Types of Trading Systems
The main types of trading systems are trend-following, counter-trend or range, breakout or counter-breakout, and pattern recognition.
Trend following systems are the most common type of system that traders use. They can be very profitable because within a strong trend, moves are often large ones. Trend following systems buy high and sell higher as prices move upwards. One example of a trend following system is a moving average (MA) crossover approach. A trader would buy when a faster MA crosses above a slower MA. In this example on the three-hour Euro chart, you can see three buy points as the 20 EMA (in purple) crosses up above the 50 EMA (in red). You also have one sell point where the 20 EMA crossed below the 50 EMA. All these trades would have been profitable had you trailed your stop.
While trend following systems work well within a strong trend, they cause whipsaws when the market is moving sideways. Notice the circled area on the chart in November. Following the system would have resulted in four unprofitable trades.
In a market moving sideways, the trader needs to switch to a range or counter-trend system. Ranges can be horizontal, ascending, or descending, but they all have a definable top and bottom. There’s greater risk in this approach because you’re trying to pick tops and bottoms—in other words, you’re trying to buy-low and sell-high. Counter-trend systems often involve the use of such indicators as RSI, MACD, and the stochastic, looking for overbought and oversold conditions. They can also use divergences between price and indicators, or crossovers in Bollinger Bands.
Look at the Euro chart below. I’ve added Bollinger Bands to the same three-hour chart during the sideways period in November. Here you’d sell when price touched the upper band and buy when it touched the lower one. It looks simple enough. Remember, though, that counter trend trading carries significantly more risk. As a result, you should always look for other, confirming evidence. (Frankly, even with trend following systems I look for additional evidence for entries.) In this case, note the difference in candle behavior on the last trade that failed. Instead of the upper shadows that the prior candles displayed when they touched the top of the bands, you see stronger candles forming with no upper shadows.
Breakout systems trade breakouts from ranges. The philosophy is that prices don’t stay in a range forever—eventually they break out of them. Counter-breakout systems trade an assumption that many breakouts fail. One example of a breakout system is on the chart above where the last failure for the range trading system was actually a signal for a breakout system. In this case, the breakout was from the Bollinger Bands. I’ve written about breakouts and their failures in another article on this site. You can find it at: /articles/2009/11/_2830_dailyforex-news_Forex_Trading_Breakouts_.aspx
Pattern recognition systems can be the most challenging because there’s the need to recognize the pattern. They include such patterns as inside and outside bars, candlestick patterns, flags, triangles, head and shoulders, and others. I’ve written about two popular candlestick patterns, the morning and evening stars at /articles/2009/11/_2801_dailyforex-news__Morning_and_Evening_Stars%e2%80%94Two_Powerful_Patterns_Worth_Watching.aspx
I’ve also written about the rare but profitable diamond pattern at /articles/2009/11/_2881_dailyforex-news_Diamond_Patterns_in_Forex_Trading%e2%80%94Rare_but_Profitable.aspx
To be useful, trading systems need to have well-defined and simple rules. In addition, the trader must be aware of the market environment and use the appropriate system at the correct time. Determining whether a market is trending or in a sideways range often requires the use of an indicator such as ADX, which I’ll cover in a future article. As always, the trader should look for confirming evidence before entering a trade and should use stop losses to limit risk.
Testing Your Forex Trading System
To achieve your goal of trading Forex profitably, you first need to develop a trading strategy which comprises a set of rules that can be readily adhered to over the long haul. You then need to acquire a very good understanding of money management principles that will help you control and restrict the impact of unavoidable losses.
Many Forex traders have difficulty understanding that their occupation involves a tremendous amount of risk. Good Money Management skills are essential in order to cope with this very serious problem. Basically, money management strategy is a statistical tool that helps control the risk exposure and profit potential of every trade activated.
When inexperienced traders entered trades with just calculated profit targets, the results can be disastrous if they have also not clearly calculated a protective Stop Loss. Money Management will also advise in determining a realistic risk to reward ratio that will limit the effects of draw-downs.
In addition, these principles are essential in selecting accurate Stop-Loss and Target-Limits for each trade entered. New trading systems should then to be back tested using historical data with the objective of producing positive win to loss ratios and expectancy values. Although this task can be done manually, it would be both very time consuming and prone to human error.
As such, traders are well advise to automate their testing using a suitable software tool or by coding their trading strategies, if possible. After properly performing this exercise, confidence will be greatly boosted because now traders will have a much better understanding of the results that their systems will generate over the long haul.
The above analysis will provide new traders with a realistic and measured performance of the capabilities and limitations of their trading system. In particular, they will now know how many losing trades might be encountered during an overall profitable period of time. This knowledge will steel them during periods of adversity so that they will still persevere with their systems by trading them in a consistent manner.
All types of trading are unpredictable and even sure-fire deals can turn surprisingly bad in a matter of moments. This is especially so with the Forex Market because of its size, complexity and volatility always means that a sufficient number of active changes are present capable of affecting the values of any currency pairs. This article is part of a course intended to show you how to build your own successful Forex Trading System.
© Dianne Fecteau, 2009.