How To Build a Forex Trading Model
If you want to be a successful forex trader, you’ll need to build a forex trading model, also called a trading plan, and follow the rules set out in your model. This is true for advanced traders as well as beginning traders. Below you can find the steps to follow in order to build a forex trading model and to test its profitability before putting it into action.
Understand Technical Analysis
In technical analysis, you use charts showing the price history of the asset you’re interested in to analyze the expected future market direction. With technical analysis, you can identify potentially profitable entry and exit points in the market, also called Harmonic Patterns.
Technical analysis differs from another type of analysis, called fundamental analysis because it focuses almost exclusively on the price and price movements of an asset. In contrast to technical analysis, fundamental analysis is concerned with the outside forces that move market prices. Technical and fundamental analysis can be combined or can be used independently.
With technical analysis, the trader is focusing on the patterns created by price over time, and they attempt to predict where price will go next based on those historical patterns. Technical analysis, as a result, is often considered a neutral market tool. If you are using technical analysis to locate good opportunities in the forex markets, you will analyze the current movements in the price of the currency pair you’re considering and then look to identify potentially profitable entry levels.
There’s no guarantee of a profitable outcome when using technical analysis, but many traders believe that it gives them an edge and improves the odds of them being correct when predicting the direction the market will take.
The Importance of Technical Analysis
As mentioned above, most forex traders will use technical analysis to attempt to predict the direction that price is going to take based on the existing historical patterns in the price. This is possible because market movements are not entirely random. Patterns are often created by the price movements, and if you can identify these patterns as they emerge, there is a good chance that other traders will also see the same patterns emerging. In this way a trend is something that is almost self-fulfilling in many cases. And because of this, it is the traders who actually help in creating the patterns found in changing market prices.
Understanding Fundamental Analysis
The previous section explained the basics of technical analysis, and you learned how it focuses primarily on the patterns created by price movements. That’s one way to look at the markets to determine what direction price is going to take.
Another method is called fundamental analysis, and it provides traders with a different method for analyzing the markets and the weaknesses and strengths of the assets under consideration by the trader.
Traders who use fundamental analysis to examine the markets look at external forces and events that are likely to have an influence on the movements in a currency’s value. These outside forces and events include political and economic data, as well as natural disasters.
Basically, the fundamental analyst is concerned with using all the information available to them in order to determine the relative strength or weakness of the currency under investigation. The major emphasis is placed on economic data and reports, such as the country’s GDP and labor data, inflation reports, changes in interest rates, and any other data that paints a picture regarding the strength of a country’s economy.
Fundamental Factors Affecting Currencies
As mentioned above, the major emphasis in fundamental analysis is placed on the economic news and data released by a country, but this information is far from the only factors affecting the price movements of currencies and forex markets. Below is a listing of some of the major factors that can have a strong impact on the relative value of a currency.
Any type of natural disaster like a hurricane, wildfires, or flooding can have a huge impact on a country’s economy, and thus on the strength or weakness of the currency. One very good example of this is the tsunami that hit Japan in 2010. It had a massive debilitating impact on Japan’s industrial sector, severely disrupting the production of industrial components, automobiles, and technological components. In turn, Japan’s economy experienced a slowdown in the following two years.
International trade is just one part of a country’s economy, but it tends to have an outsized impact on currency movements. That is because when the demand for the products and services of a country increases, the demand for their currency also increases since buyers typically need the currency of the country they are buying from when transacting. International trade is very good for the strength of a currency since it not only improves the GDP and other economic factors in a country but it actually increases demand for a country’s currency directly.
Economic Output and Growth
The most closely watched indicator of growth and output is a country’s Gross Domestic Product or GDP. It sums up the total production of goods and services in a country and is considered an indicator of the strength of a country’s economy.
When measuring inflation within a country, analysts look at both the Consumer Price Index (CPI) and the Producer Price Index. The CPI measures the change in the cost of consumer goods and services, while the PPI measures the change in the cost of goods and services for manufacturers and industry. High inflation can weaken a currency.
The interest rate within a country is one of the stronger indicators of the strength or weakness of a currency. Higher interest rates increase demand for a currency as investors look to benefit from the higher interest they can collect on investments.
Political stability helps support a country’s currency, while instability can lead to a weaker currency.
These include things like government budgets and spending, as well as taxation. Investors may choose not to invest in a country with high taxes or negative fiscal policies.
These are the policies set out by central banks, such as short-term interest rates, asset purchases, and money supply. All of these policies can have a strong impact on the strength or weakness of a currency. Read more about Fiscal vs. Monetary policy here.
Choosing Entry and Exit Points
No matter which approach is used, forex traders can always expect to be exposed to risks. That’s what makes it so crucial for traders to understand price action when placing and exiting trades. When building a forex trading model, you want to always consider the following four key concepts in price action:
- Support & resistance: These refer to important price levels that have historically prevented price from going higher (resistance) or lower (support). These are basically inflection points for supply and demand.
- Breakouts: When price moves through an established support or resistance level, it is called a breakout. These are considered strong signals that over indicate the start of a new or continued trend.
- Gaps: A gap occurs when a price jumps over certain levels, leaving a “gap” in the price action. It is a strong indication of strength for one side of the market or the other. One curious characteristic of gaps is that future price action always tends to fill these gaps.
- Sideways Trend: This is when a price remains within a tight range, bound by solid support and resistance levels. A trading model built on a sideways trend can either trade off these support and resistance levels, or it can look for breakouts.
Managing Trading Risks
Rather than simply accepting risks in your trading model, you should look for ways to manage those risks to keep them in check. Here are two ways to do just that:
- Avoid over-trading: While you might be tempted to “bet it all” on a volatile market, risk management strategies say to risk no more than 2% of your trading account on any single trade.
- Set up stop-loss orders: It’s not just your winning trades that will lead to forex trading success. It is also how well you manage your losses. Placing good stop loss orders can minimize your losses, and they also remove the need to constantly monitor trades.
Test your Forex Trading Model
Once you have a plan in place, you should take the time to test it using a demo account before you risk any real money. Testing any forex trading model in this way will let you know the chance of it being profitable when used under real trading conditions.
Some trading platforms also have the ability to back-test a trading model, which involves simulating trades based on the historical price action of the currency pair. Back-testing is not perfect, but it can be helpful in determining the likelihood of success with any trading strategy.
Once you are confident in the ability of the trading model to generate profits, you can begin using it in your trading.