Forex Trading Tips: No Better Than Guessing

No Better Than Guessing

In the latest book I am reading (The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty by Sam Savage) the author briefly takes the reader on a trip back in time to World War Ii and the work done at Princeton University by a group of a mathematicians and statisticians to help with the war effort.

In an almost throw away passage, Mr. Savage writes, “Ted Anderson currently an emeritus professor of statistics and economics at Stanford university, was a research associate there. One of their projects involved the evaluation of long-range weather forecasts. ‘ We found that there was very little accuracy beyond two days,’ Ted recalls . (Things haven’t changed much).”

I stared at this paragraph in the book for a long time wondering why it resonated with me so and then I finally remembered a meeting I had with a Russian hedge fund a few years back that had its offices in a very tony Fifth avenue building and housed more computer power than the Pentagon. The Russians had done an enormous amount of research on price behavior across almost all asset markets and concluded that at any given point of time directionality completely degraded within 72 hours from the start of observation.

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Essentially, market forecasts and weather forecasts have something in common – our ability to predict either beyond the next 48 hours is no better than a guess. That’s the reason that whenever I am on Squawk and Joe or Carl try to get me to forecast the value of the dollar in the next twelve months I squirm in my seat and protest that I am only good for the next day or two.

Chaotic systems such as markets and weather patterns are notoriously volatile and projecting their direction far out in time can be exercise in futility. But does that mean that all long term investing is not possible? Not necessarily. Warren Buffet is a testament to the fact that the turtle can sometimes decimate the hare in the race to generate alpha. They key with the long view is that investors must vastly expand their margin of error. Portfolio managers who trade stocks will rarely allocate more than 2% of their equity to one idea. This way even a 50% decline in price of the security only results in a 1% loss to their overall holdings.

Contrast that approach with what we do in FX where we regularly trade at 10 times leverage. Under those conditions an adverse move of just 1% in our position results in a 10% haircut to our account. Both ways are perfectly legitimate forms of investing as long as we acknowledge what we are doing upfront. Too often short term traders become “investors” as price moves against them. If you are trading for the short term and your are holding the position for more than 72 hours you may as well buy a lottery ticket. Your chance of success will probably be better.

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