Building a forex trading strategy
It is essential to have a plan when trading forex, that is, when you are buying and selling currency pairs on the forex market. Having a forex trading strategy helps a trader keep focus, but strategies have to be customized to each individual forex trader, taking into account personal motivations and factors. In this article, we cover some of the most popular forex trading strategies used by traders.
Forex trading strategies
The essence
- It is important to have a strategy when trading on the forex market.
- Trading strategies need to be tailored to the individual, there is no one-size-fits-all solution for the “best” forex trading strategies.
- The three most popular forex trading strategies are trend following, scalping and carry trade.
- Each forex trading strategy has its own advantages and drawbacks.
Forex trading strategies
Building a forex trading strategy
A forex trading strategy aids traders in determining when or where they should buy or sell a specific currency pair. There are many different simple forex trading strategies, but there is no such thing as the “best” or most successful forex trading strategy, as each may work differently under certain conditions. There is also a wide range of advanced forex trading strategies, with each needing different levels of technical and fundamental analysis.
Every strategy should be uniquely tailored to each forex trader, adapting it to the individual’s risk profile, emotions, mental state, motivation, daily schedule and trading time. A strategy to trade forex cannot be simply copied from someone else: you have to use parts from here and there, and put it together like a puzzle, optimizing it into a forex trading strategy that works for you. This can be quite a long process.
Also, take note that on the forex market traders have to trade on margin, or in other words, trade using borrowed money, also called leverage. Although this can increase your profits on a successful trade, it can also multiply your losses if the trade is unsuccessful.
Below, we detail the three most popular forex trading strategies used by traders.
In order to trade forex, you need to have a suitable account at a brokerage. To get some ideas on where to open an account, check out our most current list of the best forex brokers:
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- Saxo Bank
- Fusion Markets
- CMC Markets
- Interactive Brokers
- Capital.com
Forex trading strategies
Forex trading strategies
Trend following strategy
Trend following strategies, as the name says, follow the main trends, or direction, in the value of an instrument. The goal of this strategy is to cut losses quickly while letting winning trades continue to run further. The main trading directions can be identified over relatively high time frames: monthly, weekly or daily. In these cases, one candle on a chart translates to one month, week or day. These trends are long enough to determine which side is dominant, buy or sell. Strong trends are considered ones that last longer than a year.
In this forex trading strategy, it is important to identify the key support and resistance levels that represent the top and bottom of a given trading range. Longer time frames give strong support and resistance levels, which are key factors when determining the target and stop-loss prices a forex trader should use. The difference between your entry price and stop-loss will represent your risk, while the difference between your entry price and target price is your potential reward. Good risk/reward opportunities can usually be found at the break of so-called countertrends, or shorter trends that go opposite a longer major trend.
The main tool of risk management here is a stop-loss. It should be set in line with the volatility of an instrument, which is measured by the so-called Average True Range (ATR) indicator. The difference between the entry point and stop-loss should be more than 1 ATR. This way, a random market movement will not hit your stop-loss.
The difference between your entry point and stop-loss will be the amount on which positions should be sized. The size of positions are given in what are called lots. Sizing the lot is an important element of risk management.
In general, 1-2% risk is suggested per position. The bigger the account size, the lower the risk percentage should be. You should also monitor economic data, because major events may cause high volatility or trend reversals that could hit your stop-loss.
Read this detailed description of a forex trade built on trend following strategy.
Scalping
Scalping strategies are about catching small market movements with large positions within a very short time. This is characterized by executing a large number of trades, so it is completely the opposite of holding positions for hours, days, or even weeks.
The time frame of this strategy is low: usually it is done in the 1 minute chart, where 1 candle represents 1 minute of information. Tight spreads and low commissions are very important in this strategy because these costs need be covered by few market movements. You cannot be profitable if you catch 3 pips on the average, while your spread cost is also around 3 pips.
It is essential to follow this strategy only at brokers that provide quick order execution and no slippage. Fast order execution helps maximize your profit by catching the price you aimed at quickly. Trading gaps can also put your profit at risk, therefore this strategy should be executed when there is a low probability of gaps. You can avoid that by not trading at:
- times of high-volatility economic news
- low-volume trading times
- market opening and closing
The time frame of scalping is characterized by large market noise, therefore it is hard for beginners to be profitable using this strategy. This type of strategy has a lot of psychological pressure, so it is not recommended for beginners.
