Building the Perfect Forex Trading System in 5 Steps

system trading

A trading strategy is a method of trading forex, stocks or cryptocurrencies that are based on a series of analyses to determine whether to buy or sell a financial instrument and set procedures to determine the entry and exit strategy as well as risk management. Trading strategies can be based on a set of signals derived from technical analysis charting tools or fundamental news-based events.

Types of Forex System Trading

Forex trading systems can be either manual or automated. For most day traders, a forex trading system is usually made up of technical signals that create a buy or sell decision when they point in a direction that has historically led to a profitable trade. The system is generally a trading plan that outlines what a trader should do when the signal is identified and trading journal that captures what was done and why for future analysis and refinement of the system. This is manual forex system trading that anyone can engage in. Running a manual system involves sitting at the computer screen, looking for signals and interpreting your trading plan to decide what to do.

>> See an example of an accurate forex trading system with 90% positive signals.

In an automated forex trading system, the trader teaches the software what signals to look for and how to interpret them. It is thought that automated trading removes the emotional and psychological components of trading that often lead to bad judgment. Automated forex system trading, known as Forex Robot or Forex EA, tends to reduce human error and reduce reaction time when certain levels are breached. More complex automated systems also come with common strategies and signals loaded in so the trader can combine several approaches in their system with relative ease.

Automated trading systems typically require the use of software linked to a direct access broker, and any specific rules must be written in that platform's proprietary language. 

Continue reading or play around with an Expert Advisor Generator and build automated forex trading systems in a couple of clicks without writing codes.

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Building the Best Forex Trading System

Step 1 - Begin Your Search On Longer Time Frame Charts, Then Zoom In

Here’s the basic idea behind how we locate simple, low-risk, high potential trades. Start your search for low-risk trades by scanning charts with time frames that are 4 to 5 times longer than the time frame from which you intend to trade. The first goal is to find low-risk entry points by identifying the long-established, and therefore most reliable, support and resistance areas (s/r) because they’re where the risk of opening a position is lowest. Here’s why.

If price breaches long-term strong support, that’s a clear signal that price is moving decisively against you. By entering close to strong support, you can also set your stop-loss order relatively close to that support, so that you escape with only a small, affordable loss, ideally, one that is ever less than your maximum allowed a loss of 1 to 3 percent of your account.

Like a bird of prey, you begin your hunt where you can view lots of territories. The longer time frame chart allows you to view key s/r points over months or years. Then, if you see something interesting (a pair approaching one of those levels) you swoop in for a closer look at the shorter, time frame chart from which you actually trade, in order to make your final trading decisions. That’s where you’ll see if you’ve got a situation that combines a low-risk entry near strong support, with a likely resistance area far enough away from your entry point so that you have a good chance of earning three times as much as what you’ll lose if your stop-loss is hit, for a 3:1 reward/risk ratio. 

>> For support read also What is forex and how does it workhow to trade Bitcoinhow to trade Gold and how to trade Stocks guides

Step 2 - Consider the Fundamental Context

Note that the longer you think the trade will need to play out, the more important it is that the trade fits with your fundamental analysis for your planned holding period. This is less important if you think the trade will last less than a week or so unless you’re trading based on a specific news item that’s due out during that time. However, trades that may take weeks or months are typically based at least in part on some theory you have about how certain fundamentals are likely to play out.

For example, you go long the AUDJPY because you believe markets will be optimistic over the coming weeks or months (favoring risk over safety currencies), or you believe Australia’s economic data will be much better than Japan’s.

>> To better understand how to read the news just use our forex factory calendar guide.

Step 3 - Initial Screening on Longer Time Frame Charts

The purpose of your first screening is to find a currency pair that meets the following four criteria:

  • Risk Management Criterion #1: The currency pair is approaching a strong support area that provides a low-risk entry point. For example, by definition, strong s/r levels on a weekly chart will be even stronger on a daily chart, because they’re more established than the s/r levels you see on daily charts. You then set your stop loss just far enough beyond this area so that it doesn’t get hit by random price movements, but rather only when the price has turned far enough against you that you know you were probably wrong about the trade and it’s best to escape with a small loss. Thus the stronger the s/r area where you enter, the lower your risk of a losing trade (barring any unforeseen change in fundamentals and sentiment). Once you know your likely entry and stop-loss points, you can check if the trade may meet your second criteria
  • Risk Management Criteria #2: Find the nearest major resistance area, because that’s where you’d expect to exit and take profits. If the distance from entry (at support) to exit (at resistance) is 2 to 3 times farther than the distance from entry to stop loss, then you may have a 2:1 to 3:1 reward/risk ratio (rrr). We’ll know for sure only when we do the second screening.
  • Risk Management Criterion #3-Stop Loss Placement: The stop loss should be far enough away from your entry point so that it does not get hit by normal random price movements, but only by larger moves against you that suggest price may be making a sustained move against you.
  • Money Management Criterion #1: The stop loss should be close enough to your entry point so that you don’t lose more than 1-3 percent of your account on the trade.

