Choosing and testing a consistent trading strategy
When discussing how to make a consistent profit in Forex, it has to be mentioned that the first logical step is to choose a trading style. There are several options, but they mostly fall into one of those categories:
- Day trading
- Swing trading
- Long term trading
Now, the most important difference between those categories is the timeframe. In the case of scalping, the positions are opened and closed within a 1 to 15-minute window. As the name suggests, day trading typically involves the closing of all active trades before the end of the business day. In the case of the Swing trading style, traders usually keep their positions open from several days to a number of weeks. When at the same time, long term trading typically involves trades that last for several months.
The next logical step after this decision is to choose one or several trading strategies. Some people might prefer Bollinger bands, moving averages, or other technical indicators, while some other traders might focus more on economic news and other fundamentals. The most important thing here is to test those strategies. One of the essential methods to do this is by backtesting.
In order to see how this can work in practice, let us take a look at this daily EUR/GBP chart:
As we can see from the above, the Euro/Pound pair had experienced a lot of fluctuations. The single currency has reached peak levels twice but then declined significantly.
So here traders can imagine that they are trading from the beginning of this chart and ask themselves the following questions: How well would that strategy perform during the Euro uptrend? Was this method effective in identifying reversals, before EUR/GBP entered the downtrend? Was the strategy able to withstand the unexpected Euro appreciation in February, without suffering serious losses? How did prediction models based on fundamental news perform during this period?
Clearly traders can examine dozens of other questions, but the most important point is to select useful methods and disregard those tactics which failed in the past. Finally, traders can move on to real-time testing with demo trading accounts.
As a result, a trader will have one or several well-tested strategies that he or she can use on a consistent basis.
Setting a risk/reward ratio to 1:2 or higher
Traders are not necessarily guaranteed that they will always achieve more than 50% of winning trades. However, the one way to address this concern might be to set a risk/reward ratio to 1:2 or higher. For example, if a trader aims to gain 100 pips from a given position, he or she might consider setting the stop-loss order below 50 pips of the current market price. This can be very helpful in the sense that this enables market participants to earn decent payouts even with 40% winning trades.
This can considerably improve the odds of success in favor of a trader and can be a valuable insurance policy.
Setting realistic profit targets
Unfortunately, coming up with the right risk/reward ratios might not be enough for forming consistent profits Forex strategy. Another important aspect of this entire process can be to set realistic profit targets.
Every currency pair has a different average daily volatility. For example, on average during the EUR/CHF might move by 50 to 55 pips. Consequently, it might not be realistic to set a daily profit target with this pair at 100 pips. For such ambitious goals, there are other currency pairs such as GBP/AUD or GBP/NZD, where their daily fluctuations might range between 190 to 210 pips.
Avoiding the use of high leverage
It is not a simple coincidence that many financial commentators describe the leverage as a double-edged sword. The problem is that overleveraged trading can easily lead to severe losses, from which it will be very difficult to recover.
For example, in the case of 400:1 leverage, if the market goes against the opened position by 0.25%, it might be enough to wipe out the entire trade, so a trader will lose his or her entire investment.
As a result of US regulatory reforms, there is a 50:1 limit on the maximum amount of leverage used with major currency pairs and 30:1 on minor ones. Still, even 50:1 leverage can represent a serious risk to one’s trading capital, since here it might take 2% adverse change for a trader to lose his or her investment.
Consequently, some traders, especially beginners might consider using 1:10 or lower amount of leverage, in order to guard against those risks.
Not investing more than 5% of trading capital on each trade
Another essential element of a proper risk management strategy can be not to use more than 5% of one’s trading capital on a single trade. There are some professionals who recommend a much lower limit, at 1 or 2%, however, the general consensus seems to be a maximum of 5 percent.
The reason behind this is quite simple, even most experienced traders can have several losing trades in a short period of time. So for example, let us suppose that traders risk 50% of their account on one position and the market moves in the opposite direction. They closed their positions and lost half of their investment. In this case, this one loss alone will wipe out one-quarter of their entire trading capital.
As we can see from this example, the absence of proper money management can easily lead to irreparable losses to one’s trading account. Therefore, many traders avoid risking more than 1/20 of funds on a single trade.
Keeping a trade journal
There is no point in trying to pursue consistently profitable trading and at the same time being unable to track the progress. This is where the trade journal comes into play. This lets traders measure their average monthly earnings or losses. Also, there is also an opportunity to calculate the ratio of winning and losing trades, which might be very handy when formulating the proper trading strategy.
Interestingly, the trade journal can not only provide valuable insight into the results, but it can also have a great motivational value for traders. If a market participant sees that despite all of his or her mistakes and setbacks, the average monthly earnings are getting better, then this can be a very encouraging piece of news.
Doing regular fundamental research
The final step towards possibly achieving a consistently successful trading experience is to stay on top of the latest economic trends. Clearly, it might be very difficult to keep track of dozens of currencies, however, a trader can start by studying 8 major currencies, which compose Forex Majors, paying attention to the latest Gross Domestic Product (GDP), Consumer Price Index (CPI), Unemployment rate and other important releases, as well as interest rate decisions.
To see how this can benefit traders, let us take a look at this daily USD/CAD chart:
As we can see from this diagram, the USD/CAD was moving sideways for several months, one can even argue that the US dollar was in a slow downtrend. However, the situation changed dramatically from January 2020, when the pair has gained more than 1,000 pips and even nowadays trade well above the 1.40 mark.
Those developments make very little sense if we confine our analysis strictly to technical indicators. However, if a trader regularly monitored the latest economic trends, then he or she might have anticipated some of those moves.
At the beginning of 2020, the price of oil began its massive fall, from $61 collapsing below 0 and nowadays trading near $25. Clearly, this downtrend is hurting the Canadian economy, which is one of the largest producers of this commodity. Another catalyst of CAD decline was the fact that during this period the Bank of Canada cut the rates repeatedly, reducing it from 1.75% to 0.25%, making the currency much less attractive to depositors and carry traders.
When it comes to fundamentals some long term factors, such as the Purchasing Power Parity (PPP) also can play an important role in the exchange rate movements. To illustrate this, let us take a look at this daily EUR/JPY chart:
It is very easy to notice that the Euro is engaged in the long term downtrend against the Japanese yen for more than 15 months. Obviously, the European Central Bank is pursuing a very accommodative policy by keeping its key interest rate at 0%, however, the Bank of Japan went further and has set rates -0.1%.
The explanation for this downtrend might lie in the Purchasing Power Parity (PPP) indicator, according to which currencies in the long term tend to gravitate towards PPP level, which represents an exchange rate at which the average price of goods and services will be equalized between the two countries.
According to the Economist, in January 2019 the Euro was 29% overvalued against the Japanese Yen on PPP basis. So instead of being a response to one particular announcement, the decline of EUR/JPY represents the long term adjustments to address the undervaluation of the Japanese yen.