Forex Trading Tips: Trading With Discretion

Boris Schlossberg

Trading With Discretion

One of the best things about “Inside the Black Box”, the book about quants that I am reading, is the authors refreshing candor in discussing the shortcomings of algorithmic trading. The quant’s Achilles heel is something called “regime change”. Regime change is basically a fancy way of saying that the future looks nothing like the recent past. In fact it becomes almost the polar opposite of what you would expect. Black becomes white, up becomes down, value companies get shorted, junky nearly bankrupt stocks rally frenetically. This is a nightmare for computer based traders whose whole investment model is built on the idea that past patterns will repeat themselves in the future. When market behavior becomes asymptomatic, algos lose money.

I was contemplating this issue with respect to my own simple daily scalping. The irony of the matter is that I have railed for years against algorithms proudly describing myself as a “purely discretionary trader”. Yet the older and better I get, the more systematic I become. Fact of the matter is that on a short term time frame markets are mindlessly repetitive and once you observe a certain pattern in the price action you tend to take advantage of it continuously until and unless it begins to fail.

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Yet discretion still matters. No matter how solid your setup, human judgment should still be the final determinant of action. Case in point was my scalping last Thursday night. I’d taken a short in GBP/USD because my round number setup triggered a signal. However, UK housing data had just come out and it was extraordinarily hot with prices rising more than twice the market expectation. Normally this would be very bullish for the pair, but it actually fell on the news and I smugly thought to myself –“Aha! See you should never doubt your setup!” as I watched my P&L grow bigger. Needless to say the fall in the pound did not last. After a few moments the pair reversed itself and I watched in dismay as it climbed against me for about half an hour, finally putting me out misery like rabid dog as it hit the stop.


The next trigger came from a EUR/USD short which again I took. This time however I was a lot more wary. We were very bullish German unemployment data which was going to be released in half an hour time. Why do I want to be short euros into this data point? I asked myself. I didn’t. So I decided that I would cover the trade if it retraced back to my entry. That was a smart move, because after the unemployment report, the euro traded in a straight line to the upside and would have forced me to take another stop out.


There is of course the danger of constantly second guessing your system and such behavior is as bad as blindly following its every command. However on balance there is and I believe always will be room for discretion in trading. Human behavior cannot be perfectly modeled by a bot, and just as it takes a thief to catch a thief, so too it takes a trader to stop your system from making a reckless trade. Discretion, used sparingly is still the better part of valor.

Forex Trading Tips: Price Action is NOT Random

Boris Schlossberg

Price Action is NOT Random

seasonalequity

The chart above courtesy of the ChartStore, recently appeared on Barry Ritholtz’s Big Picture blog and immediately caught my eye. What I find fascinating about it is how it completely contradicts the efficient-market-all-price-action-is-random school of thought. Those of us who trade every day of course know empirically that price action is not random at all. In fact all price action breaks into just two classifications – range and trend. What makes price action appear random to an untrained eye is the never ending flow of news that buffets prices much like a beach ball riding an ocean wave.

Reaction to that newsflow however is generally quite predictable. Good eco news will push prices up bad eco news will send them down. Before everyone hollers in protest of course this is not an ironclad rule but rather a guideline. Good eco news can be overshadowed by other considerations – as we are seeing now in the EUR/USD or it can have minimal impact if prices have already risen quite high and most of the news has been factored in. However, all things being equal a strong positive economic report will have a concomitant effect on the price action.

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The reason why prices aren’t random is because they are set by human beings who are driven by just two emotions – fear and greed. Those waves of emotion, much like the waves of water follow a broadly repeatable pattern.


But back to the chart – why does it show that price action is not random? Take a look at September. If prices were truly random, if September was just another month on the calendar why would it generate consistently negative returns over more than 80 years of data? To be truly random that would mean that every 10th flip of a coin in a series of eighty 12-set flips would have to come up tails. It’s possible to occur if you have a highly unusual sample but very unlikely. It’s much more probable that the losses in September are caused by fear.


