Trading Concepts
Choosing the right concept is also a large part of system development. Not all concepts of trading are good for every trader. Some traders feel more comfortable trading in direction of the trend while others feel more secure trading against it. This has something to do with the personality of each of us.
It is not unusual for Forex traders to mix concepts, sometimes traders use different concepts for different market conditions (i.e. to have a way to determine whether the market is trending or not, then choose the appropriate system).
Trend-following
This concept simply waits for a significant price movement then buys (or sells) on the hope that the price will maintain its trend so the trader will be able to sell higher (or buy back lower).
The trader must use a systematic approach to measure the trend. The accuracy in which traders measure the trend will dictate the systems performance.
Advantages:
Trades in direction of the trend have a higher probability of success.
When a trend is caught, trades usually make large profits.
Trend-following systems usually have a very high RR ratio.
Disadvantages
It is said that the market trends only 30% of the time
Trend-following systems usually have low system accuracy.
Trend-following systems get whipsawed during consolidation periods.
Common strategies:
Breakout trading: After a period of consolidation, traders buy new highs or sell new lows (i.e. using entry orders).
Pullback trading: Traders wait for pullbacks and buy or sell off important levels (Fibonacci retracement, Bollinger lower or upper band, LOPS, HOPS, etc.)
MA strategies: Some traders use moving averages strategies (crossover, position of price in relation to MA) to trade this systems.
Chart patterns: Rectangles and triangles are used to trade trends.
Technical indicator signals: Many technical indicators can be applied to this type of trading (i.e. RSI centerline crossover, CCI extreme levels, ADX, etc.)
Counter-trend
This type of trading tries to profit from either a short-term reversal or a long term reversal. Short-term reversals are often called retracements. This strategy basically tries to buy at a reversal pattern (trend to reverse is a downtrend), or tries to sell at a reversal pattern (trend to reverse is an uptrend).
Advantages
If the signal is correct, the entry price is close to the high/low of the reversal.
Usually high RR ratios are used in this concept.
Disadvantages
Trades against the direction of the trend have a higher rate of failure.
Sometimes trying to pick the bottom or the top of the trend can lead us to have an even higher rate of failure.
Common strategies:
Chart reversal patterns: Double tops and bottoms, head and shoulder and other reversal patterns can be used.
Divergence trading: This signals when combined with price behavior tend to give a high accuracy rate.
Consolidation or Range Trading
A period of consolidation occurs when demand meets supply. It is also called sideways or ranging.
Advantages:
It is said that the market stays in consolidation periods 70% of the time.
Stop orders are placed close to the entry price
Disadvantages
Extreme volatility may occur during these periods
Sometimes the high and low of the range are not clearly defined
Common strategies
Indicator overbought/oversold condition: Stochastics are the most effective indicator to track overbought/oversold conditions.
Buy at the bottom of the range/sell at the top of the range: When applied in combination with price behavior, this technique usually has a high accuracy.
If you are going to trade different market conditions then it is important that you use different strategies, most trend-following strategies will fail under consolidation periods and most consolidation periods strategies will fail when a trend is in place.
Take for instance: You have decided to use a MA to determine the trend of the market. Therefore, when the market is trending (price above/below the MA) you use a trend-following strategy. In addition, when the market is not trending (the MA line is flat or close to flat) then you use a consolidation strategy.
Also, when you use a counter-trend strategy, for instance a chart reversal pattern, if it was a valid pattern and the trend reverses, then you can use an exit strategy based on a trend-following system so you are able to catch most of the trend.