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Who are you? What are your strengths and what are your weaknesses? Do you thrive amidst chaos or require regimentation and stability? In trading, the answers to these questions are far more important than any setup you can devise.
At its core, trading is a game of psychology, and no amount of reading, no computerized back-testing, no advanced seminar work will produce long-term success if your trading style is in conflict with your basic personality. Contrary to popular belief, successful traders do not change their approaches to adjust to the market but rather find market environments that best suit their inherent strengths.
That’s why in books like Jack D. Schwager’s Market Wizards (New York Institute of Finance, 1989; HarperBusiness, 1993) you will find very successful traders following diametrically opposite approaches to the market and often dispensing what appears to be contradictory advice. In fact, it’s not at all inconceivable to imagine two market wizards taking opposite sides of the same trade yet both walking away with a profit.
To market novices this idea may seem completely illogical. In most businesses we are taught that there is always an optimal way of doing things, that certain processes will be far superior to others. Clearly that’s the case with engineering, where scientific rules of optimization and refinement apply to everything from car production to bridge building.Financial markets, however, are emotional mechanisms, which is why engineering-based solutions to trading inevitably fail.
Financial markets are extraordinarily complex with a multitude of players, each with a different agenda and time perspective, providing the trader with a variety of opportunities for profit. Since the currency market is the largest financial market of all, the flexibility to craft a strategy conducive to your specific personality is even better in FX than in any other market.
The cold hard truth of life is that we do not really change; we just grow older. The most successful businesspeople in the world learn how to utilize their strengths while minimizing their weaknesses by having their more skilled colleagues perform those tasks which they cannot do well. Trading is very much the same. Successful traders choose those strategies that are most aligned with their psychological profiles while staying out of the market when conditions aren’t suitable for their style. It isn’t a matter of doing the easy thing or the difficult thing.
All trading is difficult. Rather it’s a matter of doing the natural thing. Why is this concept so important? Couldn’t you simply learn proper trading habits with enough practice and discipline? No. No matter how much discipline you possess, if you are trading contrary to your natural impulses you will eventually sabotage your trading plan and you will fail.
This is the reason why cookie-cutter trading maxims such as “Cut your losses short and let your profits run” are not only useless but often highly destructive for most traders. Each person is unique, and successful currency trading is the art of applying each trader’s personal skills to the array of opportunities present in the market.
Let’s take a quiz. It is by no means a scientific test. It’s just seven simple questions that I devised a while back to help discover potential trading profiles. Don’t worry—there are no right or wrong answers. But maybe you will gain some insight into who you are as a trader.
Answer the questions as honestly as possible.
There are no “correct” answers.
You fail only if you lie.
1. You need to buy one important item in the store. You run in quickly, pick it up, and approach the counter. Unfortunately, instead of the usual five cashiers only one cashier is open and there is a line of 20 customers ahead of you. You:
A. Walk out of the store immediately, leaving your item behind.
B. Get in line and wait your turn.
2. You are driving down a two-lane highway on your way to work. Suddenly a sports car tries to cut you off, nearly clipping your fender. You:
A. Slam your horn for at least 15 seconds and wish the driver dead.
B. Hit the brakes and let the driver pass unimpeded.
3. Assume you are capable of doing both activities. What’s more fun?
A. Fishing.
B. Downhill skiing.
4. The Powerball lottery jackpot is $100 million. You are at a newsstand buying a magazine when you discover a crumpled $20 bill in a shirt pocket. You:
A. Buy 20 lottery tickets.
B. Put the $20 in your wallet.
5. Your favorite entertainer is in town for a surprise show. Your choices are:
A. Get up at 4 A.M. On Saturday morning to get tickets at the box office.
B. Buy tickets online for a show nine months later.
6. What is worse:
A. A constant low-grade toothache for a month?
B. Having your wisdom tooth pulled with no anesthetic?
7. For the next 52 weeks choose one:
A. You will be paid $2,000 per week.
B. You will be paid $700 per week with a reasonable chance but no guarantee to collect a $250,000 bonus.
There is no final score for this test. There are no neat boxes to classify the answers. Rather, they are meant to uncover some inner drives to your behavior that may offer you better clues to what type of trading suits you best.
Let’s examine each question in detail.
