Forex Trading Strategies – Advantages and Disadvantages
What is a Forex Trading Strategy?
Forex trading strategy defines the system used by foreign exchange traders to determine when to buy or sell currency pairs. Traders can use a variety of foreign exchange strategies, including technical analysis or fundamental analysis. A good foreign exchange trading strategy allows traders to analyze the market and use sophisticated risk management techniques to confidently execute trades.
Forex Strategies: A Top-level Overview
Forex strategies can be divided into different organizational structures, which can help traders find the most suitable strategy. The figure below illustrates how each strategy falls into the general structure and relationship between foreign exchange strategies.
Forex Trading Strategies That Work
Foreign exchange transactions need to collect a variety of factors to develop a trading strategy that suits you. There are countless strategies that can be followed, but understanding and adapting to them is essential. Every trader has unique goals and resources, which must be taken into consideration when choosing a suitable strategy. Traders can use three criteria to compare the applicability of different strategies:
Time required, frequency of trading opportunities, and normal distance to the target.
In order to easily compare foreign exchange strategies based on all three criteria, we show them in a bubble chart. . The vertical axis is the “risk-reward ratio”, and the strategy at the top of the chart has a higher return on the risk taken in each operation. Position trading is usually the strategy with the highest risk-reward ratio. There is a time investment on the horizontal axis, which indicates how long it takes to actively monitor the operation. Due to the high frequency of regularly executed transactions, the most demanding strategy for time resources is scalping transactions.
Price Action Trading
Price action trading involves studying historical prices to develop technical trading strategies. Price action can be used as a standalone technique or combined with indicators. Fundamentals are rarely used; however, it is not uncommon to use economic events as supporting factors. As mentioned above, there are several other strategies that fall into the range of price action.
Length of trade:
Price action trading can be used in different time periods (long-term, medium-term and short-term). The ability to use multiple time frames for analysis has made price action trading valued by many traders.
There are many ways to determine support/resistance levels, usually used as entry/exit points: in price action, there is a range, trend, day, scalping, swing, and position trading. These strategies meet the different forms of business requirements detailed below. These examples show different techniques for trading these strategies to demonstrate the variety of transactions and various customization options for traders to choose from.
Range Trading Strategy
Range trading involves determining support and resistance points, and traders will use these points to trade around these key levels. This strategy works well in the market, with no significant fluctuations and no obvious trends. Technical analysis is the main tool used in this strategy.
Length of trade:
There is no fixed duration for each trade because a limited range strategy can work in any time frame. Risk management is an integral part of this approach because breakouts can occur. Therefore, range traders want to close any current range-restricted positions.
Oscillators are most generally used as timing tools. Relative Strength Index (RSI), Commodity Channel Index (CCI) and Stochastic are some of the most popular oscillators. Price action is sometimes used in conjunction with oscillators to further verify range-bound signals or breakouts.
Example : USD/JPY Range Trading
USD/JPY has been showing long-term range-bound price levels in the past few years. The above chart illustrates the clear support and resistance bands that traders use as entry/exit points. The RSI oscillator shows the time of entry/exit points, highlighted by blue and red shaded boxes: blue-overbought and red-oversold. Range trading can produce a fruitful risk-reward relationship, but this is accompanied by a long-term investment in each transaction. Use the following pros and cons to adjust your goals as a trader and how much resources you have.
Advantages: A large number of trading opportunities. Favorable risk-return ratio.
Disadvantages: It takes a long time to invest.
Trend Trading Strategy
Trend trading is a simple forex trading strategy used by many traders of various experience levels. Trend trading attempts to generate positive returns by exploiting the directional momentum of the markets.
Length of trade:
Trend trading usually occurs in the medium to long-term time-space, because the length of the trend itself fluctuates. As with price action, analysis of multiple time frames can be used in trend trading.
Entry points are usually specified by oscillators (RSI, CCI, etc.), while exit points are calculated based on a positive risk-reward ratio. Using the stop loss level distance, the trader can match or exceed the distance to maintain a positive risk-reward ratio. For example, if the stop loss level is set beyond 50 pips, the take profit level will be set to 50 pips or more from the entry point.
Example : Identifying the Trend
In the simple example above, EUR/USD shows an upward trend validated by higher highs and higher lows. The opposite is a downward trend.
EUR/USD Trading the Trend
When you see a strong trend, you have to trade it in the direction of the trend. Like the above example, a strong upward trend of EUR/USD.
Using (CCI) as a tool for entry, note that every time the CCI drops below -100 (shown in blue), the price will rebound. Not all transactions will work in this way, but because of the trend followed, each drop will cause more traders to enter the market and push up prices. So, identifying strong trends is important for a successful trend trading strategy.
Trend trading can be quite labor-intensive, and many variables need to be considered. The list of pros and cons can help you determine whether trend trading is suitable for you.
Advantages: a large number of trading opportunities. Favorable risk-return ratio.
Disadvantages: a longer investment period is required.
Position trading is a long-term strategy that focuses on fundamental factors, but technical methods such as Elliott Wave Theory can also be used. This strategy does not consider small market fluctuations because they will not affect the overall market outlook. This strategy can be used in all the markets, from stocks to foreign exchange.
As mentioned above, position trading is a long-term method that carries out on weeks, months or even years and reserved for hard-working traders. Understanding how economic factors affect the market or complete technological bias is essential for predicting trading ideas.
Due to a comprehensive understanding of the market, the key levels on the longer time frame charts (weekly/monthly) contain valuable information for position traders. Entry/exit points can be chosen using technical analysis based on other strategies.