September after all comes at the end of the summer -- usually the happiest season for most men (and men with apologies to my partner and any members of the fairer sex who are reading this – make up the vast majority of traders and investors). In North America, summer is the season of baseball, beer, barbecue, beaches and bikinis. There are few red blooded American men who do not find pleasure in all those activities. So during the summer stock returns become engorged along with men’s bellies, but when September’s cruel call brings everyone backs to the office, the cold harsh light of reality often triggers a massive sell off as fear overwhelms greed.

Is that the reason for the September slide? Impossible to say for certain. But I think it sounds more plausible than just the mere randomness of fate. In fact the more I trade the market the more I am convinced that there is little about that it is random. Sometimes it appears to act in completely illogical ways, but that’s not because it is random. It’s because you haven’t figured out the dominant force driving price at that moment. Markets being human enterprises, sometimes that force can be pure manipulation. Fortunately we trade the biggest market of them all, one that even Goldie cannot control, and in the FX market price action is definitely not random.

Forex Trading Tips: The Hidden Risk Within Your Trade

Boris Schlossberg

Temp

In “Inside the Black Box”, Rishi Narang lifts the veil away from the secretive world of quantitative trading, explaining in clear, easy to understand English the key concepts that drive so much of hedge fund trading today. Instead of becoming bogged down in the inscrutable math of the quants. Mr. Narang expertly navigates the reader through the key theoretical concepts behind systematic trading and in the process provides multiple morsels of wisdom for the retail trader to consider. I will come back to many of the ideas he explores in the book in the next few months, but this week I want to focus only on one.

Mr. Narang shows how even the simplest systematic strategy can carry unintended risk. In quant world “relative alpha” -- where a trader decides to go short “expensive” instruments and go long ”cheap” ones -- is a very common strategy. However, if the trader were to follow it blindly, according to some valuation algorithm he would be in danger of making unintended sector bets. For example if the computer screen revealed that software companies were “cheap” and oil refiners were expensive, then an unfiltered relative alpha strategy whose intended function is to bet on a variety companies in order to diversify risk would in fact be making one implied bet of high tech vs. oil. Mr. Narang shows how the biggest blow up in hedge fund history – LTCM- was guilty of precisely such a flaw. Although traders at LTCM put on thousands of trades ranging from Argentine bonds to US Treasuries they were all essentially different variation of one trade called the convergence trade. When that trade went against them, all their positions lost money simultaneously.

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I still remember several years ago being approached by someone at a Trade Show in Las Vegas who proudly told me that K and I sucked making a puny 100-200 points a month when he was making more than 500 points a week. “Really?” I asked a bit surprised and impressed by his claim. “What kind of trades are you doing?” He proudly whipped out his account statement and showed me that he was long USD/JPY, long GBP/JPY, long AUD/JPY and long EUR/JPY. This was in the heyday of the carry trade so naturally the guy was minting money. Needless to say I never heard from him again when the carry trade crashed and burned at the end of 2008.


We always stay in our trade even if data is wrong because often the overall trend saves us. Alas not today. Sometimes the only thing you can learn from your mistakes is that you have to accept them.


In currencies making this type of mistake is very common. If you are trading with a $10,000 account and have a rule that you never want to put more than $100,000 notional into any one position and you happen to be long one standard lot of EUR/USD, long one standard lot of GBP/USD and long one standard lot of AUD/USD -- guess what? You are way over your limit. You are essentially making the same anti-dollar bet three times over. Although euro, pound and Aussie are not completely correlated they are correlated enough that you a very likely to incur much larger losses than you anticipated if the position moves against you. Instead of being diversified you are actually highly concentrated and should be aware of the hidden risk in your trading position.

Coming to Singapore!

Kathy Lien Uncategorized

I am headed to Singapore for the Asia Trader & Investor and will be out of the office (ie. not blogging) starting today until May 7th.

If you are in Singapore or plan on visiting, here is my schedule. Stop by and say hi!

