After reading this article on creating a Forex trading strategy, you will have a much better idea how strategies work. You’ll also learn to know when your strategy works and when it doesn’t, which means you’re better able to filter bad trades and capitalize on good opportunities.
Creating a Forex trading strategy takes a lot of work because it gets you looking intently and studying how prices move and act. This market study is likely to improve your overall market knowledge, which will allow you to fine-tune and improve your strategy.
The starting point of creating a Forex trading strategy is generating trade ideas. Coming up with strategy ideas is all about studying the charts, isolating where opportunities existed and then asking questions on how you could have taken advantage.
Once you have generated enough ideas you can go through a more in-depth process of testing them out. The testing phase involves fine-tuning and refining the strategy based on information received by trading the strategy in a demo account. Only after a strategy produces profit over many demo trades should real capital be risked.
Price moves are what create profit potential. Highlight some big price moves on your chart, then ask yourself:
• What started the move? Was it a chart pattern, a bounce off a trendline, a specific time of the day, a news release, a breakout (or bounce off) of a resistance/support level?
• What sort of trade trigger could you use to enter that trade? A trade trigger is a specific condition which allows you to spot trade signals in real-time.
• Are there any indicators which could help identifying the trade trigger, or could the indicator be used to confirm the entry? Are Fibonacci retracements of use?
• Could you have used a limit order, or if you’d need to use a market order, will your order get filled if the trade is during fast moving market conditions.
Next, look for a way to get out of the trade the entry step produced. This stage is more important than the first one, because it is the exit that determines your profit or loss. If trading binary options, your risk and profit are fixed, so some of the questions below won’t be applicable, instead focus on exit-timing questions, and how to choose an appropriate expiry time.
• Can you find any signals that occurred just before the reversal of the price move you were trying to capture? An indicator may help in this regards. Was the price movement slowing down prior to the reversal? Did the price reach an important support or resistance area or a Fibonacci level?
• Did the criteria you use to enter the trade change? When did it change? That could be an exit point.
• Could a trailing stop be used? Maybe you could use a profit target where you look to collect multiple amounts of your risk, such as 2:1 risk to reward ratio, or take profit when you make $200 or 20 pips. These are all examples of fixed targets.
This section is discussed last, but is arguably the most important when creating a Forex trading strategy. You can have the best entries and exits, but eventually every strategy has losing trades. If you don’t manage your risk and capital properly, those losing trades can wipe out the trading account.
• Look at the entry and exit rules you’ve established. What sort of position size could you take on that trade? Do you have the capital to actually take this sort of trade?
• Based on the answers to the above questions, what is your risk on each trade(s)? Try not to risk more than 5% (preferably 1%) of your capital at any given time. When answering the questions above keep this in mind, if the trades are too risky, then the strategy isn’t worth it.
• Does the profit potential of the trade warrant the risk? Basically losses should be less than profits; if it isn’t, it means you need to reevaluate your strategy.
Testing is the next step. You have a plan, and have made a few ideas on how to enter, exit and control risk. Now, flip through your charts to find more entry signals. How would your Forex trading strategy perform? If it looks promising, test the strategy to acquire more data using a demo account. Only once there is a history of profitable performance should the strategy be funded with real money. If the strategy does not perform well, then it needs to be reevaluated.
Consider if the Forex trading strategy can be applied to other time frames, or in other markets. Consider whether it can be applied to smaller or larger time frames. Look to see if the strategy performs better at a certain time or on a certain day; if there is a poor performing day, or time of day, then don’t trade during that time. Do you need to apply additional filters or rather relax them to improve performance?