Forex Trading Strategies, Tips and Techniques

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There are some real advantages that forex traders enjoy over stock and bond traders:

  • Trading takes place with commission included. When you buy into a currency, you pay a rate that includes the broker’s commission in the spread. This means that, when a trade goes well, your profit is net.

  • Enormous size of the forex market. At one time, only a few major banks and brokers participated in forex trading, so that traders literally ‘faced off’ against each other. This has changed completely today, and you trade in complete anonymity, with or against the market’s direction.

However, with so much variety and choice in such a large market, choosing a strategy can be difficult.

There are, however, two fundamental variables:

  • How much you have to trade.

  • Appetite for risk.

If you have a very large amount of money to trade, perhaps more than US$100,000, then a low-risk small-variation strategy makes the most sense.

With such a large amount of trading funds, there are two approaches:

  • You can diversify the trades, using a percentage of your account on different currencies.

  • You can keep the mass of money together, and bet on small movements in currencies for very short periods of time.

While many forex traders are in favor of diversification, the latter strategy involving a mass of money on a very short-term movement may make more sense. It is relatively easy, using indicators like Bollinger Bands and the Relative Strength Index, to predict a small movement higher or lower.

With a large sum of money to trade, the gain on even such a movement is considerable. Repeated a number of times, such a trading strategy can be extremely profitable.

Taken to the next level, such a trading strategy is called “scalping.” is a trading style specializing in taking profits on small price changes, generally soon after a trade has been entered and has become profitable.

It requires a trader to have great stamina, because one large loss could eliminate the many small gains that the trader has worked to obtain.

Having the right tools, such as a live feed, a direct-access broker and the stamina to place many trades is required for this strategy to be successful.

A scalper intends to take as many small profits as possible, not allowing them to evaporate. Scalping achieves results by increasing the number of winners and sacrificing the size of the wins.

It's not uncommon for a trader of a longer time frame to achieve positive results by winning only half or even less of his or her trades - it's just that the wins are much bigger than the losses.

A successful scalper, however, will have a much higher ratio of winning trades versus losing while keeping profits roughly equal or slightly bigger than losses.

Many traders use automated systems for scalping. A manual system involves a trader sitting at the computer screen, looking for signals and interpreting whether to buy or sell. In an automated trading system, the trader "teaches" the software what signals to look for and how to interpret them.

A different form of risk management strategy is scaling in and out of trades. Scaling in is the process of entering a trade in pieces as opposed to putting the entire position on in one entry.

A trader that is looking to scale into a trade might break their total position size in to quarters, halves, or any other division that they feel might let them take a more calculated approach to putting on a trade.

Let’s say, for instance, that a trader was looking to take EURUSD up to 1.3300, but was afraid of a near-term movement against the position. Instead of making the entire trade at one time, the trader can ‘scale in’ to the position in fragments. If the trader wants the total position size to be 100k, they can choose to open 25k every 100 pips that EURUSD moves up.

So, our trader can open 20k to start the position when price is at 1.2900, and once moving up to 1.3000 our trader can put on another 25k. This has the added benefit of allowing the gains in the first part of the position to assist in financing the second.

After price moves up to 1.3200, the trader takes on another 25k, and again at 1.3200. Once price hits 1.3300, the trader can close the position at a strong profit.

Of course, if the trade should move in the opposite direction, against the trader, by scaling in, the trader has limited the losses on the trade.

Scaling out uses the same principle in the opposite direction. By selling out of a trade in fragments, it also limits losses should the market move against the trade.

For example, a trader opening a short trade in EUR/USD can scale off a quarter of the position, then, if the market moves favourably, another quarter, etc. Gradually, the stop can be moved up to breakeven, and then, bit by bit, profit can be taken.

Still another useful strategy for trading is the use of pivot points. The pivot point itself is simply the average of the high, low and closing prices from the previous trading day.

On the subsequent day, trading above the pivot point is a bullish indicator, while trading below the pivot point indicates bearish sentiment. The pivot point can then be used to calculate estimated support and resistance for the current trading day.

What are Forex Indicators?

A forex trader is always looking at the best point to enter a trade and to exit one.

As a trader studies the charts, he or she looks for ways to identify points at which support floors or strong levels of resistance will appear.

Sometimes prices range, and move from a clear point of support to resistance and back again.

In other markets, called “trending markets,” there is steady movement higher or lower.

It is critical to understand exactly what constitutes a trend.

