Forex, also known as FX, is the global marketplace for trading currencies. It is one of the most liquid and accessible financial markets out there, and it attracts traders with various levels of expertise. Some of them prefer to rely on trading models, which offer a systematic approach to analysing and executing trades.
This FXOpen article focuses on the process of building a forex trading model. You will learn how to create a model in five steps and look at examples that might help you better understand this complex topic.
1. Defining the Trading Approach
Before traders engage in forex modelling, they need a well-defined trading approach. It should align with one’s risk tolerance, financial goals, and time resources. The various techniques to consider are:
- Trend following. This strategy involves trading in the direction of the prevailing trend in the market. Traders use technical indicators to identify trends and make trades when they coincide with that direction.
- Range trading. The goal of range traders is to benefit from price movements within specific boundaries. They usually sell at the top of the range and buy at the bottom.
- Breakout trading. Breakout traders intend to capitalise on price changes when the market moves out of a given range. Entry and exit points are determined by breakouts of support or resistance levels.
- Scalping. Scalpers make many small trades throughout the day to take advantage of short-term price fluctuations. They focus on the minimum price change in each trade.
Once traders have chosen their style and conceptualised the trading strategy, they can move on to selecting assets and analysing data. Nevertheless, the first step considered is important because the strategy clearly dictates the rules by which the model will work, the entry and exit criteria, and the level of risk.
2. Choosing the Currency Pair and Analysing Data
Once the first stage has been completed and the trader has developed a clear trading approach, it is necessary to select an asset. In the forex market, currencies are quoted in pairs, where one currency is exchanged for another, for example, EUR/USD, USD/CAD, or JPY/AUD.
Traders need to decide:
- Which asset they will trade (spot forex, forex futures, or forex options)
- What currency group they will trade (major, minor or exotic)
- What are the current market conditions that may affect specific currency pairs
The next step is to collect and analyse data, namely the historical performance of the trader’s chosen asset. A forex market model often relies on both fundamental and technical analysis. Fundamental analysis includes macroeconomic factors such as GDP growth and interest rates that influence the overall direction of the market. Technical analysis, in turn, focuses on historical price data and key technical indicators to identify entry and exit points within the broader market trend.
3. Managing Risk
Risk management is a critical aspect of foreign exchange modelling. It involves setting parameters for the amount of capital a trader is willing to risk in each trade. Two common risk management tools are:
- Stop-loss orders. A stop-loss order is an order placed at a predetermined level to close a trade if the price moves against the forecast. This limits potential losses.
- Position sizing. The size of each position is determined based on the trader’s risk tolerance and the distance to their stop-loss level. This may ensure that the trader doesn’t risk too much on a single trade.
Example: Imagine that you have a trading account with a capital of $10,000. You have decided to risk no more than 2% of your capital on any trade. If your stop loss is at 10 pips and the pip value in a mini lot equals $1, you can calculate your position size as follows:
Position size = ((account balance x risk per trade) / pips / pip value per standard lot
Position Size = $200 / 10 pips / $1 = 2 standard lots.
By using risk management tools, it is possible to limit exposure to risk and better protect your capital.
4. Model Backtesting
Before risking real capital, it’s crucial to backtest the trading model. Backtesting involves applying a strategy to historical data to see how it would perform. It serves to assess and fine-tune the strategy before the trader starts trading with real money. It also helps to identify strengths and weaknesses in the forex trading business model. The evaluation of model backtesting includes numerous metrics, the most important of which are average win, average loss, and average return, and maximum drawdown.
Forex markets are dynamic, and the trading model may need to be adjusted on a regular basis to remain effective. Traders monitor trades and market conditions and are prepared to optimise their strategies as needed.
5. Choosing the Trading Platform and Automation
To implement a trading model, you’ll need access to a trading platform. Brokers offer platforms with advanced charting tools and great order execution capabilities. One of the examples is the TickTrader trading platform. There, you can trade with tight spreads from 0.0 pips and a low commission of $1.50.
Here’s a graphical representation of a trading platform. You can access price charts with historical data, technical indicators, and order execution functions, allowing you to automate your trading model if desired.
Automation is an option for traders who want to execute orders based on predefined conditions without manual intervention. Traders can use AI-based trading tools and algorithms.
Building a model for forex trading involves defining a strategy, choosing an asset, collecting and analysing data, implementing risk management techniques, and backtesting. You can open an FXOpen account to backtest your strategy and trade using your model.
Continuous monitoring and optimisation are also helpful to adapt to changing market conditions. By following these steps and learning from examples, you can increase your chances of performing well in the market.
This article represents the opinion of the Companies operating under the FXOpen brand only. It is not to be construed as an offer, solicitation, or recommendation with respect to products and services provided by the Companies operating under the FXOpen brand, nor is it to be considered financial advice.