For an advanced forex trading system, these are the first criteria for low-risk, high-reward trades. Remember that definitions of support and resistance are the opposite for short and long positions.

Again, we scan for situations that look like they might fulfill the preceding criteria on charts with a time frame approximately four to five times longer than the time frame on which we trade. For the examples that follow, we trade off daily charts, so we scan weekly charts in the first screening.

This first screening doesn’t take long because we generally prefer to trade only the most liquid pairs. There are only about eight really liquid pairs, and maybe about 20 liquid enough for most of your trading.1

In short, we’re scanning the weekly charts of these pairs for an entry near strong support, with any likely resistance far enough away so that there’s a chance of getting a 1:3 or 1:2 risk-to-reward ratio (rrr).

As we’ll see, the deciding factor in whether you take the trade is if the second screening on the daily charts shows you can get a combination of stop-loss, entry, and exit points that allow the desired rrr yet does not cost you more than 1 to 3 percent of your account if the stop loss is hit.

For the purpose of illustration, assume just one entry and exit, and mostly avoid consideration of variations like trailing stop losses and partial or staged entries and exits.

When we talk about strong support or resistance, that means we want to see at least one well-tested kind of support, ideally as many kinds as we can get, all converging on a narrow price range. Just to remind you, these include:

  • Prices that have clearly been support or resistance in the past; often these are some kind of round number because traders tend to think in round numbers.
  • Trend lines and/or their variations like channels, moving averages, and Bollinger Bands.
  • Fibonacci retracements.
  • Chart patterns, besides being useful in their own right, also provide additional evidence of s/r points. For example, if a head-and-shoulders pattern is about to complete its second shoulder or if the price is about to hit the neckline of that pattern, that price level takes on added significance as a possible s/r point.

Again, there are many more accurate forex indicators you could use, and we haven’t even covered momentum indicators yet. But these give us enough for some trading examples from our trading guides using the above links.

Step 4 - Second Screening

Once you’ve found some situations that meet these criteria on the weekly charts, the next step is to see if the same criteria for low-risk, high potential reward trades are present in your chosen time frame, in this case, daily charts.

Why bother with the first screening? As noted previously, the longer time frame chart shows you stronger s/r levels. We’re hoping to find an entry point on the daily charts that is near the stronger s/r areas found on the longer time frame, in this case, the weekly charts. If we find that a pair nears its weekly s/r, we’ll know it’s worth doing a second screening on the daily chart.

Again, the deciding factor in whether you take the trade will be if the daily chart (or whatever timeframe from which you trade) shows the combination of stop-loss, entry, and exit points that allow the desired rrr, yet will not cost you more than 1 to 3 percent of your account if the stop loss is hit. To reiterate:

  • The stop loss is far enough past strong support so that it would get hit only by strong price moves that signal your trade idea was mistaken and close enough so you’re out with a small but affordable loss that doesn’t exceed 1 to 3 percent of your trading capital, so you can afford lots of mistakes, recover your losses, and be profitable
  • It’s two to three times closer to your entry point than is your profit-taking point, so you have a 1:3 or at worst 1:2 rrr.

Regarding stop loss placement, remember that there are different methods. These include:

  • The Intuitive Approach: Study the chart for the relevant period and define the price range for the normal up and down oscillation of price. You want your stop loss to be no closer to your entry point than that distance, ideally, a bit more than that, while still not causing a loss greater than your 1–3 percent limit. This is a very simple approach and hence the one we choose to use in the example that follows. This method involves a heavy dose of personal judgment.
  • The Somewhat More Objective Approach: Set distance from the entry point to stop loss based on fixed percentages (also a judgment call) of the Average True Range (ATR), or other formula or statistically based methods to ensure you don’t get shaken out of your trade due to normal price fluctuations.

