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A comprehensive guide to foreign exchange trading strategies

 

Foreign exchange trading refers to the practice of trading one currency against the other, based on the rise and fall of the value. For those who have never traded this type of asset before, it may seem startling to learn that this is an industry with a market cap of at least $5 billion US dollars. Every day people are making a significant profit off the back of moves triggered by everything from central bank interest rate changes to the announcement of general elections.

But how do successful forex traders do it? What tips and tricks lie in a traders’ toolbox, and what do they do with the free forex charts and forex trends information that they pore over before placing trades? Ask any two different foreign exchange traders for a detailed answer, and they won’t give the same one. That’s because there are so many forex trading strategy options out there. Depending on the circumstances and priorities of the trader, this can easily change.

For a newbie, the hard part is choosing a strategy, then having the tenacity to try it out properly, as well as identifying when it’s failed and moving on. If a trader chooses a top-rated broker, they might be able to get access to exclusive educational resources which allow them to get pinpointed and accurate advice. But, unless a trader can choose a broker on this basis, it’s more likely that they will need to experiment on a trial and error basis – and that’s where this article can help.

It will explore a series of the most forex common trading strategies, and it will explain each one in turn – and look at the advantages and disadvantages of each, too. And it will take a look at what the future of the dynamic and interesting foreign exchange industry might hold thanks to technology, especially in light of artificial intelligence and social trading. Ultimately, the decision on which strategy – or strategies – to try will come down to the individual forex trader. But this guide will act as a starting point for further research into what each one can offer.

Breakout trading

The first forex trading strategy that this article will explore is “breakout trading”. In layman’s terms, this strategy could perhaps best be described as “getting in there early”: it focuses on opening a position (or stating what the trader think will happen, i.e. a price rise or a price fall) quite early in the process of a trend. (A trend is the indicator which appears on a price chart graph, and which can suggest what might be about to happen next.)

Foreign exchange prices often remain within the bounds of what are described as support or resistance levels, which lie on either side of a fairly stable price point. If a price “breaks out” of this range, it means that it’s moving into new territory and heralding the arrival of a new trend. The consequences of this are usually quite predictable: traders across the markets begin to worry about what this means for their own position, and hence either close existing positions or buy up new ones – leading to a period of volatility.

For an investor thinking about adopting a breakout strategy, then, it’s necessary first to assess whether or not they have the skills and time to manage this risk. Volatility is not necessarily a bad thing: it can be managed in a number of ways, which will be explained below. However, the first thing to do is to learn how to differentiate between a breakout and a so-called “fakeout”. A genuine breakout will have some degree of time and sustainability on its side: it might persist until beyond the end of the current trading session, for example, while a fakeout would end up back where it began – and prove itself to have been a simple misreading of the trend.

Managing the risk involved with this kind of volatility is also important. Usually, the platform of any top rated broker will offer a trader tools like stop losses (which let the trader specify at what potential loss point the trader’s losses should be cut, and the position be automatically closed). Specifically to this strategy, though, is the phenomenon of price targeting. This concept lets the trader work out where the best point to quit – or “exit”, as it is known – the trade might be. Using historic price chart data is wise here. If the chosen currency has shown a change of, say, three cents over the last few days, exiting when the price reaches a three-cent divergence from where it was when it broke out of its support and resistance range is a wise idea.

Currency carry trade

This trading strategy, which is one of the most common ones out there, relies on the fundamental basis of foreign exchange trading: namely that forex trades are always carried out in pairs. This stands in stark contrast to most forms of asset trading, which speculate on the outcome of either just one asset or a group of single assets. Forex trades, however, pit one currency against another: a trader might speculate that the British pound will rise against the US dollar at a given time, for example, or that the Japanese yen might fall against the New Zealand dollar.

The key to the currency carry trade strategy is to pair these strategically in order to profit of the difference in a certain type of value associated with each currency. This strategy focuses on yield: a currency which has a high yield is placed alongside one with a low yield, with the higher one paying for the trade to be placed. The first step is to work out which interest rate “spreads” work best: the spread between two currencies, in this instance, is often the interest rate in the home country of the relevant currency.

