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Creating a Working Forex Strategy in 7 Steps
In the following guide, we will show you how to create a working forex strategy in 7 steps.
First, we will always explain the essence of each step. Then, we will look at how it looks in practice.
For this, we will use a previously developed profitable strategy as an example.
It's important to note that this guide is intended for those who want to learn how to start creating their own strategies.
Anyone here just to find a profitable strategy to make a lot of money will miss the point and will likely be disappointed.
So, let’s not waste any more time and look at the first step:
Step 1: Come Up with an Idea
Easy to say, isn’t it?
Indeed, the first step may sound daunting, but having an idea is an indispensable part of strategy creation.
The idea doesn't have to be complicated.
If something comes to mind while looking at the chart, and you think, "hmm, this might work," then that's all you need for the first step of creating a strategy.
The idea could be trading a known chart pattern, a signal from an indicator, a combination of the two, or something entirely different.
One of the first ideas of a trader we know was to open a trade in the opposite direction after six candles of the same color (i.e., a buy after six red candles, and a sell after six green candles).
Such a simple idea is perfect for moving on to the second point.
How This Step Looked in Forex Strategy:
We know that the market regularly reaches overbought or oversold levels. In other words, it often moves up or down almost continuously.
The longer this condition lasts, the more inevitable a correction (or counter-move) becomes.
Our idea was to look for overbought and oversold situations. Then, as soon as the market starts to normalize, we open a trade to make some money from the counter-move.
Extreme situations can be identified visually, but to eliminate subjectivity, we decided to use a technical indicator, specifically the RSI.
Using the RSI indicator, we look for overbought and oversold situations. As soon as we see signs of a correction starting, we open a trade in the direction of the correction.
The market is considered overbought if the RSI shows a value above 70 and oversold if it is below 30.
Once we encounter such a situation, we wait until the indicator leaves the extreme value.
As soon as this happens, we get a trading signal.
Specifically, a buy signal if the indicator crosses the 30 level from below and starts moving up, or a sell signal if it crosses the 70 level from above and starts moving down.
Step 2: Decide How You Want to Make Money
Broadly speaking, there are three ways to make money:
It is very important to decide right at the beginning of strategy creation which method you prefer and stick to it.
This avoids frustrating feelings like:
"Why did I close the trade too early? If I had held it longer, I would have made more money."
Or,
"Why didn't I realize the profit? Now the market has turned, and I've lost even the small gain I had."
In this second step, we prevent such problems by deciding what we want from the market.
The sad truth is that trading requires compromises.
Looking back, it can usually be said that most losing positions could have been closed with a small profit, while most winning positions could have made more money.
Therefore, to avoid constant frustration, we need to make it clear what we want from the market and accept what we have to give up in return before we start trading.
For example, if someone decides on the third option, they accept that they will lose on most of their trades. This might be a trader hunting for market turning points.
This trader will neither panic due to frequent losses nor be surprised. They know that it's only a matter of time before their winning trades compensate for the losses.
Similarly, someone who chooses the first method accepts that they will miss out on big moves since their strategy focuses on small profits.
How This Step Looked in Forex Strategy:
We aimed for the second point, to have as many profitable trades as possible, even at the cost of fewer but proportionally larger losses.
Step 3: Choose the Exact Risk-Reward Ratio
Many trading robots available online are based on the second method because these systems are the easiest to sell.
Unfortunately, what creators (or users) often forget is the one essential thing needed for the success of such strategies: proper risk management.
A typical example of the lack of risk management is the so-called Martingale strategy, which is based on periodically doubling the amount at risk in a losing position.
As soon as the market turns in the trader's favor, even for a short time, the trader can exit the otherwise losing position at breakeven or with a small profit.
Since such a strategy can operate profitably for quite some time, it is easy to be tempted or naively believe that we can trade profitably indefinitely this way.
Unfortunately, this is not true.
Every strategy that does not limit maximum losses functions like a kind of Russian roulette. At some point, the situation will occur that wipes out the account, and then all the small wins are in vain.
That's why risk management is so important.
In addition to the take profit order securing profits, it is worth setting a stop loss order to limit losses for each trade we open.
At this point, the logical question arises: how far should the stop loss and take profit be from each other? This is called the risk-reward ratio.
