Short term FX market movement is essentially random. A Forex Trend is when average prices increase or decrease in the same direction over time, even though there may still be short term random price movement. Trend following is the basis of successful FX trading.
Changes in seasons illustrate the nature of exchange rates trends. When the season changes from winter to summer, there may be some cold days, but the average temperature increases over time, until it starts to gradually decrease (but with some warm days) as the seasons change from summer to autumn and back to winter.
Trends occur in FX markets for several reasons. Firstly, traders gradually assimilate information on long term economic changes and often change their price expectations in one direction over time. Secondly, price movements tend to be self perpetuating. When a trend is detected, traders follow the trend which reinforces it. This is an internal feedback loop within the market.
Following a trend is different to price forecasting or market prediction. Price forecasting is identification of patterns that generally lead to a future increase or decrease. This is very difficult to do.
In contrast, a forex trend following doesn’t involve prediction but simply recognition of the trend. The continued existence of the trend is a result of the nature of trends rather than any forecasting. This is similar to watching a wave. You don’t need to do any careful forecasting to know that the wave will move ahead and hit the shore – it is in the nature of a wave to continue until something stops it.
Within FX markets, there are short term, medium term and long term foreign currency trends. These are defined by the duration of the trend, as well as the amount of market movement. A long term trend has a duration from six weeks to several years and has market movement of 200 to thousands of pips. Within the long term trend, there are short and medium term trends. These may be in the same direction as the long term currency trend, or against it.
A medium term FX trend is generally from a week to six weeks long, with a market movement of 60 to 200 pips. A short term trend ranges in duration from half an hour to a week, with movement from 10 pips to 60 pips.
We generally recommend that you aim to trade medium term and long term trends in FX markets. Why? Because it is easier to identify the longer term trends, broker costs are lower in proportion to profits, and it requires less attention to the market and trading. We are not aware of many successful short term traders, outside of professional traders who have very low transaction costs.
The drawback of longer term forex trend trading is that you may need to withstand short term trends moving against you. Your trading system will set a stop loss that allows you to benefit from the trend whilst protecting your capital from a major movement. This stop loss will need to be fairly large.
This is why you need to avoid overtrading. Overtrading is opening too many positions relative to the margin in your account. For example, if you have $10,000 in margin you could theoretically open 10 positions. We recommend that you open only 1 or 2. This will give you plenty of margin to withstand short term movements against you while keeping you in the market to take advantage of longer term trends.
Professional FX traders such as hedge funds will only trade a small number of positions relative to their trading capital compared to amateur traders. This is one reason that most small FX traders do not last in the market.