What Are The Different Types Of Forex Trading Strategies?
Forex traders use a variety of strategies and techniques to determine the best entry and exit points—and timing—to buy and sell currencies. Market analysts and traders are constantly innovating and improving upon strategies to devise new analytical methods for understanding currency market movements. What follow are some of the more basic categories and major types of strategies developed that traders often employ.
Types Of Forex Trading Strategies
The following are some of the more basic categories and major types of strategies developed that traders often employ.
|Trend Trading||Potentially lucrative profits, positive risk vs reward ratios, reduced transaction costs, precision on market entry/exit not critical||Timing the market can be difficult, many false signals/reversals, minimal success rate|
|Range Trading||Limited risk, an abundance of trading opportunities, minimal initial capital outlay, clear cut stop loss and profit target locations||Smaller profit targets increase the impact of per trade costs, precision important on market entry/exit, rapid decision-making required|
|Momentum Trading||Winning and losing trades are determined quickly, reduced exposure to systemic risk, strategies may be simplified with technical analysis||Sensitivity to surprise market fundamentals, an abundance of false signals, challenging to align risk with reward, precise market timing required|
|Swing Trading||Short-term volatility not overly important, market entry and exit does not need to be exact, extraordinary profits possible||Substantial exposure to systemic risk, additional costs attributable to forex rollover, account illiquidity contributes to opportunity cost|
|Breakout Trading||Exceedingly positive risk vs reward ratios, potential for large profits, compressed trade durations, limited downside liabilities||Many false signals, difficult to properly time, an abundance of missed trades, increased presence of slippage|
|Retracement||Exact market entry points, ideal for trend trading, higher success rates, potential for large profits||Greater stop losses and capital outlay required, many fakeouts in relation to reversing and consolidating markets|
|Reversal Trading||Large profits possible, complimentary to momentum oscillators, applicable in both bullish and bearish markets||An abundance of false signals, difficult to accurately pick tops and bottoms, stop losses can be substantial, success rates minimal|
|Position Trading||Precision on market entry/exit not critical, extraordinary gains possible, intraday noise not overly important||Enhanced exposure to systemic risk, potentially large drawdowns, strong reliance on fundamentals|
|Carry Trade||Can be a high probability strategy, may generate consistent returns, reduces the impact of negative price action||Low interest rate environment reduces opportunities, increased exposure to systemic risk, rollover costs steepen losses on unsuccessful trades|
|Pivot Points||Definite market entry and exit points, an abundance of trading opportunities, complimentary for breakout or reversal strategies||Unreliable in trending markets, sensitive to fundamentals, lack of opportunities in rotational markets|
|Day Trading||Limited exposure to systemic risk, no cost of rollover, enhanced account liquidy reduces opportunity cost||Sensitive to short-term volatility, slow market conditions reduce positive risk vs reward opportunities|
|Forex Scalping||High success rate, an abundance of trading opportunities, minute exposure to systemic risk||Extremely sensitive to slippage, commissions and spreads have great influence on profitability, consistency is a must|
Trend trading is one of the most popular and common forex trading strategies. It involves identifying an upward or downward trend in a currency price movement and choosing trade entry and exit points based on the positioning of the currency's price within the trend and the trend's relative strength.
Traders will often cite the phrase, "The trend is your friend," as a reminder that recent trends can be reliable indicators of where prices are likely to go moving forward and where to best set up trade entry and exit points. Trend traders use a variety of tools to evaluate trends, such as moving averages, relative strength indicators, volume measurements, directional indices and stochastics.
Trend trading is a viable way of producing returns. Directional moves in price give active traders the opportunity to assume minimal risk while pursuing much larger rewards. The provision of favorable risk vs reward scenarios enhances capital efficiency, making it possible to generate solid profits with only a modest winning percentage.
Directional moves in forex pricing are often short-lived as there are myriad factors that can suddenly cease or reverse a trend. Also, trending markets frequently move quickly, making securing good trade location a challenge. Unfortunately, many trend-following trades are ineffective as traders miss out on an ideal entry and lose money by entering the market too late.