Singapore Seminars April 24-27

Asia Trader & Investor Confidence
Suntec Singapore

Presentations at GFT Booth on both days:

10am 3 Easy Ways to Trade Currencies
11am Forex Signals and Pattern Recognition at Your Fingertips
12pm Learn the Basics of Forex Trading

2pm 3 Easy Ways to Trade Currencies
3pm Forex Signals and Pattern Recognition at Your Fingertips
4pm Learn the Basics of Forex Trading

April 24: 12:45pm – 1:15pm Range & Trend Trade Stage Presentation
April 25: 3:30pm -- 4pm Risks for the U.S. and Singapore Dollars


Media Appearances (Watch Me!) --

Thurs April 22 Bloomberg 9:20am SG Time (9:20am ET)
Fri April 23 CNBC Squawk Box Australia Guest Host 6-7am SG Time (6-7pm ET)
Fri April 23CNBC Europe 2:15pm (2:15am ET)
Fri April 23 CNBC Squawk Box Europe 1:20pm (1:20am ET)
Wed April 28 CNBC Asia Guest Host 4-5pm SG Time (4-5am ET)

Forex Master Class Register
Suntec Convention Centre
26 April: 6-9 pm Or
27 April: 1-4 pm

+ Battle-tested short- and medium-term trading strategies
+ How to spot and react quickly to changes in market momentum
+ How to take advantage of trend and counter-trend moves
+ How to scalp fundamentally and improve the use of common forex technical indicators

Terms of EU Support for Greece

eur/usd Kathy Lien

The euro has strengthened significantly over the past 24 hours as EU officials finalize a prescription for Greece. Here are the details:

1) bilateral loans from European governments for 3 years

2) up to €30bn lending by euro area members states for the first year, in addition to the IMF’s contribution (€12.5 to 15bn reportedly)

3) lending rates near 5% calculated as 3-month euribor plus 300bp spread with further 100bp for more than 3 years and plus 50bp for operational cost

4) IMF loans priced according to their formula (currently 3.25% for a loan of 10x quota)

The package is larger than the market had anticipated and the rate is much lower than market rates.

Forex Trading Tips: How NOT To Learn From Your Mistakes

Boris Schlossberg

How NOT To Learn From Your Mistakes

“Good Morning Boris, that’s fine we cannot win every trade,” started an email from a sub that I received this week.

“There are two points I would like to mention and will only follow if you agree:

1. I set an alarm and wake up at 4:25am when the trade was only a few pips away from the T1. If I was awake, I would have exited half as that was kind of over bought as well, would you agree?”

That’s simply a matter of luck, I wrote back. We were within 3 pips of T1. You have to accept that element of the markets. You cannot try to micro manage it.


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“2. When our stop was very obvious to be hit I was watching, should we exit when we find such obvious hit, or should not worry about few pips and let the stop hit?”


We always stay in our trade even if data is wrong because often the overall trend saves us. Alas not today. Sometimes the only thing you can learn from your mistakes is that you have to accept them.


Sometimes the only thing you can learn from your mistakes is that you have to accept them…


To let things be is perhaps one of the hardest lessons to learn from trading. No one likes to tinker with his strategy more than I. I drive K crazy half the time with my never ending stream of setups. Sometimes my ideas have merit and we implement them into the BK model but if it wasn’t for K’s steely discipline and determination to stay on track I am sure the BK trading record would never be so steady.


The inclination to tweak you approach the moment a trade goes wrong is one of the most natural yet destructive impulses that we have. Trading by its very essence is the art of assuming risk. Trades inevitably lose. If they didn’t, if every trade was positive we’d all be infinitely rich. In fact when you follow the trading record of even the most successful hedge funds, the path always looks like the meanderings of a somewhat drunk gentleman – two steps forward, one step back.


The problem is that we want to associate trading with the regularity of a bi-weekly paycheck, but the reality is of course very different. Some months are feast and other months a famine. To succeed in trading we have to appreciate its inherent volatility of the enterprise. Sometimes there is nothing to learn from your mistakes, because they are not mistakes at all they are simply trades.