Regarding rrr, if the trade is in the direction of a very strong trend, it’s safer to be more aggressive, so we’re more likely to accept a 1:2 rrr.

In the end, you’re always trying to strike a balance between the size of the loss if hit versus the risk of being stopped out. In other words, the farther away your stop-loss is from your entry point, the bigger the loss if hit but the lower the chance of being hit by random price fluctuations rather than a real move against you.

If the second screening shows that you can get the desired rrr without risking more than 1 to 3 percent of your capital, you take the trade near strong support. The precise entry level you choose is a judgment call. You’re trying to strike a balance between entering at the best price and not being so greedy that price never hits your order and you miss the trade altogether.

Step 5 - Third Screening to Monitor Trade Progress

This screening occurs on a chart time frame four to five times shorter than your trading time frame. For example, if you’re trading on daily charts, then use two- to four-hour candles. This one usually doesn’t determine whether you take the trade. Instead, it’s mostly just to identify short-term s/r points that are likely to be temporary, so you’re not surprised if the trend halts or reverses around these zones. Rather than getting worried, you expect a progressing trade to temporarily halt or even reverse. These areas can also serve as points where you augment or reduce your position if you’re using staged entries and exits.

At times, this screening may alter your strategy. For example, if price repeatedly struggles to break through the resistance you see on the four-hour chart, that might indicate that the longer-term trend may be failing, especially if important new information just came out. Similarly, if there’s too much quality short-term resistance too close to your entry, you might elect to enter in stages, saving most of your planned position until price clears that resistance area. Alternatively, if there are better opportunities or if breaking newscasts doubts on your conclusions from the second screening, you might change your mind about the trade and just get out.

Final words about Forex Trading Systems

While any good trader should be using most of the techniques we cover, within this forex trading system guide, there are different types or styles of trading for any given time frame. Here’s a brief listing of the most popular styles. The idea is just to acquaint you with these terms. There are whole books written about each of these trading styles, so use this listing as both an introduction to the vocabulary of trading styles and as a starting point for further research into the styles that interest you. Just take these as general labels, because trades often combine elements of more than one style. The most popular types of trades include:

  • Position trading—taking a longer-term position to ride a trend: Trading a longer-term trend (multiple days, weeks, or months) typically involves entering on some kind of pullback to strong support, waiting to see if that support holds, and then going long soon after longer-term trend bounces back up from support and resumes (and vice versa for short positions). This style is associated with longer-term trends (so pay attention to the relevant long-term fundamentals).
  • Scalping:  Involves trading forex based on a set of real-time analysis. The purpose of the scalping technique is to make a profit by buying or selling currencies and holding the position for a very short time and closing it for a small profit.
  • Trend trading: This type is essentially the same as position trading but is associated with shorter-term trends, and is thus mostly based on technical analysis of trend strength. Again, the goal is usually to enter after some kind of support and to ride the trend as it resumes. Also, when shorting in order to ride a downtrend, a pullback means a brief move up to a near-term high that serves as support.
  • Swing trading: This type involves entering just after a trend reverses briefly, then resumes. You enter just as price is pushing or “swinging” past its former resistance, which indicates that the trend has found new strength. Your technical analysis will need to focus not only on s/r points but also on:
    Momentum indicators that either telegraph a possible coming trend reversal or confirm it.
    - Timing or wave indicators like Elliott Wave, Fibonacci, or Gann style analysis.
  • Range trading: This is when you identify a pair that is locked in a sideways (or nearly so) trading range or channel and you attempt to go long at the lows and short at the highs. As mentioned earlier, when doing this with strongly trending channels. This kind of trading works when you have both flat or weak trends, and wide channels.
  • Momentum trading: This involves locating pairs showing signs of accelerating trends via momentum indicators. 

As swing traders, momentum traders are less focused on entering on a bounce off support. Instead, they want to enter just after price as broken through key resistance, which suggests a new stage in the trend.

In sum, position, trend, range, and swing traders seek to buy low and sell high. Momentum traders seek to buy high on breakouts past resistance because these suggest price is making its next run higher.

Again, with all of these styles, the longer you think you’ll be holding the position, the more you need to consider longer-term fundamentals because they’ll have more time to influence the pair.

To understand how to build an advanced forex trading system is important, but if you need help MetaTrader 5 | MT5 provides some of the best tools for any forex trader. Additional, use an Expert Advisor Builder and generate easy forex trading systems with high profitability.

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Categories:  Forex