Carry trade
Carry trade strategy is about buying a high-interest-rate currency against a low-interest-rate currency. The profit comes from the difference between the high interest you receive and the low interest you pay, plus the favorable exchange rate movement. In other words, carry trade is focused on profiting from a swap and the exchange rate. The time frame of this strategy is months or years.
For example, let’s say that a trader decides to deposit $1,000 into a forex trading account. They choose to buy USD/CHF for a positive carry trade, which has an interest rate differential of 3.25%. Using leverage of 20:1 they can open a $20,000 position for the currency pair, meaning that the deposit is only 5% of the full value. A 3.25% interest rate difference becomes 65% annual interest on an account that is 20 times leveraged.
The monetary policies of central banks are key to a carry trade strategy, mainly with regard to the future directions of interest rates.
A carry trade strategy can result in 3 outcomes:
- If the currency bought with the higher interest rate appreciates against the currency sold with the lower interest rate, the trader will gain profit on the exchange rate and will receive the positive interest of the full position value.
- If the currency bought with the higher interest does not change to the currency sold with the lower interest, then the trader will receive the positive interest on the leveraged trade and will not encounter any other profits or losses.
- If the currency bought with the higher interest rate depreciates against the currency sold with the lower interest, the trader loses on the exchange rate, but will receive the positive interest of the full position value.
Forex trading strategies
FAQ section
What is forex trading?
Forex trading means the buying and selling of currency pairs. You are basically buying one currency while selling another in the hopes of closing the position later with a profit.
What is the most successful or profitable trading strategy?
There are no single “best” forex trading strategies that fit or work for everyone all the time. Forex traders have to find the best strategy for their specific level of expertise, experience and commitment, which may involve combining various aspects of several different strategies. Success and profits can be achieved in any trading strategy if the conditions and timing are right and the forex trader makes the right decisions at the appropriate time.
Is forex trading profitable?
It can be, but it’s certainly not for everyone. The European Securities and Markets Authority (ESMA) requires brokers to emphasize what percentage of retail investor accounts lose money trading CFDs (through which a significant part of forex trading is done). Depending on the broker, this figure is usually between 60-90%.
What is going long or short?
Essentially, this is your expectation on the direction of price movements: if you ‘go long’, you are expecting a price increase, while if you are ‘going short’ means you are expecting a price decrease.
What drives forex markets?
In general, it can be said that liquidity and market flows dictate short-term price movements on currency markets, while economic fundamentals shape longer-term trends.
Forex trading strategies
Glossary
Essential Forex Trading Terms Every Beginner Should Know
Currency pair:
Foreign exchange trading is based on exchanging one currency for another, which is why currencies are always quoted in pairs. A currency pair represents the value of one currency relative to another. The first currency listed is known as the base currency, while the second is the quote currency. Currency codes are expressed in standardized abbreviations such as USD for the US dollar and GBP for the British pound.
Financing rate:
Also referred to as the overnight rate, this fee applies when a leveraged position is kept open beyond one trading day. This commonly occurs in forex or CFD trades. Since leverage involves borrowing funds from your broker to open a larger position, interest is charged on the borrowed amount. In certain situations, depending on interest rate differentials, traders may also receive interest. This cost or credit is known as the financing rate.
Forex trading:
Forex trading is the process of buying and selling currency pairs. When entering a trade, you simultaneously purchase one currency and sell another, aiming to close the position later at a more favorable price to generate a profit.
Leverage:
Leverage allows traders to control a larger position using borrowed capital instead of only their own funds. While this can significantly increase potential returns, it also magnifies losses. For beginners especially, leverage should be used carefully and conservatively.
Lot:
A lot refers to the standardized quantity of a financial instrument being traded. In stock markets, a traditional round lot equals 100 shares, although shares can also be traded in smaller quantities. In options trading, one contract typically represents 100 underlying shares. In forex markets, positions are traded in micro, mini, or standard lots.
Margin:
Margin is the amount of money borrowed from a brokerage firm to open a trade. It represents the difference between the total value of the investment and the funds provided by the trader. When trading on margin, the investor pays only a portion of the position’s value while the broker finances the remainder. The securities in the account serve as collateral for the borrowed amount.
Stop-loss order:
A stop-loss order is designed to limit potential losses. After opening a position, traders often set a predefined price level at which the trade will automatically close if the market moves against them. This risk management tool helps protect capital and maintain discipline.
Currency swap:
A currency swap is a financial agreement between two parties to exchange interest payments in different currencies for a specified period. These arrangements are typically based on a predetermined principal amount and duration.
For a deeper understanding of forex-related terminology and trading concepts, explore trusted financial education resources and regulated broker guides.