In this article, I will show you how to create the best forex trading strategy. I will explain some of the best strategies that traders use; as well as share some valuable tips you can apply to your trading.
So without any further delay, let’s get in to it.
The best Forex trading strategy needs several components that will work in synergy.
These components combined can create a comprehensive trading plan that will outline the conditions you are looking for in order to buy and sell and how you will manage the trades thereafter.
The Components Of The Best Forex Trading Strategy
- The method used for analysis to generate the buy and sell signals.
- The money and risk management criteria to minimize risk and maximize the potential for profit.
- As well as having the right mind-set to approach trading with.
I will elaborate a little more about each component.
The things related to your method are everything to do with your analysis. The analyses generates buy or sell signals or whether you should wait and do nothing. Think of this component like your toolbox. Within it, you have various tools to use depending on the situation to help you get the job done. There are so many different ways you can analyse the Forex market but it is important to keep things simple. This is actually not the most important part of your trading strategy.
Money And Risk Management
What is more important are the things related to money and risk management. This is everything to do with how you will manage the money in your trading account. For example, this component of your trading strategy should outline what you will trade, how much you will risk per trade, what risk to reward ratios are acceptable and how many trades you will have open at any one time. You can have the best Forex trading strategy but if you risk too much, or over trade, or cut your winners early or let your losers run, you can turn a winning strategy in to a losing one.
Then we have everything related to your mind-set. This is the most important component in your forex trading strategy because your mind-set is like the glue that keeps the previous two components together. The point is to create your plan or your trading strategy and stick to it with consistency and discipline.
You can have the best forex trading strategy but if you don’t follow it; your results will become quite unpredictable and putting luck aside, probably quite unsatisfactory.
In order to get predictable and satisfactory results, you need rules to guide you in your trading.
You need to become process orientated instead of outcome dependent in order to be able to benchmark your progress against something. How are you going to know what is working and what is not if you are trading inconsistently and without discipline?
The point is to plan your trade and to trade your plan. So let’s talk more about it and start to flesh out how you can create the best Forex trading strategy.
What The Best Forex Trading Strategy Needs
All forex trading strategies need;
- A way to determine the directional bias.
- This is the first step. You need to know what side of the market to focus on and which direction to trade. Are you looking for buy opportunities or short sell opportunities?
- The next thing a trading strategy needs is an entry trigger.
- This is the event or the pattern you are looking for to indicate that it is time to execute the buy or the sell.
- The last thing you need is an exit plan.
- You need to know ahead of time what you are aiming for in order to close profitable trades and when you will get out in case the trade doesn’t work out.
Then what will run independently of this are your money and risk management rules. I will talk more about that later on.
So let’s start with the first step; let me show you a simple way to determine directional bias.
How To Determine Directional Bias
Whenever you look at a price chart, you will see that the price moves in a wave like fashion.
If the price is making a series of higher highs and higher lows, this is an uptrend. When the price is trending higher, you will increase your chances of making profitable trades if you look for buy opportunities.
If the price is making a series of lower lows and lower highs, this is a downtrend. When the price is trending lower, you will increase your chances of making profitable trades if you look for sell opportunities only.
Trade with the trend, the trend is your friend.
Another way to determine the directional bias is to use TIO Markets sentiment widgets. They are available on the website. These widgets indicate what positions TIO Markets clients have taken for any given instrument. These should be used as contrarian indicator. So if you see that most people are long the EURUSD, it might be a good idea to look for sell opportunities and vice versa if most people are short. Since most people lose money trading and get the direction wrong It might work to your benefit to do the opposite of what most market participants are doing.
You can use both the trend analysis and the sentiment indicator together to get a better idea about what direction you should be trading.
Once you have determined your directional bias, you can move on to the next step, which is to look for the trigger to execute the trade.
Buy The Dips In An Uptrend And Sell The Rallies In A Downtrend
When the market starts pulling back against your directional bias, you should be looking to buy the dips in an uptrend and sell the rallies in a downtrend.
For this example, I will talk about buying dips in an uptrend but you can just invert this for selling the rallies in a downtrend.
The ideal scenario is to enter the market after a price correction and a relative bottom has formed.
Another way to create a trigger is to use chart patterns that might indicate to you that a relative bottom has formed.
Here are 3 common chart patterns that traders use to indicate a potential reversal in price. The first one is the head and shoulders pattern. The second one is a double top or bottom and the third one is a triple top or bottom. You can further investigate these price patterns for and study them further for yourself. Simply open a chart of your favorite currency pair and study the historical turning points in the price. Do you notice any patterns? Then you have just discovered a potential trigger. All you have to do is look for it to set up again in real time to indicate to you where the price is likely to go next.
