Reader Questions Answered

Expectancy vs. MAR

I had this question come in recently:

Strategy A has better risk-adjusted returns (measured by Annual returns/Max Drawdown, aka the MAR ratio), but lower expectancy than strategy B. It manages to achieve this by having a larger number of trades, even though the backtest period is the same for both.

Which of the two performance measures should I rely on in choosing one strategy over the other?

When dealing with expectancy it is important to not just look at it in terms of per trade figures. You must also account for the frequency of trades. In other words, it will often be best to think in terms of expectancy on time basis rather than a trade one. For example, you could think of monthly expectancy to figure out what kind of returns you would expect to see in a meaningful time frame for your trading. This would be the better way to compare two systems or strategies.

Trading Tips

Trader Psychology is NOT the most important thing

I came across a post on the FXStreet site with the following statement:

“The majority of trading success comes from the mental side of trading not the strategy…”

The article then goes on to say that psychology is 85% of the equation of trading success, with money management coming in at 10% and strategy at only 5%. I reject this completely.

To explain my own position (as I also did in a recent online panel discussion), which is one I share with Dr. Brett Steenbarger, who literally wrote the book on trading psychology ([easyazon-link asin=”0471267619″]The Psychology of Trading[/easyazon-link]), let me ask these questions.

If you don’t have a positive expectancy system, does your mental state matter?

If you don’t have the risk management side of things right, will it make any difference how strong your discipline is?

The answer to both questions is “No”.

Trading completely without emotion seems to be the ideal many folks are aiming for in their trading. You could turn yourself into a robot (or program a robot to trade your system), but that’s not going to turn a losing system into a winning one or overcome poor risk management.

It takes all three elements to be a successful trader. If you’re missing any of the three legs of that tripod, it won’t stand up. Psychology does become the thing you spend the most time on once you have a good system and risk management strategy, but that doesn’t make it more important.

Reader Questions Answered

If a system works why share it with the world?

A member of the BabyPips forum asked the other day “If a system works why share it with the world?” This question comes up a lot, though probably more often in the private thoughts of traders rather than in public discussions.

My take in the question is this:

The only way letting loose a system on the world is going to impact its performance is if a whole lot of money starts using it. Notice I said “money” not “people”. Ten thousand small retail traders all trading the same system probably won’t move the needle very much (unless we’re talking a very thinly traded market), but a group of big hedge funds could.

Beyond that, most people cannot trade most systems effectively. This is why I have long argued against buying trading systems and have written about the lack of a secret. A trader needs a system that works for them, not just something off the shelf. As a result, even if a system is used by a whole bunch of people, chances are they will “tweak” it along the way to suit their own individual needs.

Consider the CANSLIM methodology introduced in [easyazon-link asin=”0132825244″]How to Make Money in Stocks[/easyazon-link]. That book has been read by millions of people yet as best I can tell it still works. Why? Because some people toss it aside right away because it requires some work or doesn’t produce instant results they way they expect. Others don’t actually implement it as laid out (for better or worse). Also, there will be variation in which stocks traders may focus on at any given time.

Reader Questions Answered

Forex broker arbitrage

There’s been a new “automatic profits” systems launched recently (and I think you know how I feel about these sorts of appeals – see Getting sucked in by easy, automated trading), and a question came in from one of my newsletter readers about it.

Hi John,

Is it true that retail Forex trader can exploit the price between Broker A and Broker B as claimed by XXXXX?

Assuming Broker A has an offer of 1.3400 EUR/USD, and Broker B has a bid of 1.3450 EUR/USD.

If a Forex trader T do a single trade with both of them using hard cash, T can pay Broker A with USD134000 to get EUR100000, and sell the EUR100000 to Broker B to get back USD134500.

He will make a profit of USD(134500 – 134000) = USD500.

But for leveraged Forex trade, if trader T buy EUR from Broker A, he still have to close out his position with Broker A.

So, how could trader T makes the so called “arbitrage profit”?

Please enlighten me! Thanks!

Best regards!


