In order for any trading strategy to actually work it must make use of an edge.
As I said, in Forex, the edge comes from the trend and a good Forex trading strategy that works will most likely make use of the market’s long-term underlying trend in some way, but what is the best way to make use of this? Now that we know what the edge is and why it occurs how do we exploit this edge to the maximum? Well, the answer is that in order to make good use of an edge, it has to form part of a well functioning trading strategy free from the flaws and pit falls that beginners so frequently make. In order to help the reader design such a strategy for themselves I will offer the reader the following general information and pointers –
“in Forex, the edge comes from the trend and a good Forex trading strategy…”
Suitable trading time frames and the frequency of trading…
One of the most misunderstood things in trading is trading time frames. As a general rule, the shorter the time frame the greater the randomness and the less effective an edge will be. An edge such as the trend takes time to work. For example, suppose that during a strong uptrend 6 out of 10 hourly candles were up and 4 out of every 10 hourly candles were down and these hourly rises and falls were by equal amounts. In such a scenario the market’s long-term directional bias would be very, very strongly towards the upside, conditions like these would be every trend traders dream. Yet even with market conditions such as these it would be very difficult to make money scalping or with trades left on for 15 or 30 minutes. However on a longer term time frame the effects of an edge like this would be enormous, but with a short term trade of 15 minutes or half an hour taking a long position would be little better than a coin toss. Taking lots of small long trades however in conditions such as these on the other would give us an edge but the costs of trading, i.e. paying the spread again and again and again would surely eat up ones profits.
The best forex strategies for making use of the tradable edge provided by the trend are therefore medium to long-term ones (typically they last several days to several weeks or longer). With trend following the best strategy is generally to measure the trend, that is, the market’s directional bias in the fairly recent past up until the present moment and assume that the trend will continue until we get a signal that it has changed as once a trend is in place it is more likely to continue than not. Once a trade is in place the edge provided by the trend needs time to work and giving it time to work (or not) is preferable to jumping in and out of trades and racking up huge trading costs. Once a trade has been placed in the Forex market by a trend following trading strategy it is best to leave the market to prove you right or wrong, there is nothing more you can do and looking at the market every minute will usually be bad for the trader psychologically speaking and will not generally help one to make the right trading decisions.
Stop-losses, leverage and profit targets
Secondly, traders should use suitably sized stop-losses and choose good sized profit targets. As a general rule, using a stop-loss other than very large one will usually degrade the performance of any trading system, but if one is not to be wiped out by a losing trade getting out of control then a stop-loss is necessary, especially when trading with leverage. Tiny stop-losses of 10 or 20 pips are pretty much useless as the market can move 20 pips at random; therefore if the market moves 20 pips against you then it does not necessarily mean that you have placed a bad trade. If a movement of 20 pips against you is a substantial portion of your trading account then it means that you have used far too much leverage.
With trend following every now and again a trader will come across a large trend that just goes on and on. When this happens it is best to make the most of it as it is trades like these, these few rare but really big winners, that will make up for all the losses and more. Even with a really good trend following trading system a large number of your trades will still be losers. It is therefore important to make the most of the good trades, these few good strong trends that just seem to last forever and go on and on.
I would sum up this section on stop-losses, leverage and profit targets by giving the following general pointers: Stop-losses should be fairly large, but not so large that they leave a bad trade open to get worse and worse but not so tight that one can be stopped out of a good trade by the market’s random noise and short-term corrections. Stop-losses should therefore be larger than the random movements and short term corrections that occur against the direction of the long term underlying trend, but only slightly larger. Profit targets, if they are even part of one’s trading strategy at all, should be larger than one’s stop-loss. Some good trend following strategies and systems however have no predefined profit targets and will just aim to take whatever the market gives them by riding the trend until they get a signal that the trend has ended. And since a stop-loss must be fairly large and losing trades are certain to occur (sometimes a fair number of them will happen in a row in the form of a losing streak) it is important that you do not lose to much of your trading account on a single trade, you should therefore be very careful with leverage and not use too much of it.
There are lots of currency pairs that you can trade with very low spreads and you will probably not want to trade them all at the same time. It is important that traders maximise the edge that the trend gives them by only trading the currency pairs with the strongest possible edge (i.e. those with the strongest trend) at any given time. The currency pairs that tend to trend the best are pairs made up of the large liquid currencies. The EUR/USD usually works great with trend following systems, the EUR/GBP pair is also quite good, and the Australian Dollar, the Canadian Dollar and the Swiss Franc also seems to trend fairly well against the Great British Pound and the US Dollar but there is no substitute for measuring the strength of the trend at the time.
My advice would be to be choosey and if you are in any doubt about taking a trade then simply don’t do it. After all, the markets will still be there tomorrow, your trading capital however might not.
I would concluding this article on Forex trading strategies that work by summarising the following bits of general information that I have given:
- Avoid trading on short time frames – the shorter the time frame the greater the degree of randomness.
- Do not trade to often, high frequency retail Forex = lots of commissions for brokers.
- Stop-losses should be larger than the random noise and short term corrections, but not much larger.
- Profit targets, if you even use them at all, should be considerably larger than the stop-losses. With trend following you are generally aiming to maximise the amount you win rather than the frequency with which you win.
- Do not over leverage. To much leverage is a very bad thing. Remember a single bad trade that is stopped out should not cost you a large percentage of your account.
- Be choosy about the trades you take and only trade when there is a strong trend in place; if in doubt leave it out.
I wish the reader all the very best in developing a profitable trading system or strategy that is right for them and I hope some of the points I have made in this article will prove be useful.