Forex trading strategy

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Forex trading strategy begins with fundamental and technical analysis. The following explains why this analysis is vital to building a solid forex trading strategy:

Fundamental Analysis

Fundamental analysis is mainly used to better understand long-term trends in the currency market. There are a number of factors that determine the value of a country's currency.

The overall political, economic, and social climates of a specific country are the primary issues measured in fundamental analysis. As you can imagine, it can be difficult measure how these issues affect one another.

Every trader should be aware of the affects of political events, central bank news, non-farm payrolls, consumer price index, imports, exports etc. on the value of currency before forex trading.

Technical Analysis

Technical analysis produces charts and graphs subsequent to scrutinizing past data on volume and price. One of the latest buzzwords in this approach to currency trading analysis is "Fibonacci retracement." Fibonacci was a 12th century, Italian mathematician whose contribution to a modern forex trading strategy consists of his arcs, fans, and retracements. The lines in these mathematical studies are currently used to anticipate a trend change as prices near the lines created by these arcs, fans, and retracements. So some of the more popular forms of technical analysis used in forex are Candlestick Formations, Fibonacci Sequence, Financial Breakouts and Trend Lines.

Traders who are profitable will develop a personal forex trading strategy and perfect it over time. Some people will focus a specific study or calculation, while others use broad spectrum analysis as a means of determining their trades.

Most experts suggest that you try using a combination of both fundamental and technical analysis, with which you can make long-term projections and also determine entry and exit points. Whatever you finally decide, the fact remains that trading is a discipline that requires preparation and hard work.

Your overall personal forex trading strategy should include three vital ingredients; the currency pair you decide to trade, what technical indicators you use for entry/exit plans and sound money management.

Strategy 1 - Simple Moving Average

Successful trading is often described as optimizing your risk with respect to your reward, or upside. Any trading strategy should have a disciplined method of limiting risk while making the most out of favorable market moves. We will illustrate one decision making model which uses a Simple Moving Average ("SMA") technical study, based on a 12-period SMA, where each period is 15 minutes. This is one example of a trading decision making strategy, and we encourage any trader to research other strategies as thoroughly as possible.

We will use a simple algorithm: when the price of the currency crosses above the 12-period SMA, it will be taken as a signal to buy at the market. When the currency price crosses below the 12-period SMA, it will be a signal to "Stop and Reverse" ("SAR"). In other words, a long position will be liquidated and a short position will be established, both with market orders.

Thus this system will keep the traders "always in" the market - he will always have either a long or short position after the first signal. In the chart below, the white line represents the price of USDJPY, the purple line represents the 12-period SMA of USDJPY, and the red line indicates where USDJPY crosses above the SMA, generating a buy signal at approximately 129.90:

This is a simple example of technical analysis applied to trading. Many strategies used by professional traders make use of moving averages along with other indicators or "filters". Note that the moving average method has an element of risk control built in: a long position will be stopped out fairly quickly in a falling market because the price will drop below the SMA, generating a stop-and-reverse signal. The same holds true for a sell signal in a rising market. Note that the SMA is generated automatically by GCI's integrated charting application.

Strategy 2 - Support and Resistance Levels

One use of technical analysis, apart from technical studies, is in deriving "support" and "resistance" levels. The concept here is that the market will tend to trade above its support levels and trade below its resistance levels. If a support or resistance level is broken, the market is then expected to follow through in that direction. These levels are determined by analyzing the chart and assessing where the market has encountered unbroken support or resistance in the past.

For example, in chart below EURUSD has established a resistance level at approximately .9015. In other words, EURUSD has risen up to .9015 repeatedly, but has been unable to move beyond that point:

The trading strategy would then be to sell EURUSD the next time it gets close to .9015, with a stop placed just above .9015, say at .9025. This would have indeed been a good trade as EURUSD proceeded to fall sharply, without breaking the .9015 resistance. Hence a substantial upside can be achieved while only risking 10 or 15 pips (.0010 or .0015 in EURUSD).

Rules of good trading strategy

1. Trading is an investment not an income

It is important to have a realistic expectation of what you can achieve through forex trading. The nature of trading is such that you may make a good return on your initial capital over an annual period, but during that period you may have a number of consecutive losing months, with only a few bumper months inbetween.

2. You can't predict the forex markets

The forex markets are influenced by billions of traders, economic and political events. You simply cannot predict the direction and manner in which the markets will move. Technical and fundamental analysis does much to provide a more educated guess than a simple coin toss but it is important to realise that each of these techniques will have a large failure rate. You will lose a large percentage of the time. Sometimes you will lose on more trades than you gain on.

3. Let profits ride and cut your losses

The only way to make money from forex trading (or any form of trading) is by making enough money on your winning trades to cover your losses and to gain additional profit to grow your capital. It is harder to put into practice than it sounds as psycologically it is much easier to "marry" your losing trades in the hope that the market will turn in your favour and grabbing your profit too soon when you see your hard earned gains slipping away as the market temporarily turns against you.

4. Trade according to a tried and tested system

This is one of the most important forex principles. The only way to cut out emotion in trading and adopt a more business-like and informed approach is to use a system of rules that have been developed and tested on market data. In this way, all the trade decisions have already been made before you even enter the forex market. This is a much less time consuming and less stressful way to trade for a living.

Forex signals

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One of the disadvantages of FOREX trading is the time investment needed to monitor the markets for advantageous entry and exit points. It's possible to sit in front of a computer monitor for hours watching the markets.