For example, if the stop loss is 10 pips from the entry price, and the take profit is 20 pips, we can say our risk-reward ratio is 1:2: we can win twice as much as we can lose.
As part of strategy planning, we need to decide what risk-reward ratio we want to work with, or what the minimum ratio is below which we will not open positions.
This is greatly aided by the fact that in the previous step we decided how we want to make money.
The probability of winning trades is greatly influenced by the distance between the stop loss and take profit.
This is illustrated in the following table:
A close stop loss and a similarly close take profit order combination will result in approximately a 50% win rate.
Since the price can move both up and down, we have a 50% chance of guessing which way it will move the same distance.
We can improve on this if our trading signal is good, meaning we trade in situations where the market is less random.
Despite this, our win rate will be around 50%, corresponding to the first method discussed in step two.
The situation is somewhat similar to betting on red or black in roulette from the casino's perspective. The odds are roughly 50-50, but not exactly, because the ball occasionally lands on 0, which is green.
With this slight modification, the casino's advantage increases to 51.35%: 19 favorable numbers out of 37, while the player has only 18 favorable numbers. 19/37 = ~51.35%
This is enough for the casino to be profitable, but the results of individual spins are still roughly fifty-fifty.
If we can somehow limit when the market is slightly more likely to move in one direction, then "we can be the casino," but we can never gain huge statistical advantages.
In contrast, a distant stop loss paired with a close take profit will result in more winning trades.
Here, the market's movement direction is also 50% predictable, but since we are not betting on equal movements, the odds change.
For example, the market moving 1% in one direction is a higher probability event than moving 5% in the other direction.
The distant stop loss, close take profit corresponds to the second method discussed in step two.
It is important to note that only the win-loss ratio changes; since the profit is smaller than the loss, even if we win more often, profitability still depends on our ability to trade in favorable situations.
Otherwise, profits and losses will average out over the long term, and we will neither make nor lose money.
(Provided there are no transaction fees.)
Finally, a close stop loss and a distant take profit will result in more losing trades.
This is essentially the reverse of the previous situation.
Here, the stop loss is closer, so the price will hit it more often than the more distant take profit. However, since winning trades bring in much more money, it is still possible to trade profitably.
This corresponds to the third method discussed in step two.
It is important to note that you can trade profitably with a positive win rate and trade at a loss with a negative win rate.
By manipulating the distance between the stop loss and take profit, we can set what we can expect from our strategy in terms of the win rate.
Whether we actually make money with this win rate depends on our trading skills.
How This Step Looked in Forex Strategy:
As we mentioned, we focused on executing as many profitable trades as possible.
To achieve this, we implemented the following rule:
The stop loss order is placed 50 pips away for each trade, while the take profit order is placed 10 pips away.
In other words, our risk-reward ratio is 0.2, meaning each dollar risked is intended to yield 20 cents of profit.
At first, this may sound unfavorable, but remember that this way, we will win more often than lose. Additionally, we do not act randomly; we try to trade when the market is more predictable.
As already mentioned, the logic of the strategy is to trade situations where the market is overbought/oversold and shows signs of correction.
Anyone who has traded before knows that the market often doesn't immediately move in the favorable direction. That's why we decided to place the stop loss far away and the take profit close.
When the RSI leaves the overbought zone on the 1-hour chart (i.e., when the market drops slightly after a prolonged upward movement), we open a position with a close target price and a distant stop loss.
Let's look at an example.
On the left, you can see a 1-hour chart framed, and on the right, an enlarged 5-minute chart:
Summary of the situation:
We are in a sell position in an overbought market that has started to move downward, and we believe it will drop 10 pips before it rises 50 pips.
This idea is supported by the fact that the market is already heavily overbought, meaning any further rise increases the likelihood of new sellers appearing.
As soon as the market moves slightly in our favor, we quickly take a small profit and exit the position.
We don’t hold the position longer (potentially gaining more profit) because the idea is to profit from corrections following extreme prices, not to find trend reversals.
Remember, compromises are necessary.
Essentially, we are trading against the trend, so we take the profit as soon as possible and exit. Yes, this way, we miss out on major trend reversals, but we must accept this.
Of course, the same concept applies to buy positions as well, where we buy in long-falling markets, placing the stop loss even lower, and closing the position as the market rises slightly.
