What is the Forex trading system?

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business_1100011612-012914-intA Forex trading system is a method or process to approach trading the foreign exchange (Forex) market, and is widely used when referring to trading styles and ways to systematically apply such investing strategies to the market for the purpose of generating trading income.

There are almost an endless number of systems, as traders often strive to tailor trading strategies to meet their specific goals and life situation, similar to how different people have different eating habits and therefore diets,  like gustatory habits – Forex trading systems can also vary from person-to-person. This article will describe what is meant when the question of ‘what is the forex trading system?’ is being asked.

Scope of Trading Systems

Trading systems can be as simple or as complex as the people behind their development, yet share a common trait where the essence is to develop a set process or combination of rules that can be applied over and over to take a similar approach to the market, as conditions change, and in order to have consistent results while controlling the process.

business_110008020-012914-intA key component is controlling the amount of potential risk taken as well as the potential reward that is being pursued, both on a trade-by-trade basis, and across a number of trades that may either be open at simultaneously or when measured consecutively over time.

This is basis for make money since the net-profits must overcome the net-losses from a traders historical results, in order to turn achieve a positive return. This is similar to running a business where after deducting costs and expenses from gross revenues the hope is that there was enough revenue to cushion the costs and result in positive net income.

Common Traits that Most Forex Trading Systems Share

  • How Trading Opportunities (Signals) are Found
  • When Signals Should Trigger Live Trades (when to enter the market)
  • The Size the trade should be relative to the account balance
  • The Risk Per Trade (Stop-Loss value) and compared with;
  • The Reward per trade (Limit Value), to form a suitable Risk-Reward ratio
  • The maximum number of open trades allowed at any given time frame
  • The maximum potential loss on all open trades versus the max. reward potential
  • The frequency of trading, expected turnover, and average trade time duration
  • A process for dealing with trades that don’t reach their target within a given time

While the above list of common traits is not meant to be exhaustive, each item mentioned itself can be an entire topic for discussion, because it’s in these details that trading strategies are differentiated. The graphic below shows an example trading idea as described on the WorldWideMarkets.com community blog.

WWM USDCHF JUNE 19 2014

Ways to Find Trading Opportunities

Of the four below scenarios for analyzing news that impacts markets, and using the markets price history to gauge the future, using either a subjective human observer or an objective computer programmed approach, reveals that different groupings for determining trading opportunities exist, and applicable for almost all financial markets.

  • Subjective Technical Analysis: Humans observe historical price action to determine past trends and trajectories that can affect the current and future price path. A computer could also use some subjective based approach, but this would be harder to program and perhaps not as reliable.
  • Objective Technical Analysis: Computer calculates mathematical and statistical criteria and uses conditions that traders set – which trigger trading opportunities or signals- when those conditions are met (a form of automated or algorithmic-based trading). Humans can also use an objective approach to calculating statistics and using proprietary indicators, however computers are normally much faster at this and therefore are more efficient.
  • Subjective Fundamental Analysis: Humans observe geo-political and fundamental economic news affecting the world economy and economies of currencies included in Forex pairs, and then determine the potential impact or effect the news may have on markets and decide on a trade direction accordingly.
  • Objective Fundamental Analysis: Computer programs analyze relevant economic news and market prices, using an approach called Complex Event Processing (CEP) in order to translate the effect into a trading edge in the market, using the computational processing speed and ability to scan a large number of news feeds for relevant information that could affect markets. This approach is difficult to perfect for the average trader as it may require resources not available to most people in order to make it a viable solution.

Other methods of approach can be said to exist such as inter-market or intra-market analysis, yet these are simply combinations of some of the above categories. Below is an excerpt from an economic calendar of news events that traders might follow to anticipate forex market movements as soon as the news breaks.

economic calendar

When should trading signals become live trades?

The foreign exchange market, probably more than any other market, is full of trading opportunities, mainly because of its vastness and deep liquidity and the sheer number of transactions taking place, but also because it is open 24 hours a day nearly six days a week.

In addition, because the foreign exchange market is observed in similar manners, using for example the above four described categories of analysis, over various time horizons, there are continually trends persisting, reversing, emerging and converging.

Not only do these trends exist, but often they are overlaid on top and within other trends across time. For example a trader looking at a 1 minute chart, which shows price updates for each one-minute time period (such as the open, high, low, and close price – during that minute) may see a trend that is not visible on a 1-hour chart, in fact the 1-hour chart may show a totally different and even opposite trend which looks equally probable to continue or reverse when compared to the 1-minute chart observation.

