Welcome to forex trading – a global market that runs
on a 24/7 basis, offering enormous opportunities for the traders ready to take
the plunge.
This article discusses the
guidelines and outline to build a trading model for forex or currency trading.
Also discussed are the relevant points about how forex trading is different
than equity trading, as well as specific points to be considered for building
the forex trading model.
The great advantage with markets is
that it accommodates all sorts of theories (fundamental, technical, price action, etc.), allowing market
participants enormous opportunities, who follow varied patterns and principals
to trade. It’s a matter of time - one is either losing or winning at any
particular moment. When carefully done, building a trading model based on a
clearly conceptualized strategy allows reducing the losing trades and improving
on the number of winning trades, thereby enabling a systematic approach to
profit.
As a general thought and process
flow, building a trading strategy can be captured within the following steps,
as demonstrated in this figure:
However, a few specific inputs may
be needed for forex specific trading, which are discussed below.
How
forex trading is different
Theoretically, forex rates are said
to move due to two fundamental concepts –interest rate parity and purchasing
power parity. Significant differences between forex trading and
stock trading are that forex market is global in nature, moves on 24/7 basis
and regulation remains limited. This leads to highly sensitive, unpredictable
and susceptible variations in forex price movements.
Identify/conceptualize
a trading strategy:
Building a trading model requires
identifying suitable opportunities, which in turn involves choosing any defined
strategies, or conceptualizing new ones as variants of standard ones. Trading
strategy remains the heart of any trading model, as it clearly dictates the
rules to be followed, entry/exit points, profit potential, duration of trade,
risk management criteria, etc. For e.g., here are two popular forex trading
strategies:News
Fade: Irrational forex market often
moves due to news following release of official numbers . An effect
commonly observed immediately after news release is a high level of
volatility leading to significant price fluctuations. However, around 15
minutes after the news break, prices are often observed to move back to
earlier levels, which were maintained just prior to news release. Inside
day breakout: Inside day pattern applies to candlesticks, where today's high and
low range is within high-low range of the previous day, indicating reduced
volatility. There can be multiple inside day patterns day after day,
indicating continuous reduction in volatility and hence significantly
increasing the possibility of a breakout. Forex traders build models and
strategies based on this concept.
Identify
the forex security to trade:
Forex trading specific strategies
require a careful selection of the following:Assets – will the trade involve
simply trading currency notes, or trading forex futures, forex options or
more advanced forex exotics derivatives ?Currency pair(s) worth trading
as per the identified strategy Which forex currency group -
major, minor and exotic currencies – do the selected forex pair belong to, as these
categories demonstrate specific characteristics.News dependency: Unless one is a very long term investor, no forex trader can afford to ignore associated news specific to geo-political developments, state of the economy, announcement of associated macros economic figures, etc. The trading model should have consideration for inclusion of news impact - wholly or partially, manually or automated – to the extent of fitting into the forex trading model.
Plug-in
the forex specific parameters:
Post trade strategy and tradable security
identification, the next step for building a forex trading model is to
introduce forex strategy specific parameters which may include:Timing
the trade: The forex trading model should account for timing
dependencies, if there are any, like follows:take a position just before
macroeconomic figures are announcedtrading a forex currency pair
which has more volatility during off hours – like an Australian trader
trading on EURUSD currency pair during Australia night timeexotic currency trading, which
takes place only during business hours at designated banks and OTC
markets
Set
Trading objectives:
This step primarily concentrates
upon incorporating the following basic features into the trading model, with
varying values to find the best fit:Profit LevelsStop Loss LevelsMoney Management: How much
money to bet on each trade, in which style.Risk Management and scenarios
analysis consideration, as applicable
Back-testing
the model:
Any trading model which is developed
by an individual reflects the characteristics, thought process, temperament and
experience of the trader who builds it. Often constrained by knowledge or even
personal challenges of ego or blind belief in self developed models, important
aspects are occasionally overlooked by the traders. It hence becomes important
to test the model on historical data, to identify the errors and avoid such
losses in real world trading.Backtesting also allows required customization
within the set objectives to further fine
tune the developed model and strategies, ensuring practical realization of
maximum profit potential.
Iterative
analysis for trading model:
Developing a trading model requires
patient analysis, which includes numerous iterations by repetitive changes to
mathematical parameters, as well as variations in underlying theoretical
concepts. During this cycle, it helps to record the failure and success cases,
so as to keep a record of what works and what’s not, which are useful over the
long years of trading career.
Using
computers for trade automation and model building:
Today, it's trendy to attempt to
automate everything. "The program is as efficient as the
underlying concepts and the practical implementation built in it."
Computers can be used to search for
patterns in historical data which can form the basis of developing new models.
One can either use the available
applications on trial or purchase basis, or build new ones on their own for
their requirements based on their familiarity with computer programming.
The
Bottom Line:
One major advantage of using trading
models is that it takes away the emotional attachments and mental roadblocks
while trading, which are known to be the major reasons for trade failures and
losses. While it’s always exciting to trade through established models in a
defined and systematic way, wise traders always keep looking for possibility of
failures and continuous customization for further success, based on market
developments.