1. You need to buy one important item in the store. You run in quickly, pick it up, and approach the counter. Unfortunately, instead of the usual five cashiers only one cashier is open and there is a line of 20 customers ahead of you. You:
A. Walk out of the store immediately, leaving your item behind.
B. Get in line and wait your turn.
How many of us have been in this situation and wanted to scream in frustration? Yet while this question seemingly examines the common problem of modern life, it is actually trying to probe your ability to abandon positions quickly. Will you cut and run at the first sign of trouble or stubbornly wait it out? In other words, answer A says you are likely to take a quick stop-out. Answer B indicates you will nurse a trade, no matter the discomfort.
2. You are driving down a two-lane highway on your way to work.
Suddenly a sports car tries to cut you off, nearly clipping your fender. You:
A. Slam your horn for at least 15 seconds and wish the driver dead.
B. Hit the brakes and let the driver pass unimpeded.
This question tries to ascertain your ability to react to surprising and uncontrollable situations in the market. Do you stoically accept the fate that is dealt you or do you fume in furor over the injustice over it all? Put simply—can you take stops well?
Again, this is not a moral question, but rather one of style. If surprises really unnerve you, the solution is not to learn to repress your emotions but, as we’ll see later in the chapter, to apportion your capital in such a way as to avoid a death spiral of impulsive, reckless trading caused by loss of control.
3. Assume you are capable of doing both activities. What’s more fun?
A. Fishing.
B. Downhill skiing.
Surprisingly enough, this is a question about trend and countertrend trading. Fishermen trend, skiers fade. Before I receive letters of protest from trend-following skiers and fading fishermen, allow me to explain.
Fishing requires time, methodology, and, most importantly, patience. Fishermen, like trend traders, will cast their line many times before they get a bite. Downhill skiers, on the other hand, look for a quick thrill with a very specific goal—end of run. This psychological drive is similar to that of faders who seek quick profits as currency prices make a quick retracement.
Does fishing always lead to trend trading and skiing to countertrend trading? Of course not. However, the activity you choose suggests a definite predilection for one style versus the other.
4. The Powerball lottery is $100 million. You are at a newsstand buying a magazine when you discover a crumpled $20 bill in a shirt pocket. You:
A. Buy 20 lottery tickets.
B. Put the $20 in your wallet.
This question is really a measure of a trader’s preference to trade long shots. If you are willing to bet the lotto, that means you are willing to take a very low-probability trade. Again that fact in and of itself is not necessarily detrimental to a trader’s success. As we will see later, if done properly currency speculation allows the trader to place highly improbable bets while limiting overall risk. However, if you chose A, you need to understand that you will most likely lose. A very common problem among traders is the tendency to trade long shots with the expectation to win frequently.
This inability to reconcile action with expectation probably leads to more trader failure than all other problems.
5. Your favorite entertainer is in town for a surprise show. Your choices are:
A. Get up at 4 A .M . on Saturday morning to get tickets at the box office.
B. Buy tickets online for a show nine months later.
This is a question of trading goals. Do you seek immediate gratification and are willing to pay the price to get it? Are you willing to stare at the screen 18 to 20 hours 5 days per week and then scrupulously review every single trade over the weekend? Then you most likely picked A. Or are you more long term oriented? Are you willing to delay your desire for quick cash in order to live a less-demanding lifestyle? Then B is your choice. Note if you picked B but have the goals of a trader who picked A, you are unlikely to realize them.
6. What is worse:
A. A constant low-grade toothache for a month?
B. Having your wisdom tooth pulled with no anesthetic?
Since neither choice is at all pleasant, this of course is a question about stop-losses. The issue that this question tries to determine is this: Are you more comfortable taking a long series of small losses or would you rather take an occasional large loss? How one honestly answers this question is crucial in determining what style to trade.
7. For the next 52 weeks choose one:
A. You will be paid $2,000 per week.
B. You will be paid $700 per week with a reasonable chance but no guarantee to collect a $250,000 bonus.
No doubt entrepreneurially minded, free-market-loving traders would scoff at the idea of a steady paycheck and will inevitably choose B. But check your ego at the door and ask yourself, are you really comfortable with this type of volatility? In choice A you stand to make $104,000 per year. In choice B you make either $286,400 or only $36,400 per year.
