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A book that I am currently reading (The Quants, by Scott Patterson) follows the classic path of a Greek tragedy. Man full of hubris (in this case due to his intellectual prowess) believes he has discovered the Truth. Drunk with arrogance from his ability to extract billions upon billions of profits from the financial markets he ignores the danger signs of the greatest credit bubble in the history of mankind and winds up nearly destroying the global financial system with his greed and megalomania.
It’s difficult to fathom that some of the smartest mathematical minds in the world could become subject to the basest human emotions of a degenerate gambler, but the protagonists of this book do indeed begin to behave exactly like roulette junkies doubling down continuously until their bankroll is nearly exhausted.
One of the key takeaways from the Quants is that despite the multi-regression factor analysis, despite cupola functions and Gaussian curves, despite elegant algorithms that constantly play mean reversion between momentum and value – financial markets are at their core not logical at all, but rather psychological. In times of fear human beings will be afraid to bid a penny for a multibillion dollar company and in times of greed they will part with their last dollar on a stock that has negative net worth.
Yet the true lesson that I learned from the book is that size and leverage kill. The real reason most of these quant hedge funds got into so much trouble is that the massive scale of their positions along with the very high lever factor of up to 30:1 set them up for a colossal failure. Like dinosaurs that ruled the earth they were nearly wiped out from one cataclysmic event – the collapse of the US housing market.
In many ways their predicament made me appreciate my position as a retail trader. My exist strategy is not dependent on liquidation of thousands of securities. One click of a button and I can be in cash within seconds. This is a much underappreciated benefit that many of us take for granted. Unless we are trading more than 50M notional of currency, our size will not impact the market allowing us unimpeded entry and exit from our trade. Of course, platforms will go down, quotes will freeze and brokers will be unable to execute our orders – but those are permanent risks of trading FX and a big reason for why you should have several accounts. In the grander scheme of things however our ability to “float like a butterfly, sting like a bee” is a huge asset. In trading being small and swift is a plus.
The other lesson from the Quants is the double edged danger of leverage. Basically anything above 10:1 is ultimately financial suicide. Leverage is a wonderful drug when the trade moves in your direction but it is pure poison when the market is aligned against you. The Achilles heel of all of the quants profiled in the book wasn’t their finely tuned analytics. It was their massive leverage that forced them to cough up their positions at the worst possible time. When Bob Pisani walks the floor of the NYSE screaming that there is non-fundamental seller in a stock – he is referring to margin liquidation – a time when your ability to choose is taken away from you. The quants were the victims of that very dynamic and not even the most sophisticated algos in the world could help them then.
With rating agency Fitch downgrading Portugal’s sovereign debt rating and Germany continuing to whine about bailing out Greece, who can blame forex traders for dumping euros? A flight to quality pushed the euro to a 10 month low against the U.S. dollar and now there is no major support in the EUR/USD until 1.30.
Why a Downgrade is so Damaging
Downgrades of sovereign debt ratings are a very big deal but in an environment where investors are already weary of holding let alone buying euros, Fitch’s decision to lower Portugal’s rating added salt to the wound. It served as a harsh reminder that even if EU leaders come to an agreement on a bailout package for Greece, other countries in the Eurozone still need assistance. This may even be a good reason why EU leaders need to craft the financial aid mechanism very carefully because if it is too generous, other countries could ask for similar support. Fitch’s decision also reminds everyone that there is always more than one cockroach in the closet.
This morning, Fitch lowered its rating for Portugal from AA to AA- with a negative outlook which means further downgrades are possible. Their reason for the downgrade is the same as the reasons for every sovereign downgrade that we have seen over the past few months -- “significant budgetary underperformance” in 2009. According to the Associate Director of Fitch’s sovereign team “A sizeable fiscal shock against a backdrop of relative macroeconomic and structural weaknesses has reduced Portugal’s creditworthiness,” “Although Portugal has not been disproportionately affected by the global downturn, prospects for economic recovery are weaker than [euro-zone] peers, which will put pressure on its public finances over the medium term.”
Although Portugal is much healthier than Greece who has a Fitch rating of BBB+, the downgrade is further embarrassment for the Eurozone and gives investors another reason to bail out of euros. A credit rating reflects the risk of default. Therefore a lower credit rating means that a country is at greater risk of defaulting on their debt. The greater the default risk, the more it will cost the country to borrow. On a local level, we expect investors to shift their money out of Portuguese debt and into countries with a higher credit rating such as Germany or even outside of the Eurozone. At the same time, downgrades in other countries is positive for the U.S. dollar because the greenback attracts anyone looking for quality.
