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If you’re new to foreign exchange (forex) trading then one of the first things you need to do is to build a strategy you can use to trade. If you don’t have a strategy, you’ll just make trades at random, which is a good way to lose all your money fast.
Your strategy should include a trading plan and some solid risk management rules. It should cover various aspects of trading, including trade entry, trade management and account management.
Here’s how you should build your strategy.
What Kind of Trader Are You?
Your trading strategy needs to suit your personality. If you impulsive, then you can look at trading activities where you are in and out of a trade fast, such as scalping. Scalpers hold a position for a very short time, and close it for a small profit, entering and exiting the market multiple times a day.
If you are a patient person then look at longer-term trading, where you hold a position for a longer period of time. An example is swing trading, where you use technical analysis to find a forex pair that you think will move. Swing traders generally hold a position for days or even weeks.
Investors hold their trades for even longer. They hope to capture a profit by riding a long-term trend.
If you trade against your natural inclination you are likely to feel anxious, and you will be tempted to go against the rules set out by your trading plan – and that will lead to losses!
Be Aware of the Competition
As a retail trader you should understand that you are facing competition from other market participants whose activities can move prices. The trading desks of central banks, commercial banks and other financial institutions, not to mention high-frequency traders and algorithms poised to react instantly, can make it hard for an individual trader to make any headway.
That’s why you need a solid strategy, that has realistic expectations.
Understanding Technical Analysis and Fundamental Analysis
Technical analysis involves studying price charts and indicators, looking for patterns that will help you to analyse the market direction. This allows you to identify possible entry and exit points for a currency pair. There are many books that can teach you about technical analysis, for example this one: 101 Charts for Trading Success by renowned analyst Zak Mir.
Fundamental analysis is about the factors that drive market prices, such as the weaknesses and strengths of markets, and political and economic events that may affect a currency’s strength. You may look at GDP, unemployment data, production data, interest rate changes, and so on.
You can use either of these types of analysis, or both combined; which one you find useful will depend on the type of trading you do.
Understanding Price Action
When you choose your entry and exit points for a trade, you need to understand some key price action concepts:
- Support and resistance – these are trading levels where the price has hit and bounced back many times. They appear to act as barriers that stop the price moving any further. Support is when a downward trend stops; resistance is when an upward trend pauses. You can think of support and resistance as the points where demand and supply meet.
- Breakouts – these are when the price breaks through the support or resistance level. They are strong indicators that the price is starting a new trend.
- Gaps – these are areas on a chart where the price has moved sharply up or down, showing a gap in the normal price pattern. For example, a report can be issued that generates so much buzz that it widens the bid and ask spread to such an extent that a significant gap appears. Gaps can be an indication of a new trend.
Managing Risk
Like all kinds of trading, forex involves risk. You are guessing which way a currency pair will move, and if you get it wrong you lose money. In a volatile market the potential for gains are high, but the risk is also higher.
You need to include risk management in your strategy. Some of the rules to consider:
- Use stop losses – a stop loss will help to minimise your risk. A stop loss ensures that if a trade goes against you, you can exit it before you lose too much.
- Avoid over-trading – never risk too much of your trading account balance on a single trade. A good rule of thumb is to avoid risking more than 2% of your balance.
- You don’t have to trade – if there are no trades that suit your preferred style or your trading plan, then don’t trade. Wait until something that does suit you pops up, even if that means no trading for a day or a week. Breaking your trading strategy rules just because you are impatient or bored is a recipe for disaster!
Test Your Trading Strategy
Your trading platform and broker should let you set up a practice account, where you can try trading without risking any real money. That will let you try out your trading strategy to see how well it works, and refine it until you are happy with.
You can compare respected brokers on our Broker Listing page.