In other words, you can almost triple your salary of choice A or make only about one-third as much. If this disparity truly doesn’t bother you and you therefore chose B, then a highly aggressive, high-leverage strategy may be more your style. However, if wide disparity in outcome does bother you, that type of trading will be financial suicide. Instead a totally different approach must be pursued.
Let’s examine in detail some strategies that may be of use depending on what type of trader you are. Just as in trading there are really only two decisions to make—trend or fade—so, too, in money management there are only two strategies to follow: You can either suffer numerous small losses and hope that an occasional large win will more than offset the drawdowns in your account or you can harvest many small profits and suffer an occasional large loss that you hope doesn’t overwhelm the profit cushion you have built.
Of course novice traders rarely face these two choices. They simply lose money. Some lose money in small increments over a long period of time, while others lose money in shockingly huge chunks and are out of the game before they even have a chance to learn how to properly use their trading software. Why do novices inevitably lose? Because they trade in a random fashion. They rarely practice consistency in their setups. They rarely understand the dynamics of price flow, and even when they learn it, they frequently misunderstand the nature of technical analysis.
A while back I received an e-mail from a very nice and earnest former student. He wrote:
Boris—
I was always taught and was repeatedly told that when it comes to a break of support or resistance, the confirmation of such a break is a clean break followed by price exceeding the close of the breaking candle.
The 61.8 percent Fib of the June and July bullwave for EUR/CHF came in at 1.5434, cleanly broken on September 1stprice closed at 1.5412. The next day the price fell further, closing at 1.5399 and inducing me to take a large short.
Having seen this proved false several times (although never as starkly as this or as expensively), I am of the firm opinion that we can take the above philosophy and consign it to the trash for the myth that it is. Would I not at least be right to take it extremely lightly as yet another one of those theories that has more than a 50 percent exception rate?
To which I replied:
This is actually a perfect example of how technical analysis is in the eye of the beholder. First and foremost, there never ever was such a concept as “always” in technical analysis, only “likely.” We are forever dealing in probabilities here.
Second, why did this trade work out badly for you? Looking at the chart, I see the first natural stop at 1.5486, above the high of the breakdown candle on September 1. It hasn’t even come close to breaking it yet.
I actually really like EUR/CHF short as I think the Swiss will outperform the EU in the near term. Having said that, I hate trading breakout and breakdown because I always feel like I am chasing price flow, but that is my personal prejudice.
One idea you might consider is to wait a bit and try to short the retracement—in this case maybe at 1.5430. You risk the chance of losing out on the trade but gain a better entry, which will make your risk/reward more favorable.
Note, by the way, that this trade turned out to be a loser, regardless of how you traded it. EUR/CHF raced higher, stopping out all approaches to short it. But that’s not the point here. The key to understanding the problem is that this trade was only a probability, not a guarantee. Furthermore, by using technical analysis we set logical risk parameters for the trade and, although we took a loss, it was good trade because we reacted properly to market conditions.
Trading randomly, however, is one of the quickest ways to lose money in FX. Many threads on many Internet bulletin boards have been started using the random entry “coin flip” approach and some basic form of money management like risking $1 for every $2 of profit; within a matter of weeks or months, the originators of those threads have found themselves either in deep drawdown or completely broke. Ironically enough, the practitioners of the random entry method inadvertently prove that market action is not random.
If it were random, then they presumably should perform no worse than skilled traders; but alas, like a lucky idiot who sinks a half-court shot during a contest but could never win a one-onone game against a professional basketball player, so, too, these novice traders will fall by the wayside when competing against professional technical traders over any reasonable length of time.
So the notion that technical analysis doesn’t matter—it’s just money management that matters—is, like so many trading myths, complete nonsense. Money management alone will not make you a successful trader. It is, however, a vital complement to any intelligent technical setup. Furthermore, money management strategies are as unique as each trader, and one of the most pernicious myths perpetrated on the gullible public is that money management strategies are sacrosanct and inviolable and thus all traders must follow the same money management rules in order to achieve success.
That is utter nonsense. In fact, the longer the traders trade, the more flexible, the more complex, the more creative their money management skills become. Because FX offers retail traders unprecedented liquidity and limitless customization, money management strategies in FX are truly variable.
