Tricks To Help You Trade Part 1

Boris Schlossberg

The other day someone who works for a very obnoxious boss asked me for advice. I flippantly answered that there are only two choices when you work for a truly odious person -- homicide or quiting. Although my remark was of course made in jest it contained a kernel of truth. The older I get and the longer I trade the more I realize that the key to success in both life and markets is to reduce unnecessary stress as much as possible.

The market of course can be the worst kind of a boss. It is highly mercurial, often unfair and frequently malicious. As traders not only are we subject to the vagaries of minute by minute changes in sentiment, but we are also frequent victims of botched executions, dropped Internet connections and a thousand other indignities that could quickly disturb our minds and send us into impulse trading orgy that inevitably ends in massive losses.

So over the next few weeks I would like to share with you some tricks of the trade that can help you minimize the stress of day to day trading and hopefully keep you calm and focused and on plan.

Trick #1 -- Open Two Separate Accounts.

Let’s face it. Most of us will never stick to our trading plan. Moreover there is no good reason for why we should. Experimentation is critical to creativity and creativity is absolutely vital to survival in the markets. Markets constantly change and the only way we can discern those changes is by interacting with price action in new and hopefully profitable ways. The critical mistake that most of us make is that we often commingle our experimental trading with our core setup trading in one account. The net result is that losses from our experimental trading almost always lead us to abandon the discipline of our core setup.

I used to believe that having two accounts at the same broker would help you solve that problem, but I no longer think that this is a good idea. It’s too easy to transfer money to an fro from two adjoining accounts at the same broker and you basically wind up sending good money after bad, as you constantly try to prop up the equity of the losing account. Instead it is very important to open two accounts at two separate brokers.

For your “junk” account you should choose a broker with lowest possible spreads and smallest possible size executable, so that you can experiment trading lots of as little as 1000 units. This is effectively your “play” account and you should open it first thing each day to satisfy your urge to trade and participate in the market.

Your “serious” account should be held at a broker who has the best possible execution rather narrowest possible spreads. Ask yourself these questions. Does my broker widen spreads inordinately during news announcements, making it impossible to enter the market at reasonable cost? Does my broker frequently reject limit entries during periods of volatility? Does my broker often lag its price feed behind the market? If the answer is yes to any of those questions, then that brokerage is not the place for your “serious” account.Your “serious” account should be traded only at a reputable broker with good dealing capabilities and top notch customer support.

Once you have set up this structure you must make a solemn promise to yourself that you will never, ever, ever ever, ever, ever trade anything but your prescribed setup in your “serious” account. Irrespective of whether you are losing or winning you cannot pollute your setup trades with experimental trades. That’s what the “junk” account is for. Having separation of purpose will hopefully create peace of mind and allow you to adhere to your trading plan with 100% consistency.

Next week I will have even more ideas of how to refine your trading structure so that you can assess your progress more effectively.

Compare the April FOMC Statement

Federal Reserve forex blog Kathy Lien

The Fed just released the April FOMC statement and I have highlighted all of the changes. As you can see, the only major change is their acknowledgment of inflationary pressures. Unfortunately they still believe the effects of higher prices will be transitory which means that rising prices are not enough to convince them that policy normalization needs to happen quickly. Overall, the tone of the FOMC statement suggests that doves remain in control

Compare with March Statement

FOMC Statement March 15, 2011

Information received since the Federal Open Market Committee met in January suggests that the economic recovery is on a firmer footing, and overall conditions in the labor market appear to be improving gradually Household spending and business investment in equipment and software continue to expand. However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed. Commodity prices have risen significantly since the summer, and concerns about global supplies of crude oil have contributed to a sharp run-up in oil prices in recent weeks. Nonetheless, longer-term inflation expectations have remained stable, and measures of underlying inflation have been subdued.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate remains elevated, and measures of underlying inflation continue to be somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation. The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations. The Committee continues to anticipate a gradual return to higher levels of resource utilization in a context of price stability.

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.
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 for the federal funds rate for an extended period.

The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen.

Tough Love

Boris Schlossberg

Although all of us claim that we like constructive criticism, in reality we rarely like to hear the truth. After all who wants to be told that you are fat, or lazy or sloppy or disorganized or selfish or arrogant? Few people have the courage to tell us the truth to our face. Our natural instinct when confronted with criticism is to deny, defer and delay any responsibility for our actions. When good friends or parents proffer some harsh advice the typical result is a screaming match followed by a stormy exit.

After many such arguments over the years I realized that screaming, shouting and denying doesn’t work in real life or in the markets. Ultimately to move forward you need to suck it up, accept the criticisms and correct your behavior. This is especially true when it comes to trading. You can either listen to what the market is telling you or you can lose all you money.

After trading extraordinarily well for most of March I went off the rails last week giving back nearly half my profits over a twp day period. In the past my natural reaction would have been to punch the screen, throw a few office supplies around and then storm out, cursing the market, the unpredictability of trading, and the idiocy of life in general. Instead I decided to grow up, accept the fact that I screwed up and find out why. In looking at my trade runs I realized that a new experimental money management strategy was actually creating massive instability in my intra-day trading. Typically, I am a single entry, single exit trader. However, a method whereby I tried to scale up into a position, blew up in my face. Without even realizing it I reverted back to my old habits of scaling down into a position. In other words by introducing some flexibility into my money management rules I rapidly lost all discipline and paid the price.

There are some traders who can successfully experiment with both position scaling and the size of their stops. Unfortunately, I am not one of them. I know my limitations. My orderly, OCD-like personality does not function well in chaos. Like an alcoholic after a sip of liquor to his lips, I immediately spiral down into wild, average-down-until-you-get-stopped-out-for-a-massive-loss trading orgy if I do not adhere to my single entry, single exit rules. So I quickly changed my approach and never made more than one entry per trade. My drawdowns quickly diminished.

However, looking at my trade runs in more detail, I realized that my other problem was that I was still making many trades that were off plan. Whether it was boredom or experimentation -- the reasons did not matter. My off plan trades were a big cost factor to my P & L. Nevertheless, I knew that any attempt to curtail them would be futile. I am just too impulsive by nature to ever contain myself strictly to my setups. Instead I decided that I would try to control the damage without forcing a personality makeover. I simply resolved that all my impulse trades would be 1/10th my regular size. That way any damage to account equity would be minimal. However, I went one step further. I set the default execution size on my trading platform to 1/10th my regular size. That way when I wanted to trade my actual setup, I would have to make a conscious effort to change the sizing before I could put on a trade. This final fail-safe method made all a huge difference in my trading. The only “serious” trades that I was taking were the ones that set up to my plan.

It’s never fun to confront your flaws, but to ignore them is much worse. My friend Rob Booker once asked me if trading was the toughest profession there is. I answered yes. And tough professions require tough love.

Dead Inventory

Boris Schlossberg

A New York times article with Jay Bean the founder of an online marketing firm OrangeSoda caught my eye this week not only because I agreed with his observation that Groupon made a huge mistake in not taking the $6 Billion Google offer ( mark my words Groupon will lose out to Living Social), but because he inadvertently provided a great insight into trading.

Prior to his successful launch of the OrangeSoda agency, Mr. Bean decided he wanted to take a break from software business and run a true retail operation. In 2005 he started a company called Sunglasses Only. Initially he planned an online business, but sunglass manufactures would only do business with him only if he had a retail location. He made his first mistake and compromised. Instead of just walking away, he modified his business plan and decided to open up two large storefronts in order to acquire the sunglasses brands he needed.

When we are trading we often find ourselves in the same position. Sometimes our trading strategy does not quite set up, but in order to participate we often compromise and jump into the market just to make the trade. No one is more guilty of this sin that I, who loves the action sometimes more than winning. But in fact if you want to be a long term winner, you should never compromise with the market. As speculators we have one incredibly powerful choice at our disposal -- we can stand down when conditions are not optimal. However, we often delude ourselves into believing that we will be smart enough, fast enough, accurate enough to violate our well worn rules and still walk away with a profit. Of course that is the biggest sucker bet of them all

In the end Mr. Bean was stuck with an inventory of 3,000 sunglasses that he had to liquidate at a massive loss when the financial crisis of 2008 killed demand for the product by 90%. Apparently sunglasses were not the first thing on consumer’s minds in the post-Lehman environment. Jay Bean said that the biggest reason for his failure was holding all that dead inventory. The sunglasses business would have been viable if he wasn’t saddled with so much unwanted stock.

Although as traders we rarely view ourselves as small storefront owners -- we should. Our business has much more in common with Mr. Bean’s than we imagine, and the issue of dead inventory is key. What is a losing position but dead inventory? Imagine if a trade was a carton of sunglasses. Would we continue to buy more and more sunglasses if the current product was not moving off the floor? As business owners we find such behavior absurd, but as traders we do it all the time when we continuously average down into a losing position in hopes of a small rebound that would put us back in black.

Granted prices in financial markets are far more volatile than in the real markets and reversion to the mean works just often enough to entice us into executing this strategy. However in the end, stockpiling losing positions just as stockpiling unwanted merchandise is a bad strategy that always end in tears. So next time the impulse strikes you to average down, ask yourself -- am I about to acquire some dead inventory?

The Weight of Our Convictions

Boris Schlossberg

Warren Buffet once said that “In the short run, the market is a voting machine. In the long run, it’s a weighing machine.” What he meant is that ultimately, in the financial markets just as in real life, action talks and baloney walks. No matter how ridiculous, how illogical, how utterly insane prices become, they always correct to their intrinsic value. Witness the Nikkei in 1980’s, Internet stocks in the 1990’s, US housing market in 2000’s.

Mr. Buffet’s maxim holds true for investors, but it can be a cold comfort for speculators like us who trade the most fickle market in the world. Ostensibly, the currency market exists for corporations to hedge their foreign exchange exposure, but fully 97% of the volume (last measured at $4 Trillion per day) is driven by speculators such as banks, hedge funds and retail traders like ourselves. The dirty little secret of FX is that everyone speculates -- even the corporates and the central banks.

The history of the market is littered with ghost stories of Fortune 1000 corporations whose Treasury departments lost millions and sometimes even billions of their shareholders capital in badly managed FX trades that had nothing to do with their core business. Even Mr. Buffet dropped a cool billion at the start of this century when his bet on the collapse of the dollar turned woefully wrong.

So how do you think about value in a market where sentiment reigns supreme? After all equities at least had some semblance of net worth because they represent hard assets of the corporations that issue them. Currencies on the other hand are a completely abstract concept backed only by the full faith and credit of their respective sovereign entities. In our world, money is just a blur of electronic bits on a computer screen.

Therefore as speculators we must operate differently. In order for us to heed Mr. Buffets advice we must make sure that the market is operating as both a voting and a weighing machine at the same time. What that means in plain English is that in order to succeed we must make sure that fundamentals and price action are in alignment. Those of you who follow me on twitter know that my ideal flow trades are always driven by a combination of price momentum off some fundamental trigger. In trading flow it is not enough to be on the right side of the news -- price action must confirm your analysis. Only then do you have a high probability trade.

The longer I trade flow, the more I am convinced of the efficacy of this approach. Whenever I deviate from my method, by trying to fight either the price action or the newsflow, I inevitably lose. In short, Mr. Buffet is right the market is both a voting and a weighing machine and it is our duty as traders to make sure we respect both factors before entering the fray.

ECB Rate Decision and Impact on EUR

ECB ecb rate hike eur/usd Kathy Lien

-- Rates currently at 1.00%
-- 25bp rate hike completely priced in for Thurs
-- 50bp priced in by June
-- 100bp priced in by end of year

The most anticipated event risk this week is the ECB’s monetary policy decision on Thursday and the euro has rallied strongly ahead of the announcement. For the first time in 2 years, the ECB is expected to raise interest rates. Having brought rates to a record low of 1.00 percent, Trichet has made it clear that a 25bp rate hike is needed to avoid a further rise in inflation expectations. Recent comments from ECB officials have been very consistent and a 25bp rate hike has been completely priced into the market. In fact, traders are pricing in a 50 percent chance that interest rates will be increased by 50bp. We believe that a half point hike is extremely unlikely given how central bank officials have stressed the need to raise rates gradually. It would be smarter for the central bank to split this up into two separate moves than one large move there is little reason for the ECB to act quickly, let alone aggressively. What is more likely however is that the ECB raises rates and then signals the need for further tightening in the months to come. The strength of the euro indicates that investors expect hawkish comments from the ECB.

Should ECB President Trichet disappoint by downplaying the need for further tightening, the euro could come crashing down because the only thing holding it up is rate hike expectations. Despite continued downgrades by rating agencies and the earthquake in Japan, the ECB still believes that normalization needs to begin now. As a result, we expect the euro to remain strong going into Thursday’s announcement but the reaction to the rate decision could be less favorable. How the euro responds to the rate hike depends on what ECB President Trichet says at 8:30 NY Time. If he indicates that this is a one off rate hike, investors could end up selling euros but if he signals that they will continue to tighten in the coming months, then not only could the EUR/USD sustain its gains, but it could extend to 1.45.

How US Government Shutdown Could Affect the EURUSD and USDJPY

Kathy Lien US Dollar

There has been a lot of talk about the possibility of a U.S. government shutdown. Republicans and Democrats in Washington continue to clash on budget negotiations, raising the risk of the first government shutdown since 1995 during the Clinton Administration. Congressional leaders are in deep discussions and a shutdown could be avoided, but with the U.S. government telling federal agencies to be prepared to implement contingency plans, it is important for currency traders to be prepared as well by knowing how the U.S. dollar could react to the shutdown.

We have been down this road before 15 years ago and based upon the price action of the EUR/USD and USD/JPY at the time, investors are not too worried about the implications of a government shutdown on the economy. When the government was shut down in Nov 1995, both the EUR/USD and USD/JPY barely budged. When a second shutdown occurred during the Clinton Administration in December of that year, the dollar actually rallied against the Japanese Yen before normal government operations were resumed. The main reason is because any shutdown is expected to be so temporary that it will pose no risk to the U.S. sovereign debt rating. It will also not scare investors away from buying U.S. debt. The only major economic implication is that Federal workers won’t be paid during the period that the government is shut down. If an agreement isn’t reached by midnight on Friday, the government will shut down all non-essential government services.

Has the RBA Announcement Marked a Top in AUD?

aud/usd Australian Dollar Kathy Lien Reserve Bank of Australia reserve bank of australia intervention

The Reserve Bank of Australia made it very clear last night that they do not plan to raise interest rates in the foreseeable future. Despite the rise in commodity prices, the RBA expressed little concern about inflation. As a result, the AUD/USD extended its losses as investors realized that unlike the ECB and other central banks who are just beginning their tightening cycles, the RBA is done.

Yesterday, I posted the following chart showing how RBA decisions can frequently mark a short to medium term top in the AUD/USD. It seems like the same scenario could be unfolding again. What do you think?

Pre Rate Decision

Post Rate Decision

Chart: Chinese Rate Hike Doesn’t Matter

china china second largest economy chinese reserve ratio forex blog Kathy Lien

For the second time this year and the fourth time since 2010, the Chinese government raised interest rates by 25bp, bringing its lending and deposit rates to 6.31 and 3.25 percent. Like many other countries around the world, China is worried about rising inflation pressures and the negative impact that it could have on inflation expectations and the overall economy. Over the past year, China has tried to combine rate hikes with higher reserve requirements for banks and the results have been limited. The recovery in the global economy has boosted growth expectations for China, forcing the central bank to take continued actions to slow their economy. While the timing of the announcement was a surprise, everyone expected more tightening from China because of the strength in commodity prices. In addition, China rarely make one-off moves which explains why the market’s reaction to China’s rate hike was so muted. High yielding currencies initially sold off after China’s announcement but since then, they have recuperated nearly all of their losses.

Diminishing Impact of Chinese Rate hikes

Each Chinese rate hike has had a smaller and smaller impact on the currency market. The first rate hike back in October elicited the biggest reaction because it was the first rate hike in nearly 3 years. At the time, all of the pro-cyclical currencies plunged against the U.S. dollar with the euro falling 1.5 percent and the Australian dollar declining by more than 2 percent. When China raised rates again on Dec 27th, the euro ended the day slightly higher against the U.S. dollar while the Australian dollar remained unchanged. In February, the reaction was slightly larger in the EUR/USD, GBP/USD and USD/JPY but the AUD/USD and NZD/USD ended the day higher. The price action today is even more muted as indicated in the chart below which suggests that investors are skeptical about China’s ability to tame their roaring economy. Slower Chinese growth is undoubtedly negative for global growth but we have been down this road before and even though there have been signs of slower growth in the Chinese economy, it has not had a significant impact on demand.

Rising inflationary pressures is the primary motivation behind China’s rate hike. With commodity prices continuing to rise, China did not want to take any risks, opting to preempt a further increase in inflationary pressures by raising interest rates. Given the health of the Chinese economy and the prospect of stronger global growth, we have not seen the last of China’s policy actions. We expect more interest rates hikes and more reserve requirement ratio hikes in 2011.

*April reaction is based on currency value change from Chinese rate hike announcement to 9am NY Time / 13:00 GMT