Step 4: Determine the Entry Rules
Entry rules define the precise criteria for opening a trade.
They need to be clear, specific, and free of ambiguity to ensure consistent application.
Common entry rule components include:
How This Step Looked in Forex Strategy:
Our entry rule was straightforward: use the RSI indicator to identify overbought and oversold conditions.
Exit rules are as important as entry rules, as they determine how profits are realized and losses minimized.
These rules can include:
How This Step Looked inForex Strategy:
Our exit rules were based on predefined stop loss and take profit levels.
Testing is crucial to validate the effectiveness of the strategy before using it in a live trading environment.
Two main types of testing are:
How This Step Looked in Forex Strategy:
We performed extensive backtesting using historical market data, focusing on periods with varied market conditions to ensure robustness.
The main parameters of the test were as follows:
Symbol: USD/JPY
Date: 2021.01.01 – 2023.04.01
Deposit: 10,000 EUR
Max leverage: 1:30
Risk per trade: 1% of the current account size
Stop distance: 50 pips
TP distance: 10 pips
RSI period: 20, extreme levels 30, 70
Timeframe: 1-hour chart
Result:
Step 7: Evaluate and Refine
Continuous evaluation and refinement are necessary to adapt to changing market conditions and improve performance.
This involves:
We regularly reviewed our trading results, made necessary adjustments to our entry and exit rules, and kept refining the strategy to adapt to market changes.
Conclusion
Creating a working forex strategy involves a systematic approach that includes:
In the following guide, we will show you how to create a working forex strategy in 7 steps.
First, we will always explain the essence of each step. Then, we will look at how it looks in practice.
For this, we will use a previously developed profitable strategy as an example.
It's important to note that this guide is intended for those who want to learn how to start creating their own strategies.
Anyone here just to find a profitable strategy to make a lot of money will miss the point and will likely be disappointed.
So, let’s not waste any more time and look at the first step:
Step 1: Come Up with an Idea
Easy to say, isn’t it?
Indeed, the first step may sound daunting, but having an idea is an indispensable part of strategy creation.
The idea doesn't have to be complicated.
If something comes to mind while looking at the chart, and you think, "hmm, this might work," then that's all you need for the first step of creating a strategy.
The idea could be trading a known chart pattern, a signal from an indicator, a combination of the two, or something entirely different.
One of the first ideas of a trader we know was to open a trade in the opposite direction after six candles of the same color (i.e., a buy after six red candles, and a sell after six green candles).
Such a simple idea is perfect for moving on to the second point.
How This Step Looked in Forex Strategy:
We know that the market regularly reaches overbought or oversold levels. In other words, it often moves up or down almost continuously.
The longer this condition lasts, the more inevitable a correction (or counter-move) becomes.
Our idea was to look for overbought and oversold situations. Then, as soon as the market starts to normalize, we open a trade to make some money from the counter-move.
Extreme situations can be identified visually, but to eliminate subjectivity, we decided to use a technical indicator, specifically the RSI.
Using the RSI indicator, we look for overbought and oversold situations. As soon as we see signs of a correction starting, we open a trade in the direction of the correction.
The market is considered overbought if the RSI shows a value above 70 and oversold if it is below 30.
Once we encounter such a situation, we wait until the indicator leaves the extreme value.
As soon as this happens, we get a trading signal.
Specifically, a buy signal if the indicator crosses the 30 level from below and starts moving up, or a sell signal if it crosses the 70 level from above and starts moving down.
Step 2: Decide How You Want to Make Money
Broadly speaking, there are three ways to make money:
- Win roughly the same amount as you lose on each trade, but have more winning trades.
- Have more winning trades than losing ones, but with smaller wins and larger losses.
- Have fewer winning trades, but win more on those trades than you typically lose.
It is very important to decide right at the beginning of strategy creation which method you prefer and stick to it.
This avoids frustrating feelings like:
"Why did I close the trade too early? If I had held it longer, I would have made more money."
Or,
"Why didn't I realize the profit? Now the market has turned, and I've lost even the small gain I had."
In this second step, we prevent such problems by deciding what we want from the market.
The sad truth is that trading requires compromises.
Looking back, it can usually be said that most losing positions could have been closed with a small profit, while most winning positions could have made more money.