Range trading is a simple and popular strategy based on the idea that prices can often hold within a steady and predictable range for a given period of time. That's particularly evident in markets involving stable and predictable economies, and currencies that aren't often subject to surprise news events.
Range traders rely on being able to frequently buy and sell at predictable highs and lows of resistance and support, sometimes repeatedly over one or more trading sessions. Range traders may use some of the same tools as trend traders to identify opportune trade entry and exit levels, including the relative strength index, the commodity channel index and stochastics.
Range trading requires less capital than many other strategies to trade properly. Stop losses are typically aligned near the extremes of a range, making each trade relatively affordable. In addition, range bound markets are common, so there is no shortage of potential opportunities. If an unexpected breakout develops, a sound strategy is wrong only once, as the market establishes a fresh trading range.
Consolidating markets typically move slow as limited participation leads to reduced price action. This means that bid/asks spreads may be wider and the cost of slippage greater. Further, established ranges can be small, thus limiting the profit potential of the trade. Given smaller profit targets, wider spreads and slippage, a higher success rate is needed to sustain profitability while overcoming these drawbacks.
Momentum trading and momentum indicators are based on the notion that strong price movements in a particular direction are a likely indication that a price trend will continue in that direction. Similarly, weakening movements indicate that a trend has lost strength and could be headed for a reversal. Momentum strategies may take into consideration both price and volume, and often use analysis of graphic aides like oscillators and candlestick charts.
Implementing momentum trading strategies is relatively easy and affordable. Robust trends are obvious on any timeframe, making spotting setups routine. Capital outlays are reduced as the success or failure of a specific trade is known quickly. This strategic functionality is ideal for cutting losing trades off while letting winners run.
The momentum of price action can be fickle, often receding unexpectedly. Also, accurately timing the market is problematic as strong moves typically come on quickly. To trade momentum strategies, discipline is needed as the temptation to "chase" a missed entry can lead to unwarranted losses.
Swing trading is customarily a medium-term trading strategy that is often used over a period from one day to a week. Swing traders will look to set up trades on "swings" to highs and lows over a longer period of time. This is to filter out some of the "noise," or erratic price movements, seen in intraday trading. It's also to avoid setting narrowly placed stop losses that could force them to be "stopped-out" of a trade during a very short-term market movement.
Swing trading strategies afford the trader with an opportunity to stay in the market despite intraday volatility. This eliminates many unfortunate market exits and promotes a higher success rate than various short-term methodologies. Also, profits from swing trades can be large, as getting in on a trend is more likely due to being active in the live market.
Executing swing trades is more expensive, as stop losses are much greater than in intraday strategies. Additionally, holding open positions for extended periods in the live market exposes the trader to a higher degree of systemic risk. Depending on the pair and position size, there may also be substantial costs attributable to forex rollover.
A breakout strategy is a method where traders will try to identify a trade entry point at a breakout from a previously defined trading range. If the price breaks higher from a previously defined level of resistance on a chart, the trader may buy with the expectation that the currency will continue to move higher. Similarly, if the price breaks a level of support within a range, the trader may sell with an aim to buy the currency once again at a more favourable price.
Breakout trading strategies can lead to big profits, as breakouts often turn into strong trends. Further, a breakout trade's success is determined rapidly. If there isn't ample order flow to support a directional move in price, the trader is able to exit the market and quickly mitigate losses.
While they do occur, true breakouts are not all too common on the forex. Unfortunately, breakout traders frequently deal with false signals as market participation isn't strong enough to move price definitively. In addition, breakouts can be tough to capture as they come on and develop exceedingly fast.
