3 Tips To Building A Powerful Forex Trading Strategy

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Buying and selling on forex market

Building a comprehensive trading strategy is not easy, and you need to think it through based on your risk tolerance, trading style and financial situation. Let me give you an insight into 3 Powerful FOREX Strategies you can implement to take your trading to the next level.

3 Tips To Build A Powerful Forex Trading Strategy

Broadly speaking, there are 3 types of market analyses: Fundamental Analysis, Technical Analysis and Sentiment Analysis.

You may be wondering, which of these is the best? It is, of course, not possible to tell you that one is better than another – they all have their role to play, and they all look at the market in different ways. Some will tell you that Fundamental and Technical Analysis are used more often than Sentiment Analysis, others will say that you cannot use one without the others, or that you shouldn’t use Technical Analysis if your strategy is predominately based on Fundamental Analysis.

Let’s talk about each one individually and see how you can use them in your trading to improve your performance.

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Fundamental Analysis

With this type of approach you are analysing the impact of the strength or weakness of a country’s economic outlook on its currency. If a country has a good current/future economic outlook, then it’s good for its currency and should strengthen against its counterpart.

When a country’s economy is strong, then more foreign investors want to invest in that country. Thus, they are going to be in need of that country’s currency and buy it, thus pushing its value higher.

With Fundamental Analysis you are looking at the FOREX market in terms of the global economic and social climate, as well as political (in)stability that can affect the supply and demand of a country’s currency.

Supply and demand forces mainly settle the price of any financial asset. So you want to know where the price of a currency pair is heading, and so you need to be able to recognize the factors that affect supply and demand forces.

Knowing the profile and characteristics of each currency is also an advantage, as you will then know what the main drivers are. Commodity currencies for example are “ currencies from countries that possess large quantities of commodities or other natural resources”, which represent the main country’s exports. If you invest on those currencies (CAD, AUD, NZD…), you need to closely monitor the evolution of commodity prices, as they will have an impact on those countries’ growth.

sentiment-analysis

a. Fundamental Analysis Strategy: Trading the News

With this particular FOREX strategy, you are following economic news, and opening positions based on live statistics being released. Important statistics have a significant impact on the FOREX market, as they will give you a hint about the strength or weakness of a given economy. You will then know if it’s good or bad for the country’s currency.

Central bank decisions have the biggest impact on the FOREX market, as they will decide how much money they will inject in the economy. We won’t come back here on the role of monetary policy, as we covered it in a previous article: Importance of Central Banks on the FOREX Market. Any news that is important for Central Banks (inflation, employment, consumption etc.) will also have a very important impact on the FOREX. The NFP report is an example of this.

You can’t work with this FOREX strategy without following the economic calendar that will tell you when to expect big news to be announced. One of the best calendars to follow is the one at FOREX Factory. You must be very careful while using news trading, as statistics can trigger extreme volatility peaks. When the market reacts after news, there are numerous opportunities to make money very rapidly, but it’s obviously very risky as well.

Currency Carry Trade
b. Fundamental Analysis Strategy: Currency Carry Trade

Basically, currency carry trade is all about borrowing a currency that has a low interest rate, so you can then finance the buying of another currency to earn a higher interest rate.

As we have mentioned in a previous article, when you are investing on the FOREX market you are buying a currency and simultaneously selling another one. So, with carry trade, you are paying interest on the currency position you are selling, and are collecting interest on the currency position you are buying.

This fundamental FOREX trading technique can be another way to make money with currencies without having to find a way to buy low and sell high, as well as to put up with volatility. Traders do not focus here on the path a currency pair is going to take, but on the rate differential. You need to be careful about the currency you decide to invest in though, as it can be very risky to choose a currency based only on whether the country has a high interest rate.

Some people will advise using Fundamental strategies in combination with another strategy. For example, when you’re trading the news, you can predict the news’ impact on the markets using market sentiment.

Sentiment Analysis

With this strategy you’re trying to assess and understand the way investors think, their mood, but above all what their expectations are about the markets. People are the ones making decisions, so it’s normal to want to know how they feel about an asset’s price direction, because this will give you a hint on how strong a movement can be, or the direction of a market.

You can, for example, identify market sentiment when a strong uptrend or downtrend movement takes place, how fast a movement is going up or down, how nervous investors are when you have higher volatility or consolidation patterns, etc.