Room for Euros to Fall
The euro has plenty of room to fall on a technical basis and last week, short euro positions in the futures market decreased significantly on profit taking. These same traders who have moved to the sidelines could return, providing the EUR/USD with new sellers. Even though the EUR/USD is vulnerable to a short squeeze after such a deep sell-off, we still believe that the currency pair could continue to fall.
For the eighth trading day in a row, EUR/CHF has failed to rally. The Swiss Franc even ended the day at a fresh record high against the euro as traders test the resolve of the Swiss National Bank. This has led many currency traders to wonder What is the SNB Waiting For? Why haven’t they intervened?
The problem is that even though the central bank has been warning about intervention, they have also been talking about raising interest rates. Over the past year, a lot of traders have sold Swiss Francs as a funding currency because of its low yield and now the prospect of a rate hike will force them to unwind their short CHF positions. Although intervention risk is exceptionally high at this time, the reason why the SNB has not intervened yet is because we are in a very different place now than in March 2009.
When the global financial crisis hit, there was a tremendous amount of deleveraging in which investors bought back Francs and closed their positions. Many Swiss banks also reduced their balance sheets, leading to downside pressure on EUR/CHF. In fact, net capital flow into Switzerland hit a record high last year. As a result, EUR/CHF fell aggressively at a time when the financial crisis was still unfolding, forcing the SNB to step into the market to weaken the Franc. The central bank intervened 3 times last year from what I can tell – in March, June and September. Since then, the global economy has stabilized, Switzerland came out of recession and the economy is improving.
With less to fear, the SNB has remained out of the market opting for verbal versus physical intervention. The trade surplus is a lot higher than last year and exports remain at healthy levels, reducing the need for intervention. Forex traders love to test the resolve of a central bank and I continue to expect them to do so until the SNB actually steps in. Everyone has an uncle point and for the SNB there is no question that we are nearing that level but as we have seen in the recent price action, betting on a move by the central bank can require deep pockets.
This is sooooo good! I highly recommend you watch this for an entertaining and educational breakdown of Keynes and Hayek’s conflicting economic theories. Kudos for the video
This morning, Japan Post Bank announced plans to double their deposit limit from 10 million to 20 million yen. Japan Post Bank is the country’s largest postal service operator and also its largest financial institution. With financial assets of 300 trillion yen or the equivalent of US$3 trillion, their holdings exceed the entire GDP of France. They are also 1.5 times larger than Mitsubishi UFJ Financial Group, the country’s largest private bank. Therefore as you can imagine, even though the Japanese Yen barely reacted to the announcement, decisions by Japan Post can and will have a long term impact on the financial markets.
Japan Post Could Invest New Deposits in Treasuries
Approximately 75 percent of the funds held by Japan Post are invested in Japanese government bonds. Since their privatization launch in October 2007, they have been looking to diversify the assets collected from postal savings deposits. In the fourth quarter for example, they bought Y300 billion or US$3 billion worth of U.S. Treasuries. Their holdings of foreign securities increased by Y2 trillion over the past year which is large in absolute terms but small compared to Japan Post’s overall holdings. However if Japanese citizens take advantage of the higher deposit limits, Japan Post could find themselves flush with cash and they will in turn be looking for a place to invest. This could create fresh demand for U.S. Treasuries and foreign bonds denominated in euros, yen or any other higher yielding currencies.
Japanese Bankers Call the Decision Unfair
Although Japan Post lifted its official guarantee for deposits, many depositors believe there is still an implicit guarantee since the bank is state owned. As a result, Japanese Bankers have called the expansion unfair because it creates a competitive advantage. The bank’s primary motivation for increasing the deposit is to raise enough funds to operate uniform financial services nationwide but with Y40 trillion yen or US$400 billion in Japan Posts deposits expected to mature this year, the bank may also fear that the country’s aging population will shift their money out of Japan in search for yields. There has already been a sharp increase in demand for foreign currency denominated mutual funds – the holdings of these funds in Japan increased 31 percent in January and 25 percent in February from the prior year. If Japan Post is successful at keeping some of this money at home, there could be less downside pressure on the Yen when the deposits mature.
