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Forex systems and forex strategies

If you already understand the basics of forex trading, you are ready to develop your own forex trading system. Most forex strategies attempt to predict a future exchange rate. If a trader expects a foreign currency to appreciate, he or she buys it and then resells it with a profit. This is called a “long trade”. If a trader anticipates a foreign currency to lose its value in the future, he or she would sell it now. This is called a “short trade”. Of course, financial markets are noisy and no one has been able to anticipate all the price movements perfectly. However, if the win/loss ratio is high enough to offset the inevitable occasional losses and the transaction costs (spread), a forex system is profitable. Assuming a low spread, the only thing you need to become a thriving trader is a forex strategy slightly more successful than simple tossing of a coin. Whenever you are consistently better in predicting the foreign exchange market's behavior than you would be by pure chance, your forex trading strategy is profitable.

Based on the employed forex system, the profit (and loss) can be realized anywhere between seconds and years. As I explain below, forex strategies also differ in how they predict the future exchange rate. But in general, almost all the forex systems may be roughly divided into those suitable for a ranging market and those suitable for a trending market.

Trend trading

The trend is the general direction of a financial market. A trader following a trend would buy a currency when it is trending upward and sell it when it goes down. Trending strategies assume that the present momentum will be kept for some time. The crucial part of profitable trend trading is to identify an entry point and an exit point. To identify when a trend starts, people often use technical indicators, such as Bollinger bands. After entering the market, they hold their position until the trend reverses.

Range trading

Range trading is suitable for the periods, in which an exchange rate oscillates in a clearly defined range, or a channel. A range trader sells a currency at the top of the range and buys it at the bottom of the range. This may be repeated many times, until the exchange rate leaves the range and starts trending. The basic assumption behind range trading is that whatever the actual direction of the market is, a price will eventually return to its origin.

Technical analysis

Forex strategies are mostly based either on fundamental or technical analysis. Technical analysis is much more popular among small forex traders, so let us start with it. Traders relying on technical analysis either visually examine forex charts or use mathematical models to estimate future price movements. Both approaches predict a future exchange rate based on the (recent) past values. A technical trader will enter and exit a trade if he or she sees a particular forex chart pattern or if a technical indicator achieves a certain value. The definitive book on technical analysis is Kirkpatrick and Dahlquist's Technical Analysis: The Complete Resource for Financial Market Technicians. The most comprehensive description of chart patterns can be found in Bulkowski's Encyclopedia of Chart Patterns. A book of similar scope and depth, but strictly focused on the foreign exchange market, is The Forex Chartist Companion: A Visual Approach to Technical Analysis from Wiley Trading.

Fundamental analysis

Fundamental analysis is usually used to identify long-term trends. Traders specialized in fundamental analysis believe that currencies are driven by economic and political fundamentals. They look at important economic indicators, such as interest rate, inflation, unemployment, FDI, and current account balance to evaluate long-term health of an economy. Some traders also trade short term on important economic news announcements (for example Non-farm Payrolls, PMI, and CPI). This is called trading news. The Trader's Guide to Key Economic Indicators offers a concise and at the same time comprehensive description of main economic indicators. International economic indicators are described in great detail in Anne Dolganos Picker's International Economic Indicators and Central Banks.

Developing your own forex trading system

There are many ways to combine economic and technical indicators. Some traders analyze only one technical indicator (for example Bollinger bands) to keep things simple. But most traders enter a position only when several different signals simultaneously point in the same directions. An example would be a price breaking through both a Bollinger band and a trend line, combined with a signal from Parabolic SAR. It is often recommended to use fundamental analysis in order to identify a long-term trend and then to use technical analysis to determine a good entry point.

You can learn to build a profitable forex system from the top-rated forex books, written by accomplished traders or academics. A friendly yet comprehensive introduction into the area of forex strategies and forex systems is Raghee Horner's book ForeX Trading for Maximum Profit: The Best Kept Secret Off Wall Street. If you prefer more practical treatment of the subject, Ed Ponsi offers a step-by-step guide in his Forex & Probabilities: Trading Strategies for Trending & Range-Bound Markets. My personal favorite is The Encyclopedia of Trading Strategies, which puts a great number of technical indicators under rigorous scientific testing.

An alternative forex strategy: Carry trading

Carry trading is a forex strategy utilizing compound interest. Carry trading exploits an interest rate differential between two currencies. Let us say, the interest rate in Japan is set to 0.50% and in New Zealand to 7.5% (true in September 2008). A trader holding NZD/JPY for one year will theoretically get a yearly interest of 7%, which is more than an interest paid on saving accounts in American, European, and Japanese banks. I used the word “theoretically” because the real interest can be much higher. But, as you will see in a moment, a higher return goes hand in hand with increased risk.

The forex market has two features that make it suitable for carry trading. The first one is the compound interest. The rollover interest (a daily fraction of those 7% paid on NZD/JPY) is usually added to a forex trading account every day. Therefore, you will get interest not only on your initial investment, but also on all the previously gained interest. Let say you are holding a long position in NZD/JPY worth $1,000. 7% of $1,000 is equal to a yearly profit of $70. With a daily rollover interest, you would get $72.50 instead.

That sounds nice, but also quite negligible unless you invest a large amount of money. Here enters the effect of leverage. With a leverage of 200:1 (offered for example by Easy Forex), your initial capital of $1,000 gives you control over $200,000 automatically borrowed from the forex broker. Now, the compound interest becomes interesting: In one year, your account would raise from $1,000 to $14,500. On the other hand, high leverage would also expose you to the risk arising from adverse exchange rate movements.

Since carry trading is reputedly the most popular forex strategy of big hedge funds, huge long position drive high-yielding currencies up. By consequence, the gap between high- and low-yielding currencies (for example between NZD and JPY) widens for most of the year. As a result, carry traders gain not only interest, but they can also profit from holding a constantly rising currency. Of course, neither this forex strategy is risk-proof. There are periods of the carry trade unwinding, when high-yielding currencies lose their value for speculative reasons. To protect their investment during these violent periods, a carry trader usually does not use all the available leverage. Some carry traders also employ sophisticated methods of money management or grid trading.

The next step is to learn how to choose a forex broker suitable to your forex trading strategy.