In Trading We Sell Greed, but Fear is the True Secret

Boris Schlossberg

This was the first week in five that I lost money on my weekly trades in BK and yet it was the best week I had.

I started out very long loonie, thinking that a relatively hawkish BOC, the high price of oil and decent eco data would give my trades a boost. I was also bearish euro as the pair faced the turmoil of EU parliamentary elections, the slowdown in Germany and the nasty fight between Brussels and Rome.

I was right but it didn’t matter. The loonie was bid up ahead of good news and euro sold down ahead of bad data, so the story impact was minimal and prices went against me almost from the get-go. Yet in the end, I managed to lose very little money which is actually the perfect way to trade.

A few weeks ago I noted that the only way to trade successfully is with a two target process, where you take half the trade off at some short risk target and let the rest float looking to bank 2 times risk or more. That second half of the trade is basically a lottery ticket. The “long profit” trade only happens 20-25% of the time but when does hit target that pip gain is responsible for the bulk of your overall return.

This, of course, is what everyone who provides trading education sells. “Risk one dollar to make ten!” “Double your account in a month!” “Trade one hour a day and make five figures a month!” The trading business is replete with bullshit because of course, that’s what we want to hear. We not only want to make money, but we want to make “easy money” with very little risk and massive payouts on a weekly basis. All trading education appeals to our instinct for greed which of course is why most traders fail miserably.

Greed trips us up in a million different ways. It entices us to chase trades with too much size but more insidiously it makes us hold on to losers way beyond reason and prudence. Most conventional wisdom says that we lift our stops because we are afraid of losing money, but I actually think it’s the opposite. If we were truly afraid we would get out. Instead, I think we hate the idea of not making money so stay in the trade against rhyme and reason desperately trying to claw back to even one pip profit so that we can feel like a winner.

How many times have you been in a trade that was deep against you – maybe even a few pips away from the stop – and then rallied halfway to your entry thus cutting your losses significantly – but you refused to get out, hoping that it would “turn around” only of course to lose it all in the end?

I don’t think there is a retail trader out there who hasn’t done that at least a dozen times. The reality, of course, is that it is really hard to take losses just when things are starting to look up which is why I don’t even try. Our instinct for greed is impossible to tame so I prefer to work on my defensive skills. The beauty of short/long exit structure is that it locks in a small profit and instantly goes to breakeven ensuring that you won’t lose money on the trade. It essentially creates an institutional process for fear. And fear is highly undervalued in my opinion. Fear is the key factor that keeps us alive. Fear is what makes us spit out tainted food so we don’t get poisoned. Fear is what keeps us from crossing a five-lane highway in the middle of rush hour. Fear is what keeps us from rollerblading down a 3000-foot mountain road without a helmet ( Yes my younger stupider self actually did that once )

Unlike the romantic notion of bravery which gets all the accolades fear never gets good press, but as General Patton once said, “The object of war is not to die for your country but to make the other bastard die for his.”

Trading is very much the same way. Returns are made not through big gains but through avoidance of massive losses. Last week I was able to lock down small gains in EURGBP and EURCAD shorts before they blew up against me and that kept my weekly loss very manageable and kept my overall pip tally way in the green.

Hooray for fear. It’s the secret to trading.

The Real Secret to Wealth is Not What You’ve Been Taught

Boris Schlossberg

Today we are faced with two opposite myths both of them wildly dangerous to your long-term financial health.

The “crypto/Lambo” myth is certainly much easier to understand and mock. This is the get-rich-quick myth that permeates all of trading. It comes in every flavor imaginable but the basic premise is the same. All you have to do is learn a few simple strategies and in a matter of months, you’ll be independently wealthy. It doesn’t matter what you trade – stocks, options, forex – the message is always the same. I. CAN. MAKE. YOU. RICH. Crypto is simply the latest incarnation of this age-old con, but equities work just as well. My personal favorite these days is a guy named Jason Bond (what brilliant scam name) whose Youtube ads are ubiquitous even on my five-year-olds Barbie channel (business rule 101 – the faster someone talks, the more they are lying)

Of course, you can’t turn $1000 into $1 Million in a matter of years. Of course, you can’t make $10,000 per day every day in just a few hours of market trading. And no, of course, you can’t trade for a living with just $10,000 worth of capital.

But while the get-rich-day-trading scheme is easy to spot, the flip side can be just as deadly. This is of course is the you-don’t-have-to-do-anything to retire myth of index investing. The financial media constantly tells you all you have to do is drop 10% of your yearly income into an index fund and NOT DO ANYTHING. It will just magically compound to $1 Million! $2 Million! $5 Million! money pot and you will to retire to Boca and play golf with the sunshine boys for the rest of your carefree days.