Therefore, to avoid constant frustration, we need to make it clear what we want from the market and accept what we have to give up in return before we start trading.
For example, if someone decides on the third option, they accept that they will lose on most of their trades. This might be a trader hunting for market turning points.
This trader will neither panic due to frequent losses nor be surprised. They know that it's only a matter of time before their winning trades compensate for the losses.
Similarly, someone who chooses the first method accepts that they will miss out on big moves since their strategy focuses on small profits.
How This Step Looked in Forex Strategy:
We aimed for the second point, to have as many profitable trades as possible, even at the cost of fewer but proportionally larger losses.
Step 3: Choose the Exact Risk-Reward Ratio
Many trading robots available online are based on the second method because these systems are the easiest to sell.
Unfortunately, what creators (or users) often forget is the one essential thing needed for the success of such strategies: proper risk management.
A typical example of the lack of risk management is the so-called Martingale strategy, which is based on periodically doubling the amount at risk in a losing position.
As soon as the market turns in the trader's favor, even for a short time, the trader can exit the otherwise losing position at breakeven or with a small profit.
Since such a strategy can operate profitably for quite some time, it is easy to be tempted or naively believe that we can trade profitably indefinitely this way.
Unfortunately, this is not true.
Every strategy that does not limit maximum losses functions like a kind of Russian roulette. At some point, the situation will occur that wipes out the account, and then all the small wins are in vain.
That's why risk management is so important.
In addition to the take profit order securing profits, it is worth setting a stop loss order to limit losses for each trade we open.
At this point, the logical question arises: how far should the stop loss and take profit be from each other? This is called the risk-reward ratio.
For example, if the stop loss is 10 pips from the entry price, and the take profit is 20 pips, we can say our risk-reward ratio is 1:2: we can win twice as much as we can lose.
As part of strategy planning, we need to decide what risk-reward ratio we want to work with, or what the minimum ratio is below which we will not open positions.
This is greatly aided by the fact that in the previous step we decided how we want to make money.
The probability of winning trades is greatly influenced by the distance between the stop loss and take profit.
This is illustrated in the following table:
A close stop loss and a similarly close take profit order combination will result in approximately a 50% win rate.
Since the price can move both up and down, we have a 50% chance of guessing which way it will move the same distance.
We can improve on this if our trading signal is good, meaning we trade in situations where the market is less random.
Despite this, our win rate will be around 50%, corresponding to the first method discussed in step two.
The situation is somewhat similar to betting on red or black in roulette from the casino's perspective. The odds are roughly 50-50, but not exactly, because the ball occasionally lands on 0, which is green.
With this slight modification, the casino's advantage increases to 51.35%: 19 favorable numbers out of 37, while the player has only 18 favorable numbers. 19/37 = ~51.35%
This is enough for the casino to be profitable, but the results of individual spins are still roughly fifty-fifty.
If we can somehow limit when the market is slightly more likely to move in one direction, then "we can be the casino," but we can never gain huge statistical advantages.
In contrast, a distant stop loss paired with a close take profit will result in more winning trades.
Here, the market's movement direction is also 50% predictable, but since we are not betting on equal movements, the odds change.
For example, the market moving 1% in one direction is a higher probability event than moving 5% in the other direction.
The distant stop loss, close take profit corresponds to the second method discussed in step two.
It is important to note that only the win-loss ratio changes; since the profit is smaller than the loss, even if we win more often, profitability still depends on our ability to trade in favorable situations.
Otherwise, profits and losses will average out over the long term, and we will neither make nor lose money.
(Provided there are no transaction fees.)
Finally, a close stop loss and a distant take profit will result in more losing trades.
This is essentially the reverse of the previous situation.
Here, the stop loss is closer, so the price will hit it more often than the more distant take profit. However, since winning trades bring in much more money, it is still possible to trade profitably.
This corresponds to the third method discussed in step two.
It is important to note that you can trade profitably with a positive win rate and trade at a loss with a negative win rate.
By manipulating the distance between the stop loss and take profit, we can set what we can expect from our strategy in terms of the win rate.
Whether we actually make money with this win rate depends on our trading skills.
How This Step Looked in Forex Strategy:
As we mentioned, we focused on executing as many profitable trades as possible.