What is an uptrend? It is a market in which each successive high is higher than the previous high. Similarly, a downtrend, is a market in which each successive low is lower than the previous low.

To help traders identify ranging or trending prices, indicators are used.

These are mathematical algorithms of one kind or another that have been shown to identify when price change takes place.

  • The Moving Average

One of the simplest to understand is the moving average. You probably know that an average is sum of a given series of numbers divided by that set of numbers: 1+2+3+4+5 divided by 5.

In the case of forex trading, you take a given period of time, say one hour, and you take a specific number of hours, take the sum of the prices of the currency pair for each hour, and then divide by the set of numbers.

The moving average that is the result smooths out price movement, erasing the volatility, so that the trader can spot a trend.

Some traders also use the exponential moving average. The exponential moving average is actually a weighted moving average, meaning that it gives greater weight to the recent days’ prices.

This makes sense given that they are more likely to be accurate than older prices – in a long moving average, very old prices get the same weight as almost new ones.

The weighting applied to the most recent price depends on the number of periods in the moving average.

There are three steps to calculating an exponential moving average.

  • First, calculate the simple moving average.

An exponential moving average has to start somewhere so a simple moving average is used as the previous period's exponential moving average in the first calculation.

  • Second, calculate the weighting multiplier.

  • Third, calculate the exponential moving average.

So, for example, for a 10-day exponential moving average:

Simple Moving Average: 10 period sum / 10

Multiplier: (2 / (Time periods + 1)) = (2 / (10 + 1)) = 0.1818 (18.18%)

Exponential Moving Average: {Close - EMA (previous day)} x multiplier + EMA (previous day)

You won’t have to make these calculations, as it will be available on the forex platform to plug in and do it for you. 

Observation of price movements with respect to moving averages often is useful – for example, a given pair will break higher or lower after crossing the 200-day moving average.

Traders watch for these patterns which are often remarked in forex commentary.

 

  • MACD

One very important indicator that is based on moving averages is called the Moving Average Convergence Divergence, or the “MACD.”

Many traders use this indicator to decide entry- and exit-points from trades. Some, on the other hand, say that it lags trends too far. Experience on your own behalf will enable you to decide.

The MACD is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. A nine-day EMA of the MACD, called the "signal line", is then plotted on top of the MACD, functioning as a trigger for buy and sell signals.

When the MACD falls below the signal line, it is a bearish signal, which indicates that it may be time to sell. On the other hand, when the MACD rises above the signal line that is a bullish signal, which suggests that the price of the currency pair is likely to move higher.

Some traders also interpret divergence from the MACD as a clear signal of momentum. In other words, a falling MACD and a rising price suggest that momentum is turning higher.

This is not a strategy that all adopt, and it depends very much on long-time observation of a given currency pair.

  • Stochastic Indicators

The word stochastic is derived from the Greek meaning "to guess" or "to aim."

The term's application in investment is to ‘guess at’ the likelihood of a continuing trend – the probability is expressed in percentage. Stochastic indicators are called ‘oscillators’ in the sense that they fluctuate somewhat rapidly up and down, in a wavelike manner, generating buy and sell signals.

Forex traders use many different types of stochastic indicators – every trader has his or her favourites. Most trading platforms will allow you to plug in more than thirty different choices.

But there are a few that are considered mainstream, in the sense that they have been tried and found useful by an overwhelming majority of traders. We’ll look at these.

  • Relative Strength Index

The Relative Strength Index (RSI) is an oscillator that moves up and down in response to changes in market rates.

It has garnered great respect among traders as one of the most accurate indicators for evaluating current market trend strength.

Here is how it works. A reading of 30 or under is considered "oversold" and identifies a potential rate increase. A reading of 70 or higher is considered "overbought" and identifies a potential rate decrease.

The platform will calculate the RSI for you, but it is good to understand how it works, because there are different ways to calibrate it.

The basic number of trading periods that the RSI is set for is 14 – this was the original value that the inventor set for it. This can be changed, and some traders have found different values useful.

However, it is wise to start with the original value and to observe its operation before experimenting.

The first components to be calculated are the total average gains and the total average losses. This information is necessary to arrive at the relative strength (RS) value for the currency pair.

Average gains are calculated by adding up all the gains for the past fourteen reporting periods and dividing by 14; average losses are calculated in the same manner with the total of all losses for the previous fourteen reporting periods summed and divided by 14.

