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Forex Trading Strategies : Unisurable Risk
Last week I sat down for drinks with guys from my UK office on a unseasonable warm and sunny afternoon at Canary Wharf and as conversation bounced from one subject to another one of the guys mentioned that he had worked for an insurance brokerage company in prior life. He started to tell a story about one of their clients, a son of a very wealthy ruler from the Gulf who had gone on a spending orgy during his stay in London. The insurance company had covered the risk on all the royal cars which were becoming too numerous to mention. At the peak the son was burning through 4 million dollars per week on his pleasures, a sum so outrageous that it even got the attention of the father back home.
My first reaction at this story was one of sheer disgust at this gluttonous display, but then my attention suddenly turned to the insurance business and I asked my colleague, “Did you guys continue to insure his cars?” “Actually,” he replied “we stopped soon thereafter.”
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At first glance it may seem insane to turn down such a lucrative insurance business, but think about it for a second and you realize that the ruler’s son represented the worst kind of actuarial risk. Since he was so wealthy, he clearly could care less if his premiums increased and since he was so profligate it was highly probable that he would his automobiles as disposable toys. Thus, unless you charged him premiums that were equivalent to value of the super cars he purchased, chances were high that you would lose money on the deal. Contrary to conventional wisdom, the ruler’s son was actually as bad an insurance risk as a homeless drunkard.
In trading we constantly face such seemingly illogical choices. Right now for example, the Bank of Japan is trying very hard to prop up the value of the USD/JPY above the 85.00 level. At first their intervention efforts appear to have worked and the pair stabilized around that figure. But now their second attempt to push the yen lower failed and they face the very prospect they fear the most. If speculators sense that the BOJ is unable to weaken the currency they will redouble their efforts and the pair will drop to 80.00 like a stone. The irony of course is that on a fundamental basis the yen is probably the least deserving of all the major currencies to see a rally. But that fact doesn’t matter. USD/JPY will go to 80.00 because it can, not because it should.
To succeed in speculative markets it is absolutely vital to understand this difference between “can” and “should”. Value investors who concentrate on the “should” part of the equation are almost always proven right in the end, yet very few of them survive to reap the rewards of their analysis. Housing prices in US were insane by 2005. I knew seasoned New York city real estate brokers who had sold their apartments at that time and started to rent. Yet the party went on for two more years because it “could” and anyone who tried to short the real estate market suffered massive losses as result. So next time you stake a trade on a seemingly logical premise, ask yourself , if the illogical alternative is actually the better risk for the moment.