A good Forex trading strategy is your edge when trading the markets. It’s what gives you the ability to consistently siphon money from the Forex market over an extended period of time.
Notice I said, “extended period of time”. That’s what differentiates a trading strategy from blind luck. Anyone can get lucky and put on one, two or even three profitable trades in a row. But only a solid trading strategy will give you the edge necessary to make consistent profits over the course of your life as a trader.
In this lesson we’re going to discuss why you need a trading strategy as well as some of the key elements that should define your edge in the market.
Why You Need a Trading Strategy
It is said that the Forex market is one of the harder financial markets to trade, if not the hardest. It’s often referred to as the “wild west” of trading. Having traded Forex since 2007, I can support that sentiment.
What makes it hard to trade is not the lack of actionable patterns or clear horizontal support and resistance levels. In fact the Forex market is one of the best (if not the best) when it comes to tradable price action – it’s one of the reasons I left equities.
The difficulty that comes with trading the Forex market is twofold. It’s the combination of volatility and leverage that causes 90% of Forex traders to fail. So before we move on, I think it’s only fitting to briefly describe both terms. This will help you to better understand why a proper trading strategy is paramount to your success as a trader.
Volatility: The risk that comes with the ability of a market’s price to cover a great distance in a relatively short period of time. In other words, the “size” of the change in a market’s value measured by time.
Leverage: Trading using leverage is another way of saying trading with borrowed funds. It allows you to multiply your gains but can also multiply your losses. The Forex market offers traders some of the highest leverage of any financial market.
Hopefully I haven’t scared you away yet. Trading the Forex market can be enjoyable and extremely profitable, but only for those who trade using a good Forex trading strategy. For those who don’t – well, their experience is often quite the opposite.
The Elements of a Trading Edge
What is an edge, you ask? As a trader, your edge is whatever it is you use to consistently stack the odds in your favor. Traders who have an edge think in terms of probabilities, whereas traders who don’t have an edge play the game of possibilities. You don’t want to be the latter.
So what turns a trading strategy into an edge? In other words, what makes a strategy work in your favor?
There is no “one size fits all” answer to this question as it depends on how you want to define your style of trading. For example a trader who scalps the market will have a much different trading strategy than myself.
That said, below are five elements that I feel should be a part of any good trading strategy.
1) Higher Time Frames
One of the first things you’re going to want to do when drafting your Forex trading strategy is to define the time frame you’re going to trade. The best way to figure out which time frame suites you is to examine your personality.
That’s right. Believe it or not, your personality plays a huge role in determine your style as a trader.
Are you someone who needs constant action and don’t mind taking some heat to get it? If so, the lower time frames will probably suit you best.
On the other hand, if you are more comfortable trading the bigger picture and want to avoid the wild movements on the lower time frames, then trading the higher time frames is probably the way to go.
From someone who has traded all time frames over the years, I can tell you without a shadow of a doubt that the higher time frames are much more reliable. This is because they act as a natural filter for news, among other things.
Read more about why I switched to the higher time frames.
2) Simple Price Action
There are a ton of ways to draft a trading strategy these days and the myriad of indicators doesn’t make it any easier.
Which indicators should you use? Should you just use one indicator or combine a few of them?
My take on the subject – don’t use any indicators, period.
Instead, learn to read the market by studying raw price action. It’s the most basic and pure way to identify favorable trade setups.
Below is an example of a price action setup that formed at a key resistance level.
Notice how the chart above is very simple and easy to read. This is truly all you need to become consistently profitable.
Simply put, all indicators such as the Moving Average Convergence Divergence (MACD), Stochastic Oscillator and even the popular Relative Strength Index (RSI) are lagging. This means that they are reactionary, constantly changing based on past price action.
On the other side of the wall we have price action, which is the study of how a market moves within the context of previously defined levels. Note that the study of price action involves studying the market itself, rather than studying a lagging indicator.
Speak to any professional trader, Forex or otherwise, and they will tell you that they use price action in one form or another. It is by far the most raw look at the market, and one that serves the most purpose regardless of your style of trading.
3) Trend Analysis
The trend is your friend, right?
The trend is your best friend. The saying is as old as trading itself, but trading with momentum at your back is timeless advice.
If someone asked me to identify the most common pitfall that holds most traders back, I would say trying to pick tops and bottoms. In other words, trading against the trend.
This doesn’t mean that you can’t take counter-trend trades. But if you do, they have to be calculated and backed by strong technical factors. Selling a market because it is “overbought” or buying it because it is “oversold” does not satisfy that requirement. In fact it’s just plain gambling.
The GBPCHF daily chart below shows how trading with the trend can help you identify favorable entries.
Notice how the third touch from trend line support produced a bullish pin bar. Just taking a step back and looking at the span of price action between the first and third touch, would you rather buy or sell this market?
Hopefully you said, “buy”. It becomes pretty obvious why you want to trade with the trend once you learn how to use trend lines.
Learning to trade with the trend is paramount to your success as a trader. Which is why, in my opinion, it should play a vital role in any good trading strategy.
4) Key Levels
Key levels are the cornerstone of any good Forex trading strategy. Think of these levels as your roadmap to trading the market.
Remember using coloring books as a kid? The idea was to color inside the lines, right?
Think of key levels in the same manner. The Forex market has a strong tendency to move between levels of both support and resistance, making it vastly easier to put on profitable trades once you understand how to identify them.
The GBPNZD daily chart below shows a great example of a key level in action.
Notice how previous resistance becomes new support. Knowing where the market is likely to bounce makes it that much easier to become consistently profitable.
Based on the preciseness of the level above, I think it goes without saying that the study and application of key levels is a necessity in any good Forex trading strategy.
5) Tradable Patterns
This is perhaps my favorite part about drafting a solid Forex trading strategy. Using simple patterns to help define your trade ideas is one of the easiest, and most overlooked, practices in the Forex market.
Which patterns am I referring to exactly?
The wedge and channel are a great place to start. In fact, you can become a successful Forex trader using only these two patterns – they are that powerful.
Let’s start with the wedge breakout.
Notice in the GBPNZD 4 hour chart above, the market consolidated into a well-formed wedge pattern, giving us an easy way to spot a favorable entry.
That entry came as soon as the market closed below support and ended up netting us a handsome profit. More on this breakout strategy here.
The second pattern is the equidistant channel. Don’t be put off by the fancy name, it simply refers to a channel with two parallel levels.
Although a channel can be traded between the levels, my favorite way to play it is to wait for a break of either support or resistance.
The chart below shows how to position yourself to take advantage of a channel breakout.
Once again we’re on the GBPNZD 4 hour chart, only this time the pair had formed an ascending channel.
Notice how once the market closed below support, it promptly retested old support as new resistance. This is the key to profiting from this pattern – waiting for the break and retest.
Learn more about this strategy here.
My hope with this lesson was to give you ideas about some of the elements that should be included in any good Forex trading strategy.
Although there is no “one size fits all” strategy, I truly believe that the topics discussed above should at least be heavily considered when drafting your own strategy. It should be noted, however, that these elements are much stronger when used together.
The real magic comes when you begin to combine these elements into a focused, strategic approach to the markets. Only then will you be able to stack the odds in your favor. Only then will you have a defined edge.