For that reason, traders will often borrow the currency which has a low-interest rate, as that’s cost-effective and use it to buy the currency of the country which has a high-interest rate. Provided that there are no dramatic moves in the exchange rates, a profit can – hopefully – be realised.

However, recent moves in the sphere of central bank interest rate setting has led this strategy to perhaps begin to be a little outdated – or, at least, now hold the potential to become outdated in the future. The strategy only works when some central banks have high rates, and others have low. Given that the moves of many central banks push their interest rates lower and lower in order to stimulate economies and get people and companies borrowing money, it could soon become the case that the currency carry trade strategy is not quite as “simple” as it might seem.

Contracts for difference (CFDs)

In the not so distant past, the only way in which it was possible to purchase a large amount of foreign currency was to buy it. If a trader wants to trade dollars, for example, they or their broker would need to the requisite amount of that currency. But now, the rise of derivatives has changed that.

One of the most popular varieties of derivative is the “contract for difference”, or a CFD. A contract for difference is not actually a currency asset: it’s a product which derives its value entirely from the underlying asset, and whose market appears to mimic that of the legitimate asset exactly. One of the many differences between a contract for difference and the asset from which it is derived is that it can be much more easily bought and sold, at least when compared to the purchasing and selling of large amounts of actual foreign currency.

To some extent, foreign exchange contracts for difference work in a similar way to the real asset. They allow for speculation on whether or not a given currency will rise or fall in proportion to another specified currency, for example, and the process of closing a trade is the same. Selling up (although of course, in this case, it is the contract for difference that is being sold rather than actual currency). The “difference” element comes from the way that the profit (or loss) is calculated in a contract for difference situation. It is calculated based on the price difference between the amount in which the contract for difference was bought and that for which it was sold. In other words – the “spread”. When the position is closed, the payout is in cash.

However, perhaps the most important aspect of contracts for difference trading to bear in mind is how it relies on leverage. CFDs are traded on what are usually described as the “margins”, which means that it is very easy to amplify the size of a trade – and, consequently, the size of a potential profit or loss. This is achieved by funding part of the contract for difference through borrowing. The size of the margin can be relatively astronomical, with leverage amounts as high as 20% sometimes observed. For this reason, it’s often recommended that only traders who are at an advanced stage in their trading career attempt to trade an asset like this: otherwise, it could backfire and leave the trader with a very big loss to nurse.

Day trading

So far, this guide has looked at specific forex trading strategies which can be used by most traders, within reason. Day trading is a strategy – but it’s also a lifestyle, a career and a choice which could have significant effects on how a trader’s life as a forex trader might play out. It refers to the practice of placing trades which open and close on the same day, with the idea being that short-term price fluctuations could lead to profit.

Fundamentally, day trading relies on the assumption that markets don’t always work quite as efficiently as they should. The foreign exchange market, in particular, is often described by day traders as a good example of such a market – although the jury is out on whether that is true, and indeed whether or not day trading as a strategy is effective.

While day trading is a strategy in its own right given that it makes a certain set of assumptions about the value of time periods, it can also be seen as an umbrella term covering many other strategies. Scalping, which will be covered in more detail below, refers to the practice of buying and selling many different forex securities over the course of each day with gaps of few moments in between each action, and trying to profit from the tiny price changes involved each time. News-based trading, which relies heavily on fundamental analysis of the wider world and the economies within it, seeks to profit from announcements of interest rate changes, data releases and many more.

Perhaps the major disadvantage of a day trading strategy is that it’s not particularly suitable for beginners who are just starting out in their forex careers. It requires a significant degree of knowledge: it often only works when the foreign exchange is particularly liquid and high volumes of currency are being bought and sold, for example. Identifying the triggers of this kind of movement (such as particular economic data releases) takes time and skill.

But it also requires a distinctive sort of emotional and psychological outlook, too. Those who find themselves making instant, non-strategic and knee-jerk reactions to price movements (especially those who move against their own favour, or which perhaps offer the illusion of a chance to make some quick cash) are unlikely to find day trading a successful strategy.

