Discover The 7 Components Of A Solid Forex Trading Strategy That Combine Into A Synergistically Sound Long-Term Approach To Extraordinary Wealth Accumulation
There are various general components all Forex trading strategies share that are essential if the strategy is to be built on a strong foundation. When these components are put together properly… they can lead to extraordinary profit potential.
Remember in a past lesson where I talked about synergy and success. This is another one of those times where the sum of the parts is greater than each part individually.
Just as the Forex Market, Trading Strategy and Trader work synergistically in order to produce the desired result, each component of a trading strategy must work together in order to produce a solid trading strategy with an edge over the currency markets.
One component of the trading strategy cannot be credited with the success or failure of the strategy.
OK, let’s go over each component one by one.
Figuring out what time frame to trade is the first thing you need to do when building a Forex strategy. In a way, the time frame you decide to trade defines both your trading strategy and you as a trader.
- If you trade the lower time frames like the M1, M5 or M15, your strategy might be considered a scalping strategy and you are a scalper.
- If you trade the M30 or H1 time frames, your strategy might be considered an intraday strategy and you are a day trader.
- If you trade the H4 or D1 time frames, your strategy might be considered swing trading and you are a swing trader.
- And if you trade on the W1 or MN, your strategy might be considered position trading and you are a position trader.
Just keep in mind, there is a right time frame for both your strategy and you as a trader. And aligning your trading strategy to your trading personality is essential for long term success.
I personally trade off the Daily Time Frame and therefore consider myself a Swing Trader.
The currency of a country is actually what is being traded on the Forex Market. Currencies are traded in pairs, and it is best to think of currency pairs as a single trading unit.
The price of the currency pair is a direct reflection of what the market thinks about a country (or group of countries) and its economic state versus another country (or group of countries) and its economic state.
For example, the EURUSD reflects what the market thinks about the European economy versus the economy of the United States.
The first currency is called the BASE currency and the second currency is called the QUOTE currency. For example, in the EURUSD currency pair the Euro Dollar is the Base Currency and the US Dollar is the Quote Currency.
When you BUY a currency pair, you are buying the Base currency and selling the quote currency. (For example, if you BUY the EURUSD, you are simultaneously buying the Euro Dollar and selling the US Dollar).
When you SELL a currency pair, you are selling the Base currency and buying the quote currency. (For example, if you SELL the EURUSD, you are simultaneously selling the Euro Dollar and buying the US Dollar).
Currency pairs have “personalities”. By this I mean they historically tend to move in a certain way. As a swing trader, I look for currency pairs that tend to produce large swings in the market.
One of my favorite currency pairs to focus on is the Great British Pound vs the Japanese Yen.
Trend Direction Bias
A "trend" is a general direction in which something is moving or changing.
For example, it might be the trend for a currency pair to be going up (Uptrend), or going down (Downtrend).
No matter what your trading strategy, it is important to know the overall trend direction, or if there is a strong trend at all.
If your trading strategy is a trend following strategy, knowing the trend direction tells you what direction to take trades. Obviously, you want to increase your chances of success by only taking trades in the direction of the trend.
If your strategy is a counter-trend strategy, where you trade against the trend, you still need to know the trend direction. After all, how can you trade against the trend if you don’t know the direction of the trend in the first place?
If your strategy is designed to trade when there is no predominant trend present, like range trading, then you still need to know when there is a strong trend and when there is not.
I personally trade in the direction of the overall trend and try to catch swings in that direction.
When to BUY a currency pair or when to SELL a currency pair is important. As a matter of fact, this is what most traders focus on when creating a trading system. Basically, what criteria are necessary for you to pull the trigger and buy or sell a currency pair in the market?
I want to make one thing clear…
When to enter the market is not necessarily the most important part of your trading strategy. Many traders think that if they can just nail down the right entry criteria, nothing else matters. This is just not true.
While deciding when you are going to enter the market is important, the other characteristics of a solid trading system are just as important or even more so.
Entry signals get a lot of attention because the topic is exciting, and other components of a trading system are boring or just don't seem that important at first glance. But if you want to be successful, you cannot just focus on the things you like.
A solid trading strategy addresses every characteristic, even the boring stuff.
So, as far as entry signals are concerned, just keep in mind that your strategy must have some REASON WHY you are entering the market when you are.
Something must take place, or multiple things must take place at the same time in order for you to take action and enter the market.
You need strict rules when to enter a trade, or else you are just trading what you "think" the market is going to do, which in my opinion is not a trading strategy at all.
I use a strict set of rules in order to enter the market.
Initial Trade Levels (Stop Loss & Take Profit)
Before you enter the market, there are 2 very important levels to take into consideration: Stop Loss and Take Profit. You need to know what you are willing to risk and what you hope to gain.
Initial Stop Loss Placement: A Stop Loss is an order at a specific price placed in order to limit a loss. It represents how much you are willing to risk on a trade if it doesn't go your way. So, when you enter the market, a stop loss order is placed to limit the loss if the market goes against you.
And here is something you should know right from the start… Always use a stop loss!
Basically what I’m saying is there is a point where you have to admit your entry is no longer a good entry. (I don’t want to use the word “mistake” because if you entered according to your trading rules it is not a mistake). But at some point, it is better to take the loss before more money is lost and wait for another trading opportunity.
Initial Take Profit Placement: A Take Profit is an order at a specific price at which you close the trade and collect your profits. It represents how much you want to make on a trade that goes your way.
