Forex Trading Tips: Dollar Honeymoon Over?

FX Market Outlook

When I used to be a headhunter during the Internet bubble days of the 1990’s, I had colleague from the deep south with whom I would chat at least once a week. We couldn’t have been more different in outlook and temperament but we got along well and always enjoyed each others company. Although Jimmy was a good ole Southern boy who lived deep in country 100 miles away from Atlanta, his understanding of human nature was far sharper than that of most urban sophisticates. Whenever I’d ask his opinion on some latest, wacky, software start-up we were sourcing for, he’d pause, consider it and then say in his Southern drawl, “Baaaaaris, I think they got lots a heat but little light,” and then break into deep baritone laugh.

Lots of heat but little light is exactly what we have going on the currency market, as no one really knows how to combat the financial crisis and authorities continue to blow more more hot air on an increasingly impatient public. Nothing was more embarrassing then the performance of Tim Geithner this week whose Richie Rich youthful looks and smarmy, pontificating delivery only highlighted the fact that he is completely unprepared for the challenge that confronts us all. The warmed over financial prescriptions from the Obama administration were nothing but a version of Bush lite -- hardly the reason the country elected the man and if Barak Obama continues on this dithering path of appeasing his enemies rather working for his friends, he -not George Bush- will be known as the Herbert Hoover of the 21st century.

Ask anyone who is a professional on Wall Street and there is almost uniform agreement agreement on the proper policy solution for the financial sector -- nationalize the big four banks (Citi, BoA, Wells Fargo, JPM) that control 80% of all deposits in the country. Guarantee the depositors, bankrupt the shareholders, ram down 50% haircuts to bondholders, recapitalize, stabilize and privitize with new management. Let the vulture hedge funds bid on all the asset backed paper sitting on the bank’s books at whatever price they want (I think most people will be surprised by the strength of the bids) and let’s just get this over with. In short as Steve Ballamer of Microsoft said, the whole system needs a reset. Welcome to capitalism 2.0.

However, instead of revolutionary change we have an incremental, technocratic approach of the Obama administration where all hope now rests on the “Hail Mary pass” strategy of the stimulus package. Yet fiscal stimulus without contemporaneous reform of the financial system is a prescription for disaster. It makes the former ineffective while doing nothing about the problems caused by the later.

For now the markets continue to give the benefit of doubt to the dollar. In one of the great ironies of financial life, the worse investors feel about the prospects for a quick US recovery, the better the dollar does as risk aversion flows continue to support the greenback -- but how long will this dynamic last? For now the risk aversion/risk assumption trade remains in place, but we’ll watching for any early signs of its rupture which could signal that the dollar honeymoon is over. Certainly the Obama honeymoon is.

————--Top 5 Stories in FX This Week—————-

Geithner Can’t Find Gun, Let Alone Silver Bullet

Adam Smith Gets the Last Laugh

Geithner Bank Bailout Plan: Fiasco

The Unmentionable Bank Solution
Let Big Banks Fail, but Save Finance

—————--Sweet Spot For Short Term Trading—————

Here is the ugly truth about short term trading. If you trade with a 10 point target and a 10 point stop you will need the price to move your way by 12 points while only giving yourself 8 points of margin for a stop. In other words, just the simple mechanics of a spread based market like FX put the odds at 65%-35% against you even under the best case scenario. That’s a very tough edge to give up to the house and is the primary reason why most short term trading approaches fail. To succeed, the 10/10 strategy needs to be 80% accurate -- a degree of precision that is almost impossible to sustain over a long period of time.

Let’s look at another way. Let’s consider the spread as your cost of doing business. If you are trading with 10 point stop/10 point target a 2 point spread is 20% of your cost of capital. If you are trading with a 100 point stop the 2 point spread is only 2% of your cost of capital. Move away from EUR/USD and USD/JPY and the contrast becomes even sharper. On a 4 point spread pair like GBP/USD or a 5 point pair like NZD/USD the numbers are 40% and 50% versus 4% or 5%. Ask yourself if you were running a business that had a 50% transactional cost versus a business that had 5% cost which one would be most likely succeed?

Most FX traders like to trade short term and most FX traders lose money. While correlation does not always imply causation, in this case it does. Short term trading requires short term risk and that by definition means that odds are stacked against you.

In an ideal world FX Traders would trade with a 100 point target and a 100 point stop greatly reducing their transaction costs and improving their chance of success, but we live in the real world where most of us have no patience to hold trades that long, so the question becomes what is the minimum reasonable stop and target parameters that we should use on short term trades?

While opinions can vary widely, my personal view is that the minimum reasonable profit target should be set at 20 points and the minimum stop is 25 points, anything smaller simply chops you out in noise. Stops are critical to controlling your risk but can also be monstrously damaging to your account. Ask anyone who has been caught up in chop and got stopped out 6 or 7 times in a row for a 10 point loss each time -- that the same as taking one big 70 point hit. If you are trading with 100 point targets that’s not too hard to make up, but if you are trading with 10 point targets the challenge becomes considerably more difficult. To paraphrases one of our former president stops should be available, legal and rare. In the meantime if we are going to trade short term we should at least give ourselves some chance of success by not making them ridiculously tight.

Now on to this week’s video

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