One of the first steps for beginning day traders is to determine one's trading philosophy. You should have an idea of how you want to approach your analysis and trading, develop a view of how the market behaves, and ultimately place trades based on this philosophy.
Generally speaking, there are two major philosophies in Forex trading: Mean reversion and trend following. Both are quite different, and the millions of Forex day traders around the world typically use one or both of these styles in their day-to-day efforts. Now, you might be wondering: What the differences between these two Forex strategies? Which one is best-suited for me? And what are their advantages? Here is a quick explanation:
Mean Reversion in Forex Strategy
The premise of mean revision trading is the idea that the markets fluctuate around a state of equilibrium. In Forex, that would be the exchange rate for a currency pair moves up or down around a mean average value, and ultimately returns to the mean average. To profit, mean reversion traders enter trades when values deviate up or down from the mean average. And when the currency pair reverts back, the trader exits the trade, hopefully taking a profit as a result.
In day trading, mean reversion is fairly common, because day-to-day currency values tend to remain fairly stable without large swings. In fact, it's estimated that the markets tend to stay in a specific range 60 to 70 percent of the time, and stability is the ideal condition for mean reversion trading.
In general, mean reverse traders look for indicators as to when a shift is happening, and two common types of indicators are Bollinger Bands and the Relative Strength Index (RSI). Both are used to determine when a currency pair is overbought or oversold. When a security is overbought or oversold, the idea is that it will move back to the average. It's reached a peak before returning to the median value. The biggest challenge is finding the perfect point to enter these trades as the pair deviates up or down, as it's sometimes unpredictable to determine how long a deviation will happen before the value returns to the median.
Trend-Following in Forex Strategy
Trend-following traders tend to look for trades that move away from the average for a longer period of time, and as such, it's typically a long-term trading strategy. Whereas with mean reversion, the idea is that the exchange rate of a currency pair is oscillating between two points, trend-following means the trader is betting that the trend will continue and not move back to the mean.
Because currency pairs tend to stay within a range for about 70 percent of the time, trend-following, in general, results in fewer winning trades. This happens because it's difficult to predict when a trend might occur. But, because trend-following includes the possibility of a large trend in one direction, the winning trend trades may have greater profitability.
Should You Use a Mean Reversion or Trend Following Strategy?
Now that you have the basic idea of both philosophies, you're probably wondering which one is better? Well, it depends. Market factors may be in place for relative stability in an exchange rate. In this case, it's likely that currency pair might enter a period of fairly stable ranging. In that case, a mean reversion strategy might be more beneficial.
And on the contrary, major economic news in a country greatly increases the chance for volatility. In these circumstances, a trend-following strategy might be the better option, as the trader can capture greater gains if the market moves in the right direction.