Without the ability to filter Forex prices over such times frames precise analysis would be difficult as all the history would be cluttered with no way to filter using quantities of time. Knowing when to establish trades based on perceived trading chances should depend more on what is the forex trading system that is being used.

Forex Rates reflect the entire market’s price action, even if only from a sample brokerage source

This phenomenon exists because nearly all brokers update their prices dynamically in real-time, and therefore prices reveal the action over all time frames. A broker that only provided a change (update) to their price once daily, would be missing all the intra-day time frames such as the smallest tick data (smallest rate change) and 5 minute, 15 minute, hourly,etc..

While the market is fragmented due to its decentralized nature, even though rates may vary slightly from one source to the next, with the advent of the internet and speed of electronic markets, rates are closer together now more than ever, also creating less chances for scalpers or arbitrage strategies that are latency-driven.

Back to trends and time-frame, this is why it’s critical to match the time-horizon of a trade with the time-frame being observed, however because of the trends that can exist in the other time-frames, it’s often advisable to see what is happening for example over the medium-term and long-term, when planning a shorter-term trade, and vice-versa.

Plenty of Trading opportunities exist, Time frame is key to identification and entry/exit

A specific trend that is discovered may for example continue, but it could first diverge and that divergence could be a shorter-term or longer-term trend continuing to affect the prices, before the market returns to the trend level you had observed. However, sometimes that market might not return to the trend, as that trend may have already ended, and it’s of no use most of the time if it even does resurrect many months, days, or years later – if waiting that long would jeopardize a trader’s strategy and not fit within its permissible rules.

In addition, being stuck in the market or waiting for it to workout can be costly. The trick is to let profits ride, and cut losses short. Ironically, traders tend to do the opposite, as fear can cause profits to be closed too pre-maturely, and losses not wanting to be realized left open with the often-hopeless expectation they will return to a profit when in fact they may get much worse.

Proper Risk/Reward Levels Critical To Increasing Odds for Profitable Net Results

BudgetFor example if a trader was looking to make $100 per trade while risking not more than $75, yet on average instead books a profit of $80, buy some losing trades past the $75 threshold into say a $80 loss, then suddenly the risk-reward ratio not only gets less favorable, but after factoring in the cost of the trade, the odds have now shifted against them.

Practicing to keep losses smaller relative to profits is the key to making money, as cliché as that may sound, it is also incredibly difficult to implement without understanding what is the Forex trading system and knowing how to tailor one to your own trading needs.

Establishing a forex trading system, such as one that will be manually applied, using a subjective approach, for example, requires planning. The amount of detail put into the research, will determine the amount of control a trade can have over the range of results.

Developing Rules and putting it to Practice

For example, a trader that has set a rule that allows not more than 5 trades per day, and ideally just  one or two trades to be made, will have more consistent rules, than a trader that doesn’t follow such as rule.

The results and overall ability to implement the strategy would also be very different for a trader that set a standard of having to do at least 5 traders per day regardless of market conditions. Therefore, these small rules, and standards, which build the foundation of a forex trading system, must not only be chosen properly but the selected approach must be used to calculate and forecast some basic metrics – which we will now discuss below.

What is the best forex trading strategy? The one you create tailored to your unique situation

Many trading strategies exists that have been popularized either by the success of their creators, successful marketing and the commercialization of these to traders, and/or due to the core common traits involved that traders can then further mold to suit their own goals and tolerances. An example of some commonly searched for strategies:

  • forex trading pro system
  • forex turtle trading system
  • cowabunga forex trading system
  • sonic forex trading system
  • forex odyssey trading system
  • martingale forex trading system

It’s important to remember that the lifespan of how successful a forex trading system might be is limited, and therefore whatever system is popular now may have already had its time in the spot light and could be ripe for a drawn-down or deviation from its historical performance.

Rather than relying on some holy-grail of strategies, since none exist, traders can be best equipped by relying on themselves, developing their own style using commonly known approaches, coupled with fine-tuned parameters to meet their specific trading schedule, available investment capital, and level of risk appetite as well as target profit.

Where to start? Let’s Do Some Easy Calculation

One example where a trade could start is by asking, how much would I like to make each day from Forex, and how much could I afford to risk each day in order to achieve that value. Then, how often would I need to be right on a trade, in order to achieve the returns and allow the strategy to remain sustainable, without running out of investment capital too early.

