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The Japanese Yen strengthened across the board as investors cheer new leadership in Japan. After more than 50 years of unchallenged power, the Liberal Democratic Party (LDP) has been finally defeated by the Democratic Party of Japan (DPJ). The big question of if and when Prime Minister Aso will announce his resignation was answered almost immediately with Aso conceding defeat and confirming that he will resign as LDP head. Mr. Hatoyama, the current leader of the DPJ is expected to be confirmed as the new Prime Minister of Japan in approximately 2 weeks.
Who is Mr. Hatoyama?
Yukio Hatoyama has politics in his blood. His grandfather was the LDP’s first Prime Minister in 1955 and Hatoyama will be the country’s first non-LDP Prime Minister since 1955. He comes from a weathly family that has made their fortune in the industrial and political sectors. He is a fourth generation politician with a Ph.D in engineering from Stanford University. Although Hatoyama inherited his father’s LDP seat in 1986, he has been reelected to that seat seven times.
Some people in the Japanese political circle have called Hatoyama the “alien” as he can come off as eccentric and aloof. The Prime Minister role of Japan has been a difficult one for anyone to hold down for more than a year since Koizumi left office in 2006. As someone who can sound more like a teacher than a politician and has been criticized for being indecisive, Hatoyama has a tall task ahead of him.
The political landscape has changed dramatically for Japan with the DPJ’s victory. As the new party attempts to announce fresh measures aimed at stimulating the economy, there could be political turmoil. The DPJ does not have practical experience running the country and their goals are ambitious. Unlike the LDP whose initiatives have focused on business and public works, the DPJ’s initatives will focus on increasing disposable income for households. The party expects to pay for their new initiatives by cutting wasteful administration costs. Having previously criticized the Japanese economy for being overly dependent on exports, Hatoyama will be focusing heavily on boosting domestic demand.
Political Change Will Not Have a Lasting Impact on the Japanese Yen
However as happy as Japanese investors are about the change in leadership, the positive impact on the Japanese Yen could be limited. Long term trends in USD/JPY are determined by market fundamentals and overall risk appetite and not Japanese politics. With that in mind, USD/JPY is very weak. The sell-off in global equities and thin trading conditions ahead of the U.S. Labor Market holiday could drive the currency pair to a 6 month low of 91.75.
In terms of Hatoyama and the Democratic Party of Japan, it remains to be see whether they have what it takes to deliver on their promises of turning the economy around. If the global economy continues to recover, the DPJ could benefit from having the wind behind their sails. Either way, it will certainty be a daunting task for Hatoyama as the economy and his party’s legacy now rests on his shoulders.
The one inviolable rule of trading is that you can either have a system that is high probability and low profit or a system that is low probability and high profit, but you can never have both. That doesn’t stop novice traders from searching endlessly for the setup that risks a dollar and makes ten while being profitable 70% of the time but like the elusive El Dorado it does not exist.
I bring this up because when you are considering algo trading you should know this rule cold. If your system looks too good to be true in backtest, I guarantee you it is. 45 degree equity curves exist only in trader’s imaginations. In real life, professional trading looks like … well real life, two steps forward, one step back IF your are good. More often than not trading can be two steps backward for any one step forward.
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Just like baseball players every system will eventually go cold. Momentum setups will get destroyed by choppy price action and mean reversion trades will be stopped out repeatedly in strong trending markets. That’s why when you are creating a system it is much more important to understand the “why” rather than the “how” behind your ideas. This is the reason that so many engineers and mathematicians fail as traders. They become enamored with the data without understanding the underlying mechanics that drive markets. Price action is only a reflection of market reality, not the actual reality itself. Patterns change as reality changes and that’s why all algos fail in the end.
Which brings me to my final point. When you are thinking seriously about risk control in system trading you have to have a portfolio approach. The best way to minimize risk is to trade several non-correlated systems at one time. The idea is that you try to make more money on your profitable system that you lose on your unprofitable one.
How do you know when a strategy has gone bad? Marcel Dion, the quant from JP Morgan offers an interesting solution. In the Active Trade interview he states, “We track a system’s equity curve and make changes when it moves two standard deviations above the mean.” Note that Dion will stop trading the system not only when it gets very cold, but also when it overheats. That’s a good thing to keep in mind. In trading when things are going gangbusters and you fell invincible, that’s not a sign of your brilliance, but a warning that the market is about to extract its punishment on your account
Having been in Singapore for the past 2 weeks, I am delighted to back sitting at my desk here in NY with Boris behind me.
