Trading strategies

Matching how you trade to market conditions can make all the difference

Choosing a strategy can be the most interesting trading decision you make – but knowing when to change it is often more important. So what strategy works in each kind of market, what signals suggest that conditions could soon change, and what are the most common mistakes that retail traders make?

Long-term trend trading is one of the most profitable strategies around, but it is sadly under-used, says FXCM's Drew Niv. Apart from 2006, it has worked well since 2002,' but a lot of retail investors don't like the strategy, because it's boring.

Cash and carry

Carry, meanwhile, is historically the most profitable FX trading strategy, although now is not the right time, he says.

The strategy involves selling a low interest-rate currency and using the money to buy a currency that yields a higher rate. If for example a trader sold a currency with a 1%interest rate and bought another with a 5%interest rate, he would earn 4%, as long as the exchange rate between the currencies did not change.

Carry worked flawlessly from early 2003 to the first half of 2007, but 'has probably had its worst time ever over the last nine months,' Niv says. And the people who have lost money are those who didn't read the signs in August and get out fast. 'They've worked so well that people are having a hard time letting go.'

Carry trade has very hard rules, where if you see option volatilities go higher, and risk reversals go negative, it's time to unwind, he explains. So for investors who think the strategy might suit them, 'all you have to do is watch those options volatilities, watch those risk reversals, and when they snap back to normal, you can get back in.'

'The carry trade methodology has worked over time,' says Deutsche Bank's Russell LaScala. 'It doesn't work in a high-volatility environment, but I think if we see volatility come off – if we have a quiet summer – we're going to see people come back.'

'There has been a major shake-out in the carry trade theme, with most if not all of these positions being closed out in recent months,' says Tom Nagle at Saxo Bank. 'I think, over time, these carry trades could begin to re-emerge but it will take time for the market to regain confidence in it'

Home on the range

Range trading works best in quiet markets, as experienced in the four or five years prior to last summer, says Niv. Unfortunately, 'it is probably the single most mis-used strategy by retail clients.'

With its reliance on selling tops and buying bottoms, 'it seems the most logical to people who come from an equity-based background,' but too many use it on volatile pairs, he says.

And in a highly leveraged arena like FX, this can be disastrous. Too often traders hang on to a trade even after a range has been broken, waiting for it to return. 'This is the reason why a lot of people lose money, but it is actually a very successful strategy if people employ it in very quiet boring pairs.'

Time to break-out

Break-out trading, where key barriers are repeatedly touched then move swiftly in the same direction once broken, has worked well in current markets, says IG Index's David Jones. 'Investors watch for a break in these levels and look to trade in the direction of the break.'

The pound against the US dollar for example has struggled with the $2 level this year, approaching it in January and February but then being knocked back. 'When it broke $2at the beginning of March, it quickly moved 400 points higher.'

However, 'where markets like that will tend to fall down is when a market just gets really choppy – goes sideways,' Jones adds. And this is where stop losses become important.

The euro-dollar has been on an uptrend and could reach 1.70 in the longer term, notes Sandy Jadeja at ODL Securities. 'One of the best ways that novice traders could have played that is to simply keep buying the pull-backs, or the break-outs – either one of those would have worked.'

'Most people trade FX technically, and 80% of technical indicators are basically break-out trends,' says Niv. Break-out trading only works well in volatile markets, meaning this strategy is hugely popular now, and have been the best strategies of the past nine months, says Niv, while for the two years prior to that they were 'awful'.

One downside of break-out trades is the long losing streaks investors sometimes have to endure. 'You must have tight stop losses and lose five or six times in a row to get a win. You've got to ride that winner.'

The strategy also demands strict discipline, he notes. 'When the market goes quiet, people really need to stop using it. In2006 you would have lost your shirt.'

Play for today

FX trading is currently dominated by short term trading and day trading, says Nagle. 'For this style of trading I think the old three to-one rule of thumb for risk-reward is not entirely appropriate because many day traders will happily take profits between one and two times their initial risk.'

Day trading by its very nature involves quite a high turnover – or number of trades –and lower margins, meaning day traders tend to take their profits when they see them, and then start again, he adds.

'This tendency towards day trading may unwind over the next six to 12 months when the overall economic climate improves and some trends begin to unfold in the FX majors,' Nagle says.

'It would be good to see a return to the FX markets of the '80s and early '90s when we saw wild swings throughout the year and daily FX movements of 3% to 5%, but it's very unlikely.'

Ultimately, the only strategy that works is going to be one that suits you – that fits your lifestyle, complements your personality and meets your objectives. This means choosing a combination of all the above – rather than sticking to one rigidly – might just be your best bet, says Marilyn McDonald at IBFX.

©Taken from Shares Magazine Forex Feature 2008.