The foreign exchange, or forex market has become extremely popular among active traders due to its extended hours, deep liquidity and the availability of leverage. While it’s tempting to jump into the market headfirst, successful traders take the time to build and test robust trading strategies before placing any live trades.
Let's take a look at the three most popular types of trading strategies for the forex market and how you can build your own strategies around them.
Trend Following Strategies
Trend following strategies involve identifying the direction and strength of a trend and placing a trade in the same direction as the underlying trend. If the trend starts to weaken, traders may take some profit off of the table or close the entire trade until the trend resumes. The challenge is capturing enough of the trend to generate a profit and avoiding a whipsaw.
The most basic trend following strategies involve moving averages, where the current value is the average of n periods in the past. For instance, traders may plot a 9-day and 21-day moving average on a chart. They may identify an uptrend when the 9-day moving average crosses over the 21-day moving average and decide to buy the currency pair.
Simple Moving Average Crossover (9, 21) on the EUR/USD Pair - Source: TradingView
There are several technical indicators that can be helpful for identifying trend direction and strength:
- The Moving Average Convergence-Divergence (MACD) looks at the interplay between two moving averages to determine if an underlying currency pair is trending or not.
- The Average Directional Index (ADX) consists of two directional movement indicators designed to show if a currency pair is trending in a given direction.
- On-Balance Volume (OBV) takes a running total of trading volume and looks at whether it's flowing in or out of a currency pair to show momentum strength.
Traders may use a combination of these indicators to assess if a currency pair is trending, and if so, take a long or short position. Often times, trend traders use a trailing stop-loss to lock in profits along the way and reduce risk in the event that the currency pair moves suddenly higher or lower. Parabolic SAR and other indicators can also help set S/L points.
Reversal strategies involve identifying the point at which a trend is likely to reverse direction and placing a trade in the anticipated new direction. Since reversals tend to happen quickly, these trading strategies seek to capture greater price movements in a shorter period of time, which creates the potential for more gains or losses.
Many traders look for overbought or oversold conditions as a precursor to a trend change. In addition, they might use chart and candlestick patterns to assess market sentiment. A Relative Strength Index (RSI) reading that's approaching overbought levels above 70 could point to a potential reversal, but a descending triangle breakdown could be the turning point.
Relative Strength Index Approaching Overbought on EUR/USD Pair - Source: TradingView
There are several indicators and patterns that can be helpful in identifying reversals:
- The Moving Average Convergence-Divergence (MACD) doubles as a tool to spot potential reversals by looking for instances where the price and MACD values are diverging.
- The Stochastic Oscillator compares closing prices to a range of prices over a period of time. Extreme overbought or oversold levels could indicate an upcoming reversal.
- Triangle chart patterns are a great way to predict reversals since they indicate successive pushes against a resistance level with less resistance with each attempt.
Traders may look at a combination of technical indicators and chart patterns to create a trading strategy. In most cases, traders have take-profit and stop-loss levels defined before entering the position based on various technical factors. These levels may be static points or moving targets to lock in profits, as in trend-following strategies.
Scalping strategies involve identifying extremely short and rapid price movements for quick profits. If a strategy has a small expected gain, traders can increase leverage to make the strategy very profitable even if each trade only results in small gains on a percentage basis. The key is developing a robust trading system to capitalize on these opportunities.
The most common scalping strategies are centered on news flow related volatility. For example, non-farm payrolls or preliminary GDP announcements can have a significant impact on currency pairs that include the USD. Many traders wait for an extreme reaction and then enter a long or short position in the opposite direction to benefit from mean reversion.
Traders may also create complex strategies involving technical indicators and automate them using tools like Metatrader. Since trades may be fast and frequent, automation helps ensure that they are executed on a timely basis without the involvement of human emotion. The catch is that any mistakes are instantly amplified, so it's important to test the system.
The Bottom Line
The forex market has become extremely popular among active traders due to its extended hours, deep liquidity and the availability of leverage. However, cryptocurrencies are quickly becoming another alternative market for the same trader demographic with greater volatility. Traders can use many of the same strategies in these new markets.
Traders interested in the crypto markets should be mindful of some key differences between the two. Crypto markets tend to be much less liquid than forex markets, which means that some strategies may not directly translate. Leverage may also be less available than in the forex markets, particularly among larger brokerages and trading platforms.
ZenLedger helps crypto traders remain current and accurate with the IRS' unique requirements by aggregating transactions across multiple exchanges and wallets and auto populating IRS forms, such as Form 1040 Schedule D and Form 8949.