In a Hypothetical scenario, where a trader wants to earn $200 per day, while risking no more than $66.00, (a risk/reward ratio of 1:3, or 1 unit of risk per 3 units of reward). Provides a basis to create a system using those specifications.

Design Definition Button Showing Sketch Plan Artwork Or GraphicLet’s say that trader couldn’t trade while at work during the morning and afternoon hours, and only had time in the evening when the Asian trading session was most active, the pairs that he might focus on could be the USD/JPY and other JPY priced pairs, including South-East-Asia currencies like the Australian and New Zealand Dollar related pairs.

This would provide a number of instruments for the trader to analyze, during the available trading window, and even if no trades were established during that time – an opportunity which could be seen to be developing- in any of the reviewed pairs- where an entry-limit or entry-stop (orders that are contingent on a specific price first being reached), could be created with specific risk (stop-loss orders) and reward (limit-order) attached in case the trade levels are reached and the orders executed.

Such pending orders, known as entry-orders are helpful when the market is not yet where you want it to be to enter it, and thus allows a way to set conditions were if the market prices are reached the trade execution instructions are processed.

Deciding How many trades, what size and how much risk

The trader would still need to determine the number of trades that would need to be done to achieve the goal of $200 while risking $66. Whether it’s on one trade, or a series of positions, the size of the trade will impact directly the value of each pip and consequently any profit or loss realized, as the forex rates change.

One example approach could be a trade size of 50,000 units of currency, where each pip is roughly $5.00 and risking 13 pips will give a $65 stop-loss level, whereas a limit of 40 pips will provide a $200 profit target (limit level).

This one trade could achieve the daily goal, but it would all hinge on that one trade. Another approach, using the same risk-reward ratio, could be to break the above trade into smaller size trades while keeping the stop/limit values, in terms of pip quantities the same.

For example, 5 separate trades, each for 10,000 units of currency but each with 13 pip stop-loss and 40 pip limit-levels. The combine trade sizes, if in the same currency pair for example, would equate to the same total risk/reward values and overall trade value. Even if made in different currency pairs, the pip values would only change the net results by a small percentage.

Fine Tuning a Trading Strategy is really what refines it to best work for you

Therefore, making this small decisions can affect the trading results, and who the strategy is applied, as well as the likelihood of it being sustainable for the given trade budget and depending on the odds determined by the risk/reward chosen.

The above example which used an overall risk/reward in terms of daily target, which was then brought down to the individual trades, means that worst-case $65 dollars may be lost per day, while $200 could be realized, and therefore the example odds over ten days of trading best case could result in a $2000 profit (10x $200) or a $650 loss (10x $65), both extreme situations.

RR matrix exampleIf on average reward targets are hit half the time, a profit of (5x $200) $1000 would exist, whereas if the other half of the time the risk-threshold was hit, the loss $65 x 5 would total $325, and thus create a net profit of $675 over the ten days. From here we can see how often on average the trades need to hit their target, in order to achieve various net profit amounts after deducting losses. A Matrix to the right, using the value discussed here, can be seen below, and shows the varying profit and loss levels depending on how often profit and loss levels are reached over the course of 10 trades, for example.

In the above example, instead of being right half the time, if the limit was hit only 4 out of 10 times, resulting in a profit of $200 x 4 or $800, and the losses hit were $65 x 6 = $390, the net difference would be a positive return of $410, but as we can see just because of one additional loosing trade, this loss dropped the net return significantly (from $675 in the above example to $410).

Determining the Best Odds for a Given Trading System

However, by maintaining a risk reward ratio of roughly 1:3, over the course of ten trades, as seen above, a trader’s target limit only  needs to be hit 3 out of ten times, and even if the other 7 times the stop-loss is triggered the net result would be a net-return of $145. Obviously, a return like that would not be something to be thrilled about, but it is the worst case profit, using the above figures.

Plan Computer Keys As Symbol for Mission And GoalsBy taking the time to answer questions such as the ones described above, and developing a Forex trading system to suit your needs, traders can gain control over their trading and not feel solely at the mercy of the market. This way, no matter what happens at the end of a trading day, as long as the self-established rules were followed, the results shouldn’t be surprising and instead returns will consistently be within a range of control provided peace of mind and security of taking charge of operating Forex trading as if it was a career or personal business.

Traders can speak with experienced Forex sales consultants at worldwidemarkets.com, a multi-asset multi-jurisdictional regulated online brokerage, to learn more about developing a trading system which can be applied and tested with either a Forex trading demo account and/or progress to apply the strategy to a live Forex trading account.

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