Many forex traders will start out as enthusiastic novices, spurred on by stories of huge profits and self-employed, dream lifestyles. In reality, however, these stories and media portrayals of the lives of real traders become only distant possibilities for new traders. Many will lose some or all of their initial investments and experience small periods of success overshadowed by larger periods of loss. All of these are the normal experiences of anyone embarking on a new career but the process can be much less painful financial if a number of key preparations are undertaken.

Practice using a forex demo account

Training for anything requires practice and, just as a pilot doesn’t immediately start by flying a plane alone, new traders should learn and simulate their trades as much as possible before risking any money. Almost all decent brokers will offer a free, no-obligation demo trading account using the company’s trading software and simulating the actual market price of a good range of forex pairs. Although it is true that there is no absolute substitute for risking real money in the markets, as far as testing trading skills and strategies goes, demo accounts are by far the best and most worthwhile experience. There is no timetable on how long a novice trader should practice trading, some january take several weeks before they feel confident to enter the markets for real, whilst others january take years developing a profitable strategy.

Money management is critical

Beyond simple practice, money management is the most fundamentally important element in any trading success. Given the fact that all traders will experience losses at some frequency during their trading careers, the ability to control the financial risk of each trade will be essential to the survival of any new trader. It is important to emphasise that even the world’s best trading strategy will fail over time if basic money management is not adhered to. This includes things such as the sensible use of stop losses to prevent huge, negative price swings against a position (even if these january not be guaranteed stops) and maintaining exposure to a maximum of 3% of an accounts value on any single trade. Additionally, ensuring that each forex trade has a positive risk-to-reward ratio, for example ensuring that profits on a single successful trade will always be at least equal to a single unsuccessful trade.

Learn what makes markets move

Finally, preparing to be a forex trader requires some basic education on what moves currency prices in order to avoid trading in to important news releases or major events. For example, the trade set-up can be absolutely perfect, but if it is on the wrong side of the Non-Farm Payroll data release the stops will very likely be hit before the trade even has the chance to develop. Similarly, gaining a basic understanding of some key technical trading patterns, which many traders use to base their decisions, will be incredibly useful and also profitable. Given the way that currency markets are linked to fundamental global events and specific interest rate decisions, keeping track of those which january affect market sentiment and influence the underlying trend will be enormously beneficial to all traders.

Stop losses are an essential tool for all forex traders. Not only do they prevent traders accruing large losses when markets move quickly against a position, but they also allow trading to be more objective and therefore profitable. Sharp and sudden market moves, or simply those trends which occur when a trader is unable to close a trade, can quickly create larger losses and even result in a negative overall account value. Stop losses will go a long way to ensuring that only a certain degree of risk is incurred on any one trade and there are two main ways to utilise this essential tool.

Maximum loss and money stop-losses

Stop losses can be applied to any forex trade on a maximum loss basis, where a trader decides in advance the value of risk that they are willing to apply to a single position. This is known as a money stop and is normally based the maximum percentage loss that a trade can incur. These stop losses are the most helpful in removing the traders emotions form the decision-making during a trade. The temptation to incur greater losses in the hope that a position will recover is something that is experienced by all new traders and the ability to cut these losses early, with the help of a money stop will allow future winning trades to outweigh the losing trades.

Technical stop-losses

Technical stops are used by more experienced traders in order to exit a trade when the chart evidence is that the trade has failed. These stops are therefore placed a strategic points in the market which will prove that the original rationale for the trade is no longer valid and the trading signal has not resulted in the expected outcome. These stop losses are particularly useful for technical traders who use areas of support and resistance alongside technical analysis to pinpoint high probability trading opportunities. Again, by placing a stop loss beyond an area of support or resistance, pivot point or technical chart patter, the trader removers the possibility of a subjective decision dominating their trading decisions. It is worth remembering, however, that technical stops are often placed further from the entry price in order to both allow the trade space to ‘breathe’ and also in order to ensure that the trade setup has failed. The losses with technical stops january therefore be higher than if a money stop were to be employed.

