This week’s question comes from Niklaus, who asks:
What factors should I consider when developing my trading edge?
I love this question because it isn’t solely about a trading strategy. Instead, he asks what factors should be considered.
The truth is, a trading edge is much more than a single strategy, or even several strategies combined. It’s a mixture of many factors that come together to give you an advantage over other market participants.
What those factors are is up to you. Your edge depends on everything from your preferred style of trading all the way down to your personality.
To get you started in the right direction, I’ve included a few of the factors that separate me from others in the market. None of them are particularly unique on their own, but together they make for a powerful combination.
Ready to get started? Let’s do this.
1. Time Frames
I’m beginning with which time frames you trade, because this alone can make or break you as a Forex trader.
Before we jump in, let me start by saying that there is no single best time frame. I’ve been around the markets long enough to understand the importance of finding a style of trading that works for you, and choosing a time frame is no exception.
That being said, I’ve tried them all since I entered the currency market in 2007. I’ve experimented with everything from the 1-minute chart to the weekly and have come to one inescapable conclusion — higher time frames are better than the rest.
What do I consider a “higher” time frame? Anything higher than the 1-hour chart.
I use the 4-hour and daily time frames the most, but if you’re just starting out, I suggest sticking to the daily. It helps to slow things down and offers greater reliability than the lower time frames.
2. Currency Pairs
You may not realize it, but the currency pairs you choose to trade are part of your edge too. If you spend your time trading exotic currencies like the Armenian Dram or the Omani Rial, chances are you’re going to struggle.
Less common currencies like the two I just mentioned aren’t liquid enough to provide reliable signals.
You see, there’s a correlation between a market’s volume and the reliability of the buy and sell signals it provides. The higher the volume, the more reliable the signals. That isn’t always the case, but it’s a good rule to follow.
Given these facts, I suggest that instead of adding 50 currency pairs to your platform just because you can, try limiting yourself to 5 or 10 of the more liquid pairs like the EURUSD, GBPUSD, USDJPY, etc.
You can always add more later, but try focusing on a small list of pairs when starting out.
For those who want the complete list of pairs I trade, see this post.
3. Trading Strategies
Most Forex traders incorrectly assume that a handful of strategies, or perhaps even a single strategy, will give them the edge they need to become profitable.
This isn’t the case; far from it, in fact.
The trading strategies you employ are just one piece of the puzzle. Yes, they are a critical factor, but they are by no means the entire puzzle.
You can have the greatest strategy the world has ever seen, but if you lack the discipline to execute it, you will fail every time.
Moreover, the time frames and currency pairs you trade using this incredible strategy will greatly influence the outcome.
So you see, a trading edge is never just about a few strategies, or even winning more times than you lose. It’s an entire process that, when executed correctly, allows you to make more money than you lose over a series of trades.
Here are a few of my favorite strategies to get you started:
- Lesson on the pin bar strategy (click here)
- Lesson on the head and shoulders reversal (click here)
- Lesson on trading equidistant channels (click here)
In case you’re wondering if you should trade within the channel or wait for a breakout, see this Q&A post.
I teach other price action strategies in addition to the ones above, but these are a few of my favorite ones.
As a side note, you could also develop an entire trading edge using those three strategies as the foundation.
4. Risk to Reward Ratio
If I said I’d give you $10 but only if you risk $50, would you take that bet?
I hope for your sake you said no. Yet this is what most Forex traders do, particularly those who utilize scaling strategies. They risk 50 pips to make a 10-pip return.
I’m by no means saying that scalping is wrong or that it doesn’t work. I have no doubt that someone out there has found that this approach works for them.
However, there is a reason you don’t hear of millionaire traders scalping the markets; at least I haven’t.
Take Bill Lipschutz for instance. At one point he was making $300 million per year for Salomon Brothers. Needless to say, he knows what he’s doing.
His minimum risk to reward for a setup with an expected duration of 48 hours or less is one to three or 3R. So if he’s risking 100 pips the target must be at least 300 pips from his entry.
For trades with an expected duration of more than 48 hours, his minimum is one to five or 5R. As you can see, it’s just the opposite of the scalper who is risking 50 pips to make 10 pips.
I’ve adopted a similar approach, the only difference is that my expected durations are a different than Bill’s.
Whatever risk to reward ratio you decide to use, just know that it will have a direct impact on your edge. Technically, there’s no wrong answer here, but risking 50 pips to make 10 doesn’t sound like a good bet to me.
Do you take advantage of times when the market moves in your favor? Or do you just put on a single position and hope for the best?
If you’re doing the latter, you’re missing out on a lot of potential profit. Not to mention that you should never hope for a particular outcome, but that’s a lesson for another day.
When the market is moving in your favor, it’s no time to sit back and relax. Instead, you want to begin looking for opportunities to strategically build upon your winning trade idea.
If you learn to pyramid, you can turn a 2R profit into a 4R profit or even an 8R profit. That alone can take you from a break even trader to a profitable one.
When it comes to developing a trading edge, techniques like pyramiding are a vital piece of the puzzle. After all, your winners have to pay for the losers.
Just like everything else we’ve discussed up to this point, pyramiding isn’t for everyone. But if you haven’t tried adding to a winning position, now is a good time to learn. It could be the final puzzle piece you’ve been searching for.
6. Loss Mitigation
This is arguably the most overlooked aspect of a good trading edge. If you want to get ahead in the Forex market, you have to know when to do nothing.
The idea of loss mitigation is to prevent yourself from having an emotional meltdown. If you’ve traded for at least a few months, you have no doubt experienced how devastating even the slightest lapse in discipline can be to your trading account and confidence level.
To prevent this from happening, it’s imperative that you know your pain threshold. In other words, how much money can you lose before your discipline starts to waiver?
Is it 5% of your account balance? Maybe 10%?
Only you know the answer. For me, if I find myself in a 5% drawdown (peak to trough) on a monthly basis, I have to remove myself from the market for at least three trading days.
I do this to avoid getting emotionally compromised, because I know my discipline is my greatest asset. Without it, I have no edge.
As you can see, a trading edge is far more than just a few strategies on a piece of paper. You need a well-rounded plan of attack if you want to stack the odds in your favor.
Factors like the currency pairs you trade and time frames you utilize can be just as important as the strategies you employ. Similarly, a favorable risk to reward ratio and an effective pyramiding strategy should be at the top of your list when developing your edge.
The factors presented in this post are by no means a complete list. There can be dozens of factors, and the ones you choose to pursue will be different from mine.
If developed and executed correctly, the factors above come together to create a way of conducting yourself in the Forex market that can yield positive results. The key is first to know how to construct each one, and then to exhibit the patience and discipline to see it through.
However, the six topics above are a great place to start. Feel free to start with these when defining your edge, and then expand to other components that give you an advantage.
Your Turn: Ask Justin Anything
I’d love for this new weekly Q&A to be successful and provide an invaluable repository of answers to common Forex questions.
To do that, I need your help.
Here’s what you can do to get involved and have your question answered in next week’s post:
- Ask questions. Post them in the comments below or Tweet them to me @JustinBennettFX
- Help me answer questions. If I missed something or if you have something to add, don’t hesitate to leave a comment below.