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Forex Trading Strategies – The Key To Every Winning Model Ever Traded
When I spent the summer of my junior college year at Sorbonne, I used to play a game in the streets of Paris whenever I was bored. I’d look out at the bulging crowds at Champs-Elysées or Rive Gauche and see how quickly I could spot a fellow American. I became so good that it often took me less than half a second to identify my target. I did not even need to see the flash of the white athletic socks, or the unmistakable combination of shorts and golf shirts to know I was dead on. I could spot my fellow citizens just by their gait.
American men walk like upright gorillas. Our shoulders slightly hunched forward, our feet pounding the pavement with force of an elephant. Unschooled in the balletic grace of soccer, Americans do not glide through space, they barrel through it like the linebackers and running backs that so many of us were in high school.
In Paris I was practicing the simple art of pattern recognition. I became so adept at it that I would often amuse my French friends at the speed and accuracy of my analysis and win a few francs in the process..
Pattern recognition is a fundamental human trait and is at heart of every trading model that has ever been designed. The underlying assumption of every trading set up be it a simple moving average crossover or a complex mutli-variable algorithm is that prices move in patterns and those patterns repeat themselves with enough frequency to give the trader an edge. If price action was truly random no one could extract any profit out of the market over a sustainable period of time. There has never been a roulette player that has won thirty years in a row, yet we know plenty of hedge fund managers that have made billions of dollars over the past sevral decades by speculating in financial markets. Whether they acknowledge it formally or informally all of their activity is based on some sort of pattern that they continue to exploit.
Patterns however are not enough to succeed in trading .Exploitation of patterns is only effective when trades are executed within a proper context. To appreciate the value of context consider the following story. A few years back Washington Post wanted to see what would happen if they put Joshua Bell, a world famous violin virtuoso, into a metro station to play for spare change during the morning rush hour. Mr. Bell held nothing back that morning and performed with the same skill and passion that he brought to his many recitals across the world. For most of his performance Mr. Bell was roundly ignored by the busy commuters rushing to work. Mind you this was the same performer who later on that night would be paid thousands of dollars for his sold concert with the National Symphony. His gross earning from the gig in the metro? Thirty two dollars and seventeen cents. Context IS everything. .
The experiment with Mr. Bell answers a very common question many traders pose. “If your model is so good, how come I always lose money when I use it?” The truth of the matter is that almost all trading models fail when used indiscriminately. For example I find that most successful equity traders that employ momentum models trade only the opening and closing hours of the day when liquidity is highest. This make perfect sense because of the law of large numbers. Momentum works best when crowd behavior is monolithic. Crowds tend to behave with much greater homogeneity the larger their size. Human beings are social animals and they will tend to mimic each other with greater intensity as people join in. Just try to walk slowly next time you are caught in a crowd rushing into a pre-Christmas sale at Toys R Us (or worse yet remain calm during a sample sale for women designer shoes at some tony showroom in New York).
Patterns and context are the key factors of every winning model ever traded. Of course neither is easy to discern which is what makes trading such a challenge. However trading models also provide many other practical benefits to the every day trader. I’ll discuss those ideas next week.