Successful forex traders always use a trading strategy. While there is no such thing as the best forex strategy, some are more popular and widespread than others. One such forex trading strategy is the trend following startegy. Below we will explain in detail how it works.
The trend following strategy in forex trading, as the name says, follows the main trends, or direction, in the value of a currency pair. To put it simply, when you use the trend following strategy, you buy when the market is trending upwards and you sell when the market is trending downwards. The goal of this strategy is to cut losses quickly when the market turns unfavorable while keeping winning trades open as long as the market direction works in favor of the investor. Traders can use different time frames (i.e. months, weeks or days) to identify the main direction or the trend in the forex market. What's important is to set a long enough time frame to determine which side is dominant in the market: the buy or the sell. Strong trends are considered ones that last longer than a year.
- The trend following strategy is one of the most common forex trading strategies
- When using the trend following strategy, you buy when the market trends upward and you sell when it trends downwards
- Identifying key support and resistance levels is crucially important for this strategy
- Use stop-loss orders as part of the trend following strategy to minimize your potential losses
How does the trend following strategy work?
When using the trend following strategy, it is important to identify the key support and resistance levels that represent the top and bottom of a given trading range. Longer time frames give strong support and resistance levels, which are key factors when determining the target and stop-loss prices a forex trader should use. The difference between your entry price and stop-loss will represent your risk, while the difference between your entry price and target price will be your potential gain. Good risk/reward opportunities can usually be found at the break of so-called countertrends, or shorter trends that go opposite a longer major trend.
The main tool of risk management when using this strategy is the stop-loss order. The stop-loss in an order type designed to minimize your losses. With a stop-loss order, you will automatically close your trading position once the exchange rate reaches a predetermined level. The stop-loss level should be determined in line with the volatility of the currency pair you are trading. The volatility is measured using the so-called Average True Range (ATR) indicator. The difference between your entry point and your stop-loss level should be more than 1 ATR. This way, a random market movement will not hit your stop-loss.
The difference between your entry point and your stop-loss will be the amount on which positions should be sized. The size of positions is given in so-called lots. Applying an appropriate position size is an important element of risk management.
In general, 1-2% risk is suggested per position. The bigger the account size, the lower the risk percentage should be. You should also monitor economic data, because major events may cause high volatility or trend reversals that could hit your stop-loss.
Read this detailed description of a forex trade built on trend following strategy.
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