How Can You Build a Forex Trading System?

How Can You Build a Forex Trading System?

Reading time: 10 minutes

Building a forex trading system can be a daunting but rewarding journey.

Your trading system, which is part of the overall trading plan, is much like a business plan, outlining how you’ll navigate the financial markets from entries to exits and trade management, as well as risk management.

This article provides a step-by-step outline for building a forex system from the ground up.

Step 1:

Understand Your Psychology

Before creating a forex trading system, one crucial element will define your trading style: your psychological makeup. Your reaction to adverse events and risk can significantly impact your decision-making processes.

If you’re naturally impulsive, you may want to define strict entries and exits that minimise subjectivity and snap judgements.

If taking consecutive losing trades is difficult, you could use wider stop-losses to avoid premature exits when volatility picks up.

The most important thing here is to be as objective as possible; there’s no right or wrong answer. It’s simply about playing to your strengths and minimising your weaknesses.

Step 2:

Identify Your Trading Objectives

Your trading objectives outline what you’d like to achieve through currency trading. Do you want a hobby offering some beer money at the end of the month, or are you looking to make a living from the forex market? Once you have a clear goal, it becomes easier to measure your success and adjust your forex trading strategy.

Many traders find setting a profit target useful. It could be a specific monthly (quarterly or even annual) return, like 2%, or an absolute amount, like 2,000 USD per month. Defining this target helps you determine how often you’ll need to trade, how much risk to take on, and potentially how much capital you’ll need in your trading account.

Step 3:

Choose a Timeframe

With your trading goals defined, the next step is to choose your timeframe. Timeframes range from seconds and minute charts (suitable for scalping and day trading styles) to hourly, weekly, and monthly charts (preferable for swing and position trading styles).

A shorter timeframe, between the seconds and 1-hour charts, is better suited to those who have the time to monitor currency pairs and make quick decisions. Conversely, the 4-hour to monthly charts are more fitting for forex traders who prefer more of an investment-style approach.

Step 4:

Choose an Analysis Technique

The next step is to choose your analysis technique. Forex analysis generally falls into two camps: technical and fundamental analysis.

Technical analysis is all about studying charts. It can be based on price action and support and resistance levels, technical indicators, chart patterns, etc. Many traders employ a combination of the above. It’s often the preferred style for intraday trading. Meanwhile, fundamental analysis focuses on economic indicators, as well as interest rates (monetary policy) and geopolitical events, that typically set the tone for market conditions. This approach is generally better suited to long-term trading strategies.

Many of the best forex traders use a combination of technical and fundamental analysis. Position traders focused on fundamental factors to determine the longer-term trend often use technical analysis to determine their entries (and sometimes their exits, too). Scalpers and day traders primarily use technical analysis to decide when to buy and sell, though they may also trade economic indicators (particularly tier-1 releases). Short-term traders may also use the economic calendar to help avoid times when potentially high-impacting news events are due or may even liquidate a position ahead of such events to avoid taking unnecessary risk (this is particularly the case when a trader solely focusses on technical analysis to trade).

There’s nothing wrong with only using one and not the other; if your strategy produces consistent winning trades, you may prefer not to complicate it.

Step 5:

Define Your Criteria

With your analysis technique selected, now for the backbone of your strategy: the criteria. This requires setting concrete rules for entering and exiting trades and managing risk.

Your entry criteria effectively form a flow chart—if x, do y. For example, you could look for a moving average crossover to determine the trade’s direction. This allows you to wait for a specific chart pattern to form. With the chart pattern materialising, you might have further criteria for how you’d like to see the pattern validated. The idea here is to create replicable steps.

Exit signals are much the same; once in a trade, you’d look for specific criteria to be met to take profits or exit an unfavourable position. This could be the price reaching a support or resistance level or the Relative Strength Index (RSI) indicating the currency pair is overbought/oversold.

Perhaps even more important than your entry/exit criteria is risk management. Establishing clear rules for stop-losses and never deviating from them is critical, as is staying consistent in your position sizing. It’s often recommended to never risk more than 1-2% on a single trade.

Step 6:

Backtest the System

Backtesting is the act of applying your trading system to historical data (in-sample data), mimicking how your system would work in practice. It’s an invaluable step, effectively allowing you to rehearse before live trading and providing one with valuable statistics.

Backtesting can be manual, flicking through charts and identifying trades according to your criteria. It can also be automated, depending on the complexity of the system and your chosen trading platform. It’s a good idea to backtest over at least 100 trades.

If possible, maintain a detailed log of your trades, emphasising areas of improvement. In doing so, you’ll also be able to calculate common backtesting metrics, like your average risk/reward ratio, win/loss ratio, maximum drawdown, and the Sharpe ratio, which measures your risk-adjusted returns.

Step 7:

Forward Test the System

If your backtesting indicates that your strategy works as intended, the next step is forward testing. Also known as paper trading, forward testing involves using a demo account to trade your system in real-time using out-of-sample data without risking real money. Some, however, prefer to open a small live account to begin familiarising themselves with the emotional influences that trading triggers. With FP Markets, you can open a trading account with as little as 100 USD or equivalent.

Final Thoughts

While these steps lay the groundwork for creating a forex trading system, it’s not a one-time task. Instead, it’s an evolving journey. Over the long term, you’ll often find ways to improve your strategy and find that market conditions have changed. As such, it’s essential to adapt your system as time goes on. Embrace the process, and don’t hesitate to experiment as you refine your trading system.