Two Effective and Simple Forex Strategies
Here are two simple forex strategies that get us into a trade right when the price is about to turn. By getting in when the price is likely to turn, we maximize our profit potential, and also keep risk low since we can get out very quickly if the price keeps moving against us. Therefore, these strategies provide trades with excellent reward-to-risk ratios, where we can expect to make more on winning trades than we lose on losing trades.
A favorable reward:risk on each trade is important, because we won’t win every trade. But if we make $600 or even $400 on our winning trades, and only lose $200 on our losing trades (a 3:1 or 2:1 reward:risk ratio), even if we only win 40% or 50% of our trades we will still be very profitable overall. Only take a trade, even with these strategies, if you can reasonably expect to make more than you will lose. How to determine this will be discussed below.
Add in your own analysis techniques or technical tools to determine which trades to take and which to leave alone. You may also opt to adjust the stop loss, entry or profit target levels to more align with your trading plan.
As with all strategies, keep the risk on each trade small relative to account size. As a general guideline, don’t lose more than 2% of the total account balance on a single trade.
For the strategies below, daily charts have been used. The strategies can be applied to any time frame though, such as 1-minute or 5-minute charts when day trading, or 1-hour and 4-hour charts when swing trading.
False Breakout From Ranges or Chart Patterns
A range is when a forex pair is moving sideways between a high point and low point. To consider it a range, the price should have moved into the high price area at least twice and the low price area at least twice. We need at least two high points and two low points to connect a trendline between them, highlighting the range or rectangle. The highs and lows don’t need to be the exact same price, but they should be quite close. Here is an example of a short-term range that developed in the USDJPY.
Charts courtesy of TradingView.com
The price moves down, bounces up, moves down to a similar low and then rebounds to a similar high. The price then drops a third time, moving below the prior lows (lower horizontal line) but doesn’t keep dropping…instead it rallies again. This is called a “false breakout”. The price dropped out of the range, which many traders interpret as a sign the price will continue lower. Sometimes it does continue lower, but quite often a false breakout occurs, which is when the price moves right back into the range.
False breakouts are a powerful strategy mainly because so many traders are only interested in breakouts. In the above range, many traders would have been waiting to jump into a short trade (sell) as soon as the price dropped out of the range. But if the price doesn’t keep dropping that means all those traders who went short will be in a losing trade if the price starts rising, and are forced to buy to cover their position, pushing the price up even higher.
Instead of trading breakouts when they occur, false-breakout-traders wait for the times when the price moves slightly outside a range, but then moves back into it. The idea is that if the price can’t keep moving in the breakout direction, it will likely head back in the other direction.
In the example above, the price dropped out of the range but then stalled right away. All those price bars hovering just below the bottom of the range showed there wasn’t a lot of selling pressure. This situation presents a trading opportunity.
When a pattern like this occurs we know we will want to buy if the price starts rallying back into the prior range, but we need a signal that tells us when to get in. I like to use engulfing patterns or consolidation breakouts. In this case, we would let the price drop below range…we do nothing on the breakout. If the price stalls out right away, like it did here, we then wait for a bullish engulfing pattern. This is when an up candle totally envelops a prior down candle. That is one possible entry.
Another entry is to wait and see if a consolidation develops. A consolidation is at least three price bars that move sideways. In the example, a three-bar consolidation develops just below the range. We buy if the price moves above the high of the consolidation. Take whatever entry occurs first. In this case, there was no bullish engulfing pattern, so the consolidation breakout is used, triggering us into a long trade when the price rallies above the consolidation high.
Once a consolidation has formed, if going long, place an entry order a pip or two above the high of the consolidation. This gets us into the trade if the price moves above the consolidation high. With a bullish engulfing pattern we can either wait for the bar to complete, or typically I will enter a trade as soon as I see the pattern in real-time.
If going long, place a stop loss just below the low that occurred prior to entry.
Targets may be placed in multiple ways. The simplest place for a target is at the other side of the range. Don’t place it exactly at the other side though, place it in the “crotch” of the price bars. The crotch is the turning point at the top of the range, and is usually associated with a number of open and closing prices in the same area.
By placing our target in the “crotch” at the opposite side of the range we increase our chance of being able to get out of the trade with a profit. In this case, the reward:risk on the trade ended up being 1.5:1. That is the absolute minimum we would accept on a trade. Since we know our target, stop loss and entry price at the time of the trade, we would skip it if the reward:risk was less than 1.5:1. Ideally, we prefer trades with 2:1 or higher reward:risk ratios.
An alternative profit target method is to assume that the price will breakout the opposite side of the pattern. In the USDJPY example, we would place a profit target above the top of the range. The likelihood of getting out of the trade decreases, because the price has to move a further distance. But, we are compensated by a much bigger profit if the price in fact breaks to the upside. For more on this style of trade, see Predicting Chart Pattern Breakout Direction.
Ranges aren’t the only pattern we can do this with. Triangles are another common pattern that we can watch for false breakouts in. Below is an example of a short trade that occurred on a false breakout above the top of a triangle pattern. Once the price started to drop again we would be waiting to go short, using a consolidation breakout (consolidation forms and then the price drops below consolidation low) or bearish engulfing pattern to signal our short trade.
In the AUDUSD example, there was no consolidation. The price pops above the top of the highest point of the triangle, and then starts to plummet, forming a bearish engulfing pattern. I prefer to take these trades as soon as I notice them, which would mean taking a trade as soon as the price passed below the open (or low, your choice) of the prior up candle. If we didn’t do this, and waited for the bar to close, in this case the price would have already dropped to the bottom of the triangle and we would have given up much of our profit potential.
If we opted to take this trade, we would need to place our target below the triangle (assume a downside breakout) in order for our reward to justify the risk. Our stop loss is placed slightly above the recent high that occured just prior to entry.