Dollar’s Reaction to Payrolls Should Last

eur/usd Kathy Lien non-farm payrolls

The dollar surged after the non-farm payrolls report because job growth excluding census workers was very strong.

With the absence of U.S. equity traders, we did not see the risk rally that tends to occur near the U.S. equity market open. Based upon how the dollar traded after the NFP report in April 2007, there is good chance that the current trend in the dollar will last. Volatility should settle by the London close and the move that we see today should continue on Monday.

The following chart shows how the EUR/USD performed on April 6, 2007 and how the move continued the following Monday. For a chart on how the EUR/USD traded on NFP day on April 6, 2007, read my prior NFP post.

Forex Trading Tips: The Paradox of Negative Edge

Boris Schlossberg

The Paradox of Negative Edge

The latest book I am reading, Fortunes Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone is a fascinating account of how some of the smartest scientific minds in America along with some of the most unsavory characters in organized crime managed to create a perfect betting formula that provided just the right balance of risk and reward in order to generate massive profits for those bettors who enjoyed an edge in the game.

The key to success however, lay in the ability of the bettor to garner an edge. Without it, the Kelly criterion as the formula is known cannot help you, despite its very clever math. The underlying thesis behind the Kelly criterion is to bet only a portion of your stake, ratcheting up the amount as you hit a winning streak and decreasing the bet size as you start to lose. By betting a smaller and smaller amount each time you lose, you avoid what’s known as gambler’s ruin – where you eventually run out of money.


The Kelly criterion is a brilliant piece of mathematical work, created by scientists responsible for the intellectual foundation for all of modern electronic technology. Literally every device we use to communicate with each other from the computer, to the cell phone, to the satellite is a direct result of these men’s inventions. The story of how the Kelley criterion came into being and generated millions of dollars for some of the earliest quant funds on Wall Street is fascinating tale of the intersection between Mafia, MIT and Bell labs and is worth reading just for its dramatic impact alone.


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However, this week I’d like to focus on just one aspect the Kelly formula – the idea of an edge. As traders we are constantly taught to seek out trading opportunities with a positive edge. Books are littered with advice to always look for trades with at least 2:1 reward to risk ratios (This way you only need to be correct just half of the time and you’ll make money! They cheerfully inform you). Some of the professional currency strategists I’ve encountered even boast that they never trade anything with less that 4:1 r/r ratio.

We have all heard the statement that 20% of your employees generate 80% of your output, 20% of your customers provide 80% of your revenue and so on and so on. In general this is true in markets as well. The Pareto distribution, as it is known scientifically is present in many types of observable physical and social phenomena including the financial markets. In theory, under the Pareto distribution a few good trades will make up the losses of many bad trades.

There is only one problem – human psychology. Suppose I gave you a choice. You can take 10 trades 9 of which would lose you $10,000 each or $90,000 in total and the tenth would make you $120,000 for a net profit of $30,000. Or you can take 10 trades where 7 would make you $20,000 each and 3 would lose you $40,000 each for a net profit of $20,000. On the surface the first strategy appears to make you more money but I can almost guarantee you that 99% of traders will wind up losers under that method. Why? Human beings hate to lose. Furthermore they hate to lose consistently. If you deconstruct the first strategy you basically have only 1 out 10 chances to make a winning trade. These are lottery like odds for an average trader. Here is what’s most likely to happen. You will quit after the third trade and never catch the winning trade in the sequence. You will cut your winning trade short because you are so desperate to recoup some – any – part of your money that the end result will still end up negative. Or worst of all you will miss the one winning trade and will simply generate 9 losers in your account.

Flip the scenarios. In strategy number two you have 7 out of 10 chances to win. That fact alone is likely to keep you on track and help you adhere to your trading strategy. Furthermore, if you are lucky you may even miss one of the large losers and improve your performance even more. That’s the paradox of negative edge. At BK we trade with a negative edge not because we think it is mathematically superior – we know that it is not. We trade with negative edge because we know that it is psychologically more palatable and trading at its core is always more psychological that it is logical. Academics never factor in human frailty as a variable and yet it is perhaps the most important element in achieving long term trading success.