The Relative Strength is then converted to an index value and plotted on a scale from 1 to 100.

Using the RSI in trading is much easier than calculating it. When the “overbought” or “oversold” indication appears, watch for the trend to move in the opposite direction.

But, if a currency pair has remained overbought or oversold for a very long time, and no movement takes place, it’s often the case that a further move in the same direction (higher or lower) will occur.

  • The Stochastic

The classic stochastic indicator is also a very useful way to determine entry and exit strategy. 

The Stochastic Oscillator consists of two lines, and, when both lines are included on a price chart, it is referred to as the Full Stochastic.

The first line follows the current price for the currency pair, and the second line treats the price as a moving average. You can adjust for the period you prefer.

The Stochastic is scaled from 0 to 100.

When the Stochastic lines move to above 80, then it means the market is overbought. When the Stochastic lines fall to below 20, then it means that the market is oversold.

  • Bollinger Bands

Another very important indicator, although not a stochastic one, is called Bollinger Bands.

Named for their inventor, technical analyst John Bollinger who invented them in 1982, Bollinger bands are indicators of volatility – rapid movement that is often a prelude to trend change.

Bollinger Bands are placed on top of a given price chart. They consist of a moving average based on the price, along with upper and lower ‘bands’ that define pricing "channels."

As always, you will not be obliged to make these calculations, as your forex platform will place the Bollinger bands on the chart for you. But you should understand how they work.

As you know, working with moving averages is a basic concept in technical analysis by forex traders. Bollinger introduced the idea of using standard deviation along with moving averages.

Standard deviation measures the amount of variability or dispersion around an average. Standard deviation is also a measure of volatility. Generally speaking, dispersion is the difference between the actual value and the average value.

By definition, one standard deviation includes about 68% of all data points from the average in what is referred to as a normal distribution pattern, while two standard deviations include about 95% of all data points.

Bollinger Bands consist of a middle band with two outer bands. The middle band is a simple moving average that is usually set at 20 periods.

A simple moving average is used because the standard deviation formula also uses a simple moving average. The look-back period for the standard deviation is the same as for the simple moving average.

The outer bands are usually set 2 standard deviations above and below the middle band.

The Bollinger Bands show the dispersal of rates when compared to the moving average, thus creating buy and sell channels. The area between the moving average line and each band produces a range, or channel.

The area above the moving average is referred to as the buy channel as spot rates displayed in this region remain higher than the moving average and suggest upward momentum.

The sell channel is created by spot rates falling below the moving average. As the spot rate is declining more rapidly than the moving average, it suggests that the exchange rate has downward momentum.

Moves above or below the bands are not signals per se. As Bollinger puts it, moves that touch or exceed the bands are not signals, but rather "tags".

On the face of it, a move to the upper band shows strength, while a sharp move to the lower band shows weakness. Momentum oscillators work much the same way.

Overbought is not necessarily bullish. It takes strength to reach overbought levels and overbought conditions can extend in a strong uptrend. Similarly, prices can "walk the band" with numerous touches during a strong uptrend.

It’s important to learn to use Bollinger Bands in combination with pattern observation and other indicators. Used in this way, they are a powerful aid to trading.

Momentum Trading

Momentum trading is a particularly popular approach to forex. Momentum trading is a strategy that aims to capitalize on the continuance of existing trends in the market.

The momentum investor believes in spotting large price movements.

These large and regular movements come from trading psychology. Traders simply react, or don’t react, to important events in the news or economic world.

The result is that they move in a group in a single direction, and this has a lot of money moving in the same way – it pushes the market in a given direction, and creates momentum.

Momentum strategy works best in ranging markets. A certain duration is required in order to establish a trend.

There are a large number of momentum indicators to choose from: For example, the Awesome Oscillator or the Intraday Momentum Index are both well-known.  All of these work on essentially the same principles.

Various oscillators are calculated by different formulas, but they are all based on the relationship of the current price to previous prices for a specified period of time. The theory is that a change in momentum tends to lead to a change in price.

Oscillators are used to help determine whether a price movement will become a trend: Will it be sustained, or has it finished, and is it likely to reverse?

There are different types of momentum values to interpret. When momentum values are positive and rising, one can assume that prices are rising, indicating that buyers are supporting a rise in price over the trend.

When values are slowing, the trend is moving to a close. When values are falling, prices are falling, and sellers are moving together to support a drop in prices.

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