Several targets have been placed at various reward:risk ratios. How do we know whether we should place our target outside the pattern or in the crotch?
Notice the difference between this false breakout and the one discussed above. The USDJPY false breakout below the range, took a lot of time to start moving back to the upside. It wasn’t violent. The false breakout in the AUDUSD was violent. On false breakouts like the USDJPY the price is moving in a choppier and meandering fashion, and therefore the crotch target works better. When we have a very violent false breakout, like the AUDUSD example, we are more likely to see the price break through the opposite side of the pattern. Therefore, with these violent patterns we can usually place our target outside the opposite side of the pattern.
When we have a violent false breakout on one side of the pattern, I often even assume that the breakout on the other side of the pattern will be large. Therefore, I am not typically shy about placing a target well outside the pattern and attempting to extract 3, 5, or even 6 times my risk.
Simple Forex Strategies – Trend Trading
With the above strategy, the initial breakout wasn’t traded. Rather, we waited to see if a false breakout occurred, and if it did we traded that. But sometimes the price does breakout of a range, or other chart pattern, and proceeds to move in that direction for an extended period of time. When a price makes higher swing highs and higher swing lows, the price is moving in an uptrend. When the price makes lower swing highs and lower swing lows, the price is in a downtrend. Not all trends start from a breakout, but they may.
The chart below shows an example of an uptrend. Each swing high is higher than then last swing high, and each swing low is higher than the prior swing low.
Trends tell us in which direction to trade—in the trending direction. Also, since we know that uptrends make higher highs and higher lows, we can use that information to our advantage for placing entries, stop losses and targets.
The following is a low risk trend trading forex strategy but it requires evidence that a trend is actually in place. In case of a uptrend, we need to see a move above a former high, a pullback which stays above the prior swing low, and then a move back higher. That provides sufficient evidence for me to start looking for buy signals once this pattern has developed.
Once we have seen price make the required moves, we then look to buy on the next pullback (move lower). As long as the price is making higher highs and higher lows, we continue to buy on the pullbacks, in the way shown below.
For a downtrend, we want to a see drop below a prior low, a pullback to the upside that stays below the prior high, and then another drop to a new low. Once that pattern has appeared, we look to enter short on the next pullback. We continue to do this as long as the price is making lower lows and lower highs.
Use the same entry signals that were used for the false breakout strategy: a engulfing pattern or a consolidation breakout that sees the price move in the trending direction. The signal must occur during a pullback. Unfortunately, lots of these signals may occur during a pullback, so which signal do we take?
We will never be right all the time, but we can improve our odds by using a few tools. A trendline is helpful at times, but only if the price has been bouncing off the trendline during the trend.
Place a stop loss slightly below the swing low that formed just prior to entry. A target goes slightly above the prior swing high. This target is the most conservative, and gives us the greatest chance of getting out with a profit. A more aggressive approach is to try to extract more profit by placing the target at a higher price. The video Fine Tuning Profit Targets describes how to do this. The chart below shows where stop losses and targets would go using the simple approach.
Trendlines aren’t always effective, as the swing lows may not line up for a trendline to run along them. When this happens, we can look to utilize other tools to help us in our trading decisions. We want the trend, plus the trade signal, plus some other piece of evidence that tells us which trade signal to take. Such tools include typical retracement levels, an indicator such as the RSI (I don’t personally use indicators), or velocity and magnitude.
Sometimes slightly changing the trajectory of the trendline can make it useful, when at first it doesn’t appear so. The chart below shows a downtrend, but if we simply connect the trendline to the exact high points, the trendline quickly loses its usefulness. We get one trade out of it, but we could have more.
If instead we remember that we only need the trendline to alert us to a general trade area, we can run the trendline through the swing highs (or lows in an uptrend). The trendline doesn’t tell us to get into a trade, it just tells us when we should be looking for opportunities. And if we run the trendline through prior trade areas, it is doing exactly that. Once the price is in the trendline area, we can then look for our trade signal (engulfing pattern or consolidation breakout).
The chart below shows the adjusted trendline, moving through our initial trade areas. By making this small adjustment, and altering the trajectory of the trendline slightly (but it still aligns with the price action) we are often able to use the trendline more effectively and potentially extract more trades. This adjusted trendline gave us two more trades, and we could have potentially even had another–right after the first trade–as the price comes close to the trendline (but not as close as the other trades) and then formed a consolidation.
In the chart above I have included a variation of the engulfing pattern. If a trend is strong, and in this case it is quite strong to the downside, and the price is near an area where I want to get short (a trendline which has worked well in that past, in this case), I will sometimes take trades based on multi-day engulfing patterns. On the USDPLN chart the price rises to the trendline on a strong up bar, but then the price falls for the next three days, totally erasing that big gain. Even though the whole pattern took four days, not just two, it still shows that the price is likely heading lower based on the other evidence. That is all engulfing patterns and consolidation breakouts tell us–that the price is likely to start moving in our expected direction. Any other reliable price pattern, or variation of these patterns, that tells us that can be used as an entry signal.
Only take trades that can reasonably provide at least a 1.5:1 reward-to-risk ratio, and preferably take trades that offer 2:1 or greater.
You may also like the Strong Trend Reversal Strategy.
These two simple forex strategies present a template on which to build your own, individualized, trading strategies. The trend strategy is the most important because that is where most of the money is made. Ranges do frequently develop as well, and watching for false breakouts capitalizes on them. The downside is that by waiting for false breakouts, legitimate breakout trades may be missed. Having a trend strategy and a false breakout strategy in your trading arsenal allows you to adapt and stay profitable in all types of forex market conditions.
By Cory Mitchell, CMT