Example : Germany 30 (DAX) Position Trading
The Germany 30 chart above shows a head-and-shoulders pattern of about two years, which is consistent with the possible decline below the neckline (horizontal red line) behind the right shoulder. In this selected example, the decline in the German 30 Index has proceeded as planned, both technically and fundamentally. By the end of 2018, Germany had experienced a technological decline, while the trade war between the United States and China hurt the auto industry.
The Brexit negotiations will not help, because the possibility of Britain leaving the European Union may also have a negative impact on the German economy. In this case, understanding the technical model and having a strong fundamental foundation enables you to combine technical analysis and fundamental analysis to build a strong business idea. A list of pros and cons based on your goals as a trader and the amount of resources you have.
Advantages: Minimal time investment Highly positive risk-reward ratio
Disadvantages: Few trading opportunities Involve a strong understanding of technical and fundamental analysis
Day Trading Strategy
Day trading is a kind of trading used to trade CFD instruments within the same trading day. In other words, all positions are closed before the end of the day. It can be one operation or multiple operations in a day. The trading time ranges from a few minutes to a few hours, as long as the trading is opened and until it is closed by the trader. The trader in the following example will try to enter a position when the price breaks through the 8-period EMA in the trend direction (blue circle) and exit with a 1:1 risk-reward ratio.
Example : EUR/USD Day Trading
The above chart shows a daily trading setup, using moving averages to identify a bullish trend and in this case, because the price is higher than the MA line (red and black lines). The entry position is highlighted in blue, and the stop loss is located at the previous price break. The profit level is equal to the stopping distance in the trend direction. Before following this strategy, the pros and cons listed below should be considered. In day trading the trader must devote a lot of time and energy by keeping eye on the trades, but the return is not so much, as shown in the example of EUR/USD above.
The advantages of this kind of trading are more trades can be operated with a median risk-to-reward ratio.
Disadvantages are the time consuming and should follow the technical analysis in deep.
Forex Scalping Strategy
Scalping in Forex is a common trading strategy used to describe the process of often earning small profits in a short period of time and carry on trading on a frequent basis. This is executed by opening and closing many trading positions throughout the day. This can be done manually or through an algorithm that uses predefined strategies on when and where to enter and exit positions. Currency pairs with more liquidity are preferred because spreads are usually smaller, which tightens the short-term nature of the strategy.
The scalping strategy is doing short-term trades with minimal return, normally operating on smaller time frame charts (1min – 15 min).
As with most technical strategies, identifying trends is the first step. Most of the scalpers use indicators such as moving averages to lengthy trends. You can use an oscillator such as RSI indicator to try scalping in this range in a small time frame. The stop loss is placed a few points apart to avoid large fluctuations in the trade. The MACD indicator is another useful tool that traders can use to enter and exit transactions.
Example : EUR/USD Scalping Strategy
The 15-minute EUR/USD above shows an example of a scalping strategy. Moving averages (prices above 200 MA) confirm the long-term trend. The smaller time frame is used to locate entry and exit points. The area of entry points is shown in the red rectangle of the trading long. Traders can also use MACD to close long positions when MACD (blue line) crosses the signal line (red line) shown by the blue rectangle. Traders use the same method to set up their algorithms, instead of manually executing the practical scalp trading described in the example above.
Swing trading is a fantastic strategy by which traders seek to use both ranging markets and trending markets. By choosing “highs” and “lows”, traders can do long and short trades accordingly. Swing trading can be called medium-term trading because positions are usually held between a few hours to a few days. Long-term trends are favored because traders can take advantage of trends and find entry and exit points at multiple points as with range limiting strategies, oscillators and indicators can be used to select the best entry and exit points. The only difference is that swing trading is applicable to both trending markets and ranging markets.
Example : GBP/USD Swing Trading Strategy
In the above example, the combination of Stochastic Oscillator, ATR and Moving Average is used to illustrate a typical swing trading strategy. The upward trend is initially determined using the 50-day moving average (price is above the MA line). In the case of an uptrend, traders will seek to establish long positions with the old adage of “buy low and sell high”. The stochastic indicator is used to determine the entry point by looking for the oversold signal highlighted by the stochastic indicator and the blue rectangle in the chart. Risk management is the last step of ATR to provide stop loss level instructions.
Carry Trade Strategy
Carry trading involves borrowing one currency at a lower interest rate and then investing in another currency at a higher rate of return. Ultimately, this will lead to carrying trades. This strategy is mainly used in the foreign exchange market. Carry trading operations depend on interest rate fluctuations between related currencies. Therefore, the operation duration supports medium to long-term (weeks, months, or even years). Markets with strong trends are more suitable for trading because the strategy involves a longer time frame. Confirming the trend should be the first step before executing a trade (higher highs and higher lows, and vice versa); see example 1 above. Carry trading has two aspects, namely exchange rate risk and interest rate risk. Therefore, the best time to open a position is to take full advantage of exchange rate fluctuations at the beginning of the trend. Regarding the interest rate component, it will remain the same regardless of the trend, because if the first currency has a higher interest rate against the second currency, the trader will continue to get the interest rate difference, for example, AUD/JPY.
This article introduces 8 foreign exchange trading strategies through practical examples. When considering the trading strategy to follow, it is helpful to compare the time required for monitoring, the risk-reward ratio, and the regularity of the total trading opportunities. Each trading strategy will attract different traders according to their personal attributes. Matching and comparing trading personalities with the right strategy will ultimately enable traders to take the first step in the right direction.