Most trading in the forex market is speculative, with traders holding their positions for minutes or hours. In these types of markets, technical analysis tends to work better than fundamentals. When trying to use fundamental analysis, traders will rely on long-term data and need time to make money on their investments; this is the preferred analysis of many stock investors, including billionaire Warren Buffett.
The high degree of leverage used in forex trading makes it impossible to apply a buy-and-hold for the long-term since borrowed money must be repaid and small moves against your position can result in large losses in dollar terms.
Forex traders frequently rely on standard technical indicators, such as RSI or MACD. These are great tools for forex trading since they can be used over any time frame and can be customized to suit your individual style. More advanced ideas like Elliott Wave theory and Fibonacci retracement levels can also work in forex, however these are difficult concepts to understand and are best left to more advanced traders.
We will develop a trading strategy using RSI. RSI, or the Relative Strength Index, is an oscillator that shows whether a market is overbought or oversold. While it works best in range-bound markets, in forex, we can apply it in a slightly different way to spot possible trades.
Traditionally, traders look at static levels of the indicator to figure out whether a market is due to move lower after it becomes overbought or is ready to go higher after reaching an oversold extreme. Under this idea, when RSI falls below 30, the market is thought of as oversold and traders should buy to take advantage of the expected rebound in prices. These traders will try to buy when the indicator rises above 30. In an overbought market, the RSI often rises above 70, and falling below this level triggers a sell signal.
The problem with this trading strategy is that everyone knows about it. Since many traders are believed to be trying to do the same thing, other traders who think they are smarter than bottom-up investingeryone else will try to get in ahead of the signal. They may buy when RSI is at 29, or even lower, seeking an edge. Others will be more cautious and wait until RSI moves higher than 30 to confirm the breakout, waiting to buy until it reaches 35 or so.
With so many possible variants, there is no single strategy that will always work. We will use the idea that at least some traders are basing their signals on RSI to come up with our entry signals. We won’t worry about the lirel of RSI as much as we will consider the change in RSI. Over the short-term, big moves in RSI should be related to large price moves. And since forex is a short-term market, this is the signal we will use for trading.
The default calculation period for RSI is 14 periods. This can be days, or minutes, or any other time frame. We will use a 5-day RSI to identify large moves in a very short period. This will allow us to spot changes in forex trends slightly ahead of other traders using the traditional method of RSI.
Instead of defining overbought and oversold levels, we will look for those times when RSI changes by 50 percent in a single day. This should spot markets about to take off. We will buy if RSI rises by 50 percent or more in a single day, and enter a short position when RSI falls by at least 50 percent.
After getting into a trade, we need to know when we will be getting out. In this case, we will use a simple short-term exit strategy developed by futures trader Larry Williams. A stop loss is immediately placed in the market in case the trade moves too far against you – this is a catastrophic stop and should be at the limit of your pain threshold. In a forex account, this may be a loss of $2,000.
If the trade is a winner, Williams advocates getting out the first time the position opens with a profit. This exit strategy offers a high winning percentage, often more than 90 percent, while keeping losses from destroying a trading account.
A sample trade is shown in Figure 1. This is a daily chart of the British Pound and Japanese Yen currency pair. When RSI moves higher by 50 percent, we buy at the open the next day. Five days later, we close the trade with an unleveraged profit of about 1 percent.
While many traders would have been scared out in the price drop two days after entry, conservative traders would have been able to hang in there and capture the profits. While leverage of 100 to 1, and even more, is available to forex traders, it can be reckless to borrow this much for trading purposes. In 2008, many financial firms got into trouble and failed when their leverage hit 30 to 1. Throughout history, this has proven to be the level where trouble occurs. Using “only” 30 to 1 leverage, this trade would provide a return of about 33 percent in a week.
This strategy trades infrequently, only three or four times a year on average. But this idea can be applied to all the major currency pairs, and with more than thirty trade possibilities every day, there should be ample opportunity to find trades. Combined with similar ideas on other indicators, this strategy can form the basis of a complete forex trading system.