Forex Day Trading Strategy
By definition, day trading is the act of opening and closing a position in a specific market within a single session. Although it is sometimes referenced in a negative connotation, day trading is a legal and permitted means of engaging the capital markets. In fact, it benefits practitioners in several ways:
- Limited Risk: Day trading is a short-term strategy that does not require the trader to hold an open position in the market for an extended period. Subsequently, exposure to systemic and market risks are greatly reduced.
- Decreased Opportunity Cost: The trading account's liquidity is ensured due to the intraday durations of trade execution. Risk capital is not committed to a single trade for a long period of time; this element frees up the trader to pursue other opportunities.
- Regular Cash Flow: Day trading allows for a regular cash flow to be generated. While profits are not guaranteed, a daily P&L is calculated. As a result, gains are realised much faster in comparison to more traditional investment strategies.
A forex day trading strategy may be rooted in either technical or fundamental analysis. Some of the most common types are designed to capitalise upon breakouts, trending and range-bound currency pairs.
Compared to other markets, the availability of leverage and diverse options make the forex a target-rich environment for day traders. In addition, one has the flexibility to benefit from being either long or short a currency pair. When taken together, these three factors effectively open the door to myriad unique forex day trading strategies.
Day trading limits the trader's exposure to broader systemic risk. Also, there are no rollover costs as positions are not held through the daily forex close. Executing day trading strategies is more affordable as stop losses are vastly reduced from multi-day strategies. In addition, opportunity cost is mitigated as capital is not tied up for long periods in the market.
When day trading, the trader is exposed to intraday noise. Breaking news items or scheduled economic reports can skew short-term volatility, leading to unexpected losses. Moreover, slow market conditions can undermine favourable risk vs reward ratios, making it a challenge to sustain long-term profitability.
Forex Scalping Strategy
Scalping is an intraday trading strategy that aims to take small profits frequently to produce a healthy bottom line. Trades are executed according to a rigid framework designed to preserve the integrity of an edge. Through applying a viable edge repeatedly on compressed timeframes, capital exposure and systemic risk are limited.
The success of a forex scalping strategy is dependent upon several key factors:
- Valid Edge: In order to make money scalping, one must be able to identify positive expectation trade setups in the live market. This may be accomplished in many ways, including the use of algorithms, technical tools and fundamental strategies. A strong edge is statistically verifiable and potentially profitable.
- Discipline: Scalping requires the execution of a high volume of trades. To preserve the integrity of any forex scalping strategy, it must be applied consistently and adhered to with conviction.
- Low Costs: In scalping, profit targets are smaller than those of swing trades and long-term investment. Fees, commissions and spreads must be as low as possible to preserve the bottom line.
- Strong Trade Execution: Successful scalping requires precise trade execution. Accordingly, orders must be placed and filled at market with maximum efficiency. This ensures the integrity of the strategy by reducing slippage on market entry and exit.
Due to the greater number of trades being executed, currency pairs that offer both liquidity and pricing volatility are ideal. These elements promote efficient trade via tighter bid/ask spreads and limited slippage, thus increasing the effectiveness of most scalping strategies.
Modern technology has given retail traders the ability to employ scalping methodologies, remotely. Many brokerage services offer low-latency market access options and software platforms with advanced functionality. Whether your forex scalping strategy is fully automated or discretionary, there is an opportunity to deploy it in the marketplace.
Scalping strategies require the use of tight stop losses, which eliminates the chance of experiencing financial catastrophe. Due to the fact that trades are executed on compressed time frames, exposure to systemic risk is vastly limited. Also, risk capital is allocated for brief periods of time allowing the trader to remain flexible in the market.
The utilisation of small profit targets and tight stop losses enhance the negative impacts of order slippage. Also, market liquidity must be robust, as wide bid/ask spreads and choppy price action significantly undermine the strategy's success. Scalpers rely on executing an abundance of trades on a daily basis, and it can be challenging to find enough setups to sustain profitability.
Retracement strategies are based on the idea that prices never move in perfectly straight lines between highs and lows, and usually make some sort of a pause and change of their direction in the middle of their larger paths between firm support and resistance levels.
