Different Strokes for Different Folks

After you’ve given some thought to the time and resources you‘re able to devote to currency trading and which approach you favor (technical, fundamental, or a blend), the next step is to settle on a trading style that best fits those choices.

There are as many different trading styles and market approaches in FX as there are individuals in the market. But most of them can be grouped into three main categories that boil down to varying degrees of exposure to market risk. The two main elements of market risk are time and relative price movements. The longer you hold a position, the more risk you‘re exposed to. The more of a price change you’re anticipating, the more risk you‘re exposed to.

In this post, I detail three main trading styles and what they really mean for individual traders. My aim here is not to advocate for any particular trading style. (Styles frequently overlap, and you can adopt different styles for different trade opportunities or different market conditions.) Instead, my goal is to give you an idea of the various approaches used by forex market professionals so you can understand the basis of each style. I think this information will help you settle on a style that best fits your personality and individual circumstances. Equally important, you’ll be able to recognize whether your style is drifting and generally maintain a more disciplined approach to the market.

Short-term, high-frequency day trading

Short-term trading in currencies is unlike short-term trading in most other markets. A short-term trade in stocks or commodities usually means holding a position for a day to several days at least. But because of the liquidity and narrow bid/offer spreads in currencies, prices are constantly fluctuating in small increments. The steady and fluid price action in currencies allows for extremely short-term trading by speculators intent on capturing just a few pips on each trade.

Short-term trading in forex typically involves holding a position for only a few seconds or minutes and rarely longer than an hour. But the time element is not the defining feature of short-term currency trading. Instead, the pip fluctuations are what's important. Traders who follow a short-term trading style are seeking to profit by repeatedly opening and closing positions after gaining just a few pips, frequently as little as 1 or 2 pips.

Jobbing the market pip by pip

In the interbank market, extremely short-term, in-and-out trading is referred to as jobbing the market; online currency traders call it scalping. (I use the terms interchangeably.) Traders who follow this style have to be among the fastest and most disciplined of traders because they're out to capture only a few pips on each trade. In terms of speed, rapid reaction and instantaneous decision - making are essential to successfully jobbing the market.

When it comes to discipline, scalpers must be absolutely ruthless in both taking profits and losses. If you’re in it to make only a few pips on each trade, you can’t afford to lose much more than a few pips on each trade. The overall strategy is obviously based on being right more often than being wrong, but the key is not risking more than a few pips on each trade. The essential motto is “Take the money and run” - repeated a few dozen times a day.

Jobbing the market requires an intuitive feel for the market. (Some practitioners refer to it as rhythm trading.) Scalpers don’t worry about the fundamentals too much. If you were to ask a scalper for her opinion of a particular currency pair, she would be likely to respond along the lines of “it feels bid” or “it feels offered” (meaning, she senses an underlying buying or selling bias in the market - but only at that moment). If you ask her again a few minutes later, she may respond in the opposite direction.

Successful scalpers have absolutely no allegiance to any single position. They couldn’t care less if the currency pair goes up or down. They’re strictly focused on the next few pips. Their position is either working for them, or, they’re out of it faster than you can blink an eye. All they need is volatility and liquidity.

Adapting jobbing to online currency trading

Jobbing is a popular trading style in the interbank market because institutional traders have the ability to bid and offer in the market as well as pay offers and hit bids. This enables them to minimize the trading spreads they’re exposed to and maximize the pips gained. If the market feels bid (buying bias), a trader may get long by buying at the 18 offer and then immediately offer to sell that position at 19 or 20. If his offer isn’t paid (bought by someone else) quickly enough, he may have to hit the 17 or 18 bid to exit and try again.

Retail traders are typically faced with bid/offer spreads of between 2 and 5 pips. Although this makes jobbing slightly more difficult, it doesn't mean you can't still engage in short-term trading - it just means you’ll need to adjust the risk parameters of the style. Instead of looking to make l to 2 pips on each trade, you need to aim for a pip gain at least as large as the spread you’re dealing with in each currency pair. The other basic rules of taking only minimal losses and not hanging on to a position for too long still apply.