Like all good myths, this one originated with a kernel of truth. Over the past 30 years the virtuous cycle of easy monetary policy (yes Virginia – this is actually the MAIN reason stocks always go up – check the 30-year bond for the past 30 years), massive technological advances and financial deregulation have created the perfect environment for the index investor. The financial press is full of gleeful stories of Mom and Pop savers eviscerating the Masters of the Universe on a daily, monthly, and multi-year basis. The “F-k me, I am a hedge fund manager” T-shirt, so popular in the early aughts seems as quaint now as the Lambo/crypto dream of 2017.

The message of the index myth is – you don’t need to know anything, you don’t need to do anything, just buy the f-ing dip and money will grow like a magic tree.

I am not going to bore you with all the empirical data that I’ve already shared before how there are many, many periods in American history where that wasn’t true. I will, however, share just one interesting tidbit that I came across this week. Did you know that since 1962 (that’s 56 years) the return on Japanese equities is 2.72% per annum, for German equities it’s 3.46% and for Italian equities its … wait for it -0.38% per year! Now you can believe in American exceptionalism all you like but you would be beyond irresponsible to risk your financial wealth on that assumption.

In any case, there is something incredibly primitive about the index myth. What after all, is the difference between the indigenous people of the Amazon who perform the rain dance without understanding a thing about meteorological patterns and the index investors who perform the “saving dance” without understanding a thing about financial markets? Eventually, the drought comes. Eventually, there will be a time when 30 years worth of savings will evaporate in 30 days of the market meltdown and … the money will never come back. Don’t believe me? Just ask Mr. and Mrs. Watanabe who’ve never seen the Nikkei at its 1988 highs in their life.

So instead of falling for the get rich quick myth or the do-nothing-and-money-will-come-to-you myth, the reality is that we all need to become trader/investors. We all need to learn how to manage risk both in terms of size and stops. We all need to learn about algo trading. We all need to learn how to trade both sides of the market (not that there is anything with that). We. All. Need. To. Become. Active. Not. Passive.

It’s not glamorous to make 10 pips per day. It’s not easy either, but therein lies the true secret to long-term wealth. Because 10 pips per day will accrue to millions of dollars over years of trading. 10 pips per day is 25% per year – which is huge if you understand the compound tables and even half that – 5 pips per day – is a pathway to financial security.

More importantly, it’s eminently doable. It’s doable not only from an absolute return point of view but from a volatility point of view. I can assure you that if you learn how to make 5 pips per day you will never put yourself in a position of losing 90% of your retirement savings in a matter of weeks. If you learn to trade actively, you will obtain the ultimate wealth building skill – control.

Trading’s Little Secret

Boris Schlossberg

The scariest decapitation of my life happened when I was ten, when the KGB cut off the head of my teddy bear before they allowed us to board the Aeroflot flight from Moscow to Vienna, delaying the plane on the tarmac for over an hour. Of course they found nothing inside, but it was just the final message on our way out of the Soviet Union.

My mother, who has the beauty of Catherine Deneuve and the steely sangfroid of Vladimir Putin remain stoic throughout the ordeal, but as the plane finally lifted off the ground she let out a tear. She had survived two tense years of waiting to emigrate which included snatch and grabs off Moscow streets and endless rounds interrogation by the KGB. But in the end she finally engineered her greatest exit. We left the miserable sh-thole of a country that was the Soviet Union and started a new life in America, where I was able to grow up and prosper beyond our wildest dreams.

My mother is the master of the exit. She is utterly unsentimental when it comes to making the needed change in herself or others and never wavers in her resolve. A while back after she had not seen me in a few months she simply looked at me up and down and as a way of greeting said, “Bob – you are fat and you will die and leave your children fatherless if you don’t lose this weight right now.” Mind you I had gained a whopping five pounds, but needless to say they were gone within a month.

Like all Russians she harbors no illusions about human nature, and basically believes that people are incapable of fundamental change, but can improve through minor behavior modification. She taught me the single best way to diet, a method that she used herself to shed 25 pounds at the age of 78 after surgery had made her immobile for a while. Her trick? Leave 10% of the food you eat on the plate and ultimately work your way leaving 25%. That’s it. Just do that every meal and I guarantee you will lose weight better than any diet you ever try.

My mother’s diet trick is simply just another example of her exit strategy, but thinking about it I realized that in a very ironic way it has also been responsible for all my trading success this summer. Just like my mom I am the master of the early exit, except in my case instead shedding pounds I have been gaining pips all summer long.

Those who trade with me in the chat room know that I am the worst when it comes to early exits. I almost never honor my take profit targets. I will blow out of the trade at the earliest hint of trouble. The net result is that many traders in my chat room trade my Boomer strategy far better than me, but no one in the room trades it more accurately. Since May of this year I’ve had only one full losing trade in more than 190 trade cycles, and that occurred post Brexit when I foolishly decided to trade the GBP/USD.

Nothing looks uglier or more pathetic than my trade runs which sometimes show 2.9 pips, 3.4 pips and so on per trade. But those pips add up and more importantly my early exits often get me out of losing situations which in the end if far more important for my strategy. Indeed, I think that really is trading’s little secret. Good traders are really masters of the exit. If you trade the insurance model, like I do, which depends on many small wins and few large losses then early exits are key. Just think back to the real insurance industry. In the term life insurance business, 40% of customers forget or unable to renew their premiums. Insurance companies love that. It allows them to collect all the reward without assuming any of the risk. It’s the real insurance world of an early exit.

If however you trade the lottery model of many small losses and few large wins, then your exit strategy must be the exact opposite. You have to exit as late as possible in order to make up for the multitude of losses you will incur.

Since I don’t trade the lottery model, I’ll leave it to others to comment on its inner workings. However, I do have an idea of why traders fail in the insurance model and it all goes back to my mother and food. Just think how simple her advice is and yet how hard it is for most American’s to follow. In a land of all-you-can-eat buffets do you really think most people can leave any food on the plate, much less part of their first serving?

Las Vegas casinos exploit this weakness for all its worth, by offering gamblers free drinks, food, anything to keep them gambling because they know that no matter how much a person may be up, they will always try to go for more and will inevitably go bust. In short Las Vegas, is basically a multi-billion dollar bet on the fact that you are incapable of an early exit, and that’s certainly reason enough to believe that it’s a good strategy.

BoE Preview – Rate Cut AND QE?

BoE rate cut eur/gbp euro forex blog GBPJPY gbpusd Kathy Lien US Dollar

Tomorrow’s Bank of England meeting is one of the most important events this month.  Back in July, U.K. policymakers made their plans to ease in August abundantly clear and now that the time has come, sterling has been surprisingly stable.  By giving investors sufficient warning, the market had the opportunity to completely discount a 25bp rate cut and the question now is if the BoE will do more. They could cut interest rates by 50bp or they could combine a quarter point cut with renewed bond buying. Quantitative Easing was a critical part of the BoE’s monetary policy during the financial crisis but with interest rates already so low, the effectiveness of QE is in question. Many economists believe they will revive the program but not this week. Since Britain decided to leave the European Union, the Bank of England has taken major steps to stabilize the financial markets and encourage lending – and so far it has worked!  Stocks are stable, yields have increased and the doomsday sentiment in the market is fading. A lot of this has to do with the U.K. government’s decision to postpone invoking Article 50 for the next year or two, reducing the immediate risk for businesses.   This means the central bank can wait to ease again when there is a greater evidence of a deep contraction in the economy.

Taking a look at the table above, there’s certainly been more deterioration than improvement in the U.K. economy since the July monetary policy meeting. However wages are up, the unemployment rate is down and consumer prices are ticking higher.  Second quarter GDP growth was also better than expected.  Although manufacturing, services and the composite PMI indices fell sharply in July, this morning’s numbers were not revised lower after the flash release.  When the Bank of England releases their Quarterly Inflation Report tomorrow, their forecasts will be grim – policymakers previously warned of a possible recession post Brexit.  Governor Mark Carney won’t have anything positive to say outside of acknowledging financial market stabilization.  Yet economic and financial conditions are not desperate enough for the Bank of England to rekindle their QE program.

In other words, we feel that the Bank of England doesn’t need to send a strong message to the market right now outside of a 25bp rate cut and a stern warning of more easing in the coming months.  If we are right, we could see a bigger short squeeze in GBP/USD that will allow investors to reset their short positions at higher levels.  The U.K. is not out of the woods, as growth will only slow further in the coming months / years because the U.K. government is simply delaying the inevitable.  If they cut by 50bp or restart their bond buying program, sterling will fall quickly and aggressively.

The Secret Law That Governs The Markets

boris Boris Schlossberg

In one of the best investment columns written this year titled “How to Make Volatility Your B-” Josh Brown goes through the step by step process of dollar cost averaging demonstrating why it is the single greatest investment strategy ever created. Brown shows how consistent and steady buying of an equity index will beat any hedge fund return anywhere, anytime.

