4 Simple Ways to Trade Forex Charts

06/10/2015 9:00 am EST

Focus: FOREX

These four approaches, which use basic technical analysis concepts to identify profit opportunities, are great ways for new traders to get a proper start in world currency markets, says David Gonzalez at Investopedia.com.

Once the forex trader has decided which venue (spot, options, futures, or ETFs) he or she will trade, it's time to develop a well-conceived trading strategy before putting any trading capital at risk. Successful traders must also predetermine their exit strategies and other risk management tactics to be used should a trade go against them. Here, we look at how to develop a trading strategy for the currency markets based on directional trading.

Develop a Trading Strategy

One way to organize the multitude of potential strategies is to group them into directional and non-directional approaches. Directional trading strategies take net-long or short positions in a market, as opposed to non-directional (market-neutral) strategies.

Most investors are familiar with the directional approach; for example, millions of people participate in some form of retirement program, which is basically a long-term portfolio of equity and/or debt securities held long by the investor. Net-long strategies are profitable in rising markets, while net-short investors should profit in falling markets. Directional strategies can be loosely grouped into the following subcategories:

  • Trend-following strategies

  • Moving average crossover systems

  • Breakout systems

  • Pattern recognition strategies

This list is not all-inclusive, as there are many other approaches to trading forex.

1) Trend-Following Strategies

Trend-following systems create signals for traders to initiate positions once a specific price move has occurred. These systems are based on the technical premise that once a trend has been established, it is more likely to continue rather than reverse.

2) Moving Average (MA) Crossovers

The moving average (MA) crossover trading system is one of the most common directional systems in use today. This system uses two MAs. Buy signals are generated when the shorter-term, faster-moving MA crosses over the longer average. This indicates that the near-term price action is accelerating to the upside.

These systems are susceptible to false signals, or whipsaws. As such, traders should experiment with different time periods and conduct other backtesting before trading.

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This crossover system posted a buy signal when the five-day crossed over the 20-day to the upside, on the left side of the chart. The position is closed once either a downside crossover occurs (as indicated with the arrow on right side of chart) or when the trade reaches a predetermined price objective.

NEXT: Breakout Systems and Moving Average Crosses

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3) Breakout Systems

Breakout systems are extremely easy to develop. They are basically a set of predefined trading rules based on the simple premise that a price move to a new high or low is an indication of a continuing trend. Therefore, the system triggers an action to open a position in the direction of the new high/low.

For example, a breakout system may state that the trader should close all shorts and open a long position if the day's closing price exceeds the high price for the past 'X' days.

Part two of the same breakout system will state that the trader must close longs and open a short position if the day's close is below the 'X' day's low print. The secret is to determine how long of a period you'd like to trade. Shorter time periods (faster systems) will detect trending markets faster than slower systems. The drawback is that more whipsaws will occur with faster systems.

4) Pattern Recognition Strategies

A thorough discussion of every pattern used by forex traders is obviously beyond the scope of this article. As such, we will look at a few popular continuation patterns used by traders.

Triangles

Triangles can signal trend reversals, but most often they are continuation patterns (meaning that the resolution of the triangle will result in the resumption of the prior trend). There are several different types of triangles, each possessing its own unique characteristics and forecasting implications.

Traders should open positions once the price action breaks out beyond the converging boundaries of the triangle. In this case, the trader will buy the British pound (GBP) once the price breaks out above the upper boundary near 1.99.

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One way to forecast the extent of the resulting move is to measure the distance of the triangle base and add that distance to the level where the breakout occurred (~.04 to ~.05 + 1.99 = 2.04)

Flags

Flags, or pennants, are continuation or consolidation patterns that usually display a period of back-and-forth action sloped against the primary trend. Pennants have shown to be extremely reliable. They almost always consolidate the prevailing trend and very rarely signify a trend reversal. As with triangles, traders should open positions upon a breach of the boundary. Like other continuation patterns, flags often occur near the midpoint of a primary move.

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These are just a few simple ways any trader can begin looking at the currency market charts and make trading decisions based on sound technical analysis.

By David Gonzalez, contributor, Investopedia.com

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