surge in buying or selling. Also watch the trading volume for the same clues.
Some technical indicators work best in a range market. These include the RSI (relative strength index). Here the technical indicator shows when your currency is relatively overbought or oversold and the price could reverse direction. This can be an excellent way to make your entries more accurate.
Range trading strategies are great for those who are more inclined to be patient. Many traders see range bound markets as a nuisance and sit on the sidelines. This means there is more room for traders comfortable in this kind of market.
But there is no guarantee that the currency you are trading is really in a trading range. It could just be taking a breather before continuing a trend, or it could be about to break out.
Many traders think this strategy is too easy. They think currencies don't care about clearly defined lines and that you should treat ranges in general terms instead of a concrete line.
Trend Trading Strategy
The second major market regime is that of a trending market. Markets trend either upward (think bonds since the 1980s, in perhaps the longest bull market in history) or downward (think equities during the 2008 crash). Currencies are no different, and most traders look to make money by riding the trend.
Any person can spot a trend that has already happened, but knowing when a trend is going to emerge or when a trend is about to reverse is what separates traders from the lay person.
Most traders look for a breakout to signal the beginning of a new trend. They find a currency in a range and look for an obvious piece of price action — such as a candlestick breaking through a line of resistance — to signal that the range market regime is over.
Using Moving Averages
Many traders rely on technical indicators to help them judge the health of a trend and whether they should jump off or not. The most common technical indicator for this is the moving average. As the name suggests, this calculation uses previous prices to get an average price. If this price keeps moving up, you're in an uptrend, and vice versa for a downtrend. This is often visualized as an ever-moving line drawn on the chart.
The length of time your moving average looks at drastically changes how it acts. A 10-day moving average is very volatile and can give many false signals, but it is also the fastest to react to a trend change. A 200-day moving average on the other hand moves very slowly and highlights the major trend.
Some traders chart both long and short moving averages and use the lines crossing over each other as a form of technical indicator too.
Trend trading is probably the strategy that best fits the description, “Easy in theory but difficult in practice.” If you get it right, the trend takes care of 90% of the work for you. Getting it right is the hard part.
Many professional trend traders are willing to take many small losses in a row in order to score the one big trend that will earn their profits. This kind of strategy of long periods of losses is certainly not for everyone, and traders should think long and hard about whether they have the mental fortitude for it.
Day Trading Strategy & Forex Scalping Strategy
Probably the most popular of the timeframes to trade is day trading. Here traders hold their trades for no longer than a day and never leave trades open overnight. The benefits here are that traders feel a lot more flexible. They jump in, hold a trade for a few hours and are done for the day. In that sense, day trading is what most resembles a “job.”
The downside here is that while you are theoretically free to trade whenever you want during the day, you need to be able to spot the opportunities. That often means watching the computer screen all day waiting for a good entry. And this sometimes gets in the way of personal plans and opens you up to overtrading.
A more extreme version is scalp trading. Here traders look to stay in a trade for minutes, not hours. The upside is that you never expose yourself to major losses and you grab small wins. The downside here is similar to regular day trading. You risk overtrading and getting into a particularly bad losing streak. Also you need to be on the pulse of the market, ready to jump in immediately.
Swing trading looks to hold positions for days or at most, weeks. For many, this is the optimal sweet spot between ultra-short-term day trading and very long-term position trading. Swing trading allows you to pick up on larger trends that develop while still giving you time to hop in and out. This offers you flexibility in your trades.
Some traders prefer waiting a few days for a trend to really develop, especially if you are waiting for a proper breakout. Other traders like not being locked into one trade for too long, while still being exposed to longer-term trades.
Finally, we have position trading. Here traders are in it for the long haul and often hold their positions for weeks or months, if not years. The dream of every position trader is to catch a major multi-year trend and hold on through all the volatility.
The upside with this kind of trend is that when you are right, you are really right — with trends being able to carry you for months without your having to do anything.
The downside is that you are locked into a trade. Because you are looking at the longer term, you can never be sure if what you are experiencing is a temporary pullback or a trend reversal, and you may end up wasting weeks before you confirm which it is.
Meanwhile, even if a trade is going well, there may be other, shorter-term opportunities that can provide you a higher rate of return that you can't pursue because your money is stuck in a position trade that will take months to happen.
Try Out Forex Strategies With a Demo Account
You can read every book ever published on a specific strategy and still be completely dumbfounded when you sit down to trade. That's because the theoretical world and the real world are two very different places.
You may learn every pattern to look for when trading, but when you actually start, you begin to find that the patterns never line up as perfectly as you had read about. That is totally fine and is all part of the learning process.
Our best advice for traders who want to take the next step is to open a demo account, like those offered by TD Ameritrade. Paper trading is a simulated trading account with the same live prices, but you are given fake money to play with. This gives you the feel of the real world of forex trading and lets you try what you've learned. It also gives traders an excellent way to find out without losing money what trading strategy suits them best.
Once you're comfortable trading on a demo account, you can start applying what you've learned and trading forex.