How to Create A Profitable Forex Strategy From Scratch

Looking for a profitable Forex strategy to be spoon-fed to you?

That might not be a good idea because what works for one trader might not work for you.

For example, in the 1980s, two legendary traders Richard Dennis and William Eckhardt recruited a group of people to teach their trading strategy.

This trading strategy had millions for both of them, but when they taught the same strategy to these group of people, now famously known as the turtle traders, not all of them were successful.

That’s because while you may know the trading strategy, if it does not suit your personality, then it’s not going to work.

So instead of finding someone else’s trading strategy, the better way is to create your own profitable trading strategy.

In this post, I’m going to share with you exactly how you can create your own profitable Forex strategy from scratch.

Let’s get started.

Choose Your Trading Methodology

The first step to creating your own profitable Forex strategy is to pick a trading methodology.

And by that, I mean to choose either to Trend Trading or Countertrend Trading.

While you can certainly trade both of these, you want to start off with just one of them.

This makes it easier for you to identify trade signals easily.

Sometimes, if you inculcate both Trend Trading and Countertrend Trading methods into your trading strategy, it can give conflicting signals.

So for a start, just choose one and stick with that.

Trend Trading

Trend Trading simply means to trade with the trend.

If the market is in an uptrend, you only want to look for Long entries.

And if the market is in a downtrend, then you only want to look for Short entries.

I’m sure you’ve probably heard of the phrase:

“The trend is your friend”

And the reason is that it’s easier to trade with the trend.

Here’s an analogy:

If you are swimming in the sea, is it easier to swim when the current is behind you?

Or is it easier to swim when the current is against you?

Clearly, it’s definitely easier to swim when the current is behind you.

And trading with the trend is like swimming with the current.

So if you’re just creating your very first Forex trading strategy, then I strongly suggest that you start off with a Trend Trading strategy.

Examples of Trend Trading Strategies

When trading with the trend, there are only two ways to get into a trend:

• Breakouts
• Pullbacks (or Retracements)

1) Breakouts

There are two ways to classify a breakout.

The first way is when the market breaks above the previous swing high.

(chart)

The second way is when the market consolidates and then makes a big move in one bar.

(chart)

2) Pullbacks

When the market is in an uptrend, it makes higher highs and higher lows.

These higher lows are the pullbacks in an uptrend.

And when the market is in a downtrend, it makes lower lows and lower highs.

These lower highs are the pullbacks in a downtrend.

The psychology behind trading pullbacks is that we traders always want to get a “good price”.

For example, we all like a good deal.

Whether it’s shopping for groceries or even buying a property, we want to get it at a steal.

And that’s behind the same mentality for pullbacks.

In an uptrend, if we think the market is going higher, then we want to get in when the market has “dipped” a little to get a better entry.

And it’s the same mentality for a downtrend.

Between pullbacks and breakouts, I prefer to trade pullbacks because it allows for an optimal Stop Loss placement below swing lows or above swing highs that’s created by the pullback.

With breakouts, if you place your Stop Loss at the same place, it might be too wide.

And if you place your Stop Loss below the low of the bar that triggered the Long Entry (or above the high of the bar that triggered the Short Entry), it might be too tight.

Hence I prefer trading pullbacks as opposed to breakouts.

But I know of traders who like to trade breakouts because with breakouts you don’t miss a move in either direction.

With pullbacks, the market might continue without giving a valid pullback entry.

And because of this, you might miss out on a good trade.

So it comes down to the individual trading style.

Countertrend Trading

Countertrend Trading is the opposite of Trend Trading and it just means you trading against the trend.

So for example, if the market is in a downtrend, you’re looking for an opportunity to go Long.

And if the market is in an uptrend, you’re looking for an opportunity to go Short.

The psychology of Countertrend Traders is very different from Trend Traders.

For example, if the market reaches a new high, Countertrend Traders might say:

“It’s too high. The market might be overbought. It’s time to go Short.”

On the other hand, Trend Traders might say:

“The market made a new high. It’s a sign that it’s going higher. It’s time to go Long.”

So while it’s the same scenario in the market, both types of traders interpret it very differently.

Who is right?

Both can be right, and both can be wrong at the same time.

It all depends on the trading strategy.

Examples of Countertrend Trading Strategies

With Countertrend Trading there are two main strategies:

• Mean Reversion
• Reversals

1) Mean Reversion

A mean reversion strategy is a strategy to capitalize on the market coming back to its mean after it’s overextended.

But how do you know what’s the mean?

One common way is to use the Bollinger Band indicator.

In the image above, the red line in the middle of the bands is the 20-period moving average.

Many mean reversion traders use that as the mean.

One common mean reversion strategy is to go Long when the market breaks below the lower band, and go Short when the market breaks above the higher band.

Then the Take Profit is when the market touches the 20 MA.

However, you do not want to take every trade that breaks above or below the bands because if the market trends, you can lose a lot of money quickly.

Instead, you want to add some sort of filter so that you only select the trades that most likely will revert to the mean.

Another popular indicator that many traders use to trade mean reversion is the Relative Strength Index (RSI) indicator.

The RSI has an “overbought” and “oversold” line.

If it goes above the top line, it’s considered overbought and indicates that the market might be going down.

And if it goes below the bottom line, it’s considered oversold and indicates that the market might be coming up.

So what mean reversion traders would do is buy when the RSI shows an oversold signal, and sell when it shows an overbought signal.

Similar to trading the Bollinger Band, you want to have some filters in place so that you don’t take every overbought and oversold signal.

2) Reversals

While mean reversion trades are traded with the expectation that the market just goes back to the mean…

Reversal trades are traded with the expectation that the market might have a change in the trend.

For example, an uptrend becomes a downtrend, and a downtrend becomes an uptrend.

So reversal trades generally have a bigger risk-to-reward ratio, and the trade can last much longer than a mean reversion trade.

There are many ways to trade a reversal.

One way is to trade technical chart patterns like double tops and double bottoms.

For a double bottom, technical traders would go Long once the market breaks above the neckline.

And for double tops, they would go Short once the market breaks below the neckline.

The way I trade these reversal patterns is with divergence on the stochastic indicator.

So if the market forms a double bottom or a lower low, I’m looking for the stochastic indicator to form a higher low to have a Long trade.

And if the market forms a double top or a higher high, then I’m looking for the stochastic indicator to form a lower high to have a Short trade.

Now that you know the different types of trading strategies, pick just one to start with.

Later on, you may trade different strategies as you have more experience.

But for now, you want to go with just one.

Once you’ve chosen a trading strategy, here’s how you ensure it will be profitable even before you risk real money to trade it.

How to Ensure Profitability In Your Trading Strategy

There’s only one way to ensure that your trading strategy is profitable…

And that is by understanding Expectancy.

This is by far the MOST important part of your trading strategy because it determines whether or not your system can be profitable in the long run.

So what is Expectancy in a trading strategy context?

Expectancy is how much your trading strategy will make or lose on average for each trade.

If you have a Positive Expectancy, that means you will be profitable in the long run.

If you have a Negative Expectancy, that means you will lose money in the long run.

There are just 3 elements to calculating Expectancy:

• Win/Loss Percentage
• Average Profit
• Average Loss

And the Expectancy Formula is:

 (Percentage Win x Average Profit) – (Percentage Loss x Average Loss)

So for example, if you have a Win/Loss Percentage of 50% and your Average Profit is $200 and your Average Loss is $100, then your Expectancy is:

(50% x $200) – (50% x $100) = $50

That means on average you will expect to make $50 on average across all my trades.

If I use R-Multiples to calculate my Expectancy, then it would be:

(50% x 2R) – (50% x 1R) = 0.5R

So if my R = $200 (meaning I risk $200 on each trade), then I’d expect to make an average of $100 across all my trades.

Now, you may lose 3 times in a row and be down $300.

But if you continue trading your strategy, in the long run, the probability will normalize and on average be making $50 on each trade.

Now, this is very important to understand because it helps you understand you stay in the game in the long run.

For example, if you have 4 consecutive losing trades in a row, you might start to doubt your trading strategy and may even fear to enter into the next trade.

In this table below, it shows your likely losing and winning streak across 50, 500 and 1,000 trades:

You will see that at a 50% win rate, there’s a likely losing streak of 6 trades in a row across 50 trades.

And across 1000 trades, there’s a likelihood of 10 losing trades in a row.

So if you only have 4 losing trades in a row, that’s within the boundaries of losing streak for your win rate.

