Forex trading styles can be classified by the length of time traders expect a winning trade to last. I have written before about position trading (where trades may be held for weeks or months), and scalping (where trades may be held for seconds or minutes). Today, I am covering Forex swing trading, where trades may be held from one to a few days.
Swing Trading for Dummies
Swing trading is very popular with retail Forex traders for two main reasons. Firstly, Forex swing trading strategies usually contain entry and exit techniques that require checking the chart perhaps only once or twice each day, or at most every few hours. This relatively relaxed schedule is very suitable for people with busy lives and full-time jobs.
It could be said that position trading also has a relaxed schedule, so is equally suitable for busy traders. This is true, but as Forex position trading is really always trend trading, profitable position trading usually requires a low win rate, and a great deal of patience in waiting until the correct time to harvest winners. Many retail traders struggle psychologically in coping with these two issues, so as an alternative, they try swing trading, where profitable trades are exited more quickly.
I believe that the best chance new traders have to trade Forex profitably is by position trading, and conversely that one of the reasons so many lose money is because they choose instead to swing trade, without appreciating fully how challenging it can be. I will try to explain why, and in the process show which swing trading strategies and swing trading techniques tend to work best in swing trading Forex.
Forex Candlestick Trading
Most new traders that go for swing trading are taught to look for certain Forex candlestick formations, in alignment with support and resistance. In this style, traders are taught to be extremely selective in picking trades, and exhorted to stay on the sidelines unless everything looks perfect.
It is certainly possible to make money trading like this, but it is hard for most people to make more than just a little profit with this style. There are several reasons for this:
Very few set-ups look perfect, so many trades are not taken.
This style can be very difficult psychologically, especially when the trader sits on the sidelines and sees a great move play out. This can lead to an overly itchy trigger finger on the next trade.
Candlestick analysis on its own is mostly useless: it must be combined with support and resistance, trend, time of day or other factors. ALL of these other factors are in themselves more powerful than candlesticks, yet the candlesticks are the number one factor traders are taught to focus on.
Fundamental and quantitative factors are usually ignored.
Trend trading is the most easy and natural way for new traders to profit in the retail Forex market. However, there are a lot of misconceptions about how to trend trade Forex, which usually come from the misapplication of methods that are more suitable to trading stocks or commodities. Forex pairs tend to move much less than stocks and commodities, therefore applying traditional trend trading breakout strategies indiscriminately will almost certainly lead to losses over time.
Swing traders are looking to exit from winning trades from one to a few days after entry. It is very problematic to apply this time frame to trend trading, as in Forex trend trading profits are statistically derived from the big winners which are allowed to run.
The key thing to know is this: Forex markets tend to spend more time ranging than trending, and even when they trend, they usually range within the trend to some extent, with many retracements. The technical term for ranging is “mean-reverting”: a situation where price tends to revert (range back to) the mean (average).
Mean Reversion Trading
An alternative to looking for candlesticks patterns or breakouts is instead to apply a mean reversion trading strategy. This kind of trading tends to be overlooked, but statistics show why it can be applied profitably in Forex, especially in swing trading. Historical data shows that the best swing trading indicators tend to be mean reversion indicators.
Let’s look at the 28 major and minor Forex currency pairs over the past six years.
A very simple mean reversion trading strategy could be to wait for the price to become over-extended. There are many indicators that can be used to measure this, but for now let’s stick with something simple: just the price.
Over the past 6 years, the chance of any of these Forex pairs moving in value by more than 2% from a weekly open to a weekly close is about 1 in 8: it is a fairly rare event. Let’s say that every time this happened, we opened a trade to last just one week right away, in the opposite direction to that move greater than 2% that just happened.
This mean-reversion strategy trading generated an average profit per trade of 0.25%*.
Compare this to a robust trend trading strategy over the same time period and using the same currency pairs, where a buy trade is made at the end of each week that closes above the price 3 months ago, or a sell trade if the opposite is true.
This trend trading strategy generated an average profit per trade of 0.02%*. It produced about 8 times as many trades as the mean-reversion strategy.
To further illustrate the point, take a deeper look at this trend trading strategy.
If we only entered trades in the direction of the 3 month trend when the previous week closed in the same direction as the trend, the strategy becomes unprofitable, with an average loss per trade of -0.02%*.
However if we only entered trades in the direction of the 3 month trend when the previous week closed against the trend direction, the strategy becomes even more profitable, with an average profit per trade of 0.07%*. Note also that this has produced relatively steadily rising equity curve over the years:
Finally, what if we combined these two strategies even more directly: say we only take a trade when the price has moved by more than 2% at the end of a week against the 3 month trend, and we trade hoping that there will be a reversion to the mean back in the direction of the trade.
This combination strategy generated an average profit per trade of 0.27%.
*Note that all profits and losses are gross and do not include typical spreads/commissions/overnight financing charges.
Bollinger Band Trading
One of the most popular mean-reversion indicators is the Bollinger Band. Classically, when the bands are relatively wide, in Bollinger band trading you enter a position when the price is reversing off an outer band, and look to exit when the price is in the vicinity of the central band. There are additional methods of Bollinger band analysis that can also be used.
Previously we looked at using simple price levels, but a more sophisticated swing trading strategy that takes advantage of mean reversion can be devised using Bollinger bands or other oscillators.
If you really cannot stand the thought of leaving trades open for more than a few days, then the raw statistics show very clearly that over several years, the odds would have favored you more if you had used mean-reversion methods, either alone, or in conjunction with momentum/trend. Considering this, it is not surprising that the classic advice to traders “buy the dips in an uptrend, sell the rallies in a down trend” has survived the decades intact.
I am careful not to say that you cannot make money by trading more typical strategies such as breakouts. I am saying that the numbers show that unless you have some good methods for choosing which breakouts and which currency pairs you trade, the odds are strongly against you.