News & Updates

Sometimes it helps to circle back around

A post on the Rogue Traderette blog came to my attention recently. In it she talks about the Mark Douglas book [easyazon-link asin=”0735201447″]Trading in the Zone[/easyazon-link]. I do not count myself among those who think it’s the best book ever written on trading, as many seem to believe, but I certainly acknowledge it has some good stuff.

RT brings up Douglas’ Five Fundamental Truths:

1.  Anything can happen.

2.  You don’t need to know what’s going to happen next in order to make money.

3.  Wins and losses are random

4.  Your edge is nothing more than a higher probability of one thing happening over another.

5.  Every moment in the market is unique.

I think #1 and #3 are closely related, and even #5 can be said to be along the same line of thinking. The second point is one a great many traders need to take to heart. The fourth one encourages taking a longer-term view, or at least thinking over large numbers of trades.

Perhaps the biggest takeaway from the post is the fact that we evolve as traders over time, and it can be very worthwhile to go back and revisit things we’ve read in the past for new insights. I’ve certainly done that with the [easyazon-link asin=”1592802974″]Market Wizards[/easyazon-link] books over the years, and it’s one reason I continue reading new books on a regular basis even though I’ve been in the markets for over 20 years now.

Trading Tips

Looking at 97 Trading Mistakes

There’s a post up on the Winner’s Trading Edge site that purports to list the 97 top forex mistakes. Most of the 97 are equally applicable to trading basically any market, not just forex. Most of the list I definitely agree with, though there’s a bit of redundancy in places. Some of the best ones are:

Not having a life: Balance is key.

Thinking the market is wrong: Your opinions of what should happen are just that, opinions.

Failure to take responsibility: This is huge. I can’t stand it when traders blame everything but themselves for their failures.

There are also a few I definitely think are problematic. They include:

Not having a profit target: This is only applicable if a system is designed to use a target. Not all trading methods and systems work optimally with them (like many trend-following approaches).

Cutting winning trades too quickly: This is basically a contradiction to the prior one in that it suggests letting winning trades run. Again, whether you let them run or have a profit target depends on the system or method you use.

Trading with fear: A little fear is healthy. It makes you respect the markets and not get carried away with risk-taking. Too much fear, though, is a problem.

Trading with the crowd: Folks get carried away with thinking they need to trade against the crowd. The problem is the crowd is often right and potentially is driving the market. It’s just when things get extreme that you want to be cautious.

Not having fun: I think most long-term successful traders will shy away from calling trading fun. It certainly isn’t drudgery, but it’s not viewed at as a game. It’s a business, not a leisure activity.

Give the list a look and let me know which ones you’ve fallen victim to and/or have had the biggest impact on you.

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A Trader’s Epiphany

A regular poster on Baby Pips recently went through a financial advisory training course. My initial reaction to hearing that was one of scepticism because a great many such advisors are nothing more than sales people. This course, however, seems to have made him see the light in regards to his own trading, though.

Here are some thoughts he shared:

Through my training and education, I’ve learned quite a bit a lot on risk management. Knowing what I know now, would have put me at an incredible advantage in this forex marketplace.

I was far to aggressive in trading. As are many of you, and despite any warning from anyone will continue to do so. My trading should have far more balanced. Taking conservative long term approaches with a large portion of my investment, while using a small portion of my investment to take a couple cracks at a home run.

I was afraid to take loses. I hated them a lot. Now I understand that it’s purely a numbers game. And if one can eliminate the emotions from the numbers, they would realize that a losing trade is one step closer to a winning trade, provided that they actually have an edge in the market place.

Scalping is stupid. It’s far to costly in relation to the amount of spread paid vs the amount invested into the market.

Most systems are profitable. However, they are over traded and dominated by fear and greed. Most traders will take a swing at anything that looks good. However, patience is far more important in this industry. Waiting for a high probable pattern is far better than taking a swing at 5 marginal patterns.

You won’t get rich quick. For every story you hear of a guy that turned millions fast, it was either because he was extremely lucky, or that he was a liar. Your 100 bucks won’t make you 20,000 in a year. Sorry. But keep trying if you like. People can only win the Powerball lottery by buying a ticket. Just know that it’s luck you’re hoping for, and not skill and knowledge to dominate the market.