Social trading platforms and social networks such as Facebook and Twitter can help give an idea of what important people think.

For that, you can also use the C.O.T. – Commitment Of Traders – which provides an inside view on the net long and short positions of the previous week held by the biggest players on the markets.

a. Sentiment Analysis Strategy: the C.O.T.

Using the C.O.T. will allow you to take advantages of professional investors’ positions on the FOREX market to exploit important trends. Forget about scalping with this strategy, as the data published are about the week before. It is more about position trading, as you are trying to find underlying trends and to spot extreme situations with a trend reversal.

This report is published every Friday by the CFTC – Commodity Futures Trading Commission. This report uses information from the futures market.

Once on their website, scroll down and find the “current legacy reports” category. You must then select “Chicago Mercantile Exchange – Short Format”, find the currency section in the document and select the currency you are trading. The following example is about the Sterling – a choice motivated by all the current debates around Brexit.

trading COT, sentiment analysis

Read our previous post: Brexit Survival Guide: 5 Power Facts To Consider In Your Trading

On this screenshot, the 4 most important pieces of information you should take note of are the following:

Direction of the price’s movement: long or short.

Non-commercial traders: they are large speculators, such as hedge funds and institutional investors, who follow the trend and try to make money from trading activities.

Commercial traders: they are mostly hedgers, who make the trend. Banks or businesses trying to get a hedge for their products, rather than making profit. They have countless means to protect themselves against unexpected price movements.

Open interest: represents the volume of positions that remain opened.

The reason why you should use this report in your trading is because it measures the sentiment of influential traders over a specific period of time, and allows you to determine market sentiment extremes. Those extremes are materialised through market tops and bottoms.

Commercial and Non-commercial traders are evolving in the opposite direction. Hedgers are buying when it’s bottoming, while speculators are selling when prices move down. On the other hand, when the market moves up, hedgers will sell to protect themselves against a market rally, while speculators will buy to go with the trend.

You can then conclude that the positions from non-commercial traders will indicate the trend’s direction, and the positions from commercial traders will signal reversals patterns. So, if non-commercial traders keep increasing their short positions, and commercial traders increase their long positions, then a market top should appear soon, and vice-versa.

To better spot extreme levels, you can also use Technical Analysis or TA, which uses past market data to forecast future prices’ movements.

sellbuy-trading

Technical Analysis

This strategy is based on the assumption that historical price movement analysis will allow you to determine current trading conditions and future price movement.

There are 3 main assumptions:

• Markets’ prices discount everything
• Price moves in trends
• History tends to repeat itself

Markets’ prices discount everything

Technical Analysis only takes into consideration market data, not fundamental data, based on the assumption that prices immediately integrate all available information. All relevant information is then already reflected in the prices’ movements.

You can then understand how sentiment analysis is important here, because it’s necessary to know how investors use those information, how they are perceived and interpreted.

Prices move in trends

With TA, prices’ are believed to follow trends: up trends, down trends or sideways consolidations. There are 2 important concepts you should learn more about: the DOW theory and the Efficient Market Hypothesis (EMH).

History tends to repeat itself

It’s all about price movement here. Market psychology tends to strengthen the repetitive nature of price movements. Market participants’ reactions are often the same over time.

a. Technical Analysis Basics: Support, Resistance and Trend lines

Support/Resistance/Trendline

The concepts of support and resistance are the basics of chart analysis. They illustrate the fact that markets often stumble on the same thresholds, and thus highlight two key elements about market: its psychology and its memory.

A support level is a level on a chart above which the buyers’ interests are powerful enough to overcome the selling pressure. When prices touch the support line, they have a tendency to go back up.

A resistance level is a level on a chart below which sellers’ interests outweigh the buying pressure. When prices touch the resistance line, they have a tendency to go back down.

A trend line is a tool, which allows you to determine if the trend is still valid. When there is an uptrend: you need to try to draw an ascending support trend line. On the contrary, if there is a downtrend: you need to try to draw a descending resistance trend line. Learn more about it with our video: Forex Channel Trading Strategies.

b. Technical FOREX Trading Strategies

Technical Analysis

As we just described, you can use chart analysis as a FOREX Strategy, trading with support lines, resistance lines, trend lines, channels and other continuation or reversals patterns etc.

