Forex trading strategies

Forex traders range from private individuals making tiny deals to huge institutional desks controlling millions or even billions of dollars. One thing that unites all these disparate individuals is their use of trading strategies: some technical, some fundamental, but all aimed at providing guidance on market moves. Very little is universally agreed on by traders, who tend to be split into camps each supporting their own style of trading, but one unanimous point of agreement is the existence of trends – consistent moves in a particular direction. Identifying when a trend has begun or is about to end is what lies behind most successful technical traders, and there is a range of strategies they can use to do it.

Momentum trading

Forex momentum trading is a strategy in which traders look to capitalize on the strength of a current trend by entering into a position in the same direction. This type of trading is based on the idea that an asset's price will continue to move in the same direction once a trend has established itself, and that by entering into a position in the direction of the trend, traders can potentially profit from this movement, assuming it still has longer ‘to go’. This is a technical strategy, but one that can normally be combined with a fundamental view, e.g. if a trader believes the balance of trade means GBP will trend up against the USD, and he sees a positive trend developing in GBP / USD, he may well seek to participate.

One way to approach momentum trading in the forex market is to use pre-set technical indicators to identify trends and determine the strength of those trends. For example, a trader might use a moving average to identify the overall direction of a currency pair's trend, taking short-term averages crossing over longer-term ones as a positive sign (and its opposite as a negative) and then use the relative strength index (RSI) to measure the strength of the trend. When the RSI reaches a certain level, indicating that the trend is strong, the trader can enter into a position in the direction of the trend. This use of the RSI is quite different from its usual application in mean reversion strategies and shows the versatility of the tool.

One potential downside to momentum trading is that it can be difficult to predict when a trend will reverse. In addition, strong trends can sometimes lead to overbought or oversold conditions, which can make it difficult to determine the appropriate time to enter or exit a trade. As a result, it's important for traders to use stop-loss orders and other risk management techniques to protect their positions from unexpected swings.

Mean reversion

Online forex trading involves multiple strategies, but when grouped together, the majority of technical strategies can be described as either ‘trend following’ or ‘mean reversion’. In the first, traders identify trends and trade with them, expecting them to continue, and in the latter, they try to identify reversal points at the end of trades. Generally speaking, trend-following strategies are more successful as they involve less market timing, but traders still need to understand mean reversion so they can identify when trends are likely to weaken or reverse.

Forex means reversion is a trading strategy that is based on the idea that the price of a currency pair will eventually return to its average or "mean" value after it has deviated from that value – an average that of course moves with time. This type of trading is based on the assumption that prices tend to move in cycles, and that when a currency pair's price moves too far in one direction, it is likely to eventually revert back to its average value. Again, it is vital to stress that this average moves, and is based on prices over a past time period – no traders seriously believe that currencies have a fixed value they always trend towards (although some central banks do…)

The RSI is a classic mean reversion indicator – values of over 80 indicate ‘overbought’ and under 30 (sometimes 20) ‘oversold’. When the RSI enters one of these regions, mean reversion traders will be on the lookout for other signs that a trend might be weakening or about to reverse and will place positions accordingly.

Fundamental and news trading

Another approach to forex momentum trading is to use news and fundamental analysis to identify potential trends. For example, if a country's central bank is expected to raise interest rates, this could potentially lead to an uptrend in the country's currency. In this case, a trader might look to enter into a long position in the currency in anticipation of the trend; alternatively, publicly available information like inflation and job numbers can guide traders to invest in the currencies of stronger economies and short weaker ones.

News trading is tricky because it often involves overreactions and brief but sudden price adjustments that can stop out trades. Normally, retail fundamental investors use a longer timeframe to avoid these temporary, disruptive market moves. Remember, today most ‘fast’ trading is done by algorithms, which have an immense speed advantage over human traders, so it is not wise to use strategies that require speed rather than thought.

Conclusion

After the division between fundamental analysis and technical analysis, a split which traders hopefully solve by combining both to produce strong signals, technical analysis splits further into two main camps: trend following and mean reversion. Here there is no possibility of compromise, and traders must identify which strategy they believe in and trade accordingly. Most reviews find that trend followers have a slight advantage; that doesn’t mean that a skilled mean reversion trader will not outperform most trend followers, and examples of successful traders exist in both camps (as well as many unsuccessful ones…) Ideally, a well-informed trend follower knows enough about mean reversion techniques such as RSI and MACD to identify when a trend may have run its course and can time his positions accordingly without influencing the overall strategy.

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Writer, trader, husband, and dad- Ludovic Gauthier, is the author of more than 2500 finance-related blogs for various FX and Stock trading sites.