Guaranteed stop-losses

Guaranteed stop losses are offered by many forex brokers as a way to ensure that, even in very fast moving markets or when price spikes occur, a stop loss will be executed at the correct price. This therefore prevents negative slippage when stops are triggered but the losses are higher due to the fact that the price moved beyond this level too fast to complete the stop loss order at the desired price. Guaranteed stop losses, however, do come at a premium which if usually in the form of a wider entry spread which makes the entry price for the trade less attractive as a non-guaranteed stop loss.

When a currency pair reverses, it demonstrates a shift in the demand for a currency and provides traders with information on where the areas of support and resistance exist. These forex reversals provide excellent opportunities to make profits if a trader is able to spot the signs that a currency pair looks set to reverse. Examples of short and long-term price reversals can be seen on any time-frame and often result in a significant price swing and an excellent way to gain pips with a great risk:reward ratio.

Spotting when a currency pair january be ready to reverse from its current trend is not a science and, as with all forex trading, is not always 100% accurate. However, there are a number of tools which can be used to spot when price january be approaching its zenith and which help forex traders to ensure that probability is on their side.

Oscillator and price action combinations to spot forex reversals

Many forex traders use oscillator indicators to inform them when a currency pair january be overbought or oversold. These are generally a good tool to use because it ensures that a lot of forex traders are thinking the same when it looks as though a price reversal january be due. The problem is that price can remain oversold or overbought for long periods which means that an oscillator cannot often be used as a trading tool alone but requires some additional confirmation that a reversal is very probable. This is where price-action analysis comes in very helpful and the use of, in particular, candlesticks to show that price is genuinely weakening and ready to reverse will greatly increase the probability of success.

The one opportunity, however, that traders january be able to trade simply from an oscillator is when divergence in the chart price and the indicator confirm the trade. This is when price moves to a higher high or lower low on the price chart but the oscillator disagrees and shows a lower/higher level than that on the price chart. This is a classic setup for a forex reversal and shows that the market is weakening and due a correction at the very least.

Using previous support and resistance to pinpoint reversal zones

Looking at any chart there are areas where price has previously reversed and which can be considered areas of support and resistance. Often, these are areas where many traders have already placed buy and sell orders in the market which are triggered and create a powerful price movement in the opposing direction. Spotting these areas on a price chart takes some practice but they become highly reliable areas for potential forex reversals.

Applying the additional verification of an indicator and price-action to these levels will offer an excellent probability of a profitable trade. Furthermore, stop-losses can be placed nearby beyond the level of support in order to minimise the risks and allow traders to take advantage of a complete forex reversal when they occur. These opportunities are also available on any time-frame and, for those forex traders who prefer to trade fast, it is well worth looking at the reversal points at recent highs/lows on the intraday 5 minute charts.

Divergence is a term used to describe the visual disagreement between the actual price on a chart and a technical indicator. This disagreement can be seen on any time frame and often happens numerous times per day, providing opportunities for successful trading. The concept is simple, although many will also argue that the effectiveness of divergence is down to the thousands of traders who act on this signal. It can be learnt by any trader, but the ability to spot genuine divergence is a skill which is acquired through practice and close observation of the market. It is rarely used alone but it is often used as a strong underlying basis for trading the forex market in a particular direction.

Regular divergence and the ability to pinpoint market reversals

Regular divergence refers to a straightforward disagreement in price and an indicator (often an oscillator such as RSI or Stochastic). When we talk of a disagreement, it means that the indicator and the actual price of the currency pair are not reflecting the same information in regards to the price-action within the market. A good example to demonstrate this would be if price of the Euro against the US dollar rallied to a new 1 hour high. Although the price chart is showing a new high, the RSI indicator is showing that this high is actually lower than the previous high. In this case there is a disagreement between the two. Although this is fairly common on the shorter time frames, if the divergence occurs when the RSI or stochastic oscillator is within its ‘overbought’ trading range (i.e. above 75 as the default overbought level), it can be considered a signal for a future reversal.

Hidden divergence as a continuation signal

Hidden divergence is also one of the most common trading signals for those traders seeking to pre-empt the general future direction of a currency market. Although, like regular divergence, it does not necessarily indicate an instant price reversal the probability of this within the near future is very high. Unlike regular divergence, hidden divergence is slightly more complicated to grasp but also relies on a disagreement between price and an indicator. As an indication of the continuation of the underlying trend, hidden divergence occurs when price doesn’t reach a new high or low but the indicator insists that it has. In this situation price january be moving higher but form a lower high to that made earlier in the day. The RSI, however, shows that the currency pair has reached a new high on the indicator thus suggesting that it is overbought even at this lower high and must continue on its trend lower. This january sound fairly complex but once a trader learns how to spot each of these they will become immediately obvious and offer excellent opportunities to trade.

How to use divergence effectively

Divergence helps to alert traders when a market reversal or continuation is due. However, it is not advisable to trade only divergence, appreciating that currencies can remain in their oversold or overbought areas for a long time before reversing. Looking historically at price charts it is clear to see that divergence really does work if the entry is time correctly. One recommended way to ensure the best possible entry is to confirm the reversal with the help of a price action trading technique such as candlestick trading. The confluence of a reversal candlestick formation alongside divergence in an overbought or oversold area is a very high probability forex trade.

Many indicators are valued for their predictive properties and ability to guide traders in making the correct trading decisions. The many hundreds of available indicators, from the most popular to those which have been custom-designed and adapted by individual forex traders rely on a host of varying data in their make-up. Within this, many indicators differ in whether they use either the open, close or mid-price of the current price bar in order to provide traders with the latest information. This key difference causes the difference between those indicators which can be considered ‘re-painting’ and those which don’t re-paint.

Why are re-painting and non re-painting indicators different?

Re-painting occurs when the indicator relies on the closing value of the current price bar in order to update accurately. Therefore, whenever a price bar is still open the indicator has the potential to move higher or lower until the close is confirmed. Non-repainting indicators, on the other hand, are usually based on the data provided through the opening of the current price bar. Once the bar has opened, the indicator will remain fixed until the next open.

Using re-painting indicators with caution

Many forex traders find that re-painting indicators can be highly frustrating due to the fact that they very rarely show an accurate interpretation of the current situation, but will still look excellent when back-tested. In fact, many new traders will fall in to the trap of thinking that they january have discovered the ‘holy grail’ of indicators before realising that its performance in real-time is far from its impressive performance during a thorough backtest.

How forex trades can be affected by re-painting and non re-painting indicators

A classic example of a re-painting indicator, but one which can still be extremely useful, is a ‘fast’ moving average. By fast we mean those which are based on a short number of bars and on a low timeframe (for example the 10MA on the 5M timeframe). For forex traders looking for MA crossovers in order to enter trades the smooth and highly accurate historical view of the 10MA look like an excellent trading strategy. However, watching the tail of the MA moving higher and lower, perhaps even crossing a larger MA several times before its close, make it incredibly difficult and actually quite inaccurate to trade on its own. Similarly, indicators such as the ‘Zigzag’ and ‘Centre of Gravity’ indicators are also notorious for repainting and should not necessarily be avoided but simply used with caution.

These are seen as less problematic in real-time trading as far as non-repainting indicators are concerned, but they tend to lag behind the current price action. However, these are far more highly valued than their repainting counterparts purely because once they have been formed, the information and signals they show do not change. Their historical value is perhaps not quite so impressive to forex traders looking for the perfect indicator but their reliability and potential to be combined with other reliable indicators make them far less risk in terms of providing accurate trading signals.

For advanced traders from outside the United States we recommend Dukascopy.