I guest hosted CNBC Squawk Box Asia this morning and we talked about the Fed meeting and upcoming elections in the U.S.. Here’s the first clip about the FOMC and the prospect of additional Quantitative Easing. Enjoy!
Having a great time in Sydney, enjoying the weather and meeting lots of forex traders!
I also had the pleasure of being on ABC Lateline Business with Ticky Fullerton last week to talk about the outlook for the Australian dollar. Click on the image to access the video and enjoy. You can also read the transcript and access the video (right hand side) from the ABC Lateline Business website
In FX where leverage is an astronomical 50:1, traders can effectively hold 50,000 units worth of currency against only $1,000 dollars worth of equity. On the surface this sounds like an attractive proposition but it is in fact a recipe for disaster. High leverage is exactly like high speed driving. The thrill is amazing, but just one tiny bump on the road will cause you to swerve and crash.
The underlying rule of trading is the higher the leverage, the smaller the margin for error. And since all of us are human, we are prone to errors constantly, which is why a trader who uses high leverage on a regular basis has almost no chance of surviving over the long run. One of the most insidious aspects of high leverage is that it forces a trader to hold very tight stops in order control risk.
But the tighter the stop, the stronger the chance of a stop out.
The reason for this dynamic is twofold. First, markets very rarely move in a straight line spending most of their time filling back and forth which almost assures that prices will retrace and nick you out of you position if your stop is small. Secondly, the spread based nature of the FX market turns tight stops into a sucker bet for the average trader.
On a typical EUR/USD trade with a 2 point spread, a 10 point stop and a 10 point target the actual odds require the price to move 12 points in the traders direction before reaching his target but only 8 points against him to stop him out. That’s a 40%-60% proposition on an even money trade. To give you an idea of how unfavorable that is the odds on roulette are only 49%-51% against the player and yet casinos are more than happy to ply you with free booze and amenities and let you play that game.
Trading massive size on a tiny slice of equity is not the only way to achieve leverage when you trade. Leverage can also obtained through turnover. Imagine that EUR/USD range trades between 1.3975 and 1.4000 for most of the European session. If you sell at the top of the range and buy at the bottom 5 times in a row using only 1 standard lot contract by the end of the day you will have made as much money as having traded one half a million unit position.
Levering through turnover is much better than levering through size. By using much smaller positions you have the ability to set wider stops and targets allowing you to remain in trades much longer and absorb losses with psychological and financial ease. And finally trading on low leverage and high turnover is how most professionals run their books, so that is perhaps the best reason to implement this strategy.
What Business Are You In?
What business do you think AMC Cinema is in? How about Cinemark or Regency entertainment? If you said the movie business you would be dead wrong. All the cinema chains in the United States, and for that matter the world over, are actually in the food business. Movies are very low profit items for most cinema houses. In US they have to pay out 70% of the first week’s gross to the distributor. That share ratio becomes more equitable the longer the movies stay in distribution but since only a few films have the staying power to play more than two weeks the movie revenues are basically a scratch for movie theaters. Movie theaters make most of their money on popcorn and soda which run 90% profit margins.
So given the fact that movie owners are really in the food business you would think that they would do a better job. You would think that instead of hiring lazy, glassy eyed high school kids to man the counter and process orders at the pace of postal office clerk they would invest in self vending machines that would cut the line times in half and offer a variety of cool products like customized sodas and gourmet popcorn. The technology is there, but movie houses still think they are in the movie business and that’s why most of them suck.
The mistake of misunderstanding your business is common one and certainly not limited to the hapless movie house sector. In the 1930’s and 1940’s US train companies thought they were in the train business rather than the transportation business and were promptly destroyed by cars and airplanes. Contrast that with Europe or Asia where high speed rail connects major cities in both comfort and style. Ever take an Amtrak train through the US Northeast corridor? It makes a 7 hour traffic jam on I-95 feel like a pleasurable experience.
So why am I suddenly so concerned with the question of understanding what business we are in? Because when it comes to trading most of us (and I put myself at the head of this list) think that we are in the market prediction business. Most of us think we are in the “being right” business. We are not. In trading we are in the making money business and making money comes from properly reading the mind of the market. So our opinion doesn’t matter. Only the opinion of the market matters. There are only two reasons for why we lose money in our trades.
1. We are dead wrong in our analysis of market opinion.
2. We are early.
In both cases we are losing money which means that we not practicing our business properly and we must cut our losses and look for a new idea or a better time to enter the trade. Once we clarify the question of what business we are in, the question of am I right becomes a lot less relevant and we can hopefully learn to trade more effectively.
