The One Rule Traders Should Never Forget!

Boris Schlossberg

The other day I read one of those “Greatest Lessons from Investors” articles in WSJ. I seem to come across one every week, given the massive amount financial reading I do every. This one was no different – basically recapping all the bromides familiar to us all. However, as my eyes glazed over the words, I stopped and found this passage on Jeffrey Gundlach the King of Bonds actually useful.

It was March 2008, and Jeffrey Gundlach was testing his nerve in a crisis.

Even assuming a rash of defaults and other bad news, debt investments priced at 65 cents on the dollar looked attractive. He began buying, though he knew there was a good chance markets would continue to drop.

“If fundamental value is compelling, you should keep buying,” he says. “It’s OK to take short-term losses.”

Mr. Gundlach was right—prices continued to fall for another full year, eventually hitting 45 cents on the dollar. One big client got nervous and withdrew money from his fund. Mr. Gundlach ran out of money and couldn’t buy more, locking in his cost basis.

By 2009 bonds started to recover as the Fed saved the world from the Second Great Depression and Gundlach’s trades started to turn profitable. Now he is recognized as the undisputed King of Bonds and everyone wants to give him all their savings to invest.

But stop for a second and consider something.

What if bonds went to 25 cents and stayed there until 2010? Gundlach would have gone from hero to zero and nobody would be hanging on his every word. He may have been forced out of business.

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So here is the lesson for us all. If you want to survive and thrive in trading – never run out of money. In other words trade small. Its the one rule that trumps all others when it comes to what we do.

Mandela Lessons for Traders

Boris Schlossberg

The last few hours have seen an unprecedented outpouring of support and mourning over the death of Nelson Mandela. There is no doubt that he will go down as one of the seminal figures in history, a man who – as one analyst said – embodied the idea that you must become the change that you seek. However since our weekly focus is the filthy lucre of the markets I would like to leave the soaring rhetoric to others and concentrate instead on the more pragmatic aspects of Mandela’s nature.

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Almost every story about Mandela talks about his amazing ability to forgive the white minority of South Africa for the horrors of apartheid rule. And that indeed is one of the greatest historical examples of human graciousness that all of us should admire and appreciate. However, beneath the supremely moral nature of Mandela’s actions I believe there lurks a pragmatic impulse that is even more impressive.

Mandela understood very well that the white minority of South Africa was absolutely essential to the future success of the country. He understood with crystal clear precision that there could be no freedom without prosperity, no freedom without peace and no freedom without collaboration. In short Mandela, more than any other late twentieth century leader kept his eye on the prize and never allowed personal grievances to get in the way of the greater goal.

Think about that as he endured the brutal incarceration on a bone chilling speck of an island, cut off from society for 26 years, performing the mindless back breaking work of splintering rocks into two.

It is not only that our day to day grievances of missed trades, crooked dealers, and capricious markets all pale in comparison to the hardships endured by the man. It is perhaps the much greater lesson that despite all the obstacles, despite all the challenges, despite all the years of struggle and humiliation Mandela never lost sight of how to win.

Not only did he never give up, but he never allowed to corrosive, corruptive maddeningly frustrating environment around him, to influence his actions or to lose his discipline. He stayed true to his goals and that is perhaps his greatest legacy of all.

How Traders Can Gain From Pain

Boris Schlossberg

As human beings we all hate pain even when its actually beneficial for us. Those of you who lift weights know that the only way to improve your muscle tone is to actually tear the fibers so that they can repair themselves and become bigger. Knowing that however, doesn’t make it any more pleasant to drag my butt to the gym every Sunday and endure the supervised torture of my German born trainer. Yet I do it because it keeps me healthy.

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However, few of us have such a positive attitude when it comes to dealing with pain in other areas of our lives. Be it physical, emotional or psychological – our general attitude towards pain is to ignore it and hope it goes away. As the very welcoming sign on the front door of the infirmary of my summer camp used to say – “Time heals all wounds.”

That may be a good strategy for an 13 year old with a stubbed toe – but its no way to go through life. I see this “ostrich head in the sand” behavior all the time in the currency markets. We are holding a position with no stop and it continues to bleed against us. So we turn the screen dark, or go for a walk, or go watch a movie and hope that when we come back the position is back to even.

Worse yet, if we are trading a strategy and it suddenly goes into a massive drawdown our instinctual response is to either turn it off or to ignore it. Both are terrible decisions and are the reason most traders can never successfully trade any strategy.

Pain is actually a signal and to ignore it is to suffer the consequences at your risk. Sometimes pain is necessary (like in the case in weight lifting). Just as in trading sometimes the drawdowns are a natural part of the market flow. But most of the time pain requires a response to mitigate and fix it. Ignoring it generally leads to only more pain down the road.

In trading this means that you must constantly examine and reexamine the underlying assumptions of the model and if possible make adjustments to current market conditions. This means that most strategies require constant tweaks in the form of filters. Just like a response to a twisted ankle is not to mindlessly soldier on, but to stop and bandage the area, so too a response to a drawdown is to try find an adjustment that can improve the performance.

What Stock Traders Can Teach Currency Traders

Boris Schlossberg

All of my investment money is run by @HedgeFundGirl – not only because she the best stock picker I have ever seen, but because she knows how to put together an intelligent portfolio. Whenever I check the statements I am always surprised at how many losing positions there are on the books and yet how she is able to make money and beat my FX returns every single month and every year that we’ve been married.

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Portfolio management is one the best lessons that stock traders can teach currency traders. Most of us in the FX land are used to basically following the prop model – one trade at a time win or lose – then count your pips at the end of the month. But constructing a portfolio of trades to diversify your bets can open up a whole new way of looking at the market.

A recent New York Times article about diversification put it best – if you are not perpetually pissed off, you are doing it wrong. The portfolio approach to trading basically assumes that you will always be losing on part of your positions. The underlying philosophy of the portfolio approach is based on humility.

The portfolio trader assumes at the outset that he does not know which bets will pay off and therefore makes a multitude of them, hoping that when the dust settles the winners will outrun the losers. Instead of serially picking his trades, the portfolio manager will spread the risk (and yes possibly dilute the return) in order to dampen drawdown.

For forex traders the portfolio approach is especially interesting when applied to algorithmic trading. If you are running the same strategy on multiple pairs then you are in fact practicing the portfolio method. However, quantitatively based currency traders often commit a very serious sin. They love to over-optimize their strategies creating very different entry and exit parameters for each currency pair.

But portfolio trading is not like prop trading. It’s kind of like the difference between team and individual sports. ( I can still hear my football coach yelling, “There is no “I” in team boys!”)
What may in retrospect be good for one currency pair may not be good for the portfolio as a whole.

The truth of the matter is that if you change the strategy parameters on one currency pair you are in fact over or under weighting that pair relative to all others and that creates a whole set of risk factors that you may not have anticipated. That’s why when trading algorithmically, its best to give equal weight (i.e. same entry/exit rules) for all the currency pairs – because after all you really don’t know which ones will succeed and which will fail.