The Myth Of 2:1
Let’s start the most classic money management technique preached by every trading book ever printed. In every trade your reward/risk ratio must be at least 2 to 1. You must try to obtain 2 points of gains for 1 point of risk. This way the trader needs be correct only 40 percent of the time and will still have a positive expectancy to his trades. On the surface this idea sounds eminently logical and practical. In real life consider what this means, however. It’s quite difficult to squeeze out 2 points of profit for 1 point of risk. Try it and see.
First look at the price action on the smallest time frame and see how hard it is to risk 1 point in order to capture 2 points. On the smallest level the FX trader faces the overwhelming barriers of the spread. Even in the most liquid financial instrument in the world, the EUR/USD, the spread is 3 points wide, so in effect the trader must make 5 points in order to earn 2, thus forcing him to generate an improbable ratio of 5:1 in order to simply meet this goal.
Moving on to a 10- point increment, a 10-point risk for a 20-point profit still requires a 23-point gain and allows for only a 7-point risk of loss in the tightest spread pairs like EUR/USD and USD/JPY; in effect, this means that a trader must generate 3 points of profit for 1 point of risk just to meet the 2:1 reward/risk ratio.
Expanding the time line to longer time frames, a 100- point risk with a 200-point profit target provides much better odds. Here the spread plays a minuscule part as it requires only 203 points of profit and allows for 97 points of risk, generating very close to a 2:1 ratio.
But let’s step back a second. Remember the quiz? What if you were the downhill racer? What if you were the customer who left the long line at the drugstore? In short, what if you were simply not predisposed to patiently stay in the trade for the time necessary to see it to fruition?
If you were impatient, wouldn’t it be much more probable that you would try to take your profits far sooner, perhaps at 100 points in the money or even 50 points in the money, turning what in effect was supposed to be a 2:1 trade into a 1:1 or 1:2 reward-to-risk setup?
You will do what every trading book preaches not to—you will cut your profits short by not letting them run. But given your personality, can you really be expected to do it any differently? But let’s suppose that you are different. You possess the patience of a saint, you have the discipline to follow this rule inviolably. Imagine the following scenario:
You place a trade in EUR/USD. Let’s say you decide to short the pair at 1.2500 with a 1.2600 stop and a target of 1.2300. The trade is going well. The price moves your way. EUR/USD first drops to 1.2400, then to 1.2350, and slowly makes its way toward 1.2300.
At 1.2335 the price action pauses and the pair starts to inch back up, first trading through 1.2350, then 1.2375. You, however, are patient. You have nerves of steel. You hold on, looking for your 2:1 reward-to-risk. The price starts to move back down and you are starting to feel vindicated. Back to 1.2350, 1.2325; slowly but surely you see the target in sight. 1.2320, 1.2310, 1.2305.
Your take-profit order sits on the platform waiting to be filled. The price ticks a few more pips down, reaching all the way to 1.2301—but then it bounces back, first slightly, then violently, until in a matter of seconds it’s at 1.2350, then 1,2370. You remain calm. The price nearly touched your target. It’s bound to test that level again. You won’t make the same mistake others make of cutting your profits short. You will stay in the trade and follow the classic money management rules!
Of course, the price never does see 1.2300. Instead the pair verticalizes and soon reaches 1.2600, easily taking out your stop. You are now faced with the idea that you had a 199-point profit and allowed it to become a 100-point loss.
Welcome to real trading. How many episodes like that do you think a novice trader can experience before abandoning all sense of discipline and proper money management? This is the reason why the 2:1 reward-to-risk strategy is mostly a fantasy, an ideal. In practice most traders will modify the strategy in one of two ways.
First and foremost, once price moves in the direction of the trade by the amount of points risked, professional traders will move their stop-loss to the breakeven point to assure themselves that a winning trade will not become a losing trade. So in the case of our EUR/USD trade the trader would move the stop to 1.2500 once the price breached the 1.2400 level.
This, however, still presents a dilemma for most traders. Suppose the price decided to retrace and came all the way back to 1.2500, stopping the trader out. There would be no losses, but also no gains. The trade would be a scratch. In trading there is nothing more frustrating and psychologically unnerving than to be right on direction and walk away with no profit. It’s the equivalent of working very hard all day long at your job and then losing that day’s pay through a hole in your pocket.
For this reason many traders practice a scale-out approach. Typically traders will let go of half of their position once the gains match their risk value. In our tried-and-true EUR/USD example the trader would sell half at 1.2400 and then move the stop to the break-even point, assuring himself of harvesting at least some profit out of the trade.
This approach allows the trader to remain in the trade for as long as necessary because it satisfies the most basic desire of trading—the need to get paid. By selling half of the position at 1.2400 and half at 1.2300, the trader is able to harvest only a 1.5:1 reward-to-risk ratio, which of course is mathematically inferior to 2:1.
However, trading is not a game of mathematics but one of psychology, and frequently what is mathematically optimal is psychologically disastrous.
Professional traders recognize this fact well. They also understand than market dynamics are fluid and will rarely conform to rigid reward/risk ratios. By constantly monitoring their positions and adjusting their risk parameters to the reality of the markets, professional traders are able to not only generate positive reward/risk ratios but also produce more profitable trades.
Killer Instinct
Do you have the killer instinct? Can you press the trade? Then this trade management technique may be for you. If you ever want to hit home runs, if you ever want to make a huge score in trading, then this is the only way for you to trade and FX is the single best market to effect this strategy.
Let’s take our EUR/USD trade. Again you, the trader, get short at 1.2500 but this time your strategy is different. If the pair trades up to 1.2550, you cut your loss quickly and await the next opportunity. If, however, the trade moves your way, you do not automatically take half the position out of the market. Rather you wait patiently and watch the price action. Imagine the price has now moved to 1.2200, fully 300 points in the money.
Instead of taking profits, you add another unit to the trade. If the price begins to retrace all the way back to 1.2350, you cover the whole position for a scratch. You haven’t lost anything on the trade, but neither have you made a profit. If, however, the price retraces only slightly but then resumes direction, you stay in position and again monitor price action carefully.
The price has now reached 1.2000 and you sell yet one more unit at that price. You now have sold three units altogether for an average price of 1.2230. As long as the price remains below this level, you stay in the trade. Your patience pays off and the price collapses to 1.1700, at which point you finally cover the whole position. Let’s review the total profits from the trade:
1 unit at 1.2500 covered at 1.1700 results in a profit of +800 points.
1 unit at 1.2200 covered at 1.1700: +500 points.
1 unit at 1.2000 covered at 1.1700: +300 points.
Total profit: 1,500 points.
Total risk: 50 points.
For those traders who can implement this strategy, this is clearly the best way to trade. Dennis Gartman (the famous investment newsletter writer), an old pit trader himself, calls this method “doing more of what is working and less of what is not.” It is no doubt deceptively simple and seductive.
In fact, here is a description taken from Elite Trader bulletin board of another famous pit trader, Richard Dennis, employing just such a strategy in the bonds.
As someone who has seen the likes of Rich Dennis and Tudor Jones operate, those “5%” winning trades involve add-on after add-on. Case in point is Dennis in the 1985–1986 bull market in bond futures. He would start with his normal unit of 500 contracts and get chopped for days. Buy the day’s high, put ’em back out on a new swing low etc. Every once in a while he’d wind up with 500 that worked. Then he’d start the process higher, all over again. Work ’em in, work ’em out. After maybe a couple of months the market has rallied 10 pts. From where he started and he has 2,000 on (meaning 2 million a point). Now the market is short and ready to pop on any size buying and he’s there supplying the noose. Bidding for 500 on every uptick, he finally gets to a point where for the last month of the move he has 5,000 on. T-bonds rally 20 pts. In just over a month and he’s up $100,000,000 on a trade that started out with him just testing the waters, losing $100,000 a few times before he could establish a position worth doubling up on.
Wouldn’t we all want to own that trade? One trade, $100 million in profit. But let’s remember what’s required to get there.
• Accurate directional entry into trend.
• An intense, multi-hundred-point trend with little or virtually no retracement along the way.
What are the chances that this type of strategy succeeds? Minimal at best. Note that the writer described these as “5%” trades, meaning that they occurred only 5 percent of the time. In fact, the perfect confluence of events to generate such profits probably happens less than that.
Far more than the fortuitous market conditions necessary to produce such windfall profits is the unbelievable psychological pressure such trad- ing will generate. The term “pressing the trade” is most apropos to describe this dynamic.
Not only is the trader pressing the market by adding more and more units as they go deep into the money, but he is also pressed by the market as his profits pile up. Put yourself in Richard Dennis’s place. Would you be able to stay in the trade once it hit $1 million? How about $10 million? $50 million? At each level the intensity is enormous, and for most people the pressure of winning can be far worse than the fear of losing. Forget Richard Dennis and just think how you would have felt if after selling the third unit at 1.2000 you had to cover at 1.2233 as prices retraced, and you had to watch a certain profit of 700 points evaporate into nothingness.
For those unconcerned with such issues, for traders who are more than willing to suffer a long series of losses and empty trades for a chance to score big, FX offers the best opportunity to do so of any financial market in the world. Why? Leverage and liquidity.
Here is how this strategy would work. Assume that you have $10,000 of trading capital.
Deposit only $2,000 of capital with your FX dealer. Keep the rest in your bank account. With 100:1 leverage, which is standard in the FX market, you will have 100 points of leeway before you get a margin call in EUR/USD. (Trading other pairs the margin requirements might be different, so consult with your dealer before attempting this idea on other currencies.) If the trade moves against you, an automatic margin call will instantly take you out of the market.
Dealers will not call you in advance and warn you of an impending margin call like they may do in exchangebased futures markets. Rather, the dealer’s software program will automatically liquidate your position. This may seem a bit brusque, but the upside of such an arrangement is that your account should never experience negative equity and your total risk should be limited to the amount you’ve deposited.
The margin call will then act as a de facto stop on your account.
If a margin call is triggered, your account should have approximately $1,000 of equity left.
$2,000 initial deposit – $1,000 loss on trade
($10 x 100 points at 100:1 leverage) = $1,000
Deposit another $1,000 from your bank and trade again once your setup is triggered. You can repeat this process up to nine times before you run out of your trading capital. Will you lose most of your money? Perhaps. Remember, this is a very low-probability trade. But at least by subdividing your capital into 10 equal pieces you’ve given yourself the best opportunity to succeed. This strategy is basically a more intelligent variation on the old trader saying, “Have a hunch, bet a bunch.”
Let‘s imagine, however, that on one of the trades you were successful and caught the large directional move. If that’s the case, you could employ the trade management strategy discussed before and continuously add to your position as prices move your way. In the best of all possible scenarios the trader could eventually build up a large position, perhaps 10 lots or more (with notional value of $1 million), that could be 1,000 points in the money. In that case the profit on the trade would grow to $100,000. Not bad for $1,000 of initial risk.
As I’ve already noted, this strategy is not for the faint of heart. This is a very high-risk, (potential) high-reward strategy that requires a unique mindset and proper trade management techniques to succeed. Fortunately, FX is perhaps the single best market to put these ideas into practice.
For those inclined toward a more steady approach, here is a completely different trade methodology and one that I employ myself.
Never add to a loser.
Never double down.
These old trading maxims are treated as sacrosanct truths by most traders.
What a bunch of nonsense. I add to losers all the time, and so do some of the most successful traders I know. Why? Because what most books never tell you is that almost all trades start out as losers. It is extremely difficult to time the entry so well that it immediately begins to move in the direction of your trade. Sometimes trades will move only a few points against the position but occasionally prices may retrace several hundred points away from initial entry only to eventually turn around and become profitable. Trading is the art of accurately forecasting direction and timing.
Between the two, timing is far harder to handicap, especially if prices seesaw back and forth for a while before ultimately moving in the right direction.
Traders who trade highly leveraged positions with tight stops will be eviscerated in such an environment, as they will continuously get stopped out. Far worse than even the hit to equity is the psychological pain of “death by a thousand stops.”
That is why traders who do not like frequent stop-outs prefer the scale-in approach to price entry. This strategy is almost diametrically opposite to the strategy discussed in the preceding section. Using the scalein approach assumes that the first entry will almost never be the best entry; as a result, the approach requires very low leverage in order for the strategy to withstand the adverse price moves.