Hopefully you got a chance to check out some of the TV interviews that I conducted from Singapore. I posted one last week. Overall, I have been bullish Australian dollars and Euros. I received some heat from the commentators about my contrarian view, but the AUD/USD, EUR/USD and EUR/GBP have risen since then which means that sometimes the contrarian view may be a valid one.
Here are some more interview clips from earlier this week. I even got the chance to be on air with the Assistant Treasurer of Australia!
Click on the image to access the video
I am in Singapore right now getting the opportunity chance to meet some enthusiastic forex traders. Last week, I was on CNBC Asia talking about my outlook for currencies and equities. If you missed the interviews, here are the clips
One of the more popular clips of me on Youtube is called “Trading is not Logical”. It was done during the meltdown of 2007 when many
algorithmic driven funds sustained massive losses on their strategies. I was being interviewed by CNBC Europe and very emphatically stated that we were “huge adversaries of algorithmic trading because “trading is not logical, it’s physiological” and machines would never be able to identify the subtle shifts in market behavior.
At the time Kathy and I were working at 32 Old Slip in the same building at Goldman’s Alpha fund which was one of the algo hedgies
most heavily hit and I admit to having some very smug satisfaction that the “masters of the universe” had finally tripped up. However a few years older and somewhat wiser, I have amended my view. Algorithmic trading can be a legitimate part of your portfolio and in fact I believe will become ever more popular in the retail FX market.
Computer assisted trading is of course huge already. Anyone who has a Metatrader account will attest to that fact. The pitch for automated traded is devastatingly seductive. No need to sit at your desk watching every tick. You can just program an algo and let the computer go to work. You can enjoy a ife of leisure while your account grows like your very own FX piggy bank.
The reality is of course far different. The toxic combination of badly designed trading setups and sub-par broker execution often result in bigger drawdowns self traded accounts. Nevertheless, the concept of computer assisted trading is quite valid as long as you recognize it limitations. One of those limitations is execution. A setup that looks nice and orderly on a chart can be a cluster*** in real life in fast moving markets. Entries will be missed, phantom stops will be triggered and one dangling order on your books could ruin a good week’s worth of profits. The first rule of business when it comes to algo trading is to understand that just because a computer is executing your setups you still need to supervise and audit the account very closely.
The second limitation to appreciate is that most of the algorithms that traders use are horrible. I bring this topic up because the
September issue of Active Trader magazine has a very interesting interview with Marco Dion who ran quant trading strategies for JP
Morgan and other institutions in Europe. The key takeaway from Mr. Dion‘s interview is that much of his quant analysis was based on
fundamental rather than technical data. Contrast that with most retail robots out there who use nothing more than glorified versions of
moving average crossovers and you begin to see why most retail traders lose money with their algos.
Think about it for a moment. Price is a derivative of news and sentiment. Technicals are a derivative of price. When you trade
techicals you are therefore trading a derivative twice removed from reality. You are inevitably late in your analysis and are reacting to
the past rather than anticipating the future.
I don’t mean to imply that technicals have no role to play in algo trading. I merely suggest that they should not be the sole reason for
your setup. Price action always has a context and Mr. Dion has a very clever way of dealing with the invertible change of context that
destroys the validity of your algo. I will discuss that issue next week.
I will be on Bloomberg Television today at 1:20pm talking about the FOMC rate decision.
I just wanted to let everyone know that I will be in Singapore next week speaking at the Investfair. If you are around the area, come and see one of the presentations! I will also be giving a Forex Master Class on Fast and Furious Trading which is jam packed with new short term trading strategies.
Upcoming Trading Seminars or Workshops
Singapore Seminars August 22-23
Suntec Singapore, Level 4, 402-403
My Presentations at GFT Booth August 22-23
August 22 On Stage -- Actionable Forex Trading Strategies 6:15pm -- 6:45pm
August 24 -- Fast and Furious Trading Forex Master Class 6pm-9pm Sign up!