Of course, you can use automated orders such as limits and stops. These allow you to walk away from your computer with the knowledge that your losses will be kept to a minimum, but by doing so, you may miss out on potential profits because your limit order kicks in too soon.

Forex Trading Signals maintain trading logs regularly to show you trends over a period. Best way to learn and form your own trading signals of Forex market is to start with a demo Forex trading account. You can get such an account through Forex brokers and practice trading through these accounts for certain time. This provides you with a feel of the market. You can then form your own signals and implement them in your trading activities to understand their implications. Thereafter you can invest little money and slowly develop your trading in Forex markets.

Forex Risks

Any company that conducts at least some of its business in another currency is exposed to currency forex risk (or foreign exchange risk, or exchange rate risk). However, this risk is present only if the company's sales currency differs from the company's cost currency – if a company's revenues and expenses are both denominated in the same foreign currency, there is no foreign exchange risk.

There are two types of currency risk: transaction risk and translation risk. Transaction risk refers to actual conversions of cash flows from one currency to another, and the extent to which exchange rate changes will affect a company's cash flow. Translation risk is more of an accounting issue, and refers primarily to the impact of exchange rates on earnings and balance sheet items when consolidating financial statements from foreign subsidiaries. From a business standpoint, transaction risk is the more relevant of the two.

There are five general types of risk that are faced by all businesses: market risk (unexpected changes in interest rates, exchange rates, stock prices, or commodity prices), credit/default risk; operational risk (equipment failure, fraud); liquidity risk (inability to buy or sell commodities at quoted prices); and political risk (new regulations, expropriation). Businesses operating in the petroleum, natural gas, and electricity industries are particularly susceptible to market risk—or more specifically, price risk—as a consequence of the extreme volatility of energy commodity prices. Electricity prices, in particular, are substantially more volatile than other commodity prices.

Country risk can be divided into two parts, economic risk and political risk. Economic risk refers to the stability of a country's economy. It embodies concerns such as dependence on individual industries or markets, the ability to sustain a vibrant level of activity and to grow, and the supply of natural resources and other important inputs.

Political risk is more concerned with the stability of the government that manages the economy. It encompasses concerns such as the ability to move capital in and out of the country, the likelihood of a smooth transfer of power after elections, and the government's overall attitude toward foreign firms. Obviously, these two branches of country risk overlap significantly. There are a variety of services that provide in-depth assessments of country risk for virtually every country; multinational firms make considerable use of these services to form their own decisions regarding international projects.

Protective measures to guard against transaction exposure include:

* forward contracts
* price adjustment clauses
* currency options
* borrowing and lending in the foreign currency
* invoice in home currency

A common problem in managing currency risk is that companies only realise that they have a risk when the exposure has been generated. However, currency risk management should begin before exposure risks have been generated otherwise fundamental operating decisions have been taken on the basis of complete information. Companies approaches to exposure vary widely; perhaps by the nature of the business, the competition or the culture of the company. A company could accept a high degree of risk and expect commensurate returns or it could be very risk averse and be prepared to pay quite a high price for certainty. Indeed it may have no stance on currency at all and take everything as it comes with a 'swings and roundabouts' approach.

If a company decides to take an active approach to foreign currency management this will centre around the concept of hedging. Hedging a particular currency exposure means establishing an offsetting currency position such that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. Volatile foreign earnings can cause volatile growth which is more costly than slow stable growth.

Hedging can reduce the company's volatility of cash flows because the company's payments and receipts are not forced to fluctuate in accordance with currency movements. This can, in the extreme, reduce the possibility of bankruptcy and therefore allow easier access to credit and lower interest payments due to lower perceived risk. Hedging should also allow for greater certainty about future receipts and payments and consequently enhanced budgetary decisions. Most hedging strategies are costly in terms of fees, premiums or the time involved.

Derivatives allow investors to transfer risk to others who could profit from taking the risk. The person transferring risk achieves price certainty but loses the opportunity for making additional profits when prices move opposite his fears. Likewise, the person taking on the risk will lose if the counterparty’s fears are realized. Except for transactions costs, the winner’s gains are equal to the loser’s losses. Like insurance, derivatives protect against some adverse events. The cost of the insurance is either forgone profit or cash loses. Because of their flexibility in dealing with price risk, derivatives have become an increasingly popular way to isolate cash earnings from price fluctuations.

The most commonly used derivative contracts are forward contracts, futures contracts, options, and swaps. A forward contract is an agreement between two parties to buy (sell) a specified quality and quantity of a good at an agreed date in the future at a fixed price or at a price determined by formula at the time of delivery to the location specified in the contract.

Forward contracts have problems that can be serious at times. First, buyers and sellers (counterparties) have to find each other and settle on a price. Finding suitable counterparties can be difficult. Discovering the market price for a delivery at a specific place far into the future is also daunting. Second, when the agreed-upon price is far different from the market price, one of the parties may default (“non-perform”).

As companies that signed contracts with California for future deliveries of electricity at more than $100 a megawatt found when current prices dropped into the range of $20 to $40 a megawatt, enforcing a “too favorable” contract is expensive and often futile. Third, one or the other party’s circumstances might change. The only way for a party to back out of a forward contract is to renegotiate it and face penalties.

Futures contracts solve these problems but introduce some of their own. Like a forward contract, a futures contract obligates each party to buy or sell a specific amount of a commodity at a specified price. Unlike a forward contract, buyers and sellers of futures contracts deal with an exchange, not with each other.