Here are some other important guidelines to keep in mind when following a short-term trading strategy:

ü  Trade only the most liquid currency pairs, such as EUR/USD, USD/JPY, EUR/GBP, EUR/JPY, and EUR/CHF. The most liquid pairs will have the tightest trading spreads and will be subject to fewer sudden price jumps.

ü  Trade only during times of peak liquidity and market interest. Consistent liquidity and fluid market interest are essential to short-term trading strategies. Market liquidity is deepest during the European session when Asian and North American trading centers overlap with European time zones - about 2 am to noon eastern time (ET). Trading in other sessions can leave you with far fewer and less predictable short-term price movements to take advantage of.

ü  Focus your trading on only one pair at a time. It you’re aiming to capture second-by-second or minute-by-minute price movements, you‘ll need to fully concentrate on one pair at a time. It’ll also improve your feel for the pair if that pair is all you’re watching.

ü  Preset your default trade size so you don’t have to keep specifying it on each deal.

ü  Look for a brokerage firm that offers click-and-deal trading so you’re not subject to execution delays or requotes.

ü  Adjust your risk and reward expectations to reflect the dealing spread of the currency pair you’re trading. With 2- to 5- pip spreads on most major pairs, you probably need to capture 3 to 10 pips per trade to offset losses if the market moves against you.

ü  Avoid trading around data releases. Carrying a short-term position into a data release is very risky because prices can gap sharply after the release, blowing a short-term strategy out of the water. Markets are also prone to quick price adjustments in the 15 to 30 minutes ahead of major data releases as nearby orders are triggered. This can lead to a quick shift against your position that may not be resolved before the data comes out.

Keeping sight of the forest while you’re in the trees

Trading a short-term strategy online also requires individual traders to invest more time and effort in analyzing the overall market, especially from the technical perspective.

If you pursue a short-term trading strategy online, where dealing spreads can equal profit targets, you need to be right by a larger margin. To give yourself a better chance of capturing slightly larger short-term moves, always know where you stand in longer charting timeframes. By all means, use tick, one minute, and five-minute charts to refine your trade timing, entry, and exit. But be aware of the larger picture suggested by 30-minute, hourly, and multi-hour charts, because they’re going to hold the keys to the larger directional movements.

Medium-term directional trading

If you thought short-term time frames were exceptionally brief, medium-term time frames aren’t much longer Medium-term positions are typically held for periods ranging anywhere from a few minutes to a few hours, but usually not much longer than a day. Just as with short-term trading, the key distinction for medium-term trading is not the length of time the position is open, but the amount of pips you’re seeking/risking.

Where short-term trading looks to profit from the routine noise of minor price fluctuations, almost without regard for the overall direction of the market, medium-term trading seeks to get the overall direction right and profit from more significant currency rate moves. By the same token, medium-term traders recognize that markets rarely move in one direction for too long, so they approach the market with well-defined trade entry and exit strategies.

Almost as many currency speculators fall into the medium-term category (sometimes referred to as momentum trading and swing trading) as fall into the short-term trading category. Medium-term trading requires many of the same skills as short-term trading, especially when it comes to entering/exiting positions, but it also demands a broader perspective, greater analytical effort, and a lot more patience. We classify ourselves as medium-term traders. Short-term traders love the noise of moment-to-moment price changes; directional traders have to suffer through it to see how their view will play out.

           

Capturing intraday price moves for maximum effect

The essence of medium-term trading is determining where a currency pair is likely to go over the next several hours or days and constructing a trading strategy to exploit that view. Medium-term traders typically pursue one of the following overall approaches, but there’s also plenty of room to combine strategies:

ü  Trading a view: Having a fundamental-based opinion on which way a currency pair is likely to move. View trades are typically based on prevailing market themes, like interest rate expectations or economic growth trends. View traders still need to be aware of technical levels as part of an overall trading plan.

