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.

Fundamental Analysis

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.[1]

Technical Analysis

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.[2]

Trend Trading

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.[3]

Range Trading

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.[4]

Momentum Trading

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.[3]

Swing Trading

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.[5]

Breakout Trading

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.[3]

Retracement

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.[6]

Reversal Trading

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.

Traders use a variety of tools to spot reversals, such as momentum and volume indicators or visual cues on charts such as triple tops and bottoms, and head-and-shoulders patterns.[7]

Position Trading

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.[8]

Carry Trade

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.[9]

Pivot Points

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.[10]

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.

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.

Contract-For-Difference (CFDs)

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.

  1. 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.
  2. 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.

Summary

Traders have a wide variety of strategies at their disposal to try to interpret price movements and take advantageous trading positions. Some traders may use a particular approach almost exclusively, while others may employ a variety or hybrid versions of the strategies described above.

While none is guaranteed to work all of the time, traders may find it useful to familiarise themselves with a number of strategies to build an arsenal of available tools for adapting to changing market conditions.

This article was updated on 2nd October 2019.