To answer Paul’s primary question as to whether it’s possible to do arbitrage trades between two or more different retail forex brokers, the simple answer is Yes.

There are, at times, variations between the prices quoted by brokers. The vast amount of the time they are very small, and untradable when the spread is taken into account. On rare occasions, though, there’s the potential to arb the differential if you have multiple accounts and can execute both sides instantly with no slippage, requotes, or execution lags.

Now, let me address Paul’s example.

The first part is absolutely right. If you could go to Bank A and swap USD134,000 for EUR100,000, then turn around and take those euros to Bank B and exchange them for USD134,500, you would indeed make $500 in profits. Of course competition among the banks isn’t likely to see the spread be 50 pips wide in EUR/USD. You’d be lucky to get 1 pip, which would be a whole $10 gain. It becomes a question of the value of the gain given the resources and effort required to make it.

Leveraged (real-world brokers)
Things aren’t quite so each when working with retail forex brokers because you aren’t actually exchanging currency at any point. What you have to do instead is enter a long position with one broker at the same time you enter a short with the other. Using Paul’s numbers, you’d have to get long EUR/USD with Broker A at 1.3400 and go short with Broker B at 1.3450 to take advantage of the spread.

Here’s the rub, though. Now you’ve got two open positions – one long, one short. You can’t lock in your profit until the two brokers get their prices back in line – or at least until the spread between the two shrinks. When that happens you close both the short and the long with the respective Brokers. Depending on what the market does in between, you may make money on either the long or short, but they would offset and you’d book a profit of however much the spread narrowed.

For example, EUR/USD rallies and both brokers are quoting 1.3500/01. The spread has collapsed, so now you can exit the positions. The long at Broker A will make 100 pips (1.3500-1.3400) while the short at Broker B will lose 51 pips (1.3501-1.3450), so you’ll net 49 pips.

Sounds like a good deal, right? Don’t get too excited yet.

The Risks
This strategy isn’t as simple and easy as it sounds. Here are the considerations.

  1. As I noted, the opportunities are few and far between. Brokers have common liquidity providers coming from the inter-bank market. They aren’t making their own prices beyond adjusting the spread.
  2. The spreads between brokers will be small, even smaller when factoring in the bid/ask spread.
  3. The spreads will generally close quickly, so you need to be able to move fast.
  4. You have to execute the trades through both brokers at the same instant with no slippage because even just a little bit (perhaps caused by an execution delay on one side in moving markets) could turn a sure winner into a sure loser in a blink.
  5. It would almost certainly be a massive waste of time constantly watching the markets to find arb opportunities manually, so you’d need an automated system.
  6. On the off chance a spread between brokers does persist and the market moves quickly in one direction while you’re holding the open long and shorts, you could end up margin called out of one leg, leaving you exposed in the other.
  7. If the spread persists through daily roll-over, you’d be subject to carry. Yes, you’d receive on one side of the position, but not as much as you’d pay on the other. This will impact the profitability of the arb position.
  8. Are the brokers involved ones you’d want to have your money with (which can speak to execution in #4) or are allowed to have your money with (if you live in certain places)?
  9. If the brokers catch on they will adjust and arb opportunities will vanish.

Those are the ones that come to me off the top of my head. There could be others.

Credibility Issues
I’ve looked at the promotional copy for the arb system in question. There are some red flags that jump out at me right away. First, the fact that the guy who is promoting the system refers to the market it as “the forex” drops his credibility to me by several notches. Second, there’s one instance where he talks about having actually done a trade, but beyond that it’s all “could have” types of wording.

Then there’s the sample charts. I have SERIOUS questions about the opening gap examples shown seeing as you can even make out the dates or times on them. How do I know if they match up and thus if those spreads are actually even tradable? Two brokers could be 1000 pips apart in their quotes, but if one of them is close then you can’t take advantage.

Oh, and this system is only semi-automatic. You actually have to pull the trigger to both enter and exit yourself. That means you have to be camped out in front of the screen both looking for opportunities and waiting to close out the trades once you’re in them. That reduces your number of possible arbs considerably. It also brings up the very valid question of whether the system’s gains are worth the time invested, not to mention the two thousand dollar price tag.

A Limited Lifespan
While arbing is a valid way to make money, keep in mind it’s not going to do anything to help your long-term development as a trader. That’s an important consideration because these sorts of systems tend to have a limited life.

I have my issues with Efficient Market Theory, but it gets certain things right. Competition in the forex brokerage business is stiff, and getting more so, and regulatory oversight is increasing. High frequency trading (algos, etc.) is on the rise. Folks with a lot more computing power than you are working to take advantage of just these types of mispricings. That all works to bring everyone toward a common point. It will tend to mean tighter spreads, both bid/ask and between brokers.

We are rapidly moving toward homogeneity of pricing, and if you don’t develop your trading to adapt to the constantly changing trading environment you’ll find yourself with nothing very rapidly.

Trading Tips

The new trader system loop

A poster at Trade2win started a discussion recently which I think is very worth addressing here. It starts off with looking at the typical process of the unsuccessful trader:

1. Find or develop a system you think will work
2. Trade the system
3. Experience a few losers and discard the system

Sound familiar? Probably so. It’s a very common loop new traders get caught up in.

Why is this so? Why do new traders give up so easily, when successful traders follow through?

The suggestion is that this happens because of a lack of confidence. While I can understand the case to be made for that being a problem, I’d take it a step further and say that it starts much higher up than that with the fact that new traders totally fail in the vast majority of cases to think beyond the immediate and develop a proper frame for their trading.

To put it simply, if you don’t know what you’re working toward how can you have any confidence that what you’re doing will get you there?

That’s high level thinking, of course. At a more ground level view, I’d contend that most new traders never learn what the elements of a trading system really are and how they contribute to its performance in different market conditions. They just want to plug-and-play and have profits come spilling out. The markets tend to disavow them of that impression quite rapidly.

Trading Tips

Drawbacks to packaged trading systems

There’s a post on the Winners Edge Trading blog that looks at automated trading systems. The article takes a very negative view on these systems, focusing mainly on ones that are being marketed and sold. The case against them are as follows:

  1. Many system sellers don’t actually care whether they work for you or not.
  2. The system creator(s) don’t do sufficient testing to come up with significant, trustworthy results.
  3. The system is built around recent market conditions, which stops working as soon as conditions change.

Of course the post then goes on to talk about all the things they do with their own system(s) – which they then promote – in order to overcome these three issues. Unfortunately, even the most sincere, honest, and ethical system developer cannot account for the fact that most systems won’t work for most people because they are not a good psychological fit for the user.

I am personally not in favor of buying trading systems. You are much better off researching and developing your own. It’s much more likely to be a good fit for you and to be something you can stick with.

Trading Tips

Testing Trading Exits vs. Reversals

I’ve been reading a book of late that I will shortly be reviewing. There was a comment of the author’s that I wanted to address now, though. In talking about system testing the author made the statement that it’s better to run strategy tests based on position reversals (long to short, short to long) rather than position closures. It’s a statement with which I’m not very comfortable.

Now, to provide a little context, the focus here is mainly a longer-term investment one, so it’s generally looking at things from long-only perspective. That means a sell signal is an exit signal. It’s not really meant to be a short entry signal, though obviously there’s the potential for playing the short side as well. The author’s argument for testing a strategy as if shorts will be entered is that it will provide the best selling signals.

Here’s the thing, though. Good long exits are not necessarily the same thing as good short entries.

Pure traders, of course, have somewhat different considerations, but investors should be thinking about total return considerations. If the market is going to go sideways for a lengthy period, for example, it would be better to be out of your long near the start of the move into consolidation than it would be to wait until a short signal was triggered at the end of it. That would save a lot of emotional capital being wasted during a choppy back and forth period and provide the opportunity to put the money to work in a way which would actually provide a return (fixed income investments, for example).

My point is that optimal short entries do not necessarily make optimal long exits (or vice versa). Of course, it always comes down to testing.