In this strategy the trader continuously adds more units as prices move against him, trying to achieve a blended price that remains near the current price. If prices do eventually turn, the constant averaging of price levels will make the position profitable much faster than if he expended all of his trading capital on the first price entry. While this can be a successful trading strategy, it can also be highly dangerous if the trader does not follow two key rules:
1. Set a hard stop for the whole position.
2. Trade in very small increments.
To understand just how destructive this strategy can be, let’s examine what happens if the trader uses this method employing the standard allocation of 2 percent of capital per trade. Imagine that the trader with a trading account of $10,000 initiates the first trade in the EUR/USD currency using two mini lots. Prices move against his entry by 100 points and he now doubles his allocation to four mini lots. Again prices continue to move against him by another 100 points and he doubles his position yet again to eight mini lots.
Prices continue to follow this adverse pattern and move against him by 100 points more. Finally, the trader gives up and covers his position in dismay. What is his total loss? A whopping 22 percent of his total capital!
–$600 on two mini lots (prices moved 300 points away from entry).
–$800 on four mini lots (prices moved 200 points away from entry).
–$800 on eight mini lots (prices moved 100 points away from entry).
The irony of the matter is that after an uninterrupted 300-point move against the position, chances are quite high that the trade may turn around and could quickly become profitable. But by overleveraging the position the trader is unable to withstand the drawdown.
Imagine the same scenario but instead of using mini lots with the value of $1 per point, the trader uses micro lots with each point having a value of only 1 dime. In FX, where many dealers offer such small lot sizes, this strategy is eminently possible. In that case the drawdown would be a far more manageable 2.2 percent of capital and the price would need to move back only 150 points instead of the full 300 points in order for the trade to become profitable.
This type of scaling where the trader doubles the size of the position at every interval is called geometric scaling. Unlike regular average-in scaling that cuts the break-even point by 50 percent, geometric scaling requires that prices retrace by only 33 percent to reach the break-even point. While this can be a very effective way to quickly make a losing trade
profitable, the strategy can also spiral out of control. A better compromise between the straight average-in method and the geometric scale-in is the arithmetic scale strategy. Instead of doubling up the position at every interval, the arithmetic scale calls for an increase of the position by a fixed amount. Table 9.1 shows the key differences between the geometric and arithmetic approaches using a hypothetical scale-in strategy in EUR/USD starting with entry at 1.2500 and a hard stop at 1.1950.
Note that in the worst-case scenario the geometric strategy loses more than $2,000 on a $5,000 account while the arithmetic strategy loses only $143. At the same time the break-even point on the arithmetic strategy is 1.2166, only slightly higher than the 1.2049 break-even on the geometric approach. The data clearly shows that for multiple-interval scale-in approaches the arithmetic strategy is the best bet.
An interesting trade management compromise between the low-probability, (potential) high-reward method of scaling up into a position and the highprobability, low-reward technique of scaling down into a trade is something that I call the 10 percent solution, which I picked up from a trader on one of the FX trading bulletin boards. Here is the basic strategy for this method.
Let’s suppose once again that we would like to short the EUR/USD pair at 1.2500. For simplicity’s sake we are willing to risk 100 points and seek a 100-point target on the trade. In other words, our stop is at 1.2600 and our target is at 1.2400. Let’s further imagine that we will trade 10 mini lot contracts with total notional value of 100,000 units. We place our short at 1.2500. However, here is the rub. Instead of stopping out at 1.2600 with the whole position, we place stops at 10-point intervals for 10 percent of the position.
So, if the trade moves against us by 10 points we would sell one mini lot, leaving us with nine mini lots (90,000 units) in the trade. If the trade moves 20 points counter to our entry we would sell one more mini lot, leaving us with 80,000 units—and so on until the price reached our ultimate stop-out value of 1.2600, at which point we would only have to liquidate one mini lot left in our inventory. On the opposite side we would maintain our target of 100-point profit regardless of how many lots we had left, so if we got stopped out on three mini lots but prices then turned in our favor we would harvest a 100-point profit on the remaining seven lots
Think about the implications of this strategy for a moment. In the original trade we risked 100 points on 10 mini lots or a total of 1,000 points (100 x 10 = 1,000). Using this compromise stop-out approach we were able to winnow down the total loss from 1,000 points to only 550 points if the trade became a complete bust. However, if the trade turned in our favor at any time before reaching the eighth stop-out, we would still have been able to bank a gain. The attractiveness of this approach is twofold. It automatically reduces risk if the trade moves against you, but it allows the trader to partially remain in the trade up to the very last moment.
Not only is this a good practice of risk management but it is also a very clever way to get the trader to actually accept his stops. Just like a mother who feeds her baby medicine in tiny little portions in order to make it more palatable, this technique forces the trader to do what is best for his account with minimal psychological damage.
Steve Cohen, probably the greatest trader in the world today—so good that he is able to charge 50 percent of gross profits in his multibillion-dollar hedge fund STC Capital—once said in an interview with Jack Schwager in Stock Market Wizards (Harper- Collins, 2001), “What happens when you are short a stock that is moving against you, and there is no imminent catalyst? I always tell my traders, ‘If you think you’re wrong, or if the market is moving against you and you don’t know why, take in half. You can always put it on again.’”
When I first read that comment it went “in one ear and out the other.” But upon further reflection I realized that Steve Cohen was practicing just this type of risk control methodology for all of his trading.
The 10 percent solution strategy is only a template. We need not scale out at every 10 percent of the distance to the ultimate stop. We could use
20 percent, 25 percent, 33 percent, or any other type of ratio that makes sense. The strategy can also be refined further to enhance the probability of success, though at a cost to profitability.
For example, instead of keeping the profit target at a static 100 points from original entry, we could adjust the target in response to price action. If the price moved 10 points against our position we could reduce the profit target by 10 points, so that instead of 1.2400, we would decrease the profit target for our short to 1.2410; if the price moved 20 points we would decrease the profit target to 1.2420. Table 9.2 shows what happens when the system is adjusted in such manner.
Note that while the profitability of each trade is somewhat reduced, the probability of the success for each trade is likely to be better as it needs to travel less and less distance in order to reach the profit target.
Conclusion
Whenever I teach new sales traders at my firm about proper trade management in the currency market, I often start out with the example of Richard Dennis and the method of pressing the trade. Before I even have a chance to finish, some overeager rookie will inevitably jump up and confidently proclaim, “Yes! That’s the only way to trade!” I hope this chapter has convinced you of the fallacy of such thinking. In trading there is no “only” way of doing anything, especially money management.
One of the great strengths of trading is that it is an art, not a science—and there is a highly flexible discipline that allows for numerous individual modifications.
Are you comfortable with the classic 1:2 risk/reward approach? If so, it can be quite profitable, especially if you modify it as most traders do by scaling out of half of the position at profit distance equal to risk and trail the rest with a break-even stop. Do you have a killer instinct? Can you easily give up small to medium-sized gains in quest of one huge win?
Then pressing the trade by constantly adding to a winning position may be the best strategy for you. What if you like taking small, frequent gains and can accept an occasional large loss? Then arithmetic scaling may be just the right approach for you to succeed. Finally, what if you are a true moderate, neither seeking remarkable gains nor afraid to absorb a series of small losses? Then the 10 percent solution may be just the “solution” for you.
As you can see, risk management trading is truly contingent on the trader’s personal preferences. The currency market makes the task immeasurably easier by allowing retail traders to customize the size of their positions without incurring any marginal costs. Whether the trader wants to deal 1 million units of EUR/USD contract or only 100 units, the transaction cost among most of the reputable dealers will almost never exceed 0.03 percent.
This fact allows even the smallest traders to implement any of these sophisticated risk management techniques on the exact same terms as the biggest interbank FX traders. However, the one inviolable truth that no trader, big or small, should ever forget is this: Everybody loses in trading at some time in their career. The difference between those who survive and those who do not is that winners honor their stops while losers make excuses.
About the Author
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Boris Schlossberg serves as Fundamental Analyst at Forex Capital Markets. He has been an independent trader since 2000. He is also a frequent contributor to SFO Magazine with articles focused on risk management. (Chapter taken from "Technical Analysis of the Currency Market : Classic Techniques for Profiting from Market Swings and Trader Sentiment" (Wiley Trading)
Book Synopsis
Global currency markets combine unparalleled leverage, high short-term volatility, low execution costs, and significant long-term trends in an atmosphere of laissez-faire regulatory oversight to create the nearly perfect trading environment. Multinational corporations and multibillion-dollar hedge funds have long relied on these markets to efficiently hedge risk while taking advantage of its many rapid profit opportunities.
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