I am headed to Sydney and here’s my schedule! Hopefully I will be able to meet some of you all in person. I am particularly looking forward to the warm summer weather -- its gotten sooooo cold in NY!
Traders Expo, Sydney October 2010
Sydney Traders Expo Oct 29-30
Venue: Sydney Convention and Exhibition Centre -- Darling Drive, Darling Harbour New South Wales 2000
Times: 10am – 5pm daily
Schedule for both Fri and Sat:
11am Forex Trading 101 GFT Booth
12pm 3 Ways to Trade Currencies GFT Booth
2:15pm Actionable Forex Trading Strategies
3pm Forex Signals and Pattern Recognition GFT Booth
4pm The Warren Buffet way of Trading Currencies GFT Booth
Monday Nov 1:
Forex Workshop: Day and Swing Trading Strategies Signup -- It’s free!
Four Seasons Hotel Sydney
199 George Street
Sydney, NSW 2000
Registration: 6 p.m.
Client Session: 6:30 p.m. -- 7pm
Main session: 7 -- 9 p.m.
Listen in as Kathy Lien, GFT’s Director of Currency Research, discusses:
* 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
Media Appearances (Watch Me!) -
Thurs Oct 28 Bloomberg 12:40pm Sydney Time
Thurs Oct 28 ABC Lateline Sydney Time
Fri Oct 29 Sky News Guest Host 7-8am Sydney Time
Mon Nov 1 CNBC Asia Guest Host 9-10am Sydney Time
** Videos will be posted on my blog
G20 Finance Ministers and Central Bankers are gathering in Korea right now talking about currencies. There has been a lot of speculation about whether or not a statement will released on Saturday that show a unified view on currencies. In my article G20 Wildcard, I wrote extensively about the possible language that the G20 could agree on and other topics that are being debated at the meeting as we speak.
However as currency traders, what we really care about is how it impacts currencies. The following monthly chart shows how the EUR/USD traded after the G7 changed the language in the currency portion of their communique (fancy word for official statement). This will be the first G20 statement on currencies because in the past, these big announcements would be made at the G7/G8 meetings. As you can see in the chart, the language changes have marked both short and long term tops in the EUR/USD. Since this is a monthly chart, even the small reversals have been more than 1000 pips or roughly to 7 to 10 percent.
Any coordinated message on currencies will look more like the Plaza Accord, which was aimed at weakening the dollar than the Louvre Accord which supported it.
Take a look at how the EUR/USD traded after the G7 changed the currency portion of their communique:
Over the past few weeks we have been focused on the question of whether the Fed will increase stimulus. Now that another round of QE is all but certain, the new question becomes how aggressive will the Fed be?
One Fed President has provided clues on what he thinks the Fed should do come November.
Fed President James Bullard has laid out his preferred stimulus plan. If you recall, Bullard was the Fed official that previously said “more easing is not obvious” but his latest comments show that he has joined the dove camp and will be supporting a very specific plan for boosting the U.S. economy. He wants the Fed to buy assets in $100 billion increments with no specific size after the November FOMC meeting. These increments are small but leaving it open ended would give the central bank the flexibility it needs to continue the program for as long as necessary. He sharply disagrees with the calls for “big bang” purchases. Most of the Fed officials who have called for large scale purchases are not voting members of the FOMC. Voting members such as Duke and Pianalto have been far more skeptical about the effectiveness. Bullard also indicated that he does not expect the FOMC to change the “extended period” language in the statement which would have been very bearish for the U.S. dollar. Based upon the market’s reaction, investors are not impressed by the second version of QE. There is a good chance that Bullard will be spot on because dissent within the central bank could lead to a compromise between the members of the FOMC that support more stimulus and those who oppose it. By leaving the purchases open ended and letting the market know that the size can be increased or decreased at anytime buys the Fed time and gives them the flexibility to adjust the size based upon the U.S. economy’s reaction.
There are many reasons for why the EUR/USD should continue to rise, the strongest of which has been the Federal Reserve’s plans to ease monetary policy. However, there is another reason why the uptrend in the EUR/USD has been so strong. The following chart shows the correlation between the German IFO Report (white line) and the EUR/USD (orange line). As you can see, the IFO report has been a reliable leading indicator for the price action in the EUR/USD with the white line frequently turning before the orange line.
This is relevant not only because the latest trend in IFO supports a further rise in the EUR/USD, but because the next German IFO report will be released on Friday and it could give us clues on where the EUR/USD is headed next.
How close is the Federal Reserve to easing monetary policy in November? Pretty close if we look at the views of different FOMC members. However the skepticism of some officials could compromise the overall size of the asset purchase program.
Read on to find out where FOMC voters stand:
Voting Members of the FOMC
Believe More QE is Necessary
1. Ben Bernanke – Said earlier this month that “additional purchases will ease financial conditions and help the economy.”
2. William Dudley – Said on Oct 1 that “more action from the Fed is warranted unless the outlook changes.”
3. Eric Rosengren – Said on Sept 29 that the Fed needs to respond “vigorously” and “creatively” to the serious economic problem” posed by high unemployment, sluggish growth and undesirably low inflation.
Oppose More QE
1. Thomas Hoenig – Has been voting for tighter monetary policy since the beginning of the year.
2. Kevin Warsh – Traditionally leans towards more hawkish policies – said on Sept 28 that the “markets are normalizing if not normal” already and the “economy is improving if not improved.”
1. Sandra Pianalto (Possibly Dovish) – Leans towards more stimulus, very worried about sluggish growth and high unemployment and said Oct 1 that she is assessing the effectiveness of the Fed’s tools to stimulate the economy.
2. Daniel Tarullo (Traditionally Dovish) – Hasn’t talked about monetary policy recently but is traditionally a dove and supported a high degree of policy accommodation back in April.
3. James Bullard (Possibly Dovish) – On Friday, he said “more easing is not obvious” but he leans towards more stimulus after having previously said that “more help from policy may be needed to push up inflation.”
4. Janet Yellen (Unclear) – Is traditionally a dove but in her first speech as Vice Chair yesterday, she expressed concern that accommodative policy may prompt risk taking while further easing could fuel leverage build up.
5. Sara Raskin (Unclear- Slightly Dovish) – Hasn’t made comments since joining the Board of Governors, but at her confirmation hearing, she said that the Fed only has a partial victory with stable prices when “many American households continue to face the perils of unemployment.”
6. Elizabeth Duke (Skeptical About More Stimulus) -- Leans towards opposing additional stimulus – is skeptical about the effectiveness of large scale asset purchases and the Fed’s decision August decision to reinvest proceeds from mortgage backed securities
The Human Element
“Success brings emulation, emulation brings leverage and leverage brings disaster. Disaster comes not because the idea is wrong, but rather because there too many people doing it.”
The Invisible Hands: Hedge Funds Off the Record -- Rethinking Real Money by Steven Drobny
No matter how you analyze the market, you must never forget the human element. The human element is what makes trading so intriguing but at the same time so challenging. The human element is what creates massive distortions in the markets that defy even the wildest logic bankrupting many while making profits for the few. The human element is also why I believe it is impossible to “engineer” you way to success because trading can never be mastered completely.
————--Top 5 Stories in FX This Week—————-
Over a long period of time every algorithm eventually becomes a loser as humans adapt and change their behavior destroying the profitable patterns of past price action. Just think about gold and bonds. The fact that both are at record highs speaks volumes about the unpredictability of the markets.
Even the High Frequency Trading algos that rule the equity markets today will eventually face destruction. HFT’s essentially cheat their way to profit through front running and quote stuffing, They have made massive profits over the past few years, but their streak will not last. They will either be outlawed or equity volume will wither away as humans abandon the market leaving computers to trade with only with each other in a Faustian pact of mutually assured destruction.
The human element is why trading is as much a qualitative as it is quantitative activity. It is why psychology matters as much as economics and why guys with only a street level education can often run circles around PHDs with IQs above 130.
The human element applies not only to the markets in general but to ourselves in particular. Contrary to what we like to believe we never make our trading decisions based solely on merit and fact. History colors all of our actions. If we have lost several trades in a row we will be much more hesitant to plow aggressively into a position even if the trade has tremendous profit potential. Conversely, if are on hot streak we will often get arrogant and sloppy and try any half baked idea that comes our way. Little wonder then that sharp drawdowns inevitably follow steep gains.
The logical thing to do when trading is to cut your size after a long winning streak and maintain your nerve during a losing streak, but the human element makes such actions nearly impossible to implement. Still, we should always be keenly aware of its power to affect the markets and ourselves and try to the best of our ability to understand and control its impact on our trades.