The Japanese government will also decide on Wednesday whether or not to privatize the bank. In all likelihood, privatization plans will remain on hold. The government will most likely sell a portion of their holdings, which allows them to retain the power to veto any major changes in the bank.
Last week I wrote, “Each day I attempt to ask and answer only two questions –What’s Happening? And How Will It Affect Price? Get that answer right and you’ll be on your way to being a successful short term trader.”
That’s only partially true.
Short term trading is never only about analytics. It is also about systemic risk control. Your analytics can change from day to day, moment to moment. In fact flexibility and open mindedness are the key attributes of all skillful short term traders. However when it comes to risk control your system must be well thought out and rigid as a column of steel. You can experiment all you want with your trading setups, but deviate from your risk control rules and you will always pay a heavy price. It doesn’t matter if you run a 500 dollar retail FX account or 5 Billion dollar hedge fund like LTCM. Ignore the rules and the market will smite you.
————--Top 5 Stories in FX This Week—————-
The World’s Strangest Financial Instrument
The Accounting Trick That Inflated the Bubble
The Coming Rebound in Private Credit Demand
Why ETFs Are Better
Although everyone has a different tolerance for risk, here are my day to day rules.
In trading there are two ways to generate leverage. You can use high margin or you can have a high turnover. I prefer the later. I don’t trade with more than 10:1 margin and generally keep my ratio to 5:1. That means that for every $10,000 in my account I will not hold more than a 100,000 unit position at any given time. My goal is not to “press the pedal to the metal” on every trade but rather to make money one pip at time. My plan is take many trades throughout the day and average 20 pips/day or 100 pips/week. If I can do that consistently that means I am generating $25,000 of profit per year for every $10,000 of capital at risk. That would be pretty damn good.
I trade with fixed stops of 20 pips – regardless of whether I am trading yen, pound or any other pair. I know this ignores the whole issue of volatility but I don’t care. It simplifies my trading enormously. I trade with fixed stops of 20 and fixed take profits of 20. During a typical day when I am busy with a million things this system has saved my hide more than once. I NEVER WIDEN MY STOPS, but I may bust out of the trade early if I don’t believe it has the power to reach my target. Over a long period of time and after doing thousands trades I learned that 20 points is the perfect amount of risk for me. If I get stopped at -20 it’s because I am dead wrong in my analytics or my timing.
3. Position sizing
Again I opt for simplicity. I generally open with 1 unit (so if I had 20K in my account my opening trade would always be 100,000 units) but if I am extremely confident in the trade I will double my bet and trade with two units from the start. That’s the maximum position sizing I allow myself. I never add to a losing position but I will double my bet to two units if I get stopped out and I am confident that the trade should work and I was just early. If I get stopped on 2 units I step back and bring my size back to one because I am clearly wrong on the trade.
4. Day Limits
Generally I never reach them, but if I am down 5% on my equity (-$500 on 10K account) I stop trading for the day. There are a million factors that could be responsible for such a drawdown but the single most important action at that time is not to try to figure them out, or to try to get the money back, but to simply STOP TRADING. This is the most common reason why most short term traders blow up their account. When it come s to trading the Hippocratic oath is a pretty good rule to follow – “first, do no harm”.
Last week, I wrote that shorting AUD/NZD is my favorite trade. At that time, I said that if the currency pair rallies back above 1.31, then the uptrend has resumed and my call is wrong. However, AUD/NZD tortured me and came within 2 pips of 1.31 (1.3098) before reversing sharply lower. There is no major support in the currency pair until 1.2775, but as indicators adjust to the movements in price, so have support levels. The 1.2850 level is now the new support and that’s where I am targeting.
On a side note, I am kicking myself for not posting an official call because the moves have become deeply oversold in these currencies. However I think USD/CAD is going test parity (currently at 1.0105) and EUR/GBP is could fall to at least 0.8915 (now 0.8975).
Here is my dissection of the March 16 Fed Statement
FOMC Statement March 16, 2010
Information received since the Federal Open Market Committee met in January suggests that economic activity has continued to strengthen and that the labor market is stabilizing ( upgraded “from deterioration in the labor market is abating”). Household spending is expanding at a moderate rate but remains constrained by high unemployment ( upgraded from weak labor market), modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software has risen significantly ( upgraded from appears to be picking up). However, investment in nonresidential structures is declining, housing starts have been flat at a depressed level( concern about housing returns) , and employers remain reluctant to add to payrolls. While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.