The idea is that some of your capital will have massive double digit returns as you scoop up assets at firesale prices and some of your capital will have average returns and some of the capital may even have negative returns as you pay up during market rallies but the overall value of your holdings will almost certainly rise over any 10 year period of time. The only way that this strategy would fail is if stocks slowly but surely drifted to zero over a 10 year period in which case you probably would have much bigger issues to worry about. As long as equities have an upward drift you simply can’t do better as an investor than dollar cost averaging into the index.

The dollar cost averaging strategy of success relies on two factors – the natural upward drift of equity markets and the much more important idea of the law of large numbers. The law of large numbers simply says that outcomes will almost always reach their expected end, as long as you have enough samples. For example if you flipped a quarter 3 times in a row chances are good that you could get all heads or all tails. In fact 12% of the time that’s exactly what would happen. Does that mean that the coin is rigged? No. It just means your sample size is very small and highly biased. Flip the same coin 1000 times and the probability that heads or tails will fall within a few basis points of 50% are almost assured. Do it 10,000 times and they are practically guaranteed.

The law of large numbers is an amazing principle. It essentially tells you all need to know about how to get rich. Just chop up risk into tiny little pieces and take many ( hundreds or even thousands ) samples of that risk and over time you will be much wealthier than you are now. Of course this little mind experiment assumes that the risk you consider is actually worthy. For example if you dollar cost averaged gold for the past 50 years you would still be worth a lot of money ( if for no other reason that you would own a lot of gold!) but not nearly as much money as if you bought the S&P 500. Still even in that example you can see the power of this principle in action.

That’s why it always amazes me that traders routinely ignore this foundational idea of risk control. In fact I think that the primary reason why most lose money in the market is that they don’t appreciate the power of the law of large numbers. The underlying concept behind the law is that you need to trade SMALL. There is actually some poetic irony in that dynamic. You need to do a lot of trades in order to assure yourself of long term success and the reason you need to trade trade small is precisely because you need to be able to withstand the bad runs that will inevitably occur.

The first thing that I do in order to improve a trader’s performance is to make them trade so small that it seems almost miniscule. Frankly it almost doesn’t matter what system they trade, reducing size has an instant and dramatic impact on performance. They stop panicking and execute the strategies much more effectively. Marry the law of large numbers with a sound trading algorithm and you have nearly a full proof recipe for success.

Don’t believe me. Look at high frequency firms like Virtu that trade millions of shares per day 100 shares at a time and haven’t had losing days in years. As an individual trader you don’t need to mimic the hyperkinetic pace of HFT shops, but you do need to slice risk into tiny increments just like they do. It’s truly unbelievable that the answer to 90% of our trading problems lies in size rather than strategy, yet so few traders take advantage of the key law that governs the markets.

The Secret To Trading Well

Boris Schlossberg

Last week in my Day Traders Manifesto I mentioned that tactics are more important than analytics. That’s a topic worthy of deeper discussion. Basically when we are doing analytics we are asking the question – What do I think will happen? When we are dealing with tactics the question becomes – What will I do if XXX occurs? Between the two the second question is much more important when it come to trading.

If you were to record my daily trading brainstorm sessions with Kathy you would burst out in laughter at how wildly inaccurate our forecasts may be. Sometimes we are wrong about data, sometimes we misread sentiment, sometimes we are simply blindsided by unexpected events. My point is that even informed traders are wrong a lot. Just watch CNBC for a week and meticulously record every tradable prediction. My guess is that the win/lose ratio will not be much better than 50/50.

That’s why tactics are so important. Tactics basically come in after the forecasting decision has been made and they involve every other aspect of the trade – from stop and take profit considerations to entry criteria, to trade management plans, to reaction to market conditions. A recent trade in short AUD/NZD that we put on in our BK signal service is a good example of tactics at work. We sold the pair at 1.2270 and it moved towards our first profit target of 1.2240 several times during the European and early North American trade but just missed making the target by 1 pip each time. At that point I made a decision to take half the trade off at +25 and move to breakeven.

Eventually the pair did slip lower and made our first target, but then quickly rebounded when the New Zealand labor data came in much weaker than we thought. So was that a good decision? you betcha. It cost me 5 pips to save 120 (the size of our stop on 2 units). I would do that anytime. Tactics are often the difference between winning and losing in FX. We are all wrong a lot – they key is to know what to do when your plans blow up in your face. The key to trading is tactics, not analytics.

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