To achieve this, we implemented the following rule:
The stop loss order is placed 50 pips away for each trade, while the take profit order is placed 10 pips away.
In other words, our risk-reward ratio is 0.2, meaning each dollar risked is intended to yield 20 cents of profit.
At first, this may sound unfavorable, but remember that this way, we will win more often than lose. Additionally, we do not act randomly; we try to trade when the market is more predictable.
As already mentioned, the logic of the strategy is to trade situations where the market is overbought/oversold and shows signs of correction.
Anyone who has traded before knows that the market often doesn't immediately move in the favorable direction. That's why we decided to place the stop loss far away and the take profit close.
When the RSI leaves the overbought zone on the 1-hour chart (i.e., when the market drops slightly after a prolonged upward movement), we open a position with a close target price and a distant stop loss.
Let's look at an example.
On the left, you can see a 1-hour chart framed, and on the right, an enlarged 5-minute chart:
Summary of the situation:
We are in a sell position in an overbought market that has started to move downward, and we believe it will drop 10 pips before it rises 50 pips.
This idea is supported by the fact that the market is already heavily overbought, meaning any further rise increases the likelihood of new sellers appearing.
As soon as the market moves slightly in our favor, we quickly take a small profit and exit the position.
We don’t hold the position longer (potentially gaining more profit) because the idea is to profit from corrections following extreme prices, not to find trend reversals.
Remember, compromises are necessary.
Essentially, we are trading against the trend, so we take the profit as soon as possible and exit. Yes, this way, we miss out on major trend reversals, but we must accept this.
Of course, the same concept applies to buy positions as well, where we buy in long-falling markets, placing the stop loss even lower, and closing the position as the market rises slightly.
Step 4: Determine the Entry Rules
Entry rules define the precise criteria for opening a trade.
They need to be clear, specific, and free of ambiguity to ensure consistent application.
Common entry rule components include:
- Technical indicators
- Chart patterns
- Candlestick patterns
- Price levels (support and resistance)
- Time of day
How This Step Looked in Forex Strategy:
Our entry rule was straightforward: use the RSI indicator to identify overbought and oversold conditions.
- Buy signal: When RSI crosses above 30 from below.
- Sell signal: When RSI crosses below 70 from above.
Exit rules are as important as entry rules, as they determine how profits are realized and losses minimized.
These rules can include:
- Profit targets (take profit)
- Stop loss levels
- Trailing stops
- Time-based exits
How This Step Looked inForex Strategy:
Our exit rules were based on predefined stop loss and take profit levels.
- Stop loss: Placed at a distance that matches our 1:1.5 risk-reward ratio.
- Take profit: Placed at a distance that achieves the 1:1.5 risk-reward ratio.
Testing is crucial to validate the effectiveness of the strategy before using it in a live trading environment.
Two main types of testing are:
- Backtesting: Applying the strategy to historical data to see how it would have performed.
- Forward Testing: Using the strategy in a simulated environment with real-time data.
How This Step Looked in Forex Strategy:
We performed extensive backtesting using historical market data, focusing on periods with varied market conditions to ensure robustness.
The main parameters of the test were as follows:
Symbol: USD/JPY
Date: 2021.01.01 – 2023.04.01
Deposit: 10,000 EUR
Max leverage: 1:30
Risk per trade: 1% of the current account size
Stop distance: 50 pips
TP distance: 10 pips
RSI period: 20, extreme levels 30, 70
Timeframe: 1-hour chart
Result:
Step 7: Evaluate and Refine
Continuous evaluation and refinement are necessary to adapt to changing market conditions and improve performance.
This involves:
- Monitoring performance metrics (win rate, profit factor, drawdown, etc.)
- Making adjustments based on feedback from real or simulated trades
- Ensuring the strategy remains aligned with the original trading goals and risk tolerance
We regularly reviewed our trading results, made necessary adjustments to our entry and exit rules, and kept refining the strategy to adapt to market changes.
Conclusion
Creating a working forex strategy involves a systematic approach that includes:
- Developing a trading idea
- Deciding on a method to make money
- Choosing an appropriate risk-reward ratio
- Defining clear entry and exit rules
- Thorough testing of the strategy
- Ongoing evaluation and refinement