April 15, 2024

Building Advanced Horizons

Navigating the World of Business Trading

How to Create and Manage an Effective Forex Trading Strategy

7 min read

Table of Contents

What Is a Forex Trading Strategy?

A forex trading strategy is a technique used to determine whether to buy or sell a currency pair at a certain time. Forex trading strategies can be based on technical analysis or fundamental, news-based events. A trader’s strategy is usually made up of trading signals that trigger buy or sell decisions.

Forex trading strategies are available on the Internet or they may be developed by traders themselves.

Key Takeaways

  • The forex market is the largest market in the world with a daily volume of around $6 billion U.S. dollars in November 2023.
  • Forex trading strategies involve the use of specific techniques to generate profits from the purchase and sale of currency pairs in the forex market.
  • Manual or automated tools are used to generate trading signals in forex trading strategies.
  • Traders working on their own trading systems should backtest their strategies first before committing capital. Paper-trade them first to ensure they perform well.

Basics of a Forex Trading Strategy

Forex trading strategies can be either manual or automated methods for generating trading signals. Manual systems involve a trader sitting in front of a computer screen, looking for trading signals and interpreting whether to buy or sell. Automated systems involve a trader developing an algorithm that finds trading signals and executes trades on its own. The latter systems take human emotion out of the equation and may improve performance.

Traders should exercise caution when purchasing off-the-shelf forex trading strategies because it’s difficult to verify their track record and many successful trading systems are kept secret.

One way to learn to trade forex is to open a demo account and try it out.

Creating a Forex Trading Strategy

Many forex traders begin with a simple trading strategy. They might notice that a specific currency pair tends to rebound from a particular support or resistance level. They might then decide to add other elements that improve the accuracy of these trading signals over time. They might require that the price rebound from a specific support level by a certain percentage or a number of pips.

An effective forex trading strategy requires several components:

  1. Selecting the market: Traders must determine what currency pairs they want to trade and become experts at reading them.
  2. Position sizing: Traders must determine how large each position is to control for the amount of risk taken in each individual trade.
  3. Entry points: Traders must develop rules governing when to enter a long or short position in a given currency pair.
  4. Exit points: Traders must develop rules telling them when to exit a long or short position, as well as when to get out of a losing position.
  5. Trading tactics: Traders should have set rules for how to buy and sell currency pairs, including selecting the right execution technologies.

Leverage

You can see if your broker offers high leverage through a margin account if you have limited capital. Any broker with a wide variety of leverage options should do so if capital isn’t a problem. A variety of options let you vary the amount of risk you’re willing to take. Less leverage and thus less risk may be preferable for some individuals.

When Is It Time to Change Strategies?

A forex trading strategy works very well when traders follow the rules but one particular strategy may not always be a one-size-fits-all approach. What works today may not necessarily work tomorrow. Traders might consider a few options before changing a game plan if a strategy isn’t proving to be profitable and if it isn’t producing the desired results:

  1. Match risk management with trading style: It may be time to change strategies if the risk vs. reward ratio isn’t suitable.
  2. Market conditions evolve: A trading strategy may depend on specific market trends so a particular strategy may become obsolete if these change. This could signal a need to make tweaks or modifications.
  3. Comprehension: There’s a good chance that a strategy won’t work if the trader doesn’t quite understand it. The effectiveness of the strategy is lost if a problem comes up or a trader doesn’t know the rules.

Change can be good but changing a forex trading strategy too often can be costly. You could lose out if you modify your strategy too often.

Example of a Basic Forex Trading Strategy

Most successful forex traders develop a strategy and perfect it over time. Some focus on one particular study or calculation. Others use broad-spectrum analysis to determine their trades. One simple strategy is based on relative interest rate changes between two countries.

Imagine a trader who expects interest rates to rise in the U.S. compared to Australia when the exchange rate between the two currencies (AUD/USD) is 0.67. It would take $0.67 USD to buy $1.00 AUD.

The trader believes higher interest rates in the U.S. will increase demand for USD and the AUD/USD exchange rate will then fall because it will require fewer, stronger USD to buy an AUD. Assume that the trader is correct and interest rates rise. This decreases the AUD/USD exchange rate to 0.50. It would now require $0.50 USD to buy $1.00 AUD. The investor would have profited from the change in value if they had shorted the AUD and had gone long on the USD.

Where Can I Trade Currencies on the Forex Market?

There are many online forex brokers to choose from, just as in any other market. Look for platforms that feature low fees and tight spreads. Make sure your broker is covered by a regulatory body and has a solid reputation. A platform with charting tools and algorithmic trading is also a plus for more advanced traders.

What Is a “Pip” in Forex?

Pip is an acronym for “percentage in point” or “price interest point.” A pip is the smallest price move that an exchange rate can make based on forex market convention. Most currency pairs are priced out to four decimal places and the pip change is the last (fourth) decimal point. A pip is thus equivalent to 1/100 of 1% or one basis point.

What Is a Carry Trade in Forex?

A currency carry trade is a popular strategy that involves borrowing from a low-interest rate currency to fund purchasing a currency that provides a higher rate of interest. A trader using the carry trade attempts to capture the difference between the two interest rates. This can be substantial depending on the amount of leverage used.

What Is Trade Size in Forex?

There are several standard trading or lot sizes for forex accounts depending on your level of expertise and amount of capital. Standard forex accounts require order lots of 100,000 base units and mini accounts are standardized at 10% of that or 10,000 lot trades. The even smaller micro accounts allow 1,000 base unit trades and nano accounts allow just 100 although nano accounts aren’t always available.

Standard accounts must enter orders in multiples of 100,000. Mini account holders place trades in multiples of 10,000.

The Bottom Line

There’s no free money in forex trading but the simplest strategy from a mechanics perspective is simply speculating that one currency will rise or fall in value relative to another. Of course, you could lose money if you wrongly gauge the direction of the bet. Consider using programs like MetaTrader that make it easy to automate rule-following. These applications let traders backtest trading strategies to see how they would have performed in the past.

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