With this in mind, retracement traders will wait for a price to pull back, or "retrace," a portion of its movement as a sign of confirmation of a trend before buying or selling to take advantage of a longer and more probable price movement in a particular direction. Traders will often pick a particular percentage movement as a sign of confirmation (such as 50%), or rely on Fibonacci ratios (of 23.6%, 38.2% or 61.8%) to help identify optimal points for entering and exiting trades.
Buying or selling retracements is an ideal way of entering trending markets. Thus, potential big profits are possible through the implementation of positive risk vs reward setups. Additionally, positions are opened in concert with a prevailing trend, which typically leads to higher success rates than counter-trend strategies.
Trend reversals are often misconstrued as being retracements, which can lead to substantial capital loss. Frequently, a market pulls back before entering a rotational phase, effectively reducing a retracement trade's profit potential. In trending markets, periodic ranges can be significant, requiring a large capital outlay to trade retracement strategies properly.
As the name implies, reversal trading is when traders seek to anticipate a reversal in a price trend with the aim to guarantee entrance into a trade ahead of the market. This strategy is considered more difficult and risky. True reversals can be difficult to spot, but they're also more rewarding if they are correctly predicted.
Reversal trading can lead to potential profits and optimal market entry for a new trend. There are a multitude of tools for identifying reversals, such as stochastics or the MACD. Stop losses can be affordable as a trade's effectiveness is determined in relation to the market's periodic extreme; the trend either changes direction from this point, or it doesn't.
Identifying market reversals can be problematic as trending markets frequently produce many false signals. In the live market, differentiating between a retracement and reversal is challenging as the structure of both is initially similar. Further, although a trend may become exhausted, markets often lack ample follow through to fully change direction.
Position trading is a long-term strategy that may play out over periods of weeks, months or even years. Position traders often base their strategies on long-term macroeconomic trends of different economies. They also typically operate with low levels of leverage and smaller trade sizes with the expectation of possibly profiting on large price movements over a long period of time.
These traders are more likely to rely on fundamental analysis together with technical indicators to choose their entry and exit levels. This type of trading may require greater levels of patience and stamina from traders, and may not be desirable for those seeking to turn a fast profit in a day-trading situation.
Position trading can potentially generate gains as the trader is in position to capitalise on strong trends. In addition, the trader is not concerned with short-term market volatility, only the macro direction of the market. When position trading, one does not need to be precise in market entry or exit to maintain profitability.
Position trading strategies require the trader to hold open positions for extended periods of time. This ties up risk capital, directly increasing the trade's opportunity cost. Also, the exposure to systemic risk is vastly greater than shorter-term strategies. Losses from position trading can be large, as stop loss locations are much wider in relation to macro market conditions.
Carry trade is a unique category of forex trading that seeks to augment gains by taking advantage of interest rate differentials between the countries of currencies being traded. Typically, currencies bought and held overnight will pay the trader the interbank interest rate of the country of which the currency was purchased. Carry traders may seek out a currency of a country with a low interest rate in order to buy a currency of a country paying a high interest rate, thus profiting from the difference.
Traders may use a strategy of trend trading together with carry trade to assure that the differences in currency prices and interest earned complement one another and do not offset one another.
In a stable global economic environment, carry trades have a robust success rate. Carry trades are ideal diversification tools as they may appreciate in comparison to separate stock or commodity positions. Further, the functionality of the carry trade is straightforward and can produce regular cash flows.
The adoption of low interest rates by central banks can make the upside of certain carry trades negligible. Also, carry trades come with the added risk of being exposed to the economic underpinnings of countries with "higher" interest rates. If central bank policy suddenly shifts, or an unfavorable economic report surfaces, the effectiveness of any carry trade may be immediately compromised.
Pivot point trading seeks to determine resistance and support levels based on an average of the previous trading session's high, low and closing prices. This average is considered to help predict the next likely highs and lows, and intraday market reversals.