ü  Trading the technicals: Basing your market outlook on chart patterns, trend lines, support and resistance levels, and momentum studies. Technical traders typically spot a trade opportunity on their charts, but they still need to be aware of fundamental events, because they’re the catalysts for many breaks of technical levels.

ü  Trading events and data: Basing positions on expected outcomes of events, like a central bank rate decision or a G7 meeting, or individual data reports. Event/data traders typically open positions well in advance of events and close them when the outcome is known.

ü  Trading with the flow: Trading based on overall market direction (trend) or information of major buying and selling (flows). To trade on flow information, look for a broker that offers market flow commentary, like that found in FOREX.com‘s Forex Insider (www forex.com/forex_research.html). Flow traders tend to stay out of short-term range-bound markets and jump in only when a market move is under way.

When is a trend not a trend?

When it's a range. A trading range or a range-bound market is a market that remains confined within a relatively narrow range of prices. ln currency pairs, a short-term (over the next few hours) trading range may be 20 to 50 pips wide, while a longer-term (over the next few days to weeks) range can be 200 to 400 pips wide.

For all the hype that trends get in various market literature, the reality is that most markets trend no more than a third of the time. The rest of the time they’re bouncing around in ranges, consolidating, and trading sideways.

If markets reflect all the currently known information that’s available, they’re going to experience major trends or shifts only when truly new and unexpected information hits the market. On a day-to-day basis, incoming economic data and events usually result in an adjustment of prices only within a prevailing range, rather than a breakout, but that’s enough for medium-term traders to take advantage of the opportunity.

Taking what you get from the market

Medium-term traders recognize that sizeable price movements and trends are more the exception than the rule. So rather than selling and holding in the case of a downtrend, for example, they're looking to capitalize on the 50- to 150- point price declines that make up the overall downtrend. The key here is that medium-term traders will take profit frequently and step back to reassess market conditions before getting back in.

Although medium-term traders are normally looking to capture larger relative price movements - say, 50 to 100 pips or more - they're also quick to take smaller profits on the basis of short-term price behavior. For instance, if a break of a technical resistance level suggests a targeted price move of 80 pips higher to the next resistance level, the medium-term trader is going to be more than happy capturing 70% to 80% of the expected price move. They’re not going to hold on to the position looking for the exact price target to be hit. It goes without saying that it’s better to catch 75 % of something than 100% of nothing.

Long-term macroeconomic trading

Long-term trading in currencies is generally reserved for hedge funds and other institutional types with deep pockets. Long-term trading in currencies can involve holding positions for weeks, months, and potentially years at a time. Holding positions for that long necessarily involves being exposed to significant short-term volatility that can quickly overwhelm margin trading accounts.

With proper risk management, individual margin traders can seek to capture longer-term trends. The key is to hold a small enough position relative to your margin that you can withstand volatility of as much as 5% or more. Mini accounts, which trade in lot sizes of 10,000 currency units, are a good vehicle to take advantage of longer-term price trends.

For example, let's say you’re of the view that the U.S. dollar is going to weaken and that USD/JPY, currently at 120.00, is headed for 110.00 or lower. But if USD/JPY rises above 125.00, you think the downside scenario is over, and you want to be out of the trade. In this case, you would be risking 500 pips to make 1,000 pips. For a 10,000 USD/JPY trade size, that translates into a risk of losing $400 according to the trade parameters (10,000 × 500 JPY pips = JPY 50,000 ÷ 125.00 = $400) or making a gain of over $900 (10,000 × 1,000 JPY pips = JPY 100,000 + 110.00 = $909.09).

