The first thing you should know about Forex is that there is no holy grail in trading – there is no strategy or system which is guaranteed to profit 100% of the time.
They say that all successful traders make profits differently and all losing traders lose the same way. This isn't hard to accept, considering the variety and versatility of trading tools available to Forex traders, and at the same time only a handful of the most common trading mistakes to make.
In order to be successful, every trader must take the time to try out different strategies and systems to see which one works for them.
The most profitable Forex trading system is made up of 50% of a strategy that you understand thoroughly and the other 50% is a strategy that you can follow consistently with patience and confidence, which only happens when you trust the strategy to yield a return.
Allow us to emphasise the latter 50% by directing your attention to one very important fact that might save your account one day. Most traders fail not because of the flaws in their systems, but because of flaws in their discipline to execute it.
Strategy Building Blocks
At the beginning of his journey, a rookie trader will quickly discover that a rich pallet of tools are available in Forex trading. There is plenty of room for creativity. Sometimes, a trader will borrow a strategy in the form of pre-determined techniques and styles and adjust it to his liking.
Most of the time, traders start from scratch and gradually create their own mix of charting techniques, technical indicators, fundamental indicators, and trading styles. They will then continuously mould the strategy as they progress, perhaps adding new tricks or getting rid of what is considered to be obsolete.
A strategy changes with the trader, the trader changes with the market and the markets change with time.
In this article we will discuss the two broad groups of trading tools that more or less classify all trading indicators available. Hopefully, you will develop an understanding of what is available to you, how tools from various groups complement each other, and what the most profitable Forex system could look like for you.
Technical analysis is chart bound. It takes one of the Dow theory postulates as the premises – the market discounts everything. Whatever factor has an impact on supply or demand it will inevitably be reflected in the price, and by extension technicalists claim, it will be reflected on the charts.
Charts are made from the time/price field with the price action displayed on it as if on a plate, waiting for your interpretation. No matter which trading style – long-term positional or short-term intra-day – you are using, everything starts with charting.
This wasn't always the case, but now what is considered the most favourable method of price action charting in the world, not only for the Forex market, is the Japanese candlestick. This method is around 300 years old and there are trading strategies based on reading candlestick patterns alone.
These strategies are somewhat subjective, since there is always a degree of disparity between the example pattern and what you see on your charts. This leaves room for interpretation and decision making in the hands of a trader.
As a side note, whether you want freedom in interpretation of charts or prefer algorithmic type trading that leaves no room for self debate, is something you will have to find out for yourself as a trader. Nobody else can do this for you. It may be worth mentioning that algorithmic trading is more instructional and rule based and therefore possibly safer for beginner traders.
Now, back to candlesticks. Candlestick pattern based strategies may be used for various markets and on various time frames. They are simple to understand as a concept, but often lack signal precision. If not being the alpha and omega of your trading strategy, candlesticks and their variation like Heikin-Ashi, may prove to be a solid building ground.
Now that your charts have the price action mapped out, let's talk about your supporting constructions.
In the foundations of price action trading lies an observation that the market often revisits price levels where it reversed or consolidated – this introduces the concept of support and resistance levels into trading.
Support or resistance levels are less of a line defined strictly to a pip and more of an area that can range from a couple to a couple of dozens pips in width, depending on the time frame you are looking at. Traders generally refrain from trading near S&R as it is unclear whether the price will bounce off or break though.
The most common, not necessarily the most profitable Forex system though, that incorporates S&R is breakout trading. When a breakout occurs and it is confirmed by a candle closing reasonably beyond a level – this serves as a signal that the market has the momentum to move further in the direction of a breakout.
Besides the S&R levels, technical traders may use charting patterns like trend channels, triangles, or charting techniques like Fibonacci retracement patterns to assist them in price action prediction. Remember that as the same chart may appear to consist of different patterns to different traders, it may produce opposing signals, pointing towards the imperfections of the method.
As for Fibonacci, techniques that include data from outside the market, like 23.6% a seemingly random and irrelevant number explained neither by fundamental, nor by technical forces, are considered methodologically doubtful by some.
Retracement traders use Elliott's wave theory as a basis that suggests the market moves in waves. After a significant move comes a smaller one in the form of a pullback or retracement as the price of an asset adjusts to its true trend. Anybody who has ever seen a chart will have noticed something similar.
However, claiming that Fibonacci ratios accurately predict the swings is very brave at least.
As a beginner trader who is interested in looking for chart patterns, remember the human brain is highly suggestive and is wired to see regularity even in the most random data. Just because the brain sees it, it doesn't mean it is really there.
The pinnacle of technical trading is a combination of two more Dow postulates – the market trends and it trends until definitive signals prove otherwise.
A trend is a market condition of the price action moving in one evident direction for a prolonged period of time and if there's one thing all traders agree upon, it is that the trend is your friend.
Financial traders are great fans of trend measuring and trend following and they have a variety of technical indicators to support their strategies. Most of the indicators available on your trading platform from moving averages, to the classic MACD and Stochastic, to the more exotic Ichimoku are all designed to point out whether there is a trend and if there is, how strong it is.
Such traders always buy when the market is going up and sell when the market is going down. They usually miss the beginning of a trend, never trading at the tops and bottoms, because their systems require confirmation that the new swing in fact resulted in the development of a new trend, rather than being just a pullback within the old trend.
