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You Don’t Sell Insurance in a Hurricane
Since the start of February USD/JPY is down more than 1400 pips. For those of you in the lottery business -- congratulations. Your once in longtime payout has hit paydirt. You can take your bow and walk off the stage with pockets full of profits. But if you are in the insurance business then this is definitely not the time to play.
Trading at its core is a very simple business. You only have two choices. Trend and Anti-trend. Every time you bet you are effectively predicting one of two possible paths -- the next move will be the continuation of the present one or it will be a reversal of it.
Since trends are much rarer than ranges all of trading essentially devolves into two models -- the lottery model where you make many small bets and lose most of them with the hope of hitting a ten bagger trade on just one of your tries and the insurance model where you win almost all your small bets and try take as few big losses as possible.
Most gurus teach the lottery model, but in real life especially in day trading the lottery model fails miserably. Since most of the currency dealers operate on the insurance model lottery traders become an easy opportunity to make money as market makers run stops day in and day out slowly collecting all of the lottery capital.
So in my chat room we trade the insurance model. We bet on anti-trend. We trade with negative risk to reward ratios and we try to win more than 75% of the time. So far so good. After more than a year of trading we are up in double digits while drawing down less than 3%. John Hancock would be proud. This year many of the new traders in my room are trading much better than me having fully absorbed my “insurance” principles and some are up 30% already.
But there is a time when the insurance model of day trading fails miserably. When volatility spikes and trends take over, trading against the move is a sucker bet. Volatility is exactly like a hurricane. It’s basically when price just like wind starts to move at 3, 5, 10 times its normal rate. The cardinal rule in the insurance business is that you don’t sell policies as the wind starts to blow and you certainly don’t stand in the middle of a full blown hurricane offering to cover the damage. Which is why when Yen went crazy, the first thing we did in our chat room was step away which was probably the best decision we made all week.