Overall, I was initially a losing trader that eventually learned to turn profits, however, I believe that perhaps those profits may have been short lived based on the fact that I still allowed my emotions to manipulate my trading and I was thinking short term and not long term. And I traded way to many pairs. Master one. Move on and then master another. I had no patience for any of that. I would rather take an entire year to master one pair before moving on to the next.

I’m humored by the fact that I once considered myself an extremely conservative trader, when I know see myself as wild and aggressive.

I can’t find anything in there to disagree with, and most of it is stuff I’ve tried to share here, in my book, through my course, and anywhere else I get the opportunity. Sometimes it takes a variant experience or perspective to get us to see things as they really are, though.

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Be Sure to Diversify Your Life

The Financial Blogger posted Wednesday that he doesn’t believe in burnout. Ironically, even though he claims burnout doesn’t exist, he spends much of the post talking about how to avoid it. The inherent contradiction of that aside, there are a number of good tips. They start with three primary tips:

– Do stuff you like doing
– Maintain a good work, life, leisure balance
– If you don’t like the situation you’re in, stop complaining and make changes

Now these are general ideas, but they definitely have application to trading. Active traders are very much at risk of getting run down and burned out being closely involved with the markets hour after hour, day after day. There’s a massive amount of information to be processed and absorbed and turned into important decisions. That tends to run stress levels up. If you don’t spend time away from the markets doing different things, thinking about other stuff, the accumulated build up will almost definitely lead eventually to impaired performance.

Yes, the markets can be extremely fun and exciting. Even the most interesting of things can wear you down, though, so take time away to let your batteries, focus, and enthusiasm recharge.

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Using Secondary Indications in Your Market Analysis

Yesterday Adam at Forex Blog put up a blog post looking at the British Pound, specifically in terms of GBP/USD. He throws a lot of different stuff into his assessment of the UK currency, part of which is looking at the prospects for a rate hike by the Bank of England. To that end, let me share two charts I keep an eye on in my work.

This first chart shows the spread of UK 2 year Gilt rates over the US 2yr Treasury Note rate, with the spread’s correlation to GBP/USD in red as the lower plot.

The second chart is the same as the one above, but swapping German Bunds in place of US Treasuries and running the correlation against EUR/GBP instead of GBP/USD.

I offer up these charts for a couple of reasons. One is to show the sort of secondary analysis professionals use to assess the markets. Another is to show how frequently market correlations can change. We would expect a positive linkage between the UK/US rate spread and GBP/USD and a negative one between the UK/German spread and EUR/GBP, but that’s not always the case.

The third reason for showing these charts is to show what’s been going on in these spreads lately. The UK/German spread has fallen sharply, strongly indicating the market’s view on whether it will be the ECB or BoE the moves first to hike rates has moved strongly in favor of the former. Things are less dramatic in the UK/US spread, but the breakdown there hints that fixed income traders have become less confident about a BoE rate move in the short-term in general, not just as opposed to the timing of the ECBs action. These are the sorts of things the professionals are looking at and thinking about in making their market judgements. It’s all related.

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Non-Arguments Against Fundamental Analysis

I’m going to join Adam from Forex Blog in taking on a post at Counting Pips titled The Problem with Forex Fundamental Analysis. Obviously, the focus of these pieces is on forex, but really the ideas apply to pretty much all markets.

The author of the latter has defined fundamental analysis in this way:

Fundamental analysis mainly focuses on the overall state of the economy, interest rates, monetary policies which are basically the economic conditions of a country.

These are three arguments made why having a fundamental analysis focus “will be disastrous”.

By the time you receive economic news it will have already been reflected in the charts.
This will tend to be true if the data is largely anticipated. If everyone expects the Fed to hike rates by 25bp at the next meeting then that is bound to get factored into market prices in advance of it happening. A recent example of this is the rise in the euro following hints from the head of the ECB that there could be a rate hike in April.

This, however, doesn’t not account for surprises where an event or data item is nowhere near market expectations. Those sorts of developments are the ones that produce high volatility reactions.

But it doesn’t take a big variance from expectations to cause a market reaction. Unless the market is 100% sure of something there will remain room for reaction. Think of it this way. If the market is only 75% sure the Fed is going to raise rates at its next meeting, it’s probably only going to price about 75% of the hike into current prices. This is why trades pay such close attention to all the Fed speak so they can gauge the probabilities and factor them in.

