Forex Trading Strategy — What Is It? (Backtest)

Last Updated on November 18, 2022

The Foreign exchange market (Forex) is by far the largest financial market in the world in terms of traded volume. It used to be accessible only to the rich and financial institutions, but with the emergence of the internet, electronic trading, and online brokers, there has been an upsurge in the number of individual traders participating in forex trading. But what exactly is a forex trading strategy?

Forex trading refers to buying and selling different currencies with the aim to make profits from the changing exchange rates. It is basically speculating on the direction of the exchange rates of various currencies. Because the exchange rate differences are usually small, traders use leverage to increase their potential profits.

We end the article by showing you an example of a forex trading strategy (of course, the strategy is backtested).

In this post, you will learn about forex trading and the building blocks of a forex trading strategy. Keep reading!

What is forex trading?

Forex is short for foreign exchange, which means the process of changing one currency into another currency. There are many reasons for performing a foreign exchange transaction, and they include commerce, tourism, education in a foreign country, and international trade. But one popular foreign exchange transaction is currency speculation, which we call forex trading.

Forex trading, or currency speculation, is the act of buying and selling currencies with the hope of making profits from fluctuating exchange rates. Currencies are traded on the forex market, which is an over-the-counter market that is open for buying and selling currencies 24 hours a day, five days a week, and is used by banks, businesses, investment firms, hedge funds, and retail traders.

By far the largest and most liquid financial market in the world, the forex market is estimated to have an average global daily turnover of more than US$6.5 trillion — a rise from the $5 trillion it was just a few years ago. The forex market is unique in that there is no central marketplace or exchange in a central location. It is an over-the-counter market, as all trading is done electronically via computer networks that connect the trader to the broker and to the liquidity providers.

In forex trading, currencies are quoted in pairs. That is, the value of one currency is quoted against another currency. For example, EUR/USD is a currency pair of euro against the USD — the value of the euro is quoted in USD. A forex trader usually trades by selling one currency to buy another, and this is why currencies are quoted in pairs.

The concept of a base and quote currency

Forex trading always involves selling one currency in order to buy another, which is why it is quoted in pairs. A forex pair consists of a base currency and a quote or counter currency. The base currency is the first currency listed in a forex pair, while the second currency is the quote currency against which the base currency is quoted. In other words, the price of a forex pair is how much one unit of the base currency is worth in the quote currency.

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Backtested trading strategies

For example, USD/JPY is a currency pair with USD as the base currency and JPY as the quote currency. If the value of the currency pair is quoted as 120.23, it means that you would need ¥120.23 to buy 1$. If the dollar rises against the yen, then a single dollar will be worth more yen, and the pair’s price will increase. If the dollar value drops, the pair’s price will decrease. So, in forex trading, if you think that the base currency in a pair is likely to strengthen against the quote currency, you can buy the pair (go long). And when you think the base currency will weaken, you can sell the pair (go short).

Notice that each currency in a forex pair is listed as a three-letter code, usually formed from two letters that stand for the country and one letter that stand for the currency itself. For example, the United States dollar is given the code, USD, and the Japanese yen is given the code, JPY.

Categories of currency pairs

Currency pairs are often categorized into different groups based on liquidity, trading volume, and other factors. The main groups are as follows:

  • Major pairs. These are currency pairs that consist of the currency of the seven major economies paired against the USD. Thus, the major pairs include EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD, and AUD/USD. These seven currency pairs make up 80% of global forex trading.
  • Minor pairs. These are the major currencies paired against each other instead of the US dollar. They don’t usually have as much liquidity as the major pairs. Examples are EUR/GBP, EUR/CHF, GBP/JPY, and so on.
  • Exotics. These are formed by pairing a major currency against one from a small or emerging economy. Examples include USD/PLN (US dollar vs Polish zloty), GBP/MXN (Sterling vs Mexican peso), EUR/CZK
  • Regional pairs. These are forex pairs classified by regions, such as Australasia. Examples include AUD/NZD (Australian dollar vs New Zealand dollar) and AUD/SGD (Australian dollar vs Singapore dollar).

How the currency market works

Unlike equities and commodities that are traded on exchanges, forex trading takes place directly between two parties. The forex market is an over-the-counter (OTC) market run by a global network of banks across three major forex trading regions in different time zones: Europe, North America, and Australasia (Australia/Asia). Since the time zones of these regions overlap, you can trade forex 24 hours a day.

Most forex trading occurs in the spot forex market where the physical exchange of a currency pair takes place at the exact point the trade is settled — on the spot. Another OTC setup is the forward forex market, where a contract is agreed between two parties to buy or sell a set amount of a currency at a specified price, to be settled at a set date in the future or within a range of future dates.