And if your win rate is even lower, then you’re going to have more losing streaks in a row.

But that doesn’t mean that you will lose in the long run.

It just means that you have yet to let the probability play out.

How Casinos Always Win In The Long Run

The reason why casinos always win in the long run is that they know that their probability will play out in the long run.

Let’s take for example the game of Roulette.

In the European Roulette Wheel, there is a total of 37 numbers on the wheel.

18 black, 18 red, and 1 green.

The payout to bet black or red is 1:1.

That means if you bet $100 on red and you win, your payout is $100 (on top of your original $100).

The misconception that many people have about this bet is that it’s a 50% chance of a win.

But the truth is that it’s less than 50% because of the green “zero” on the wheel.

So the win percentage is only 18 / 37 = 48.65% (rounded to the nearest two decimals).

What this means is that 48.65% of the time you will win $100.

And 51.35% of the time you will lose $100.

Let’s now calculate your Expectancy with this input:

(48.65% x $100) – (51.35% x $100) = -$2.70

This means that on average you are LOSING $2.70 each time you bet.

Now, you may get lucky and win 3 times in a row and make a profit of $300.

But the casino knows that if you stay and continue to play long enough, the probability will play out and you will lose.

That is why the casino isn’t concerned if you win a few times.

They know that in the long run, they will be profitable.

That’s how you should treat your trading strategy as well.

And that’s why it’s very important to know your trading Expectancy.

So how do you find out the Expectancy of your trading strategy?

By testing.

Testing Your Forex Strategy

When it comes to testing your trading strategy, the way I like to do it is in 3 phases:

• Phase 1: Backtesting
• Phase 2: Demo Testing
• Phase 3: Live Testing

The general idea is to ensure your trading strategy is profitable before risk your hard-earned money on it.

Many new traders after learning a new trading strategy love to immediately trade real money on it without knowing whether it’s profitable or not.

They hear about the new and latest holy grail trading strategy, and start trading real money with it and lose their shirt…

And sometimes even lose their life savings.

Here’s an analogy:

Would you sit in a vehicle that has not been tested for safety?

Absolutely not right?

You want to make sure that the vehicle has been tested for safety, so you know for certain that the vehicle won’t blow up suddenly while you’re in it.

And you should have the same attitude when it comes to any trading strategies you want to trade.

So here’s how you test through the 3 phases.

Phase 1: Backtesting

Backtesting simply means to test your trading strategy on historical data.

You can either do it manually…

Or if you know how to code, you can program your trading strategy into an Expert Advisor.

The idea here is to test your trading strategy across a big enough sample size to have statistical significance.

However, to get statistical significance can be quite subjective…

Because if you have a trading strategy that only trades 10 times a year, then 10 years of historical data would only give you 100 trades and that can be significant enough.

And if you have a trading strategy that trades 10 times a day, then getting just 100 trades (10 days worth of data) wouldn’t be considered statistically significant enough.

So what we want to do here is use some common sense.

If you have a trading strategy that trades about 3 times a day, then testing across 1 year of historical data would be good enough for you to get to the next phase.

If after your backtesting you have a Positive Expectancy, then you go to Phase 2.

Phase 2: Demo Testing

In this phase, this is where you will trade a demo account.

Some traders think it’s pointless to trade a demo account because it doesn’t actually take into account your emotions during trading.

And I totally agree with that.

Demo testing will not help you take into account your emotions, which can affect your profitability.

However, demo testing is purely to test your trading strategy viability.

For example, if in demo testing you are profitable and when it comes to trading a live account you’re not profitable…

Then there’s a chance that it’s not your trading strategy that’s the problem.

It could be you.

Because when you’re trading real money, you’re testing both the system in a live environment, as well as testing you.

With that said, I know that it’s also possible that your trading strategy works on demo account but not on a live account because of your broker.

For example, many Forex brokers are known to give you excellent condition in demo accounts without the Big 3 “S”:

• Slippage
• Spread widening
• Stop hunting

But when it comes to Live accounts, these 3 can come into play and affect your trading strategy.

That’s why it’s also important to choose the right Forex brokers, and also have a trading strategy that limits the effect of the Big 3.

Now, if in backtesting you need statistical significance, how many trades do you have to take in demo testing before assessing your Expectancy?

The answer is the more the better.

