What is Forex Trading ?
Forex, or foreign exchange, can be explained as a network of buyers and sellers, who transfer currency between each other at an agreed price. It is the means by which individuals, companies and central banks convert one currency into another – if you have ever travelled abroad, then it is likely you have made a forex transaction.
While a lot of foreign exchange is done for practical purposes, the vast majority of currency conversion is undertaken with the aim of earning a profit. The amount of currency converted every day can make price movements of some currencies extremely volatile. It is this volatility that can make forex so attractive to traders: bringing about a greater chance of high profits, while also increasing the risk.
How do currency markets work?
Unlike shares or commodities, forex trading does not take place on exchanges but directly between two parties, in an over-the-counter (OTC) market. The forex market is run by a global network of banks, spread across four major forex trading center's in different time zones: London, New York, Sydney and Tokyo. Because there is no central location, you can trade forex 24 hours a day.
​
There are three different types of forex market:
​
-
Spot forex market: the physical exchange of a currency pair, which takes place at the exact point the trade is settled – i.e. ‘on the spot’ – or within a short period of time
-
Forward forex market: a contract is agreed to buy or sell a set amount of a currency at a specified price, to be settled at a set date in the future or within a range of future dates
-
Future forex market: a contract is agreed to buy or sell a set amount of a given currency at a set price and date in the future. Unlike forwards, a futures contract is legally binding
​
​Most traders speculating on forex prices will not plan to take delivery of the currency itself; instead they make exchange rate predictions to take advantage of price movements in the market.
​
What is a base and quote currency?
A base currency is the first currency listed in a forex pair, while the second currency is called the quote currency. Forex trading always involves selling one currency in order to buy another, which is why it is quoted in pairs – the price of a forex pair is how much one unit of the base currency is worth in the quote currency.
Each currency in the pair is listed as a three-letter code, which tends to be formed of two letters that stand for the region, and one standing for the currency itself. For example, GBP/USD is a currency pair that involves buying the Great British pound and selling the US dollar.
To keep things ordered, most providers split pairs into the following categories:
​​
-
Major pairs. Seven currencies that make up 80% of global forex trading. Includes EUR/USD, USD/JPY, GBP/USD and USD/CHF
-
Minor pairs. Less frequently traded, these often feature major currencies against each other instead of the US dollar. Includes: EUR/GBP, EUR/CHF, GBP/JPY
-
Exotics. A major currency against one from a small or emerging economy. Includes: USD/PLN, GBP/MXN, EUR/CZK
-
Regional pairs. Pairs classified by region – such as Scandinavia or Australasia. Includes: EUR/NOK, AUD/NZD, AUD/SGD
What moves the forex market?
The forex market is made up of currencies from all over the world, which can make exchange rate predictions difficult as there are many factors that could contribute to price movements. However, like most financial markets, forex is primarily driven by the forces of supply and demand, and it is important to gain an understanding of the influences that drives price fluctuations here.
​
Central banks
Supply is controlled by central banks, who can announce measures that will have a significant effect on their currency’s price. Quantitative easing, for instance, involves injecting more money into an economy, and can cause its currency’s price to drop.
​
News reports
Commercial banks and other investors tend to want to put their capital into economies that have a strong outlook. So, if a positive piece of news hits the markets about a certain region, it will encourage investment and increase demand for that region’s currency.
Unless there is a parallel increase in supply for the currency, the disparity between supply and demand will cause its price to increase. Similarly, a piece of negative news can cause investment to decrease and lower a currency’s price. This is why currencies tend to reflect the reported economic health of the region they represent.
​
Market sentiment
Market sentiment, which is often in reaction to the news, can also play a major role in driving currency prices. If traders believe that a currency is headed in a certain direction, they will trade accordingly and may convince others to follow suit, increasing or decreasing demand.
​
​
How does forex trading work?
There are a variety of different ways that you can trade forex, but they all work the same way: by simultaneously buying one currency while selling another. Traditionally, a lot of forex transactions have been made via a forex broker, but with the rise of online trading you can take advantage of forex price movements using derivatives like CFD trading.