Finally, it’s also worth noting that a trader should always choose a top rated broker before deciding to press ahead with a day trading strategy. The reason for this is that fraud related to day trading is highly common. Scam adverts which claim that it is possible to accrue a significant return in a very short space of time through day trading pervade many parts of the Internet. Using broker reviews to choose a broker is essential here, as it means the risk of falling victim to one of these scams can be significantly reduced.

Reversal trading

 In some ways, reversal trading is perhaps the simplest of the foreign exchange trading strategies to understand – at least on a superficial level. It refers to a sustained change in the way a currency’s value goes. If a currency was previously rising in value, then a reversal would mean it was losing value. If it was previously losing value, then a reversal would cause it to gain value. In technical terms, these are often referred to uptrends or downtrends, with the reversal itself being described as “to the downside” or “to the upside” – although it is always worth checking the figures and working this out for sure rather than just relying on third parties’ description of price movements.

But not just any move in the opposite direction constitutes a price reversal. The reversal has to be sustained for a while before it can be properly labelled as such: prices in the often-volatile currency markets can be seen to be all over the place, and a trend needs to emerge before a reversal can be declared. What matters most in working out whether or not a reversal has occurred is what a trader’s overall context looks like. For a day trader, a reversal in the space of minutes could be significant. For an investor looking to make a profit over the course of months, charts which are week-by-week could be more useful.

Finding out and confirming whether or not a reversal has occurred can be tough. Some traders use what is called a moving average to work this out: a moving average takes into account relevant past price action movements within a given timeframe to reveal and emphasise the most relevant ones in the form of a trend. There are other methods available, though, and it may be worth experimenting to see which one provides the most accurate identification and flagging of reversals.

In terms of profiting from this strategy, there’s no surefire way to do it. Many traders, however, use it as a signal. Once a reversal has been rigorously established, a trader might make a decision to close a trade which – if the trend the reversal has created continues – would cause them to lose out. It can also be used in the other direction, too, with traders using reversals to identify trends in assets and then snap them up.

Momentum trading

Anyone who has ever traded an asset of any sort will know that there’s a lot to be said for purchasing it at a low price and then doing something (either adding value, or waiting for time to elapse) before selling it on for a profit. So, it may come as something of a surprise to learn that some traders, especially in the foreign exchange world, don’t adhere to this as a strategy.

In fact, there are plenty of traders who instead focus on buying up stocks that were already performing well, and then aiming for them to become even more valuable. “Momentum investing”, as it is known, relies to some degree on the idea that if an asset is already valuable, there must be a reason why that has occurred – and hence there is some “momentum” behind it which can propel it forward even further. The strategy also relies on the idea that stocks which are dipping in value should be sold off, which – in theory, at least – enhances the overall value of the portfolio.

Often, momentum trading is somewhat short term in nature. That’s because it relies on volatility, which is by its very nature of unpredictability a short term phenomenon. In fact, it relies entirely on avoiding long term volatility: by making the most of short term up but excluding long term down downs, the momentum can be protected. This is, of course, a risky strategy – although some momentum traders would perhaps argue that it’s not necessarily any more or less risky than any other forex trading strategy, and that no strategy is perfectly risk-free.

Perhaps one other dimension to consider is volume. The momentum is what makes the profit, but the momentum can also be what can harm the potential for profit in the long term if too many other investors have the same idea. In the event that lots of traders attempt to follow the same trend, it’s in the interest of the momentum investor to be sure that they can get out of the market on time before the large volume of other traders leave and cancel out the momentum gained. For this, a momentum trader needs to have complex tools at hand to be sure that price charts are accurately analysed all the time – and that the risk is kept in mind.

Position trading

A position trader is someone who relies on the speculative prediction that an asset in a foreign exchange market will eventually move in favour of the speculative position. In this sense, they are perhaps the diametric opposites of day traders: by leaving assets to mature for weeks or even months on end, position traders are often hopeful that time will be on their side.

