Basic Trading Strategies
There are fundamental components for trading the Forex market. The first component is the Currency Pair. Here are key points to know:
- A currency pair consists of the base currency and the cross currency. The base currency is the first currency in a currency pair and the dominant of the two currencies.
- The base currency is equal to 1 unit of the cross currency monetary unit of exchange. Suppose the value of the EUR/USD is 1.1500, then 1 Euro is equal to 1.15 US Dollars. In other words, to buy 1 Euro will cost $1.15.
- In trading, the strength or weakness of the base currency in comparison to the cross currency generally determines the direction of the trade.
- When a currency pair rises in price, the base currency is gaining strength over the cross currency and traders may seek to trade Long.
- On the other hand, when the currency pair declines in price, the base currency is weakening compared to the cross currency and traders may seek Short positions.
Thus, a currency pair consists of one currency gaining strength while the other currency is weakening. So, when the US Dollar is weakening in the market, the Euro and Swiss Franc are strengthening; and, as a rule of thumb, the EUR/USD rises and the USD/CHF falls.
Understanding this relationship between the base currency and the cross currency leads to a couple of basic trading strategies: Parallel Strategy and Inverse Strategy.
Parallel Strategy - One of the easiest trading strategies is to follow pairs that tend to move in the same direction or parallel when the US Dollar strengthens or weakens.
- EUR/USD and GBP/USD
- USD/CHF and USD/JPY
- AUD/USD and NZD/USD
(Often when EUR/USD rises in price, the GBP/USD rises.)
Inverse Strategy - This strategy seeks to follow currency pairs that tend to move in the opposite direction or inverse when the US Dollar strengthens or weakens:
- EUR/USD and USD/CHF
- GBP/USD and USD/JPY
- AUD/USD and USD/CAD
(Generally, when EUR/USD rises in price, the USD/CHF falls.)
Even though some currency pairs tend to have parallel and inverse relationships which give traders exceptional trading opportunities, market conditions may exist at any given time that can affect currencies to react counter to normal tendencies. Therefore, avoid relying on a rule of thumb strategy without evaluating your trading parameters and current market conditions.
Another component of trading the Forex market is Price Action. It is key for a trader to recognize current price movement in relation to price support, price resistance, and overall market direction or trend. In doing so, price action may indicate potential trade setups which are additional trading strategies.
Buy Dips - As price trends upward, it has a tendency to retrace, pullback, or "dip-down" before resuming its upward direction. This retrace creates a temporary support level. If market up-trend and conditions remain, a trader can place a Long position at this support level.
Selling Bounces - As price trends down, it has a tendency to retrace or rise temporarily during its descent. This slight rise in price creates a temporary resistance in which price appears to bounce off similar to a ball bouncing off the ceiling of a room. In this case if market down trend and conditions remain, a trader can place a Short position at or near this temporary resistance.
Breakout Strategy - One of the most popular trading strategies, the Breakout is a strategy of monitoring a currency pair as it oscillates up and down in a narrow price range, then placing a trade depending upon the direction of the break of the range. A Long position can be placed if there is a break above the range; or, a Short position can be placed if a break below the range occurs. Usually, traders buy or sell after the price makes a move out of the range. Traders can either wait for a breakout to occur to place a trade or set an entry order to be executed in the event of a breakout of the range.
When considering a Breakout, a trader should evaluate the following:
- Has price remained in a narrow range for an extended period of time? The longer price remains flat or in a narrow range, the possibility of a breakout increases.
- What was the overall market direction or trend before the narrow range ? Often, when a breakout occurs, price continues in the direction of which it originated.