So, when you enter the market, a take profit order can be placed at your desired profit level if the market goes your way.
I always set a stop loss and take profit when entering a trade.
Combining the stop loss levels and take profit levels brings us to a very important ratio...
Risk Reward Ratio
The Risk Reward Ratio is used to compare the expected returns of a trade to the amount of risk you are willing to take in order to capture these returns. Basically, how much are you willing to risk compared to how much you desire to gain.
Risk to reward ratios are one of the most important concepts to grasp if you want to be a consistent, long-term, profitable trader. The initial goal should always be to make more money on winning trades than you lose on losing trades.
If you can do this over the long-term, you will be profitable. It is as simple as that.
I only enter a trade with a risk to reward ratio that allows me to make more on winning trades than I lose on losing trades.
Position Size - Called Lot Size In Forex
Position size is the volume of a trade or order. In Forex trading, this is represented as Lots. You need to assign a lot size value to the trade, and determine how many lots to trade per smallest price change that a given exchange rate can make (called a pip).
So first, let's talk about pips.
A "PIP", Price Interest Point, is the basic unit in Forex trading that measures the change in value of a currency pair. Basically, a pip is the smallest amount by which changes in a currency pair's value can be measured.
Most currency pairs have 4 decimal spaces, and the PIP is represented by the fourth decimal space.
For example, if the price of the EURUSD is 1.2305, the 5 at the end represents the PIP.
- If the price moves from 1.2305 to 1.2306, that is a 1 pip increase.
- If the price moves from 1.2305 to 1.2304, that is a 1 pip decrease.
Some currency pairs, like the GBPJPY have 2 decimal spaces, and the pip is represented by the second decimal space.
For example, if the price of the GBPJPY is 121.05, the 5 at the end represents the PIP.
- If the price moves from 121.05to 121.06, that is a 1 pip increase.
- If the price moves from 121.05 to 121.04, that is a 1 pip decrease.
IMPORTANT: A lot of brokers show 5 decimals or 3 decimals. The 5th or 3rd decimal is not a FULL PIP, but rather a fraction of a pip.
Ok, now let's move on to lots. There are 3 basic lot size types:
- Micro Lots (1,000 units): 0.01 lots = @ $0.10 per pip
- Mini Lots (10,000 units): 0.1 lots = @ $1.00 per pip
- Standard Lots (100,000 units): 1.0 lots @ $10.00 per pip
So, if you wanted to risk $2.50 per pip, you would use a lot size of 0.25 when placing the trade.
Now it is possible to understand position size better.
Let's say you place a BUY order on the EURUSD at 1.10420 and place your stop loss at 1.10220. You are willing to risk a total of 20 pips on the trade. If you place the trade using 0.1 lots per pip, you are risking $1 per pip, and a total of $20 on the trade.
This is the position size of the trade.
Finding the right position sizing strategy for your trading personality and risk tolerance is like walking a tightrope.
- On one side you have how much risk you are comfortable taking.
- On the other side, you have your profit goals.
You want to find a position sizing strategy that lets you sleep at night… but still be able to reach your profit goals in a reasonable amount of time.
You need to find the "sweet spot" that lets you make profits while helping you stick with trading over the long term.
I use a position size strategy that does not put my account at undue risk, but still can result in extraordinary profits.
Everything we've been talking about so far has been about what to do BEFORE the trade is placed. Figuring out what time frame to trade, what direction to trade in, the exact entry criteria, where to place your stop loss and take profit and what lot size to use all needs to be done before you click the button to Buy or Sell.
Now we need to talk about what you do AFTER the trade is placed.
How are you going to manage your trade from beginning to end?
No Trade Management: Simply let the trade run until either the stop loss or take profit is hit.
Time Based Trade Expiration: Close the trade at a specific time every day, regardless of whether the trade is in profit or loss.
Move Stop Loss To Breakeven: At some point in the trade, you might want to move your stop loss to eliminate the risk on the trade when it goes in your favor. For example, you might start the trade with a 50 pip stop loss, and move the stop loss to +5 pips once the trade moves 75 pips in your favor.
Trailing Stops: Similar to moving your stop loss to breakeven, you could trail your stop at certain points to lock in profits. There are many trailing stop strategies, but the point is you would trail the stop loss when price goes in your favor to lock in profits as the trade progresses.
Partial Profits: Partial profits are when you take a portion of your position out of the market at a specified level, and let the remaining portion run.
Manually Closing Trades: At some point market conditions might change and you might have a rule to close the trade early.
Trade management is very important and you need to have rules on how you are going to act after the trade is placed and real money is on the line. It is very important to have strict trade management rules in place to help keep you from making decisions based on emotions.
I personally spend a lot of time on my trade management rules, as I feel this is an essential part of successful trading.
Talking about the different components of a solid Forex Trading Strategy might be scary to some people, especially people new to trading Forex. There are a lot of things to take into account and put together if you are to create and use a successful trading strategy. It can feel really complex and overwhelming.
But don’t worry… it is not necessary to figure all this out on your own. It is necessary to know the strategy you are following has taken all these things into consideration and is built on a solid foundation.
Remember, it is impossible to build a Forex trading strategy that always wins. There will be losses. But using a strategy that combines all 7 components together synergistically to gain an edge in the markets can still lead to extraordinary profits… despite the inevitable losing trades.