For new foreign exchange traders, this might seem like an appropriate and even advisable way to trade an asset. After all: other assets, such as properties, are traded on the basis that they need to be left for the long term in order to appreciate in value (whatever the long term might look like in that specific context). But it’s worth remembering that the foreign exchange market does not necessarily work in the same way as other asset markets, and a forex trading position which falls in value can lead to continued falling that could wipe out an investor’s entire stake.

It’s not unheard of to come across situation in which a position trader is agonising over whether or not to cut their losses as they watch the value plummet: according to their strategy, time is required – but if time is going by and a position is getting worse and worse, the decision about what to do can be tough. This comes back to discipline: by setting a stop loss which is based on the amount the trader can afford to lose (and nothing else), the strategy’s riskier elements can remain contained.

It also requires leaving money concentrated on a particular asset for a particular length of time. If that happens and then a stronger, more appealing trend appears, the position trader is unlikely to be able to do anything about it given that the cash has all been diverted elsewhere.

However, it’s not all disadvantages for this strategy. Usually, position traders follow a trend line: if a trend can be noticed, or so this strategy goes, so can the ability to determine whether or not that trend is sustainable. If it is predicted to be sustainable, then it is worth holding on to for a particular period of time. 

Swing trading

Swing trading is perhaps one of the most interesting trading strategies out there. It relies on a period somewhat in between the potential months involved with position trading or the minutes involved with scalping: in practice, many swing traders choose to use periods of around a few weeks or a few months.

Swing trading can be popular to forex traders who want to avoid risk. The reason for this is that it avoids volatility altogether – which, as outlined above, is a common aspect of many forex trading strategies. It doesn’t aim to profit from the entirety of a price change: on the contrary, it instead aims to make some revenue from just a small part of the price change. In that sense, swing traders can be characterised as being on the more manageable end of the risk-reward spectrum as they are often keen to make a respectable profit before finding another trade to open.

One of the key characteristics of swing trading is that many traders who follow this strategy choose to use technical analysis as opposed to fundamental analysis. Fundamental analysis refers to the practice of looking at broader macroeconomic conditions, such as the decisions of central banks or any upcoming data releases, in order to inform the opening and closing of positions. For swing traders, the so-called “pure” technical analysis – which focuses on price charts, i.e. the decisions of other traders to open or close their positions on a cumulative basis – is often the area of focus.

The downside to leaving a position open for a few weeks, however, is that fees charged by brokers to keep it open overnight or on the weekends can be very high. Traders might start searching for a broker by looking at the highest rated and those with affordable overnight fees. However, they must keep in mind that they will often have to factor in the amount charged by that broker to leave a position open overnight. If this could wipe out or even significantly dent the profits made from swing trading, it may not even be worth pursuing.

Forex scalping strategy

The practice of scalping is something of a controversial one in the foreign exchange world. It refers to attempting to make a large volume of tiny profits in a short space of time by opening and closing positions very regularly, and profiting from the tiny movements in price that this can lead to. In this way, it’s the opposite of many of the other types of trading strategies – some of which are focused almost exclusively on the idea of making large profits on less frequent occasions.

Forex scalping is a very real-time strategy: it requires the trader to be in front of the computer for the entire duration of the position, and to concentrate hard on the price movements in front of them. It can also be somewhat repetitive, especially if similar forex assets are being traded day in and day out. It can be a hyperactive process, with many trades needing to be opened and closed over the course of a day – or even within an hour. It’s not uncommon for a scalper to open a position and then close it again within minutes or even seconds.

One key problem that many scalpers end up running into is the issue of rules and regulations from the broker. Some brokers ban scalping outright, and traders who pursue a scalping strategy on a site where it is not permitted might find themselves getting banned or even losing some of their upfront capital. In part, this is because scalping is relatively easy – or, perhaps more accurately, not within the spirit of many of the established trading rules.

Retracements

Most forex traders need to be basically numerate in order to do well at this strategy. But for those who have a particular aptitude for mathematics and patterns, the retracement strategy is often a particularly popular choice. This strategy relies on the Fibonacci sequence (or of a variation on it).

