INTRODUCTION. People looking to become profitable traders usually take one of two approaches.

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2 INTRODUCTION People looking to become profitable traders usually take one of two approaches. The first approach is to find and apply a trading system that tells them exactly what to do at all times. Let s call this the system approach. The other approach is to try to learn the basic skills of trading and apply them flexibly to the Forex market in order to trade successfully. Let s call this the education approach. Both approaches can cause problems and surprises, and it s a good idea to understand what each approach offers before jumping in. The System Approach You will find a lot of material on the internet outlining many different trading systems, but you will find very little verification of the kind of results they usually produce. Even if you do see some results, they are rarely detailed enough to be statistically meaningful. Most trading systems simply do not work reliably, and are just given away carelessly to attract traffic and advertising or affiliate revenue to websites. This is the brutal truth. The problem with most trading systems is that they tend to be inflexible by nature, and if so, they are naturally too naïve to be systematically profitable. Please understand, that even the few systems which are profitable, will from time to time go through losing streaks that will test anyone s patience. There are only two types of systems that have been proven to be profitable by financial academics, across hundreds of markets and hundreds of years of historical data. The systems are actually fairly simple: you do not need fancy indicators or magic tricks to make profit from the markets. The first type of system relies upon the fact that prices have a tendency to revert to their average value. This is known as mean reversion. We will not be looking at this here, as there is a better risk-adjusted approach to take using an alternative method known as trend following. 1

3 With trend following systems, you simply buy what has been going up over a period of time, exploiting the statistics which show that assets which have been rising in value tend to continue rising for a while longer. You sell them later, when they stop going up. It really can be that simple! Later on, I am going to explain a complete Forex trend following system, with full rules and instructions. This system has been nicely profitable over the last 15 years or so and is based upon sound trading principles that academics have shown tend to work profitably in speculative markets. The Education Approach The other approach is to try to learn to become a profitable trader in the same way you might learn to fly a plane or drive a car. In this way, you hope to develop your own skill and judgement, watching the markets, making enough good calls, and profiting from them, avoiding overly inflexible trading systems. This is an admirable approach and something that the best traders do finally achieve one day. The difficulty though, is that it can take a long time to develop the required skills, partly because the psychological stress of trading for money drives most people at least a little crazy. During this learning curve, the beginner trader is extremely likely to lose money, possibly even to the extent of wiping out his or her entire account. Returning to the example of flying a plane, someone can tell you everything you need to know to be able to do it in theory, but if you go and try it without many hours of hands-on practice first, you are almost certainly going to crash. It is the same with trading. Of course, it is possible to open demo accounts with Forex brokers and trade real market prices, but without risking any real money. This is an essential first step, but usually cannot solve the problem because when the trader progresses to using real money, the new stress tends to badly affect their previously good judgement. Is There a Solution? A good way to build up the necessary hours of practice could be to start trading the trend trading strategy outlined in this e-book, first on a demo account, and then using real money. After a while, when you place 2

4 the trades, try to forecast which ones you feel will be winners and which will be losers. Keep a diary and follow the results of your predictions. Ask yourself why you have a feeling that a particular trade will be a winner or loser when you look at the charts or the news or fundamentals, and see if the winning trades usually have some factors in common. If you get to a position where after a few hundred trades you are outperforming the system, you could decide to risk more money on the trades you feel have a better chance of success. Whichever path you decide to follow, please consider carefully the map that has been laid out here of the challenges typically faced by novice Forex traders. Now I present a complete Forex trend trading strategy. 3

5 THE STRATEGY Which Forex Pairs Should You Choose? During the modern Forex era, the longest and strongest trends within the Forex market have involved the U.S. Dollar, and to a lesser extent the Euro. This is not a coincidence. The U.S. Dollar is the lynchpin of the global financial system and the number one reserve currency. Other currencies are usually positioning themselves against the U.S. Dollar. Many traders make the mistake of thinking all Forex currency pairs are more or less equal. They are not: the USD pairs are traded directly, while currency crosses are generally just the by-product of two USD pairs. The classic 4 majors tend to trend best of all. Based upon these principles, and upon historical performances over recent years, this strategy employs only the 4 major Forex currency pairs: EUR/USD GBP/USD USD/CHF USD/JPY It also seems probable that the strategy could work well with major commodities long only (more about that later). Money Management / Position Sizing The strategy utilizes fractional money management principles. In other words, a fixed percentage of equity should be risked on each trade entry. This is because winning or losing trades will have a tendency 4