With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period ( here are the words again). To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve has been purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt; those purchases are nearing completion, and the remaining transactions will be executed by the end of this month ( Fed ending asset purchases). The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability ( New!).
In light of improved functioning of financial markets, the Federal Reserve has been closing the special liquidity facilities that it created to support markets during the crisis. The only remaining such program, the Term Asset-Backed Securities Loan Facility, is scheduled to close on June 30 for loans backed by new-issue commercial mortgage-backed securities and on March 31 for loans backed by all other types of collateral ( Fed ends liquidity facilities!).
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh. Voting against the policy action was Thomas M. Hoenig, who believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to the buildup of financial imbalances and increase risks to longer-run macroeconomic and financial stability ( Hoenig elaborates on dissent).
This week, after our live trading session was over (24 out of the last 25 months making money, pat, pat on my own back ) I was swamped with requests to put together an FX toolbox – web tools that I use every day to help me make sense of trading. So this week we’ll take a step back from our typical ruminations on trading and will focus on basics.
Short term trading is a combination of watching the news and watching the charts, so I have a lot of monitors in front of me. At the office I work with a 3 monitor set up, a laptop and a double screen Bloomberg terminal that K and I share. We also have 2 flat panel TV sets -- one tuned to Bloomberg TV the other to CNBC.
At my home office where I do most of my short term trading my set up is a little different. I have four separate computers. Now before you gasp at the cost, let me say that these are the cheapest, most basic boxes that you can buy at TigerDirect.com or a million other computer dealers for less than $300 each. Why do I use so many computers? Because Windows sucks. I want my application to stay up for days (sometimes I will keep a computer running for a month). The only way to achieve that in Windows is to allocate one application per computer. So at home I have one computer that only runs news, one computer that runs my trading software, one computer that just shows me the 15 minute charts for euro, cable and yen (that one has a 32 inch screen) and one computer on which I do my day to day work. Overall I sit in front of 7 screens in an L shaped desk configuration.
————--Top 5 Stories in FX This Week—————-
Race to the Bottom in G4
Nine Women can’t have a Baby in a Single Month
Promising Wholesale Figures
Greek Debt Crisis Could Raise Problems for U.S.
Reaching, Once Again, For Yield
Meanwhile, just to give you some perspective K trades from her tiny Macbook laptop – but she does not scalp furiously every single day like I do.
What do I use for news? For $9.99 per month you can watch all three CNBC channels (Asia, Europe and US) online. I highly recommend it. There are plenty of critics of CNBC who think it is nothing but financial blather, I disagree. Occasionally there are some very interesting insights from the guests, especially on the London show which I watch every day. But opinion doesn’t matter. For trading purposes I watch CNBC for one reason only – to determine what is the Big Story of the day. For example when they reported that the Greek bond auction went off well, I instantly go long euros and the pair rallied 50 points over the next half hour. So when it comes to trading I watch CNBC for the headlines, not the opinions.
For a pure newsfeed I like nothing better than the Dow Jones newswire that comes free if you have a GFT account. I am not certain what other brokers provide it as well, but for my money nobody covers the currency market better than DJ. They will print the latest rumors from the dealing rooms, breaking eco numbers and a running analysis of price action 24 hours a day 5 days a week. I have a 22 inch screen devoted just to the DJ feed.
To see the latest eco data results I use the forexfactory calendar which has the simplest and cleanest interface and will usually post results within 5 seconds of the release. Dow Jones also publishes the eco data, but its scrolling interface can make it difficult to read in the heat of the battle.
Finally charts. I use no indicators on my charts, so almost any chart will do. However, I am partial to FXTrek by Intellicharts because they have a very easy to use interface that allows me to demarcate the chart both vertically and horizontally ( for time and price). However at $100/month that’s an expensive luxury if you don’t need its full array of functions.
That’s it despite all the hardware, my daily trading setup is relatively straightforward. Each day I attempt to ask and answer only two questions –What’s Happening? And How Will It Affect Price? Get that answer right and you’ll be on your way to being a successful short term trader.
I was on CNBC Squawk Box Australia last night talking about the outlook for the Japanese Yen as well as the European currencies: