“The trend is your friend.” You’ve heard that before, right? When you trade forex, many traders live and die by that rule. There’s a reason why. Trend following is a major trading strategy employed by even expert traders. But, it’s not the only trading strategy or methodology out there. Forex is primarily a directional-driven market where traders must decide how they will exploit movements in the market. A static or “sideways” market is nobody’s friend.
At the same time, directional trading can easily turn against even the most experienced trader. These trading strategies exploit small movements in currency pairs. If the trader is correct, he wins money. If he’s wrong, the losses could be catastrophic. It’s a high-stakes game. If you’re ready to play, here are the major sub-strategies that will get you off the ground.
Trend Following When You Trade Forex
The idea of trend-trading or trend-following is that an established trend will continue in the same direction rather than reverse course. The strategy uses technical analysis to try to spot trends or patterns in the market, and then it exploits those patterns for profit. It’s a form of data mining and analysis. To trade on a trend, you can either trade in a general direction with unlimited upside potential or trade within a range.
For example, a general trend-trading strategy might have you find a trend and then take a long or short position on it. You may then place your stop loss at a conservative point given the volatility of the market.
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Trading within a range means that you attempt to find a pattern of movement within the daily trend and then enter and exit within that range. So, you profit on the daily oscillations of the market, rather than a long-term trend that lasts either all day in one direction or multiple days.
Moving Average Crossover
This common directional trading scheme uses two moving averages to signal a buying opportunity. These opportunities are triggered when short-term and faster-moving averages cross over into a longer-term average. In other words, short-term prices are indicating a possible long-term upward trend. These trading systems are risky in that they’re subject to something called “whipsaws” – a phenomenon where the market zig-zags and reverses, making profit extremely difficult or impossible.
Traders who employ moving average crossovers depend on the market to follow a specific trajectory. When it doesn’t, the trade becomes a loss.
A breakout strategy isn’t difficult to develop. It consists of a set of predefined rules indicating how the market should move and what your response to those movements should be. It’s based on the idea that a currency’s price will move to a new high or low and that trends will develop based on these price movements.
When the software spots one of these new trends, it generates a buy signal and you open a position in that currency pair. For example, let’s say that a currency moves to a new 20-day high. It’s been hanging out in this new neighborhood for the past month. This new high may indicate the start of a new trend, and so the system may tell you to close out a short position and go long. Going long means you’re holding onto a position hoping that it will increase in price.
Likewise, a new currency low may trigger a shorting opportunity. If a currency’s closing price is below the 10 or 20-day high, it may be an indication that you need to short this currency and close out any long positions.
In either case, you have to decide how long of a period you want to trade and then go with it. Shorter (and faster) time periods carry more risk, but they also contain the potential for higher returns. Longer trends are slower-moving, but also lower risk.
Pattern Recognition Strategies
Many directional forex trading strategies rely on pattern recognition. In general, pattern recognition includes every attempt to quantify movements in the forex market and measure directional changes over time.
These patterns represent profit opportunities for traders, if they can spot them and enter a position in time. For example, a triangle pattern can signal a trend reversal, but they are also often associated with trends within a specified range. In fact, they can be used to define a range.
Flags are another pattern that indicate “mini-trends” within a larger trend. It’s a form of oscillation within a large trend. Like flags, pennants are also reliable for “trend-spotting,” and rarely reverse on you.
While no pattern is fool-proof, a good pattern can help you loosely define where a trend starts and ends. For example, the flag usually signals the mid-point of a trend. So, you can be somewhat confident that trading after seeing this trend can yield at least some profit. All you need to do is look back to the beginning of the trend and extrapolate the end.
Lastly, remember that any directional trading strategy is only as good as its assumptions. If you make a fact-based mistake, or you miss a crucial piece of evidence, no amount of charting or backtesting will help you. Of course, this is the trick in forex. Since the market is so large, perfect information is practically impossible. Still, you should shoot for that as an ideal.
Callum Ford likes to keep up with the newest and most effective trading strategies out there. When he finds one that is interesting, he likes to blog about it on various websites to let others know about them, too.