Once, Yogi Berra’s wife Carmen asked, "Yogi, you are from St. Louis, we live in New Jersey, and you played ball in New York. If you go before I do, where would you like me to have you buried?" Yogi replied, "Surprise me."

Surprises of course are the lifeblood of our business. Those of you who have subscribed for a while know that we like to trade “event risk” which is simply a fancy way of saying we try to trade economic surprises. Event risk trading is a short term approach to the currency market with most trades typically lasting no more than 24-48 hours. Why do we trade in the short term? Because in the long term all trading is essentially random and we have very little edge to succeed.

That conclusion is not a matter of opinion but a statement of fact. A few weeks ago I visited with a founding partner of a very tony hedge fund at their 5^th avenue offices. The fund is involved in a very arcane form of reversion to the mean trading between various stock indexes (very successfully I might add) – but after the initial discussion about the mechanics of their strategy, conversation turned to more philosophical matters about markets in general at which point the founder shared some very interesting research with me.

Understand that this hedge fund employs some of the brightest math Ph D’s around and runs enough computer hardware to challenge the Department of Defense. What the founding partner showed me is that projecting future direction from past price data is an illusion that cannot be predicted with any degree of certainty. Using some very sophisticated statistical techniques applied to all markets from equities, to commodities and especially to currencies he showed me that within 48 hours all price behavior degrades into randomness. In fact price prediction was strongest in the first 24 hours and the lost more than half its potency by 48 hours from the start of the trade finally dissolving into complete uncertainty beyond that point. Needless to say this fund only trades short term.

Kathy and I often bristle when reporters try to ask us about the long term economic implications of a particular event. We always say that we are traders first, economists second, far more concerned with the immediate price impact of particular economic news rather than with any long term consequences to that country’s currency. Yet as human beings we are incessant “pattern seekers” always trying to project order out of chaos. As a species, that trait has served us well, allowing us to create a fantastically complex civilization and assert the most precise control over our natural environment. Unfortunately, the same attributes that help us build the George Washington bridge and the new rotating skyscrapers in Dubai can be our downfall in the markets.

To better understand why this is so, I highly recommend that everyone read Nassim Taleb’s new book, “The Black Swan” http://www.amazon.com/Black-Swan-Impact-Highly-Improbable/dp/1400063515/ref=pd_rhf_p_1/102-8650304-8432141?ie=UTF8&qid=1158510728&sr=8-1 which discusses our inherent need to produce post-fact explanations for market events when in reality we are utterly incapable of predicting them a priori. Taleb, shows with empirical precision the utter futility of all long term predictions by experts. (As an example, realize that despite more than $50 billion dollars worth of research, not one CIA analyst was able to accurately predict the collapse of the Soviet Union. Or for those with more of financial interest, remember Robert Precher’s notoriously wrong headed call of long term target of Dow 700 after the 1987 crash.)

Yet while long term predictions are impossible, short term forecasts can be much more accurate but are by no means bastions of certainty. For example, our proactive trade setup depends on two assumptions.

1. The event will surprise in the directions that we predict
2. The price will react in the direction of the surprise.

Generally this is the case in trading, but not always. Sometimes we can be right on the fundamentals but the price will respond in the exact opposite manner. This is the trading equivalent of a bad bounce. Sometimes in baseball a ball will hit a pebble instead of dirt and will bounce in a manner impossible to anticipate by the fielder resulting in a lucky hit for the batting team. Faced with a bad bounce, baseball players shrug them off understanding that there is nothing to be done. We as traders should maintain the same attitude towards trades that are analyzed right but go wrong or vice versa.

Allow me to stop philosophizing and put these ideas in concrete terms. This week we had four trades.

Short AUDUSD +100

This was the most perfect trade of the week as we analyzed the fundamentals perfectly and prices responded exactly as we forecast.

Short USDJPY + 15

A true “making lemonade” out of lemons trade as we were correct on our dollar bearishness, but chose the absolutely the wrong pair to express that view as USDJPY movements were driven by US equity market rather than US economic fundamentals

Short EURCHF +17

A trade where we were completely wrong on the fundamentals but managed to walk away with profits due to our T1 (short target) T2 (long target) money management style

And of course the most maddening trade of all

Short NZDUSD (-74)

A trade where we were wrong on the RBNZ rate hike got stopped out right at the top of the knee jerk spike only to see prices collapse and move our way. Classic bad bounce trade. The amateur lesson to draw from this experience is that our stops were too tight. Nonsense. Our stops were placed at the right point. In fact given the news it was just as probable that the pair could have climbed much higher only increasing our risk. Just as a good tradesman never blames his tools, a good trader never blames his stops. A stop almost always means that you were wrong on the trade. Good trades do not ever come close to triggering their stops.

But is there perhaps something else to learn from the kiwi trade? Yes there is. When a news trade goes bust it can present an interesting profit possibility – a concept we call the “anti-trade” and works something like this. If the price action cannot sustain the direction of the news, the probability of a reversal is quite high. The key are of focus is the price level prior to the news event. If, after the initial knee jerk reaction, the currency pair returns and then breaks that price level, it sets up a great reversal trade because it indicates that the news was not powerful enough to sustain further directional movement and the path of least resistance lies the other way.

Please take a look at the following two examples

http://docs.google.com/Doc?id=dn8z7zs_92fz2b5d

http://docs.google.com/Doc?id=dn8z7zs_94fh4bxv

Therefore, whether we trade with the news or against it, the market provides us with many opportunities for profit. It’s simply our job to uncover them.

Have a great weekend.

B & K