Put simply, a Fibonacci retracement is a way to find out what the support and resistance levels for a particular forex asset are at one particular point in time – and then to use that data to work out what trades to place. Often, Fibonacci retracements are only calculated when there has been a significant move in market value – perhaps has a result of a big shift for an economic or political reason, or perhaps due to market overcrowding, or for some other reason altogether. Fundamentally, what matters most from a retracement calculation is that the currency in question has approved its support or resistance point on the price chart.

The aim here is to work out how much the market might move back in its former direction – or “retrace” – once the market has shifted, and before the trend settles down. This works on the assumption that the price of the asset may go up and down a little once it settles into its new position on the price chart. When a Fibonacci retracement is drawn on to a graph, it is often drawn with a mind to calculate certain percentage intervals – and in particular 38.2%, 50% and 61.8%. Most forex currency broker platforms will offer tools and software packages that allow the trader to do this, such as MetaTrader.

Perhaps the most appealing element of the Fibonacci retracement strategy is the fact that it is so maths-oriented. For traders who are worried about their vulnerability to emotional trading decisions, this can be a godsend. It can make all the difference between whether or not knee-jerk reactions occur – which

The downside is that it does come with a higher barrier to entry in the form of skills and knowledge – but if that can be overcome, this strategy could work well.

Pivot point

The “pivot point” is the term given to the location, which indicates the overarching trend of many different time periods in a particular part of the foreign exchange market. It’s especially useful when trying to work out how a market has performed, on the whole, in between lots of different ways of measuring time. Usually, it’s worked out by adding together the highest price, the lowest price and then the price at the time of market closure within a given period, and then dividing it by three to find the average. The idea here is that there is a benchmark to use the next day, which can, in turn, be used to inform strategic decisions about where the market is likely to go next. Ultimately, the aim is to identify where those all-important support and resistance lines lie: once that is worked out, the trader can make informed choices off the back of that.

Sometimes, the pivot point strategy is confused with the Fibonacci retracement strategy – and it’s easy to see why. Both of them are highly technical strategies, and they each aim to bring together different points on the price chart. But they are different. Fibonacci retracements can be worked out using a whole host of different areas on the chart, whereas a pivot point strategy has to be decided on the basis of the three fixes points outlined above. It’s often down to the individual trader which one to go for, and may depend to some extent on the experience and technical knowledge. With the pivot point strategy, there’s no need to worry about choosing the points to feed into the calculation – and while this may be a little bit more restrictive, it can also be freeing for those who are just starting out

How has tech shaped forex strategies for the better?

These strategies all reflect the foreign exchange world as it looks at present, in the here and now. But it does not reflect what the forex market will necessarily look like in five, ten or even twenty years’ time – and that’s because of the impact of technology on the sector.

The first key thing to think about when assessing the potential impact of technology on forex trading is artificial intelligence, or AI. AI refers to computing technology which has been designed to mimic human thinking and behaviour, and this has played a crucial role in the forex sector in recent years. One of the key benefits of this technology is its supposed ability to predict the future based on events that have happened historically. For a forex trader who is using price charts, this can be a very useful tool. Of course, the usual caveat for any trading strategy ought to apply here: past performance is not necessarily an indicator of future performance. However, what AI can potentially do is built up data-fuelled forecasts. By outsourcing all of this work to a computer, a trader can both save time (and hence reduce their opportunity costs) and also reduce the risk of human error, which is a noted aspect of forex trading.

Often, navigating the intense volume of data on offer can be where a forex trader falls down: despite the fact that data is often the best way of building out a strategy, there it can be extremely time-consuming to do so. But there’s also a salience dimension, too. As well as just analysing whole clumps of forex market price data, though, AI can go one step further. It can also work out which parts of a price chart are particularly relevant, and which ones are not. Some of the most successful forex traders are those who can filter out some of the irrelevant materials, information and indicators they come across, and filter in – or emphasise – those of which are more relevant. By facilitating the management of this data, artificial intelligence is often seen as a way around some of the barriers to achieving this goal.