Currencies are also traded in the future forex market, which is facilitated by a futures exchange. This involves a contract to buy or sell a set amount of a given currency at a set price and date in the future. Since it is trading via an exchange, a futures contract is legally binding. Most retail traders speculating on forex prices do not plan to take delivery of the currency itself; they only bet on the price movements in the market to make profits, which is why they tend to deal with online CFD brokers.

Factors that move the forex market

As with most financial markets, forex is primarily driven by the forces of supply and demand, and it is important to gain an understanding of the influences that drives price fluctuations here.

  • News: Institutional firms like commercial banks and investment banks tend to invest in economies where conditions seem favorable. So, a piece of positive news about a certain country will see an inflow of investments in that country, thereby raising the value of its currency. News such as climate change, treaties, wars, political tensions, and policies can have significant impacts on the market.
  • Market sentiment: This is a collection of traders’ sentiments about the market, which can be bullish or bearish. The sentiment is often derived from the digestion of market news and technical analysis. If investor perceives an economy as being in trouble, they may look for alternatives elsewhere. Uncertainty is one of the leading causes of fear in the market.
  • Economic reports: Economic data reflects the current state of an economy. Some of the major economic indicators include GDP, Non-Farm Payroll (NFP), Consumer Price Index (CPI), inflation data, interest rates, etc. Some of these reports are known to impact the market. For example, the NFP is known to increase market volatility. It is important to pay attention to this report as it can hurt your trades in the short term.
  • Central Banks: The money supply is controlled by a country’s central bank. They are responsible for economic policies that are known to have a huge impact on a country’s currency. Paying attention to the central bank’s announcements and key events is crucial to know what’s next in a given economy.

How to choose the best forex trading strategy?

When choosing a trading strategy, there are certain things you must consider. These are the key ones:

Your trading style

Before you start trading forex, you must understand your personality and how you want to trade. This will determine the most suitable approach for you. Generally, there are four trading styles:

  • Scalping: This is fast-paced trading that aims to profit from small price fluctuations that happen all through the day. It involves making multiple and taking small profits from each.
  • Day trading: This involves opening and closing a trade before the end of the trading day. No position is left overnight and therefore does not incur overnight swap charges. The aim is to benefit from the main swings of the day.
  • Swing trading: Those who use this style of trading leave their trades open for several days or weeks until a price swing is completed. The idea here is to capture the individual price swings on the daily timeframe. So, it might mean making a few trades in a week.
  • Position trading: Here, the trades are left for several weeks or months. The idea is to ride long-term trends to completion.

If you like a fast-paced environment and the fun of getting profits, the scalping or day trading approach might be for you. But if you like things that happen slowly and in big sizes, you may consider swing trading or position trading.

How frequently you want to trade

When you have understood your trading personality, it is easy to determine how frequently you want to trade. If you want to be making several trades in a day, you already know you fit into scalping or day trading, so you look for scalping or day trading strategies.

On the other hand, if you are not as interested in finding as many trading opportunities as you are in making trades that yield bigger profits, you may want to consider swing or position trading. If you want, you can spend more time and resources on analyzing macroeconomic reports and fundamental factors and practice long-term investing.

A suitable timeframe

If you decide to be a short-term trader, you have to determine the right timeframe for your trading style and strategy. You don’t want to be trading a scalping strategy on the daily or weekly chart, and neither would you like to implement swing trading on a 5-minute chart.

If your style is scalping, your timeframe should be from 1-minute to 15-minute charts. On the other hand, if you consider yourself a swing trader, formulate strategies that work on the daily and 4-hourly timeframes. If you are a day trader, consider 1-hour to 15-minute charts, and if you prefer position trading, you should be looking at weekly and daily charts. So, before you choose your preferred trading strategy, be sure of the timeframe you want to trade it on.

Stop loss, position size, and risk management

For any given position size, the bigger the stop loss, the bigger the risk. The relationship is given in this formula:

Account Risk (in dollars) = Position Size (in lot) x Stop Loss (in pips) x Pips Value (in dollars/lot)

If you have a $10,000 account and want to risk 1% per trade, it means your account risk is $100. If you trade a mini lot (0.1 lot) of EUR/USD, which has a pip value of $10 per lot, your stop loss would be:

$100/(0.1lot x $10per pip per lot) = 100 pips

To trade a higher position size than 0.1 and still maintain the $100 risk amount, your stop loss has to be smaller. For example, a 0.2 lot size would have to use a 50 pip stop loss. But the smaller the stop loss, the higher the chance of being stopped out. So, you have to put your stop loss level and position size in mind when planning your strategy.

That said, we are pretty negative to stop loss orders, for a variety of reasons. The major reason is that our backtesting shows that stop-loss orders are very inefficient. Most of the time they make the trading strategy worse. Obviously, this is not what you want.