6 to run in streaks. By risking a percentage of equity instead of a fixed cash amount, two things are achieved: 1) The trader can never wipe out their entire account in theory: in practice, it delays the possibility of reaching a ruin point. 2) The trader makes proportionately more profit from a winning streak and less profit from a losing streak. For example, consider a streak of 10 winning trades where profits are made at 2R (profit is 200% of the amount risked). Here is how equity is affected using both fixed dollar and fixed fraction money management, starting with $100 of equity: Figure 1: Money management comparison: winning streak Note how risking a fraction of equity ensures a better profit from a winning streak, due to the principle of compounding. A losing streak of ten trades would look like this: 5

7 Figure 2: Money management comparison: losing streak Note how risking a fraction of equity ensures a lesser loss from a losing streak, again due to the principle of compounding. The differences here might not look very big, but after hundreds of trades it makes a significant difference. Finally, how much of your equity should you risk on each trade? That is a personal decision based upon the maximum drawdown (losses from an equity peak) you can psychologically tolerate. If you risk 0.25% of your equity per trade, you are likely to experience a drawdown of approximately 25% of equity at some point within the next few years. Always make sure that when you have a trade or several trades open, when opening a new trade, assume that any open trades will lose when calculating your equity in sizing the new trade. Trade Entry Rules This strategy is a trend trading strategy. Long trade entries are taken only in pairs that are in an uptrend. Short trade entries are taken only in pairs that are in a downtrend. 6

8 A currency pair is defined as in an uptrend if the current price is higher than its prices 3 months ago and 6 months ago. (A commodity is defined as in an uptrend in the same way but the price should also be higher than it was 1 month ago.) A currency pair is defined as in a downtrend if the current price is lower than its prices 3 months ago and 6 months ago. There will be periods where the market gives very few or even no trades. Patience and sticking to crucial rules are vital to find profitable trading conditions. The trade entry trigger is as follows: 1. On a 4 hour (H4 chart), a candle closes having made a new low below the lowest price of the previous 6 H4 candles, if the pair is in an uptrend. Alternatively, if an H4 candle closes having made a new high above the highest price of the previous 6 H4 candles, if the pair is a downtrend. 2. When the candle closes, if it is a long trade entry, a buy/long stop order is placed 1 pip above the high of the closed candle. If it is a short trade entry a sell/stop order is placed 1 pip below the low of the closed candle. 3. The stop loss is put at just the other side of the candle, 1 pip beyond the high or low. 4. The entry must be hit within the next 4 hours, i.e. during the very next H4 candle. If it is not, cancel the trade entry. 5. If during the 4 hours of waiting, the price reaches the stop loss price even though the entry has not been triggered, cancel the trade entry. An example of a trade entry is shown in the diagram below: 7

9 Figure 3: Short trade entry on GBP/USD currency pair In the example shown above, we are watching for a short trade to set up on the GBP/USD currency pair, as its price is below its levels from both 3 months ago and 6 months ago. We wait for a candle to close having made a high price higher than the highest price of the previous 6 candles in this example, starting at the gap after the very large candles on the left, the only candle in the H4 chart above that does so is the one marked by the downwards arrow. The trade entry (sell stop order) is set 1 pip below the low price of the candle. The stop loss is set 1 pip above that same candle. The trade entry is triggered during the next candle. If it was not triggered during that next 4 hours, or if the price had exceeded the stop loss price during that time, then the sell stop trade entry order would have been removed. Note that you might have a situation in a slow-moving market where you get a signal to enter a trade for a particular currency pair, and then only a day or so later you get another signal to enter a trade while the first trade is still open. For example, you open a short GBP/USD entry at Neither the stop loss nor an exit is triggered, and one or two days later, you get a signal to open another short GBP/USD entry at

10 This is best dealt with by either allowing a maximum of only two positions in the same currency pair at the same time, and/or by having a minimum gap between entry prices of two trades of about the average range of the last 20 or so candles. These are the basics of entry. We apply two filters to pick only the best entries: volatility, and time of day. Volatility It is a fact that the better entries will tend to be from relatively larger candles, because they usually show firmer buying or selling intent to reverse the short-term movement. So how can this best be measured? By using the Average True Range (ATR) indicator applied to an H4 chart and set to 30 periods. This will show the average size of a candlestick over the previous 5 trading days. Entries are valid only if the entry candlestick is at least as big, or bigger, than the ATR value. For example, if the ATR is 29 pips, and a possible entry candle is only 25 pips from its high-to-low, then that is not a valid entry candle. Time of Day The Forex market is most liquid during London and New York business hours. However, the Japanese Yen is also heavily traded around the time Tokyo opens for business each day. Therefore, trades should only be entered between 8am London time and 5pm New York time, except regarding the USD/JPY currency pair where entries may also be made between Midnight and 4am London time. The GBP/USD currency pair is also a special situation, as it is traded very thinly outside the London session, so trades for this pair are valid only between 8am and 4pm London time. This is an important filter and if it does not suit your time zone that is unfortunate. However, as you can trade this off 4 hour charts, it could mean just waking up a little earlier or going to sleep a little later, or maybe even setting an alarm to check the price of USD/JPY during your night time when it is trending, if you can. Trade Exit Rules There are several different exit strategies that can be applied successfully within this type of trendfollowing strategy. Volatility-Based Targets The easiest exit strategy is to use fixed profit targets based upon the average true range (ATR). This indicator can be found within almost all trading platforms / charting software. 9

11 Set the ATR indicator on the H4 chart of the currency pair you are trading, using 30 periods. This will show an average range in pips. Take this amount, double it, and add it to the entry price and set it as a profit target. You can then sit back and forget about it, the trade will either be stopped out for a loss or will hit the take profit. A win will on average be about twice as large as a loss. Risk-Based Targets Alternatively, the profit target can be based upon the amount of pips risked: just double it. For example, if the risk on a trade is 50 pips from the entry price to the stop loss, place a take profit level of 100 pips (50 X 2) from the entry price. Some people find this kind of set and forget procedure very difficult psychologically to implement. This is because they will watch the trade, and sooner or later there will be a time where the price gets to within just a pip or so of the profit target before it reverses and finally is stopped out for a loss. If this describes you, I suggest that you learn to be patient and calm, because what you might gain from one trade you close early at its peak, you will almost certainly lose ten times as much from the trades you close early before they go on to become winners. Back Test Results I wrote earlier that most Forex trading strategies rarely come with detailed back test results. To justify this criticism, I can present detailed statistics and an equity curve showing how this strategy performed from the start of 2010 until the end of 2015: a period of 6 years, covering thousands of trades. Commissions and slippage are not factored in, although reasonable spreads are. They can be expected to reduce positive expectancy somewhat, but not by a very significant amount as the strategy works on an H4 time frame. There was a total of 628 hypothetical trades. The average expectancies per trade, based upon profit targets as a multiple of pips risked, were as follows: Reward to Risk 1 to 1 2 to 1 3 to 1 5 to 1 10 to 1 20 to 1 50 to 1 ALL TRADES 10.19% 22.29% 28.66% 38.54% 61.15% 57.17% 57.17% Figure 4: Average expectancies per trade by reward to risk profile 10

12 The chart below exhibits a simulated equity curve based upon profit targets set at 1,2 and 3 X Risk), starting at 100% of equity: Figure 5: 6 years back test by reward to risk profile In reality the equity curves are a little exaggerated for the 2X and 3X Reward to Risk targets, as not every winning trade would have been closed before the next trade was opened, but in this simulation, equity is rebased straight away. In the 2X Risk Target back test, the maximum drawdown was very low, but the longest drawdown lasted for more than one year. Over the full 6-year period, the strategy produced a profit of about 96.92%, assuming a target of 2X reward to risk. Higher profit targets, as shown in the small table above, have even more profitable expectancies overall. The problem with aiming for higher targets is that the win ratio decreases dramatically, so the compounding effect is eroded. For this reason, it was better to aim for targets of about 2 to 1. Finally, please be advised that a stimulated past performance is no guarantee of future performance. 11

13 Conclusion It is a fact that over the past decade and a half at least, the most predictable momentum effect that can be exploited in Forex trading has been in major USD pairs that are in strong multi-month trends. While any complete trading strategy will go through losing streaks, it is possible (and, statistics would argue, even recommended) to apply rules which seek to buy the dips in strong Forex uptrends and sell the rallies in strong Forex downtrends. New traders would be well advised to explore the profitability of these methods and the strategy shown using a back testing tool such as Forex Tester. When enough confidence has been achieved, practice applying the rules or the complete strategy by trading a demo account, followed eventually by a real account when you are fully comfortable and familiar with the risk involved. Remember not to risk more capital than you can afford to lose. Thank you for reading We invite you to share your thoughts and reactions About DailyForex.com DailyForex is a market leader in providing Forex traders with all the information and resources they need to master the Forex market. DailyForex is a long term partner of Google News as well as a content contributor to Seeking Alpha and other leading financial sites. In addition to providing in depth and current news, articles, and market analysis, DailyForex is also very well known in the industry for its professional reviews of Forex brokers, signal providers, and general Forex services. DailyForex has become the Forex trader's one stop shop for all their trading needs, and it continues to grow and add new features and functionality to its already rich portfolio. Visit us: 12