Boris and Kathy's FX Blog www.bktraderfx.com

Power Laws

I am writing this from Dallas Forth Worth airport as we are about to go back to New York after a great expo as Dallas where we had a chance to meet some of you in person. So this week’s missive will be brief but quite important.

The subject this week is power laws. For those you not familiar with this notion it can be best expressed in the well know example that in business 80% of profits come from only 20% of transactions. Many entrepreneurs or salespeople are probably shaking their head in agreement as they read this having seen this dynamic repeat itself over and over.

Yet while many people accept this fact in regular business, most novices somehow refuse to believe that power laws apply to trading. Everyone who starts out trading wants to achieve 80% profits and only 20% losses. As pleasant as that idea may be it’s utterly unrealistic. One can of course achieve such favorable ratios but only at the expense of suffering ruinous losses. In fact one can even record 99% accuracy in trading, by simply never taking any stops but the one wrong trade will wipe out all of your profits and all of your equity. History is littered with such examples and most recently investors into the subprime hedge funds of Bear Stearns learned that fact the hard way.

If traders could truly achieve 80% accuracy with minimal risk in their trades they would within a decade become trillionaires as such a powerful skew in odds would almost assure that they would be able to capture all of the profits in all of the financials markets of the world. In fact Jamie Saettele my technical analyst and I always smile at the naïve desires of most investors to look for a consistent track record. There isn’t a more dangerous investment to be made than one into a hedge fund that has had three winning years in a row. Inevitably those investments will experience losses rather than wins , because typically such steady returns are achieved through massive risk taking which is hidden from view.

Why do I bring up the idea of power laws this week? Because our trading approach very much follows those rules. We try to do the opposite of what is physiologically pleasing in order to achieve that which is financially prudent. In our journey for profits we will often take many small losers, but these losses will be overcome with only one or two winners. Instead of trying to please the psyche we try to adhere to the universal rules of power laws as we try to show you what reality based trading is really like.

That having been said our model this week, performed poorly, partly because the data simply did not go our way – something that is very much to be expected from time to time but also because of sub-optimal execution – something that can be definitely corrected. So let’s tackle the issues that we can correct and see what we can do better.

One of out vexing problems with trading event risk has been the lags in communication. Email is notoriously inconsistent in delivering messages on time. That was one of the reasons we used to issue our alerts an hour or two ahead of the event – in order to make sure that you received the message. Unfortunately, taking a trade so far ahead of the event subjects the position to negative drift and slippage. Prices can hit our stop before the news is even released, something that happened twice this week. Most of the time the stop out actually foretells that our direction was wrong as the news misses our expectations, but occasionally negative drift takes us out of what turns out to be a very profitable trade. Furthermore, our model is based on the idea of quickly cutting our losses and negative drift has the insidious effect of generating maximum rather than minimum losses.

So starting next week we are going to alter our message and entry delivery protocol to minimize the problem of negative drift. We will still issue our trade recommendations about 2 hours before the event, and we will still provide you with our 24 hour trading plans, but we will now actually enter trades 10-20 minutes before the event, minimizing the pre-event noise. We will post our entries in both chat room and on the website, which have a timestamp and provide as near an instantaneous information flow as possible –eliminating some of the slippage and communication problems we saw this week. We will continue to send out all exit and trade update alerts via email and SMS as before. In short this is a rather minor change. We will continue to offer you as much information as possible through email, SMS, web site and chat room, but by making this adjustment we will be able to provide you with better entry signals and hopefully offer you a more robust model to trade.

There will be no trade alerts on Monday but the rest of next week promises to be busy so stay tuned for our updates.

Boris and Kathy