A trading strategy is at the heart of your success because it determines how you enter and exit a market. Every trader wants to be consistent and successful, and a good trading strategy looks for trade entry opportunities while managing risk.
What is a trading strategy?
There are three critical components to every forex trading strategy:
- Trade entry rules
- Stop loss rules
- Profit taking rules
You have a complete trading strategy once you have those three components.
Therefore, a forex trading strategy is a method for selecting when to enter and exit the market. But are the strategy rules fixed? Or do they have room for interpretation? A "discretionary" trading strategy is one where you can interpret the rules and use judgment instead of a "systematic" trading strategy, which has set rules.
Beginners looking to understand trading strategies should know that all trading strategy rules are based on one of two big analytical styles: technical or fundamental analysis.
Technical analysis uses price and volume data to make trading decisions. Technical analysis includes, for instance, the determination of support and resistance levels and price-based indicators like moving averages.
Fundamental analysis uses economic or financial data. So, for example, if you're analyzing how a country's interest rates might affect its currency value, that's fundamental analysis.
Most FX traders base their trading strategy on technical analysis when engaging in short-term trading, particularly intraday trading. Strategy can be further broken down into price action trading, which only considers price action, and indicator trading, which uses certain types of momentum or statistical reference values to time entry and exit points, typically at reversal or overbought/oversold points.
Price action trading
Price action trading relies only on looking at a price chart without indicators to make trading decisions. Price action trading is the purest form of technical analysis but is also the most individualized and challenging to master. Its advantage is that it can be adjusted to any market circumstance, and ranges can become reversal patterns depending on how the price moves afterward. For example, if a triangle or sideways range appears in a trend, the price will likely resume its original direction if that triangle or range is small. On the other hand, there is a higher likelihood that the price will reverse, or at the very least stop moving in the direction of the trend, if the range is wide and the price fluctuates wildly. So, of course, many traders wait for the price to break out of a range to give them more certainty.
Correctly identifying and entering trends is the foundation of many traders' profits.
An uptrend is a series of higher lows and, correspondingly, higher highs. A downtrend is the opposite of an uptrend—it's a series of lower highs and lower lows.
All trends experience minor pullbacks against the direction of the primary trend. These can provide excellent spots to enter a trend.
For a trader following an upward trend, entry orders are placed near the baseline that connects the higher lows and take-profit orders near the line connecting the higher highs. A short-selling strategy of selling at the decreasing highs and buying back to take profits at the decreasing lows trendline would work in a downtrend.
Some other rules of thumb for trend trading are that short periods are likely to see more reversals than long periods when viewing the trend. For example, a trend on a 5-minute timeframe can reverse much faster than a daily trend.
Indicators are usually some form of aggregation of recent prices designed to show momentum or a change in the current trend's strength. They can also highlight when price momentum displays signs of being overbought or oversold and is likely to pull back or retrace some of the recent move.
The most commonly used indicators are the simple ones: Moving Averages, MACD, and RSI.
These are popular partly because they are so easy to understand. For example, you can use a single moving average line to help indicate if the price is in an uptrend or downtrend or use moving average crossovers to find potential changes to short- or long-term trends. For example, the 50 and 200 Exponential Moving Averages (EMAs) are a popular combination on daily charts. If the 50 EMA falls back across the 200 EMA, you can use that as an objective signal that the trend is over.
The MACD (Moving Average Convergence Divergence) indicator measures the difference between two moving averages and plots it as a histogram or bar chart below the price chart. The longer the MACD bar, the stronger the trend. MACD often works best when used as a divergence indicator. A divergence is when the price makes a higher high, but the MACD makes a lower high. It can mean the uptrend is losing momentum, and the price is about to reverse direction.
RSI (Relative Strength Index) is a momentum indicator that measures the magnitude of recent price changes to signal overbought or oversold conditions. The RSI indicator ranges from 0 to 100, and you can observe from previous price patterns where to set overbought and oversold levels for the asset or exchange rate you are trading. The most common overbought and oversold level settings are 80 and 20 or 70 and 30.
You can also use RSI as a divergence indicator. For example, if the price makes a higher low but the RSI doesn't make a higher low, this could mean the trend is losing strength.
There are many possible trading strategies, and choosing a strategy can confuse beginner traders. It is much better to master one trading strategy than try to trade many different techniques. Practice and test different strategies to find the one that best suits your personality and goals.