But you certainly do not have to wait until you have 100 trades under your belt before getting an idea of your trading strategy’s Expectancy.

In the book Trading In The Zone by Mark Douglas, he mentioned about taking 20 trades and then evaluating your trading system.

And I like that as a benchmark.

So with demo testing, make 20 trades and see if you have a Positive Expectancy.

If you do, you can move on to the final phase…

Phase 3: Live Testing

Now that you are profitable in demo trading, it’s time to put your trading strategy to the real test by trading in a live environment.

This is where the Big 3 “S” will come into play.

With some brokers the effect can be big, and with some brokers the effect can be minimal.

With that said, in this live testing, I don’t want you to worry about position sizing.

Instead, just trade the minimal size, which should be 1 Micro Lot (0.01 Lot or 1,000 units).

The reason is that you want to test your trading strategy to see if it has a Positive Expectancy in a live environment first.

Only once you’ve ascertained that your trading strategy is profitable, then you can get into position sizing and start trading with the aim of making money.

And again, get into at least 20 trades and assess your trading strategy.

If it’s profitable, then you can consider to either test it across more trades…

Or start trading it for real.

How to Turn A Negative Expectancy Into A Positive Expectancy

What happens if after your testing you end up with a Negative Expectancy?

Do you throw your trading strategy away and go back to the drawing board?

Not necessarily.

There are ways that you can actually manipulate your trading strategy to come up with a Positive Expectancy.

Here are 4 methods:

Method 1:  Increase your average profit per trade by taking bigger profits.

For example, I had been testing a trading strategy with a 1:1.5R risk-to-reward ratio and had a win percentage of 45%.

So my Expectancy would be:

(45% x 1.5) – (55% x 1R) = 0.125R

While this is profitable, it’s only slightly profitable.

So what I did was tweak my Take Profit to 2R instead of 1.5R and my win percentage changed to 40%.

In general, the bigger your Take Profit, the lesser your win percentage will be.

So with that, my new Expectancy is now:

(40% x 2) – (60% x 1R) = 0.2R

Just by increasing my Take Profit per trade, I was able to increase my expectancy by 60%.

Method 2: Increase your win percentage by taking smaller profits.

Now, this is the opposite of the first method.

So how do you know when to use this method?

Generally, method 1 should be used when you have a Trend Trading strategy.

Because when you trade with the trend, you should be able to get more profits.

But if you’re trading a Countertrend Trading strategy like Mean Reversion, then you might want to consider taking smaller profits to increase your win percentage and overall increase your Expectancy.

What I suggest would be to try both and see which works better for you.

Method 3: Decrease your loss percentage by increasing your Stop Loss distance.

If you’re getting stopped out too often and have a high loss percentage, then it could be that your Stop Loss placement isn’t ideal.

For example, many traders place their Stop Loss at obvious places that get stopped out.

So a simple hack would be to simply increase your Stop Loss by 5 – 10 pips, but keep the win-loss multiple the same.

For example, if you have a trade where the Stop Loss distance is 20 pips from the entry, and your Take Profit is at 40 pips for 2R…

Change your Stop Loss distance to 30 pips from the entry, but also change your Take Profit level to 60 pips.

This way you maintain a 2R Take Profit level in both cases.

Method 4: Tighten your Stop Loss but maintain or increase your Take Profit.

For this method, we want to manipulate your risk-to-reward ratio by tightening your Stop Loss.

For example, you may have a Long trade where you place your Stop Loss below the swing low and the Stop Loss distance is 20 pips away, and you have a 2R Take Profit level at 40 pips away.

So what you can do is shift your Stop Loss to 10 pips away instead, and keep your Take Profit level the same.

This way you have turned an initial 1:2 risk-to-rewards ratio to 1:4 risk-to-reward ratio.

While this might decrease your win percentage (as you will have more stop-outs), it might overall lead to an increase in your Expectancy.

Conclusion

Creating a profitable trading strategy isn’t as difficult as it seems.

But there’s certainly hard work involved as it will take you time to test your strategy and come up with one that you’re satisfied with.

However, as you now have a good understanding of how to create a trading strategy…

All you have to do is tweak and test using the 4 methods I shared with you to fine-tune your trading strategy until it’s profitable.

Now it’s time for you to get busy and start creating your own profitable Forex strategy!

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