Identifying the macro elements that lead to long-term trends

Long-term trading seeks to capitalize on major price trends, which are in turn the result of long-term macroeconomic factors. Before you embark on long-term speculation, you want to see how some of the following macroeconomic chips stack up:

ü  Interest rate cycles: Where are the two currencies’ relative interest rates, and where are they likely to go in the coming months? Narrower interest-rate differentials will tend to help the lower-yielding currency and hurt the higher-yielding currency; wider interest rate differentials will help the higher-yielding currency and hurt the lower-yielding one.

ü  Economic growth cycles: What‘s the outlook for relative growth over the next several months? An economy that is in an expansionary phase of growth is likely to see higher interest rates in the future, which would support that currency. An economy that is showing signs of slowing may see interest rate expectations lowered, hurting the currency in the process.

ü  Currency policies: Are the currencies considered to be excessively overvalued or undervalued by the major global trading powers? Are the G7 or the national governments of the currencies agitating for changes in the currency’s relative value?

ü  Structural deficits or surpluses: Do the currencies have any major structural issues that tend to see currencies weaken or strengthen, such as fiscal deficits/surpluses or trade deficits/surpluses?

Trading around a core position

Just because you’re trading with a long-term view doesn't mean you can‘t take advantage of significant price changes when they're in your favor in the medium term. Trading around a core position refers to taking profit on a portion of your overall position after favorable price changes. You continue to hold a portion of your original position - the core position - and look to re-establish the full position on subsequent market corrections. Remember: It never hurts to take some money off the table when you’re winning.

Taking partial profit on a long-term position works best when the currency pair you’re trading is reaching significant technical levels, such as multiday or multiweek highs. If the trend of the currency pair you‘re holding is displaying a channel on the charts, taking partial profit near the top of the channel in an uptrend or near the channel bottom in a downtrend is one way of judging when to take partial profit.

The risk with trading around a core position is that the trend may not correct after you’ve taken partial profit, never giving you the chance to re-establish your desired full position. But you’re still holding the core of your position, and because the market hasn’t corrected, it means your core position is doing just fine.

Carry trade strategies

A carry trade happens when you buy a high-yielding currency and sell a relatively lower-yielding currency. The strategy profits in two ways:

ü  By being long the higher-yielding currency and short the lower-yielding currency, you can earn the interest-rate differential between the two currencies, known as the carry. If you have the opposite position - long the low-yielder and short the high-yielder - the interest-rate differential is against you, and it is known as the cost of carry.

ü  Spot prices appreciate in the direction of the interest-rate differential. Currency pairs with significant interest-rate differentials tend to move in favor of the higher-yielding currency as traders who are long the high yielder are rewarded, increasing buying interest, and traders who are short the high yielder are penalized, reducing selling interest.

So let me get this straight, you may be thinking: All I have to do is buy the higher-yielding currency/sell the lower-yielding currency, sit back, earn the carry, and watch the spot price move higher? What's the catch?

Right you are. There is a catch, and the catch is that downside spot price volatility can quickly swamp any gains from the carry trade‘s interest-rate differential. The risk can be compounded by excessive market positioning in favor of the carry trade, meaning a carry trade has become so popular that everyone gets in on it. When everyone who wants to buy has bought, why should the price continue to move higher? Even more daunting, if the price begins to reverse against the carry trade, it may trigger a panic exodus out of the trade, accelerating the price plunge. Take a look at Figure below to get an idea of the trends that can develop around carry trades as well as the sharp setbacks that can happen along the way.

NZD/JPY  trends higher in line with carry trade fundamentals (New Zealand's interest rates are much higher than japan's), but it meets sharp setbacks along the way)

Carry trades usually work best in low-volatility environments, meaning when financial markets are relatively stable and investors are forced to chase yield. Keep in mind that carry trades need to have a significant interest-rate differential between the two currencies (typically more than 2%) to make them attractive. And carry trades are definitely a long-term strategy, because depending on when you get in, you may get caught in a downdraft that could take several days or weeks to unwind before the trade becomes profitable again.