CFDs are leveraged products, which enable you to open a position for a just a fraction of the full value of the trade. Unlike non-leveraged products, you don’t take ownership of the asset, but take a position on whether you think the market will rise or fall in value.
Although leveraged products can magnify your profits, they can also magnify losses if the market moves against you.
What is the spread in forex trading?
The spread is the difference between the buy and sell prices quoted for a forex pair. Like many financial markets, when you open a forex position you’ll be presented with two prices. If you want to open a long position, you trade at the buy price, which is slightly above the market price. If you want to open a short position, you trade at the sell price – slightly below the market price.
What is a lot in forex?
Currencies are traded in lots – batches of currency used to standardise forex trades. As forex tends to move in small amounts, lots tend to be very large: a standard lot is 100,000 units of the base currency. So, because individual traders won’t necessarily have 100,000 pounds (or whichever currency they’re trading) to place on every trade, almost all forex trading is leveraged.
What is leverage in forex?
Leverage is the means of gaining exposure to large amounts of currency without having to pay the full value of your trade upfront. Instead, you put down a small deposit, known as margin. When you close a leveraged position, your profit or loss is based on the full size of the trade.
​
While that does magnify your profits, it also brings the risk of amplified losses – including losses that can exceed your margin . Leveraged trading therefore makes it extremely important to learn how to manage your risk.
What is margin in forex?
Margin is a key part of leveraged trading. It is the term used to describe the initial deposit you put up to open and maintain a leveraged position. When you are trading forex with margin, remember that your margin requirement will change depending on your broker, and how large your trade size is.
Margin is usually expressed as a percentage of the full position. So, a trade on EUR/GBP, for instance, might only require 3.33% of the total value of the position to be paid in order for it to be opened. So instead of depositing £100,000, you’d only need to deposit £3300.
What is a pip in forex?
Pips are the units used to measure movement in a forex pair. A forex pip is usually equivalent to a one-digit movement in the fourth decimal place of a currency pair. So, if GBP/USD moves from $1.35361 to $1.35371, then it has moved a single pip. The decimal places shown after the pip are called fractional pips, or sometimes pipettes.
The exception to this rule is when the quote currency is listed in much smaller denominations, with the most notable example being the Japanese yen. Here, a movement in the second decimal place constitutes a single pip. So, if EUR/JPY moves from ¥106.452 to ¥106.462, again it has moved a single pip.
Understanding Forex Charts
What is a Forex Chart?
A forex chart is simply a graphical depiction of the exchange rate between to currencies.
It shows how the exchange rate of currency pair has changed over time.
For example, the chart below (Euro vs. U.S. Dollar) shows how the exchange rate between Euros and US dollars has fluctuated over time.
Forex charts can be plotted for variety of currency pairs, from major pairs like EUR/USD and GBP/USD to minor pairs such as AUD/CAD and NZD/JPY.
The choice is yours.
How do Forex Chart Timeframes work?
The amount of time shown on the chart depends on the particular timeframe you select.
By default, our forex charts are set to daily (1D) timeframes.
What this means is that each point on the graph, whether it be a line, candle or bar represents the trading data for one day.
If you were to change the timeframe to a 60 minute chart, each point on the chart would now represent 60 minutes worth of trading data. Example below:
With most free forex charting tools you can choose to display timeframes from as low as 1 minute all the way up to one month. If get more advanced charting software, you can view lower timeframes.
Types of Forex Charts
Forex traders have developed several types of forex charts to help depict trading data.
The three main chart types are line, bar, and candlesticks.
For forex traders, candlestick charts seem to be the crowd favorite, and it’s easy to see why.
Compared to a line chart, which shows the price close to close, candlestick charts show four times the amount of information, displaying the close, open, low and high price of a given period.
By having this extra information, you can study ‘how’ price has moved over a period of time compared to just seeing where the price closed.
The red and green portions of a candle are termed the ‘body’.
The body of a candlestick represents the difference between the opening and closing price of the currency for a given time period.
