Trading Styles Appropriate in Different Market Types

Chapter progress:

by Vicki Schmelzer

Finding Your Own Rhythm and Beat

You are intrigued by the Forex market and want to try your hand at trading. One of the first things you must decide is what kind of trader you want to be. Do you like trading in a 9 to 5 environment where you do not get text messages or calls about stop-loss orders in the middle of the night? Then, perhaps you would do better as a "day trader."

Are you technically oriented? If you like looking at such indicators as moving averages and Fibonacci retracements and do not really care about fundamentals and flows, then you might like being a purely "technical trader." Maybe you have no problem handling risk and have the stamina (i.e., "balls of steel") to hold positions in situations where there might be more volatile price swings. Then you might be a longer-term trader.

If you are not sure about your personal style, you will soon discover which style suits you best, although that might come at a financial cost. Some websites offer lists of examples of trading styles (position trader, technical trader, day trader, trend trader, etc.) with examples of traders who utilize that style (Warren Buffet, Paul Tudor Jones, George Soros, Paul Rotter, etc.). Such examples are good for their specifics, but suffer from simplification and generalization. We will go into greater detail about some of these strategies in the next lessons of this chapter.

Short-Term Versus Long-term

Most speculative traders in the spot foreign exchange market will be day traders or take positions that are short-term in nature. They want to enter and exit a trade during the day or over the course of a week, or at most two or three weeks. Day traders and scalping traders will fall into this camp, although technical traders might also.

The other strategies, including technical trading, fall into the longer-term camp, which might range from a few weeks to a few months to a year or more, depending on the time horizon for the position.

Big Versus Small

When entering into a position, after having decided which currency to buy or sell, a trader has to decide what size position to hold, within the limits dictated by his or her bank, institution, or platform. Someone taking a punt on a currency pair five minutes before the release of US nonfarm payrolls or a European Central Bank announcement might opt to take a smaller position, say a quarter or no more than half of X, X being the position limit. This is because the risk/reward in this situation is great. It is basically a coin toss. Even if the trader believes he knows how the market will react to the data outcome or central bank decision, the risk is too great to put on a larger position. Conversely, let's use an example of a currency pair that has fallen far below what the market sees as fair value. In addition, speculative positions are wildly short and the chart indicates the currency is oversold. In this situation, a trader might feel more comfortable using something close to his full limit.

Pro tip: It is hard to recover from a losing position. When traders lose money, they tend to panic and make bad decisions. It is better to start small and once successful, build up to larger positions. It is always a bad idea to put on a larger position ahead of a key event. It is better to save the big guns for an opportunity when technicals, fundamentals and flows are more in the currency's favor.

Combined Strategies

Most traders, whether short-term or long-term, use a combination of strategies. A day-trader may decide that, based on fundamentals, the euro is too low. However, if the pair is trading below a key technical support level, the trader may chose not to buy. Similarly, a carry trader may want to go long euro-yen, but feels it is necessary to wait until after the Bank of Japan meets just in case the central bank is more hawkish or less dovish than expected. Longer-term players may like a euro short position because they think the US economy will outperform the eurozone economy. And yet, if positions are already heavily short euros, they may prefer to wait for a euro rally towards a key technical resistance level before actually putting on the euro short trade.

What Strategy and When?

There are days and sometimes months where currencies just do not move or remain largely rangebound. Under these circumstances, positioning for a big picture change in trend and or a more fundamental shift in sentiment just does not make sense. Day traders thrive in this environment since they have become adept at spotting short-term trends. In rangy trading, where volatility is low, technical analysis tends to shift also.

In a trending environment, technical indicators such as the 200-day moving average or relative strength index (RSI over 70 or under 30) would tend to play a larger role, but in a non-trending environment, a more successful strategy might be to look at the 55-day moving average or even 5- or 10-day moving average. The default period for RSI is 14 days but this too can be decreased (or increased for a bigger picture view) to increase (decrease) sensitivity. When currency markets are not moving, some traders go long a higher yielding currency (say currency A) and go short a lower yielding currency (currency B), which is one example of a "carry trade." Each day that passes, the trade makes a profit on the interest rate differential between currency A and currency B. Even though the spot prices may not move much, over time, the trader makes a profit.

Other times, big picture trends emerge, such as when a central bank embarks of a series of rate cuts or rate hikes. If Central Bank A is raising rates and Central Bank B is on hold or lowering rates, going long currency A versus currency B may make sense. In the case of the US financial crisis, and later the eurozone crisis, once it became clear that the interest rates in the developed nations would remain low for a long time, the quest for yield and return sent global investors into emerging market currencies. The fact that this would be a long-term trend was not clear initially back in 2008, but emerging market currencies benefited for nearly five years.

Quiz:

1. What trading strategies are compatible and can be combined?

2. Most speculative trading in spot Forex by bank professionals is short-term (the spot date up to several weeks).

3. When is the best time to put on a larger position?

4. A range-trading environment is best for putting on a carry trade.

Done