Because these averages are widely used in the market, they are considered a healthy gauge for how long a short-term trend may continue, and whether a particular range has been surpassed and a new price trend breakout is occurring.
Pivot points furnish the trader with viable support & resistance levels and help to identify prevailing trends, reversals or breakout points. Thus, pivots take much of the guesswork out of market analysis. Additionally, pivot points offer concrete market entry and exit points that may be incorporated into nearly any trading strategy.
In trending markets, pivot points can be unreliable. Surprise news events, economic releases, or changes in monetary policy can quickly render their presence moot. Amid rotational or consolidating market conditions, forex pricing may rarely approach either upper or lower pivot points, making trading opportunities rare.
Contract-For-Difference (CFDs) Trading
Contract-for-difference (CFDs) products are financial derivatives that provide traders with an avenue to the world's leading markets. A CFD is a binding contract between a trader and a broker to exchange the price difference of a product from the time it is opened until it is closed.
CFDs allow participants to profit from the price movements of an underlying asset, without actually assuming ownership. Due to the fact that operations are conducted outside of standardised exchanges, CFDs are considered to be over-the-counter (OTC) products. Below are a few of the benefits afforded to active traders:
- Leverage: CFD products boost the purchasing power of participants, making it possible to open large positions with minimal capital. With available leverage at upwards of 30:1, these instruments feature limited margin requirements.
- Flexibility: Traders are free to take active long or short positions in the market, thus making it possible to profit from rising or falling asset prices.
- Diversity: CFD listings are extensive and vary from broker to broker. Popular instruments are based upon corporate stocks, equity indices, currencies, commodities and debt products.
- Liquidity: A CFD is a contract with two counterparties―the trader and broker. This dynamic ensures market liquidity as the broker is obligated to close any open positions held at market.
- Limited Costs: Costs are limited to the bid/ask spread and are typically free of commissions as well as maintenance fees.
While the advantages of CFDs are extensive, there are also drawbacks to be aware of.
- The implementation of enhanced leverage makes CFD trading inherently risky. Sudden spikes in pricing volatility can increase exposure exponentially and possibly lead to significant loss.
- Bid/ask spreads can vary with respect to evolving market conditions and brokerage outlet, thus cutting into profitability. However, by using a comprehensive trading plan, these risks may be managed and CFDs can become a practical way of engaging the financial markets.
In fundamental analysis, traders will look at the fundamental indicators of an economy to try to understand whether a currency is undervalued or overvalued, and how its value is likely to move relative to another currency. Fundamental analysis can be highly complex, involving the many elements of a country's economic data that can indicate future trade and investment trends.
A good place for traders to start, however, is in analysing currency inflows and outflows of an economy, which are often published by the nation's central bank. Additionally, they may rely on news and data releases from a country to get a notion of future currency trends.
Technical analysis is another main category of currency trading strategies that is highly favoured among traders. Most often it involves reviewing the past and recent behaviour of currency price trends on charts to determine where they may move going forward. The rationale behind using technical analysis is that many traders believe that market movements are ultimately determined by supply, demand and mass market psychology, which establishes limits and ranges for currency prices to move upward and downward.
Technical analysis encompasses a long list of individual methods used to detect likely currency trends. Many traders appreciate technical analysis because they feel it gives them an objective, visual and scientific basis for determining when to buy and sell currencies.
Bottomline: What Is The Best Forex Trading Strategy For You?
Competently selecting a forex trading strategy involves first conducting a rigorous, honest self-evaluation. This may be accomplished by completing a checklist breaking down your trade-related assets. Among the most important are your experience level, available resources, and primary objectives. It's imperative that these inputs complement your trading strategy. If not, succeeding in the marketplace becomes an even more challenging task.
If you want to generate a regular income trading forex, then you need to have the time, money and expertise necessary to make this objective attainable. Ultimately, your best forex trading strategy is the one that aligns your resources to your goals.
This article was updated on 20th April 2021.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…