However, the type of strategy is also a factor in determining the effect of a stop loss. For example, any mean reversion strategy is likely to perform worse if you include a stop loss. Opposite, a trend-following strategy is less likely to be influenced by a stop-loss, although Curtis Faith wrote a paragraph in his book The Way Of The Turtle where he showed his backtests were negatively affected when he put in a stop. Curtis was part of the famous Turtle Trading Experiment.

Luckily there are some alternatives to a stop loss. One method is to trade smaller than you’d like (this is what we believe is the best advice ever), and another option is to diversify your strategies. Trade many asset classes, trade different types of strategies, and trade different time frames. There is a holy grail trading strategy, and that is having a portfolio of strategies.

What is the best strategy for forex trading?

There are many forex trading strategies out there. In fact, there may be more strategies than there are forex traders. Common strategies include moving average crossovers, trend-following strategies, mean-reversion, momentum, and price action strategies, such as chart pattern breakouts.

But which one is the best strategy for trading forex? The truth is that no one knows. Only you can find out the one that is best for you, our trading style, and the markets you are trading. The only way for you to find out is by back-testing the various strategies you think are suitable for your trading style on the markets you intend to trade.

Forex trading sessions

A positive thing about the forex market is that it’s a 24-hour market. It’s always open! This opens up opportunities to divide trading into different sessions.

For example, when Japan is open, how does the yen perform? Does it change when the Japanese session closes and most of the forex dealers in Tokyo go home? What happens to the GBP when dealers in the City of London go to the pub after work? Does the GBP change patterns when the same dealers go to eat fish and chips for lunch?

As you might imagine, the opportunities are many, but it’s a competitive market.

Forex trading strategy (backtest)

Making a forex trading strategy with strict trading rules and settings is a pretty difficult task. We believe the forex market is perhaps the most difficult market to trade, yet it is probably the market that most beginners gravitate toward.

It’s difficult to trade because any backtested strategy with a good historical performance and trading metrics, is unlikely to perform well in the future.

Why do beginners trade forex? We suspect it boils down to two factors: First, it offers lots of leverage that lets people with small accounts trade more (with disastrous results). Second, there are lots of advertisements that look tempting for many with little trading knowledge. This is a deadly mix! In a separate article, we explained in more detail the reasons why you should avoid the forex market.

We would love to bring you a few forex trading strategies in this article, but we are much more successful in using forex as a variable for trading other markets. For example, we trade both crude oil and commodities based on the behavior of the USD (by using UUP for example).

Anyway, let’s backtest a couple for forex trading strategies:

Forex trading strategy backtest no 1

In this backtest we are not using forex data, but rather the ETF that tracks the dollar index: UUP. We do this mainly for simplicity because we have the data at hand, but we believe it’s a useful proxy for the overall idea.

Let’s backtest the following (unoriginal) trading idea:

  • We are long UUP when it’s above the 200-day moving average
  • We flip and sell short when it’s below the 200-day moving average

Why use the 200-day moving average? We use it because it has proven to be a pretty useful trend indicator for a wide range of assets.

The equity curve looks like this:

Forex trading strategy

Unfortunately, this is not a tradeable strategy. However, both directions contribute: the average gain for longs is 1.13%, and for short 0.34%. The annual return (CAGR) is 3.5% while buy and hold is 1.44%.

Forex trading strategy backtest no 2

The last backtest we do today is a backtest we did for our paying subscribers for our weekly strategy report that we send out every Sunday. This is a report where we cover the most likely performance in the coming week for stocks, bonds, and gold. Additionally, we make a weekly backtest (like the one we provide below) plus relevant articles we have published previously. We believe the 99 USD annual cost is well worth the 2 dollars a week cost.

Ok, enough shameless promoting.

Philip Morris (PM) is a stock that is listed in New York and reports in USD. However, after Altria and Philip Morris were split into two different companies in 2008, PM is the owner of all the international business. This means that all revenue is NOT in USD, albeit it reports in USD.

This has the following consequence: a weak dollar is good, and a strong dollar lowers revenue and profits. Thus, the fluctuations of the dollar might have a huge impact on PM’s results.

We made a backtest for our paying subscribers that shows how you can make a trading strategy based on the movement of UUP. The equity curve looks like this:

Forex trading strategy backtest

There are 856 trades, the average gain per trade is 0.31%, the CAGR (annual returns) is 18% (double the buy and hold including dividends), and the profit factor is 1.6. 2008 and 2018 are the only negative years.

We mention this backtest because it’s a brilliant example of how you can use forex data in a very creative way to trade related assets.

Forex trading strategy – conclusion

Forex is the world’s biggest market, but it’s probably the most difficult asset to trade. It’s a zero-sum game where you don’t have a natural tailwind like you have in the stock market. While the stock market goes up over the long term due to inflation and productivity gains, you don’t get that effect in forex. Forex is a relative game between two currencies.

We made two backtests in this article, and we believe the best way to use forex and currencies is to use it as variable to predict future movements in other asset classes, just like we did with Philip Morris.

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