Most FOREX traders that employ Technical Analysis will be scalping or day trading, as they are very popular speculative strategies based on short and quick trades. Find out more: Day Trading For Beginners.

When deciding on what kind of FOREX strategy based on Technical Analysis to use, you have plenty of choices. We will briefly present here the most popular ones. You can use either one or more technical indicators for your strategy.

Statistical Technical Analysis relies on mathematical indicators, which can be divided into 3 main groups:

Trend indicators: built around moving averages, they determine the dynamics of a market

Oscillators: indicators that are ranging either around 0, or between two ranges. They allow you to anticipate acceleration phases and overbought and oversold situations. Examples of these are RSI and Stochastic.

Strength indicators: they calculate the power of a trend, such as the DMI index.

c. 3 examples: Moving Averages, MACD and Bollinger Bands

Moving averages

Moving averages (MA) answer the question: what is the average price an asset has been traded in the last n period. They also reflect the market’s opinion on those n periods.

Moving Averages

Common n periods used by traders are: 20 and 50 for short-term traders as above, and 100 and 200 for longer-term traders – see below.

MA long

You can either use a fast MA with n being small:

• MA provide buying/selling signals
• MA can sometimes trigger counter trend signals
• MA can potentially provide false signals if there is market noise

Or use a slow MM with n being more important:

• MA give a good outlook of the general trend
• MA work well with long-term bullish/bearish trends
• MA do not provide false signals in case of temporary consolidation inside a strong underlying trend
• MA give delayed signals, as they are following long-term trend


MACD – Moving Average Convergence Divergence

This is one of the most used mathematical indicators.

MACD

The MACD is the difference between two exponential moving averages, a short one (12 days) and a long one (26 days). When the short MA passes above the long one, the MACD is positive and it’s generally a buying signal. Conversely, when the shorter MA is below the long one, the MACD is negative and it’s then a selling signal.

The MACD is also composed of its own moving average called the “signal line”. When the MACD crosses the signal line upwards, buyers dominate the market. When it crosses down the signal line, sellers dominate the market.

So, the 2 most common methods used to interpret the MACD are crossovers between indicator’s lines, and divergences with the prices’ evolution. A divergence is observed when the current value of a given asset and the MACD diverge, or move in opposite directions.


Bollinger Bands

Bollinger Bands (BB) reflect moving averages with a new parameter: volatility.

The indicator consists of three lines:

1. A MA of generally 20 days
2. A lower band located two standard deviations (volatility) below the moving average.
3. An upper band also located two standard deviations (volatility) above the moving average.

Bollinger Bands

This indicator gives you information about:

• The trend: it will be stronger when the bands widen (see point A of the graph). Conversely, a weak trend will show a narrowing of the gap between the bands.
• Price levels: above the upper band, prices are considered to be high.
• Reversal signals: the short break of the upper band is generally a bearish reversal signal, and conversely (see point red and green arrows).
• Acceleration signals: a narrowing channel, often forecast a future acceleration phase of prices (see point B).

Conclusion

Most common FOREX strategies are based on Fundamental Analysis, Technical Analysis or a mixture of them, though you shouldn’t ignore the power of Sentiment Analysis while trading. It’s important to know how traders think and how they will react to statistics or any news that can influence the market.

Do not forget that the market has a psychology and a memory, and traders tend to react the same way over time. This is why one assumption of Technical Analysis is that “history tends to repeat itself”. Support and resistances levels represent past reactions and are supposed to tell traders that something can happen close to those levels, as it has done in the past.

Those levels, materialising traders’ opinions, are also the basics of chartist analysis, and are often used in combination with mathematical indicators. Those indicators can be analysed individually or with the prices in order to spot divergences.

What are you waiting for?

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Carolane de Palmas
Carolane de Palmas

After graduating with a Masters in Corporate Finance & Financial Markets, and getting the AMF Certification (Financial Markets Regulator in France), Carolane went to market analysis software company Highwave360 to take part in the European launch of their new market analysis software. She then become an independent trader, investing mostly in European and American stocks and indices, as well as writing market analyses for a number of different brokers. She is the COO of a Canadian fund that specialises in alternative investments.

What are you waiting for?

CHOOSE YOUR COURSE NOW AND START LEARNING FOREX TODAY!

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