Simple Forex Strategies
There are 4 strategies beginners can use to trader Forex:
- Carry trade
- Utilizing moving averages
- Trading interest rate decisions
- Using Purchasing Power Parity indicator
Before moving on to the simple FX trading strategies for beginners, there are some fundamental principles that have to be mentioned. Firstly, as a part of risk management, the majority of experienced traders do not recommend risking more than 5% of the capital per trade. This limits the potential downside of losses.
Another important factor to consider before starting trading is leverage. Many professional Forex traders do not advise beginners to trade above 1:10 leverage. This essentially gives some breathing space to people who just started trading, so that they can survive market volatility without taking huge losses.
Before the 2008 Financial Crisis, there were many brokers who offered 1:200 or even 1:400 leverage. However, by 2010 the US Commodity Futures Trading Commission introduced regulation setting the maximum limit of leverage at 1:50 for the major currency pairs and 1:20 for non-major pairs.
To illustrate why those two factors are important, let us use an example. Suppose that a trader has deposited $10,000 into a trading account. If he or she ignores those two principles, it opens the long EUR/USD position with his entire money with 1:50 leverage.
Under those circumstances, it takes only a 2% decline of pair for the trader to get a margin call and lose all of the funds. This kind of currency fluctuation is not very rare, especially during some major announcements EUR/USD can move even by more than 2%. So potentially traders can lose the entire deposit in a single day.
Now let us consider a scenario, where he or she takes those principles into account, opens a long EUR/USD with $500, which is 5% of funds, and uses only 1:10 leverage. In the case of 2% of the exchange rate, the trader will be down only by $100 and there will be no margin call. Depending upon the situation It is possible to either cut losses and take 1% loss or keep the position open and wait for a reversal.
So as we can see, those might seem like small adjustments in setting, but proper risk management can make a difference between losing $10,000 or just $100.
Carry trade is a famous and simple Forex trading strategy. The basic idea behind this is to buy high-yielding currency against the low-yielding currency. As long as the position remains open, the broker will pay the interest rate differential to the client. This is also called a ‘rollover swap rate’. Every broker might have different rates, for example, Axiory publishes the latest updates on its website.
So the trader can take a look at the latest interest rates of major currencies, get a full picture of the latest trends. Let us take two examples of USD/JPY and USD/RUB.
The higher end of the Federal Funds rate range is 0.25%, the bank of Japan keeps its key interest at -0.1%. Therefore, the differential between the two is 0.35%. The Bank of Russia’s interest rate stands at 6%. So the spread between USD and RUB rates is 5.75%.
So how can this work out? Well, in case USD/RUB, if a trader opens a short position with $10,000 with 1:10 leverage and if the broker offered a 5.75% rollover rate, then he or she would earn $15.75 per day, which is $472.60 per month and would accumulate to $5,750 in a year. So essentially it is similar to have a 57.5% CD but with the principal at risk.
Obviously trading emerging market currencies can be riskier because some of them have a great deal of volatility or history of long term depreciation. This is why for many years the Australian Dollar and New Zealand dollar were favorite currencies for carry traders. Unfortunately, with the COVID-19 outbreak, both of their yields have been cut to 0.25%.
It is worth also noting that the majority of brokers do not offer rollovers which exactly matches the interest rate differentials, usually, it is slightly lower. However, since there are plenty of options, traders who do carry trades can look for the one with the most competitive rates.
Some traders looking for a simple winning Forex strategy turn to analyzing moving averages. The Simple Moving Average (SMA) formula is calculated by the average closing price of a currency pair over a specific number of periods.
For example, to calculate 20 SMA, one has to sum up the last 20 closing prices of a currency pair and divide it by 20. Usually 5,10 and 20 days simple moving averages are considered short term indicators. While most long term traders look at the 200-day SMA.
Basically this simple Forex strategy involves looking at several currency pairs and their Simple Moving Averages to identify strong trends. After opening positions based on this, a trader might consider closing the trade if SMA changes direction significantly because it might point to reversal.
It is not a secret that everything else being equal the higher-yielding currencies are more attractive to traders and investors than lower-yielding ones. Consequently, currencies with rising interest rates tend to appreciate against its peers. Therefore, trading potential rate changes can be another simple strategy for Forex trading.
So how can we forecast those types of changes? Well, every major central bank in the world has some sort of target for the annual inflation rate. So by monitoring the latest Consumer Price Index, one can get some idea of how close it is to the intended aim. Major divergences are something that could trigger a change in the policy.
For example, the Reserve Bank of New Zealand has a target range for CPI from 1 to 3%. So if the latest reports show that the inflation rate in the country is 4% or higher, then perhaps it might be likely that the central bank will start hiking rates. As a result, the New Zealand Dollar will become a higher-yielding currency. This might be an appropriate time to expect a rise in NZD/USD, NZD/JPY, or similar pairs.
Here it might be helpful to keep in mind that central banks also take note of other economic measures like unemployment and Gross Domestic Product growth rate. Returning to our previous example about NZD, if the unemployment rate is very high and the country is in a recession, then the Reserve Bank of New Zealand might decide that 4% CPI rise is only a temporary phenomenon and therefore abstain from the interest rate hike. So it is always helpful to keep an eye on other economic indicators as well.
Purchasing Power Parity
Another simple profitable Forex trading strategy is to compare the current exchange rates to the Purchasing Power Parity levels. This represents a rate at which the average prices of goods and services can be equalized. Therefore, if the currency trades below PPP, then it is considered undervalued and when its exchange rate is higher than Purchasing Power Parity, then it is considered overvalued.
This does not necessarily mean that Forex will always follow PPP, however, in the case of major pairs most of the time currencies move within plus or minus 20% range. Let us take a look at the USD/JPY long term chart.
The purple line shows the actual market exchange rate, the blue one denotes the OECD estimate of Purchasing Power Parity levels for each year. For the purpose of better visualization, there are upper and lower bands, represented by red and green lines respectively, which are located 20% above and below the PPP level.
Despite significant early undervaluation at the beginning of the millennium, the USD/JPY recovered and traded closer to the Purchasing Power Parity levels. In fact, as we can see, nearly 90% of price action takes place well within those PPP bands. Essentially, every time the pair became more than 20% undervalued, it eventually made a significant move, closer to the Purchasing Power Parity. There was also a brief period of overvaluation during 2015, however, USD/JPY fell back and eventually settled near the blue line.
So the simple Forex strategy that could work here is to take a look at the OECD PPP rates, compare them to the present market valuations and choose currencies, which are significantly overvalued or undervalued and place trades accordingly.
This is indeed a simple Forex strategy for beginners, however, it might be helpful to keep in mind that PPP is most useful for longer-term trades. On a daily basis, the currency pair can diverge wildly from the Purchasing Power Parity levels, and very often it might take weeks before the balance can be restored.