Money And Risk Management Basics
The best Forex trading strategies are not right all the time. You have to accept that trading involves risk and that losing trades cannot be entirely eliminated. You cannot know with certainty the outcome of the next trade because you are making decision on incomplete information.
Instead, you should focus on what you can control. That is when to enter and exit the market and managing the risk.
What you are aiming for is to stack the probabilities of success in your favor. To be net profitable over a series of trades. If you can trade in a way where you make more when you win to offset the losses when you lose, you will be on the right track.
So with that being said, let’s move on and talk about money and risk management. This is more important than the method used to generate your buy or sell signals.
A Simple Illustration Of Money And Risk Management
I am going to start with a simple illustration and then show you how this relates to money and risk management in Forex trading.
Imagine I have a bag and there are 100 marbles in the bag. 50 of them are red and the other 50 are blue.
What is the probability of pulling a red marble out of this bag? You are correct if you said 50% or 50:50.
Now imagine you are playing a game, where if you pull a red marble out of this bag, you win $100, but if you pull a blue marble out of this bag, you lose $200. Would you play this game for 100 turns?
If you answered NO, then you probably understand that the probability of making money over 100 turns is low. Although you have a 50% chance of winning, you lose twice as much when you pick the wrong marble. So over 100 turns of playing this game, you would probably lose twice as much as what you would have won.
Ok, lets change the parameters a little bit. Lets say that there are 20 red marble in the bag and 80 blue ones. What is the probability of pulling a red marble out of the bag? If you answered 20%, you are correct.
Now imagine you are playing the same game but now, you will win $100 if you pull a red marble out of the bag and lose $10 if you pull a blue marble out of the bag. Would you play this game for 100 turns?
If you answered yes, then you probably understand that the probability of winning is low but when you do win, the reward far exceeds the risk and you would probably make money if you played this game over 100 turns.
The Variables You Must Balance To Become A Consistently Profitable Trader
Without realising it, traders are playing a similar game with the money in their trading accounts. The thing to understand is that there are two variables that need to be balanced if you want to become a consistently profitable trader.
When it comes to money and risk management, you have to balance your success rate with the risk vs the reward of your trades. In other words, how often you make money and what your average profit is versus your average loss. It doesn’t matter if you have a very high success rate if you loss much more than what you win.
Most beginners focus on being right and having a high success rate. They take small profits but let losers run because they don’t want to accept a loss. What usually happens then is that a small percentage of their trades wipe out all the money in their trading accounts.
Experienced traders focus on capital preservation, keeping the risk low and maximizing the potential for profit. They cut losing trades quickly and let profitable trades run their course.
So what are you doing? Are you risking 50 pips to make 10 pips, on average? Then you need to have a success rate greater than 80% to make money over time.
Are you risking 50 pips to make 100 pips or more? Then you only need to be right half the time or less to make money over time. It’s just math, but you have to set yourself up for success and this starts by recognizing the math and then applying it to your Forex trading strategy.
How To Manage Risk
First, decide how much you are willing to risk per trade. This should be a small percentage of your account balance and you should also be consistent with it.
Once you know what that amount is, simply divide it by the distance from where your entry price is going to be and where you plan to put your stop loss in pips. If the distance is 50 pips then divide your amount to risk by 50 pips. This should give you a value per pip. Then select a lot size that is the equivalent or less than this value per pip. Now if the price moves against you by the distance of your stop loss, the trade will close without exceeding the amount that you are willing to risk on the trade.
Now that you know what your risk is, you can aim for more than that for an asymmetrical risk to reward ratio. Then as long as you maintain a success rate of at least 50%, you should be on the right track to consistently making money.
If you are risking 50 pips and aiming for less in potential profit, then you need to be right that much more often to offset the losing trades when they happen.
As you can see, there is not one answer regarding how much you should risk and how much you should aim for but generally speaking, the best Forex trading strategies keep the risk low and have asymmetrical profit objectives.
Lets Recap With A Summary
- Trade in the direction of the longer term trend.
- Use the sentiment indicators for additional confirmation.
- Wait for a pull back and look for the price to bounce or top out.
- Use multiple time frames to look for reversal patterns in the price.
- Minimize your risk and look for an asymmetrical reward.
- Plan your trade and trade your plan. Be consistent and disciple.
I hope that I have explained things in an easy to understand way and you can use this as a guide and adapt it to make the strategy your own.
The thing is that you need to practice within a consistent frame work of doing things and the more experience you get, the better you will become.