Another distinctive way in which technology has opened up new opportunities is in the realm of social trading. Social trading refers to the practice of a new forex trader selecting a more experienced forex trader and committing their trading capital to automatically mimic the trades of the more experienced trader – either in its entirety or on a proportional basis. Usually, the more experienced trader in this situation will receive some sort of financial reward which increases the more popular they get. Social trading is a tech-focused forex strategy which comes with a variety of benefits. One such benefit is that it means the new trader is not on their own; with so many different strategies on offer, it can seem very overwhelming to select one and get started. Social trading allows a newer trader to find a more experienced person who can guide them, and who has already accrued the expertise to trade the forex markets well. So, in essence, the newer trader is paying for a forex information product and service rolled into one.

Sites which bring together newer traders and more experienced ones tend to offer the newer trader a chance to filter the pool of potential traders to copy based on a series of characteristics. The newer trader may decide, for example, that they want to only consider traders who match their own risk profile. Or they may want to copy traders who have a certain length of experience already under their belts – or, indeed, traders who have a track record of delivering a certain amount of profit when averaged out. The search functions built into many of the most prominent social trading sites permit this to be done easily, meaning that the customer experience for the newer trader is often smooth and simple.

Words of warning

However, technology has not been relentlessly kind to foreign exchange traders – and, unfortunately, there is evidence to suggest that it has on some occasions, enhanced the risk of fraud. Fraud has always been a problem for traders of any asset – but as this article has demonstrated, some foreign exchange trading strategies have been packaged up by fraudsters and marketed as “get rich quick schemes”. This is especially true for day trading strategies, but it’s also true for some of the others as well. In the technological age, the all-pervading and snappy nature of web advertising means that there’s only room for fraudsters to promote the positive sides (such as profit and independence), and not the less appealing sides – like hard work and risk management.

Before even deciding on a strategy, it’s usually best to read broker reviews and unearth any hint of “get rich quick” or a similar message before depositing cash. If something seems too good to be true, it usually is. Another way to reduce the risk of this problem is to check out the websites of the relevant regulators in the country in which the broker is operating. These often contain freely available lists of information about potential scams in the forex markets and can alert even the savviest of traders to potential scam elements (such as registration violations) which they might not have even noticed. While some traders could perceive this as a time drag, it’s best construed as an investment in the security of trading capital.

While the rise in social trading makes it easier for traders who want to access experienced communities along their trading journey, it’s worth remembering that it doesn’t necessarily lead to a situation where the newer trader makes as much money as an experienced trader. There could be many variables which help the more experienced senior, copied trader which do not necessarily apply to the new, copying trader. The copied trader may be using risk capital rather than a large chunk of their trading capital, for example, and hence any potential losses may affect them less. And, as ever, the copied trader may have a good track record – but this does not mean their record will hold forever. There are cases of even the most experienced and successful traders finding that their portfolios are wiped out and that they incur significant losses. So, while it could save the newer trader time and energy to copy a more experienced trader, it could also end up being wiser to invest the time in learning the strategies for themselves after all.

As this comprehensive guide has demonstrated, foreign exchange traders who want to get ahead of the game have a wide range of tools at their disposal. There are many different ways to make it in forex – although there are many different ways to lose out as well, which is why a judicious assessment of the strategies on offer is pretty much vital.

One thing is for certain: strategy is an essential part of the process – and without it, the whole enterprise may be fruitless. In terms of which strategies work best, that’s for the individual foreign exchange trader to decide. From the margin-based, leverage-focused world of contract for difference trading to the tiny profit accumulation aim of foreign exchange scalping, there are lots of different ways that a trader can delve into the forex world.

By trying out each of the distinctive trading methods over time, a trader can identify which one works best for them – and, ultimately, which one is delivering them the most sustainable, consistent and healthy profit margins. There’s no silver bullet in forex trading, and – despite the rhetoric and promises of some of the forex trading websites out there – there’s no one single strategy that is guaranteed to avoid losses and prioritise big gains. Fundamentally, choosing a strategy comes down to a person’s own hard work, resilience and rigorous thinking.

Tools for you to try: