The advent of international trade brought with it a number of advantages, key among it was cementing the foundation on which globalization was premised. While other factors such as world peace and stability played a critical role in founding globalization and the laws governing it, international trade was critical in expediting the process. Through it, countries were able to export crucial resources to other countries globally and in turn import much-needed resources from them.
Further to this, changes which occurred during the period also led these countries to establishing a currency system. Initially, these currencies were pegged to a specific commodity – gold back then – and later on pegged to the United States dollar. However, as history would have it, most countries eventually opted out of this and ended up adopting a floating currency regime – a regime in which the currency of a country is left to fluctuate based on forces of demand and supply within the market and not controlled by a government or pegged to a specific dominant currency (as was the case during the aforementioned regime). As more and more countries began taking part in international trade so did the above currency regime become widely adopted by these countries.
This entire progress came at a time when economics and finance were on a growth trajectory as more and more research was being conducted on pricing and hedging mechanisms for different financial products. Research into stochastic methods, bivariate analysis and other complex financial models dominated this space leading up to new methods of forecasting movements in and future prices of currencies and other financial products such as currency derivatives. The result of the instruction of currency trading thus meant that currencies were atop of this new paradigm of finance and currency trading consequently resulted from the above.
As with any new financial product, the evolution of the financial markets led to the prompt adoption of different pricing mechanisms for currencies. With this came a change in the hedging structures of these financial products resulting in the start of trading of currencies. These trades were based on the movements in the financial markets, specifically the currency markets, which were in turn driven both by foreign exchange – the import and export of products from a country – as well as foreign investments in a country (these meant that countries with stronger policies encouraging investment as well as those with higher mechanization – used to ensure higher value addition to their natural resources – had much stronger currencies than their counterparts).
Over time since then, more research has gone into this field leading up to technical and fundamental analysis of currencies. These methods have revolutionized how different currency traders view trading and the strategies and analysis which go into it. In this piece, we thus look at some of the currency trading strategies and briefly assess some of the tools necessary for one to successfully trade currencies.
Forex Trading Strategies: An Introduction
The key to understand currency trading movements in the currency markets, correctly predicting expected movements and taking advantage of one’s understanding of future movements, making a return/money in the process.
When trading currencies (also known as forex trading), there are a number of factors which determine which strategy one should follow. Key among this is to understand the term of your investment: short, medium or long. While some investors look to short-term trades such as minutes or even hours, some strategies work better with medium- or longer-term investors who hold positions for days, weeks or in some cases, months.
An analysis of market conditions also plays a crucial role in forex trading. Furthermore, while it is seemingly lucrative to leverage more or include higher capital in one’s trade so as to boost the returns, given the volatile nature of the forex market, unexpected swings may have dire consequences on one’s portfolio and wipe out one’s investment. As such, an understanding of risk management is advised for investors in this market.
Read: What is Forex Trading?
It is also important to point out that there are numerous factors which determine how well your forex trades will perform, some of which are specific to different individuals. While there are a number of methods which have been back tested and reviewed by specialized currency traders, personal biases and temperaments also affect the trading process.As a result, while the methods reviewed in this piece have worked for pervious traders, one will need to test them for their specific trades so as to ensure that they work for them.
Types of Trading Strategies
There are a number of forex trading strategies which have been adopted by the financial markets, some which are specific to certain trades which have been made in the past. However, in this section, we review mainly strategies which have been adopted, reviewed and back tested by forex traders.
Day trades involve one holding their portfolio for no longer than one day. Such trades take advantage of intraday volatility thus investors look into short-term trades as a way of boosting their portfolio growth. As with the name, such trades are not meant to be held for longer than a day and this enables the investor to avoid the risk associated with large forex movements which may occur overnight.
Such investors will therefore more likely be involved in five-minute to hourly trades based on their analysis of technical tools rather than on macroeconomic and fundamental analysis. The result, however, is that such trades are prone to significant fluctuations, some which can wipe out one’s entire position. They therefore require one to have a clear understanding of technical analysis, especially on the timing of entry and exit of a trade.
As with any currency, there are both bid and offer prices. The difference between these two prices is known as the bid/offer spread. Scalping is a short-term trading strategy which involves a trader trying to beat the bid/offer spread and make some profit out of skimming a few points before closing the trades. In most cases, scalpers have an interest in downturns in the market and how they can take advantage of them and this is mostly reviewed through the order flow tool.
While this is the case, the introduction of machines to currency trading has come to revolutionize this segment due to the much faster adaptation to changes. As algorithms review this spread and make quick trades, they disable individuals from making ‘arbitrage opportunities’ or skim away points as with scalping. Scalping therefore requires one to be consistently reviewing their trades (for hours sometimes) and making rapid trades in the process. Finally, it also requires that individuals invest high amounts of capital as the transaction costs associated with these trades may wipe out any profit which may be made from small size trades.
Unlike the previous two, this is a more long-term trading strategy (hold one’s position for weeks or even months) which entails a trader trying to make profit from large changes in the market. Given the nature of such large currency movements, most of these movements are driven by fundamentals and changes in macroeconomic variables.
For such trades, one first has a view of the macroeconomic conditions affecting a specific trade such as understanding the reasons for the GBP being expected to gain against the USD over a specific period, say interest rate hikes in Britain. One that is clear, the trader will then analyse technical tools so as to understand when is the best time to get into a trade as well as exit the trade. This process is known as forming a position, hence its name.
This type of trading has much lower risk as compared to other forms of trading given that the trader isn’t affected by intraday volatility. However, while it tends to be more profitable than other trading strategies, this strategy also requires one to inject a lot of capital and have a clear understanding of fundamental analysis.
Every so often the forex market experiences significant single movements. Technically, some of them are known as moving average bounces or trade pullbacks and breakouts, all which see the market shift on one direction or drastically sway from a declining position to a profit position. Each of this is included in a category known as a swing.
Swing trading allows a trader to trade on such large single movements. This strategy is a short- to medium-term strategy which sees the investor hold on to trades for days or weeks and which sees them reviewing price patterns and trying to profit from them. Unlike position trades, there are more opportunities for one to profit from swing trades thus investors who have a clear understanding of technical analysis tools can benefit greatly from this.
Moving Average Trading
Moving averages form a very large portion of technical analysis tools. The moving average is a statistical analysis toolkit which analyses the average value over a series of data: for a pool of weekly data of about one year, the moving average will be used to analyse the continued average value over the last say four weeks. This method then continues to find the average over a four-week period recursively across the entire year. The moving average is a lagged average and is useful in explaining the difference in performance between the short and long-term. In the case of a rising moving average, the short term usually tends to be outperforming the long-term and vice versa holds true for declining moving average.
When coupled with candle sticks, the above forms an important trading toolkit. In this case, one can set their technical tool to buy when the candle stick is above the moving average and sell when the candle stick is below the moving average. The rationale is backed by the fact that the average for the former, there is an upward momentum which is expected to push the currency higher than its short-term average value therefore a buy recommendation is given. On the contrary, for the latter, there is a downward pressure which is expected to cause the stock to underperform the short-term moving average thus necessitating a stock sale.
50 pips Pullback Trading
The above is a trading option for scalpers which take advantage of early morning movements. It works better with the more liquid currency pairs such as the EUR/USD or GBP/USD. The trader sets a 50-pip outlook on the currency’s position, both on an upturn and downturn. The trader opens two opposite position, meaning that they seek to profit from a reversal in the above positions. Upon the opening of one of the above positions, the other trade is immediately closed.
As with other short-term strategies, the above is a risky strategy and requires that stop losses be included so as to ensure that the trader doesn’t suffer significant losses. However, such swings tend to see traders skim profits early in the morning prior to other movements during the day.
While there are numerous methods of trading; however, the above six strategies have been tested in the past, and have been seen to actually work for traders. These, however, do not include all strategies as more and more investors keep coming up with their own strategies which have worked for them. Furthermore, technical analysis tools such as the Bollinger bands, candle sticks, the moving average convergence divergence (MACD), alligator and Fibonacci tools also play a critical role in ensuring that investors actually analyse their trades.
In conclusion, while different strategies exist, one needs to assess them and establish which works best for each individual. Each of the above strategies is categorized first into short or long-term and later by the capital investment required to make a successful trade. While some investors prefer risky investments, others will require some certainty when investing thus is more risk averse. As such, different options will work better for different people based on these different factors.
All in all, forex trading is an important financial product which offers investors a great path for wealth creation in both short and long-term trading options. Investors will benefit greatly from having a look at this wealth creation option.