If the opening price of the candle is lower than the closing price, the candle body color is green. If the opposite occurs, and the opening price is higher than the closing price then the candle body color is red.
The black lines above and below the candles are called ‘wicks’ or ‘shadows’.
Wicks represent the highest and lowest prices reached during the given time period.
An Overview of Forex Indicators
Currency charts help traders evaluate market behavior, and help them determine where the currency will be in the future.
To help make sense of the currency movements depicted on a chart, traders have developed a number of different visual guides to assist them – indicators.
There are hundreds of different types of trading indicators developed to cover every aspect of forex trading, from trend following to mean reversion.
Below we cover some of the most popular indicators used by currency traders.
Bollinger Bands
Bollinger Bands are volatility bands placed x standard deviations around a moving average. Developed by John Bollinger, the bands widen in periods of increasing volatility and narrow when volatility decreases.
From a traditional perspective, the bands are used to highlight potential oversold and overbought areas.
For example, if a price move breaches the upper band, it might be expected that the price would then revert back to its mean, or in this case the middle moving average.
Calculation:
Middle Moving Average = 20 period simple moving average (20 SMA).
Upper Band = 20 SMA plus the 20 period standard deviation multiplied by 2.
Lower Band = 20 SMA minus the 20 period standard deviation multiplied by 2.
Relative Strength Index (RSI)
Developed by J. Welles Wilder the Relative Strength Index (RSI) is a momentum oscillator which measures the direction and velocity of price movements.
The indicator compares upward price movements in the closing price to downward movements in the closing price over certain time periods. The default period, suggested by Wilder, is 14 periods.
Calculation:
RSI = 100 – 100 / (1 + RS)
Where RS equals Average Gain divided by Average Loss
Average Gain = [(Sum of gains over previous 14 periods / 14) * 13 + current gain] / 14
Average Loss = [(Sum of losses over previous 14 periods / 14) * 13 + current loss] / 14
Simple Moving Average Line
SMA or simple moving average is the most common indicator plotted on forex charts.
Moving averages are used as they help smooth price fluctuations over a certain period, giving the trader a clearer picture of the direction of the price movement.
Calculation:
SMA = Sum of the closing prices / number of periods.
WHAT IS A FOREX TRADING STRATEGY ?
A forex trading strategy defines a system that a forex trader uses to determine when to buy or sell a currency pair. There are various forex strategies that traders can use including technical analysis or fundamental analysis. A good forex trading strategy allows for a trader to analyze the market and confidently execute trades with sound risk management techniques.
​
-
Price Action Trading
-
Range Trading Strategy
-
Trend Trading Strategy
-
Position Trading
-
Day Trading Strategy
-
Forex Scalping Strategy
-
Swing Trading
-
Carry Trade Strategy
​
FOREX STRATEGIES: A TOP-LEVEL OVERVIEW
​
Forex strategies can be divided into a distinct organizational structure which can assist traders in locating the most applicable strategy. The diagram below illustrates how each strategy falls into the overall structure and the relationship between the forex strategies.
FOREX TRADING STRATEGIES THAT WORK
Forex trading requires putting together multiple factors to formulate a trading strategy that works for you. There are countless strategies that can be followed, however, understanding and being comfortable with the strategy is essential. Every trader has unique goals and resources, which must be taken into consideration when selecting the suitable strategy.
There are three criteria traders can use to compare different strategies on their suitability:
-
Time resource required
-
Frequency of trading opportunities
-
Typical distance to target
To easily compare the forex strategies on the three criteria, we've laid them out in a bubble chart. On the vertical axis is ‘Risk-Reward Ratio’ with strategies at the top of the graph having higher reward for the risk taken on each trade. Position trading typically is the strategy with the highest risk reward ratio. On the horizontal axis is time investment that represents how much time is required to actively monitor the trades. The strategy that demands the most in terms of your time resource is scalp trading due to the high frequency of trades being placed on a regular basis.
Price action trading involves the study of historical prices to formulate technical trading strategies. Price action can be used as a stand-alone technique or in conjunction with an indicator. Fundamentals are seldom used; however, it is not unheard of to incorporate economic events as a substantiating factor. There are several other strategies that fall within the price action bracket as outlined above.
​
Length of trade:
​
Price action trading can be utilized over varying time periods (long, medium and short-term). The ability to use multiple time frames for analysis makes price action trading valued by many traders.
​
Entry/Exit points:
​
There are many methods to determine support/resistance levels which are generally used as entry/exit points:
Within price action, there is range, trend, day, scalping, swing and position trading. These strategies adhere to different forms of trading requirements which will be outlined in detail below. The examples show varying techniques to trade these strategies to show just how diverse trading can be, along with a variety of bespoke options for traders to choose from.
​
​
Range trading includes identifying support and resistance points whereby traders will place trades around these key levels. This strategy works well in market without significant volatility and no discernible trend. Technical analysis is the primary tool used with this strategy.
​
Length of trade:
​
There is no set length per trade as range bound strategies can work for any time frame. Managing risk is an integral part of this method as breakouts can occur. Consequently, a range trader would like to close any current range bound positions.
​
Entry/Exit points:
​
Oscillators are most commonly used as timing tools. Relative Strength Index (RSI), Commodity Channel Index (CCI) and stochastics are a few of the more popular oscillators. Price action is sometimes used in conjunction with oscillators to further validate range bound signals or breakouts.
​
Example 1: USD/JPY Range Trading
USD/JPY has been exhibiting a prolonged range bound price level over the past few years. The chart above illustrates a clear support and resistance band which traders use as entry/exit points. The RSI oscillator demonstrates timing of entry/exit points as highlighted by the shaded blue and red boxes – blue: overbought and red: oversold.
Range trading can result in fruitful risk-reward ratios however, this comes along with lengthy time investment per trade. Use the pros and cons below to align your goals as a trader and how much resources you have.
​
Pros:
-
Substantial number of trading opportunities
-
Favorable risk-to reward ratio
Cons:
-
Requires lengthy periods of time investment
-
Entails strong appreciation of technical analysis
​
Trend trading is a simple forex strategy used by many traders of all experience levels. Trend trading attempts to yield positive returns by exploiting a markets directional momentum.
Length of trade:
Trend trading generally takes place over the medium to long-term time horizon as trends themselves fluctuate in length. As with price action, multiple time frame analysis can be adopted in trend trading.
Entry/Exit points:
Entry points are usually designated by an oscillator (RSI, CCI etc) and exit points are calculated based on a positive risk-reward ratio. Using stop level distances, traders can either equal that distance or exceed it to maintain a positive risk-reward ratio e.g. If the stop level was placed 50 pips away, the take profit level would be set at 50 pips or more away from the entry point.
Example 2: Identifying the Trend
In the simple example above, EUR/USD exhibits an upward trend validated by higher highs and higher lows. The opposite would be true for a downward trend.
EUR/USD Trading the Trend
When you see a strong trend in the market, trade it in the direction of the trend. For example, the strong uptrend in EUR/USD above.
Using the (CCI) as a tool to time entries, notice how each time CCI dipped below -100 (highlighted in blue), prices responded with a rally. Not all trades will work out this way, but because the trend is being followed, each dip caused more buyers to come into the market and push prices higher. In conclusion, identifying a strong trend is important for a fruitful trend trading strategy.
Trend trading can be reasonably labor intensive with many variables to consider. The list of pros and cons may assist you in identifying if trend trading is for you.
Pros:
-
Substantial number of trading opportunities
-
Favorable risk-to reward ratio
Cons:
-
Requires lengthy periods of time investment
-
Entails strong appreciation of technical analysis
4. POSITION TRADING
Position trading is a long-term strategy primarily focused on fundamental factors however, technical methods can be used such as Elliot Wave Theory. Smaller more minor market fluctuations are not considered in this strategy as they do not affect the broader market picture. This strategy can be employed on all markets from stocks to forex.
Length of trade:
As mentioned above, position trades have a long-term outlook (weeks, months or even years!) reserved for the more persevering trader. Understanding how economic factors affect markets or thorough technical predispositions, is essential in forecasting trade ideas.
Entry/Exit points:
Key levels on longer time frame charts (weekly/monthly) hold valuable information for position traders due to the comprehensive view of the market. Entry and exit points can be judged using technical analysis as per the other strategies.
Example 3: Germany 30 (DAX) Position Trading
The Germany 30 chart above depicts an approximate two year head and shoulders pattern, which aligns with a probable fall below the neckline (horizontal red line) subsequent to the right-hand shoulder. In this selected example, the downward fall of the Germany 30 played out as planned technically as well as fundamentally. Towards the end of 2018, Germany went through a technical recession along with the US/China trade war hurting the automotive industry. Brexit negotiations did not help matters as the possibility of the UK leaving the EU would most likely negatively impact the German economy as well. In this case, understanding technical patterns as well as having strong fundamental foundations allowed for combining technical and fundamental analysis to structure a strong trade idea.
List of Pros and Cons based on your goals as a trader and how much resources you have.
Pros:
-
Requires minimal time investment
-
Highly positive risk-to reward ratio
Cons:
-
Very few trading opportunities
-
Entails strong appreciation of technical and fundamental analysis
5. DAY TRADING STRATEGY
Day trading is a strategy designed to trade financial instruments within the same trading day. That is, all positions are closed before market close. This can be a single trade or multiple trades throughout the day.
Length of trade:
Trade times range from very short-term (matter of minutes) or short-term (hours), as long as the trade is opened and closed within the trading day.
Entry/Exit points:
Traders in the example below will look to enter positions at the when the price breaks through the 8 period EMA in the direction of the trend (blue circle) and exit using a 1:1 risk-reward ratio.
Example 4: EUR/USD Day Trading
The chart above shows a representative day trading setup using moving averages to identify the trend which is long in this case as the price is above the MA lines (red and black). Entry positions are highlighted in blue with stop levels placed at the previous price break. Take profit levels will equate to the stop distance in the direction of the trend.
The pros and cons listed below should be considered before pursuing this strategy. Day trading involves much time and effort for little reward, as seen from the EUR/USD example above.
Pros:
-
Substantial number of trading opportunities
-
Median risk-to reward ratio
Cons:
-
Requires lengthy periods of time investment
-
Entails strong appreciation of technical analysis
6. FOREX SCALPING STRATEGY
Scalping in forex is a common term used to describe the process of taking small profits on a frequent basis. This is achieved by opening and closing multiple positions throughout the day. This can be done manually or via an algorithm which uses predefined guidelines as to when/where to enter and exit positions. The most liquid forex pairs are preferred as spreads are generally tighter, making the short-term nature of the strategy fitting.
Length of trade:
Scalping entails short-term trades with minimal return, usually operating on smaller time frame charts (30 min – 1min).
Entry/Exit points:
Like most technical strategies, identifying the trend is step 1. Many scalpers use indicators such as the moving average to verify the trend. Using these key levels of the trend on longer time frames allows the trader to see the bigger picture. These levels will create support and resistance bands. Scalping within this band can then be attempted on smaller time frames using oscillators such as the RSI. Stops are placed a few pips away to avoid large movements against the trade. The MACD indicator is another useful tool that can be exercised by the trader to enter/exit trades.
Example 5: EUR/USD Scalping Strategy
The EUR/USD 10 minute above shows a typical example of a scalping strategy. The long-term trend is confirmed by the moving average (price above 200 MA). The smaller time frame is then used to target entry/exit points. Timing of entry points are featured by the red rectangle in the bias of the trader (long). Traders can also close long positions using the MACD when the MACD (blue line) crosses over the signal line (red line) highlighted by the blue rectangles.
Traders use the same theory to set up their algorithms however, without the manual execution of the trader.
With this practical scalp trading example above, use the list of pros and cons below to select an appropriate trading strategy that best suits you.
Pros:
-
Greatest number of trading opportunities from all forex strategies
Cons:
-
Requires lengthy periods of time investment
-
Entails strong appreciation of technical analysis
-
Lowest risk-to reward ratio
7. SWING TRADING
Swing trading is a speculative strategy whereby traders look to take advantage of rang bound as well as trending markets. By picking ‘tops’ and ‘bottoms’, traders can enter long and short positions accordingly.
Length of trade:
Swing trades are considered medium-term as positions are generally held anywhere between a few hours to a few days. Longer-term trends are favored as traders can capitalize on the trend at multiple points along the trend.
Entry/Exit points:
Much like the range bound strategy, oscillators and indicators can be used to select optimal entry/exit positions and times. The only difference being that swing trading applies to both trending and range bound markets.
Example 6: GBP/USD Swing Trading Strategy
A combination of the stochastic oscillator, ATR indicator and the moving average was used in the example above to illustrate a typical swing trading strategy. The upward trend was initially identified using the 50-day moving average (price above MA line). In the case of an uptrend, traders will look to enter long positions with the old adage of ‘buy low, sell high’.
Stochastics are then used to identify entry points by looking for oversold signals highlighted by the blue rectangles on the stochastic and chart. Risk management is the final step whereby the ATR gives an indication of stop levels. The ATR figure is highlighted by the red circles. This figure represents the approximate number of pips away the stop level should be set. For example, if the ATR reads 41.8 (reflected in the last ATR reading) the trader would look to place the stop 41.8 pips away from entry. At DailyFX, we recommend trading with a positive risk-reward ratio at a minimum of 1:2. This would mean setting a take profit level (limit) at least 83.6 (41.8 x 2) pips away or further.
After seeing an example of swing trading in action, consider the following list of pros and cons to determine if this strategy would suit your trading style.
Pros:
-
Substantial number of trading opportunities
-
Median risk-to reward ratio
Cons:
-
Entails strong appreciation of technical analysis
-
Still requires extensive time investment
8. CARRY TRADE STRATEGY
Carry trades include borrowing one currency at lower rate, followed by investing in another currency at a higher yielding rate. This will ultimately result in a positive carry of the trade. This strategy is primarily used in the forex market.
Length of trade:
Carry trades are dependent on interest rate fluctuations between the associated currencies therefore, length of trade supports the medium to long-term (weeks, months and possibly years).
Entry/Exit points:
Strong trending markets work best for carry trades as the strategy involves a lengthier time horizon. Confirmation of the trend should be the first step prior to placing the trade (higher highs and higher lows and vice versa) – refer to Example 1 above. There are two aspects to a carry trade namely, exchange rate risk and interest rate risk. Accordingly, the best time to open the positions is at the start of a trend to capitalise fully on the exchange rate fluctuation. Regarding the interest rate component, this will remain the same regardless of the trend as the trader will still receive the interest rate differential if the first named currency has a higher interest rate against the second named currency e.g. AUD/JPY.
​
Could carry trading work for you? Consider the following pros and cons and see if it is a forex strategy that suits your trading style.
Pros:
-
Little time investment needed
-
Median risk-to reward ratio
Cons:
-
Entails strong appreciation of forex market
-
Infrequent trading opportunities
FOREX STRATEGIES: A SUMMARY
This article outlines 8 types of forex strategies with practical trading examples. When considering a trading strategy to pursue, it can be useful to compare how much time investment is required behind the monitor, the risk-reward ratio and regularity of total trading opportunities. Each trading strategy will appeal to different traders depending on personal attributes. Matching trading personality with the appropriate strategy will ultimately allow traders to take the first step in the right direction.
ENHANCE YOUR FOREX TRADING
-
If you’re new to forex trading, download our Forex for Beginners Trading guide.
-
Register for free to view our live trading webinars which cover various topics related to the Forex market like central bank movements, currency news, and technical chart patterns.
-
Stay up to date with major news events and economic releases by viewing our economic calendar.
-
Successful trading requires sound risk management and self-discipline. Find out how much capital you should risk on your open trades.
-
We also recommend viewing our Traits of Successful Traders guide to discover the secrets of successful forex traders.