What neither trend following traders not their strategies like is ranging markets. A ranging market is like a horizontal trend, with the price action bouncing up and down within a confined corridor. There seems to be neither a bullish nor bearish trend at those times and everybody sits tight until a breakout occurs and a new trend develops and proves its legitimacy.
Trend following strategies, when followed correctly of course, are the safest and arguably the most profitable trading strategies out there.
They perform best when used over the long-term, as trends take weeks and months to develop and may potentially last for years or even decades. Being relatively safe, they can, in theory, yield an average of around 10-15% per annum.
If you're looking to be a trend following trader you need to be patient and make sure you have a lot of risk capital at your disposal. Making 10$ out of a $100 will hardly satisfy your trading appetite, while making $1k out of $10k just might.
Even if you are not looking to be a technical trader, or a long term-trader, the concept of markets trending should be incorporated into your trading system, if not as a primary action tool then at least as an underlying market principle. Knowing which way the market is going in the long run never hurts, which is why even 15 minute intra-day traders always check the bigger time frames before opening trades.
Fundamental analysis, as opposed to technical analysis, focuses on the fundamental forces influencing supply and demand as the primary price moving vehicles. Fundamental analysts claim that markets may misprice a financial instrument in the short run, yet always come to the 'correct' price eventually.
Despite fundamental analysis having close to nothing to do with the price action, it overlaps in a few areas with technical analysis. For example, both recognise the concept of the trend and the importance of the key levels, albeit for different reasons.
All in all, it is worth mentioning that the Forex market is mostly a domain of technical analysis, with fundamentals used as supporting indicators or as a base only for a few extravagant strategies.
Fundamentals in Forex
Fundamental analysis was born in the stock market in the times when barely anybody on Wall Street even bothered laying price action on charts. Since there are no company balance sheets and income statements to analyse in Forex, currency traders focus on the overall conditions of an economy behind the currency they are interested in. The only problem is that even though countries are much like companies, currencies are not quite like stocks.
A company's financial health is directly reflected in its stock price. Both improving and declining performance can be identified by fundamental analysts, which would help predict how stocks should behave. For countries, however, an improving economic performance does not necessarily equal growth in its currency's relative value.
Here are a couple of examples.
A central bank responds to a directive by the government and decreases interest rates to weaken the currency, thus making domestically produced goods relatively cheaper and stimulating exports. The economy improves, though the currency weakens.
Next is quantitative easing. When the interest rates are near or at the zero point, a central bank implements an aggressive monetary policy aimed at injecting large quantities of money into a national economy in the hope of improving the inflation, thus weakening the currency as a byproduct. In practice, however, it might lead to an increased outflow of the national currency offshore through speculation on the markets, leading to deflation.
A currency's relative value turns out to be a function of a great multitude of factors from national monetary policies, to economic indicators, to the world's technological advancements, to international developments, and to so-called acts of god that nobody could possibly see coming. For most traders fundamentals forever remain the go-figure type of indicator – never reliable enough on its own to ever claim to be the most profitable Forex system.
That being said, the ingenuity of fundamentalists means they have developed a few interesting strategies worth researching for ideas.
For example, news scalping is technically a fundamental based strategy, since a trader tracks down news releases and acts upon them. A very seldom traded yet considerable market exposure in addition to a leveraged account, as in this strategy, is the potential for a profitable Forex trading system, as it offers the possibility of swift gains in the hands of an knowledgeable/experienced trader.
Another example are carry trade strategies. These are long-term, low yield investments that work on currency pairs with the base currency having high interest rates and the counter currency having low interest rates. This results in positive swaps that can accumulate through time to significant amounts. Do note that this style may require the deployment of your funds for long periods of time.
There is one particular market approach available to fundamentalists that comes directly from the stock market. Its logic is this – if supply and demand is what moves the market, then it is the big player tapping the bases of the scales that move supply and demand.
Whether the market is bullish or bearish depends on the investment mood of the big players and is called the market sentiment. This concept is shared by all financial markets, including Forex.
In stock, if the volumes are rising while the open interest (the amount of trades that stay open) is dropping, chances are that the market sentiment is changing and soon so will its direction.
Since the Forex market is traded over-the-counter, tracking the trading volume or measuring open interest is impossible the way it is done on the stock market. The next best thing to help traders gauge the market sentiment is the Commitments of Traders report for the Forex futures market.
CoT measures the net long and short positions taken by both speculative and investment traders – the market sentiment, basically – and is published weekly by the US Commodity Futures Trading Commission.
Following the CoT gives no precise points for entry or exit, but gives an idea of the mood on the market. To be specific, this method may be upgraded with methods of technical analysis and eventually turned into a potentially profitable long-term Forex system, that not only follows the trend, but also catches the swings.
There are many profitable Forex trading systems. Determining which one is the most profitable is impossible as it really depends on individual preferences.
How profitable a Forex system is depends on a variety of factors, starting with the trader and ending with the market. Trending strategies perform poorly in ranging markets, long-term strategies fail on short time frames. Aggressive traders can't afford to wait for a month, while careful traders are unwilling to risk their money in day trading.
Using various tools, a traders is free to create his own strategy or customise an existing one, or both, having several strategies ready to be applied at his whim. Either way a deep understanding of how a strategy works is always required as well as the discipline to follow it.
One can almost say that a Forex trading system is only as profitable as the trader using it.