Media Appearances (Watch Me!) --
Fri Aug 21 CNBC Asia 8:20am SG Time (8:20pm ET)
Fri Aug 21 CNBC Asia 10:40am SG Time (10:40pm ET)
Tues Aug 25 CNBC Squawk Box Australia 6:20am (6:20pm ET)
Tues Aug 25 Bloomberg 9:00am (9:00pm ET)
Tues Aug 25 CNBC Squawk Box Europe 1:20pm (1:20am ET)
Back when he was young and lithe and strong as a White Bengal tiger Patrick Swayze made one of the best thrillers of the early 1990’s called Point Break. The film made a female director, Kathryn Bigelow, is considered to be one of the most adrenaline fueled action adventure screenplays put on celluloid. Playing against Keanu Reeves in one of his very few non-wooden performances, Swayze is the head of a surfer gang who rob banks in order to finance their carefree lifestyle.
What makes Swayze’s crew so brutally efficient is that they are in and out of the bank in less than 90 seconds, making it almost impossible for the authorities to catch them in action. Unlike most robbers who get lured by riches hidden deep within the bank, Swayze’s crew never goes for the vault. Until of course the final sequence, when their need for one last big score tempts them to override their discipline triggering a set of very predictable consequences.
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I’ve been thinking about Point Break a lot during the past several weeks while constantly trading my 00 setup. As some of you may recall I went to a ridiculously tight money management model taking only 5 points of profit against 10 points of risk on every trade. However, the results were nothing short of stunning. Despite missing many setups, making more than a few execution mistakes and trading occasionally off hours I was still able to post 14 out of 17 winners maintaining an 80% win rate necessary for the strategy to work.
The reason for my success was the same as that of the surfers in Point Break. I never went for vault. In short I never allowed greed to get the better of me. I got in, got out and banked my money. While hardly glamorous those 5 point wins added up to 40 basis points of gains for the week. Do that 50 weeks a year and you are looking at 20% rate of return unlevered. That’s killer money in the hedge fund world, and if you come anywhere near to achieving that goal consider yourself a great trader.
In another seminal movie – Wall Street, Gordon Gekko make the famous “Greed is Good” speech, but I am here to tell you that greed is not only NOT good from a moral point of view but from a market perspective as well. If you are greedy, your competitors will easily defeat you by exploiting that weakness, as Gekko discovers in the end. Greed in fact is the mortal enemy of success in trading. How many times have we tried to press the trade too far only to lose all our profits and more? Financial markets are extraordinarily unforgiving places of business that constantly prey on your instinct for greed. That’s why the lesson of Point Break should be seared into every trader mind – never, ever go for the vault.
I was on Bloomberg earlier today talking about how the dollar could react to FOMC
We are witnessing a very powerful move in USD/JPY ahead of the FOMC rate decision. After falling to a low of 95.11 intraday, the currency pair has recovered all of its losses and then some. USD/JPY is now trading back within the Buy Zone, which i determine using Bollinger Bands with a strong hammer formation.
In my FOMC Preview and Daily Report on FX360.com, I talked about how the best game plan for the FOMC decision is to trade USD/JPY. I have been bullish the currency pair going into the rate decision because I think the Fed will have to acquiese by upgrading their outlook for the U.S. economy. If they do, we could see USD/JPY make a run for 97. However if they dowplay the significance of the improvements in the labor market, the reversal could be violent.
Game Plan for FOMC
Based upon the Fed fund futures which are pricing in a rate hike as early as Q1 and the sentiment in the markets, we know that traders are looking for some sign of optimism from the Federal Reserve. This can come in the form of an upgraded economic assessment, talk of an exit strategy or any other indication that interest rates will not remain low for an extended period of time. In our opinion, the Federal Reserve will probably retain the tone of the previous statement, mentioning only some of the improvements in the economy and avoid talking about an exit strategy. You can find more details about this in our FOMC Preview ( Will the Fed Deliver any Surprises ). However as the U.K. central bank has surprised us with their dovishness while the central banks of Canada and Australia have surprised with their hawkishness, we do not rule out market moving comments from the FOMC. If the Fed changes or drops their “the pace of economic is slowing” and” economic activity is likely to remain weak for a time,” statements, expect a rally in USD/JPY. If they talk of exit strategies and bond yields start to rise, we could see a more dramatic dollar rally. If the Fed disappoints by downplaying the improvements in the U.S. economy, we could see an ugly reversal in the greenback. The currency pair that will have the purest reaction to the FOMC decision will be USD/JPY. Although we also believe that the dollar could rally against the euro on the heels of a positive outcome, it is too early to tell if the dollar is trading on fundamentals or risk appetite. So the best game plan is to focus on USD/JPY.