Economic data is skewed and biased by those reporting it
This may be true, but I’m not inclined to think it matters. Traders and market analysts tear apart every piece of data they get their hands on to see what’s what. They also have secondary sources of information beyond just that reported by the government. They know when things look dicey and react accordingly.

Everyone reacts the same way to news, producing a herd mentality
This would seem to tie in closely with the question from my Trading FAQs book “Why doesn’t everyone trade in the same direction?” The fact of the matter is, they don’t. Anyone who’s been in the markets long enough has seen plenty of times when the market reacts very strongly in one direction only to eventually reverse. That seems pretty good evidence to me that not everyone is included in the initial herd.

But We Miss the Point Entirely
All of the arguments against fundamental analysis listed above are strongly slanted toward trading off immediate term developments – the data and news that’s just hit the wires. This, though, isn’t fundamental trading. It’s news trading. It’s trying to figure out what the market is expecting and how it’s positioned ahead of time and knowing how best to react to the headlines when they hit. Fundamental analysis is taking the bigger picture view with macro trends and valuations in mind. That’s the complete opposite to news trading.

If you want a reason not to use fundamental analysis in your trading, there’s really one one major one. Because of it’s longer timeframe focus, fundamental analysis is of little use for short-term traders beyond providing of the underlying macro scenario.

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Quick and Dirty Position Sizing Rule for Traders

There’s all kinds of discussion and advice about how much risk should be taken on a trade-by-trade basis. Figures like 1%-2% are often tossed out in the active trader community. William O’Neil suggested 8% in his book How to Make Money in Stocks. If you really want to do it right, and you have the appropriate statistics, you can come up with a risk level based on your strategy’s/system’s win rate and the relative sizes of the winners to the losers. We don’t always have a really good set of performance metrics to work with, though, so here are a couple of quick and dirty ways to get to per trade risk.

Fixed Risk
If you’re planning on taking the same nominal risk (say $100) then it’s very simple. You take the maximum amount you’re willing to risk over a given period and divide that by the number of trades you expect to make in that period.

Let’s say you’re maximum risk for the week is $500 and you expect to make 10 trades. Take $500, divide that by 10, and you come up with $50 risk per trade.

Alternately, if you want to think in percentage terms, let’s say you want to set your max risk at 5% for the week and will do 10 trades. In this case you’re per trade risk would be 0.5% (5%/10).

Fixed Ratio
The math gets a bit more complicated when you start talking about setting your risk as a percentage of your account equity. This means, for example, that if you decide to risk 5% and your first trade was a loss, your second trade would mean risking 5% of the now 5% smaller account equity (95% of the initial value). That would be 4.8% of the initial account balance (95% x 5%). This sort of strategy means as your account balance falls from a series of losing trades you’ll actually take smaller and smaller risks through a negative compounding process.

Let’s bring back the 5% risk for the week and the 10 expected trades.

We can figure out what the per trade risk would be by using this base formula in Excel:


Where r is the total risk for the period we’re looking at and n is the number of trades expected for that period.

Plugging in our 5% total risk and 10 trades we get:



= 1 – (0.95^0.1)

Which works out to 0.512% for the per trade risk.

Note that this is actually slightly larger than what we got in the fixed risk calculation above. That’s because of the negative compounding involved.

Scale it Up!
Note that you can use this same sort of process for setting up your per period risk limits. For example, you could figure out what your per week risk limit should be given where you want your per month risk cap to be. It’s the same math, just scaled up from trades to time periods.

Very Conservative
Now, in both of the sets of calculations above we’re going on the assumption of a worst case scenario where every one of our trades in the period in question is a loser (or in the case of time periods, that each of the smaller ones sees a maximum loss). That makes it inherently very conservative in nature. To that end, it’s good for setting the floor in terms of how small you should trade. As such, new traders can make very good use of these quick and dirty calculations to keep them trading conservatively during the learning process (so long as they are pretty close in their estimates of how many trades they’ll do). More experienced traders will want to adjust up based on rational assessment of performance.

How do you set your risk?
I like to use the quick and dirty stuff above when looking at more position-oriented trades. They are inherently less frequent, so as such more subject to strings of losses because the law of large numbers cannot necessarily come in to play.

What about you? How do you decide what to risk on your trades?