The Prettiest Girl on the Floor

If markets are always right how come they are always changing?

Ben Stein

Ben Stein’s snarky observation in this Sunday’s New York Times, put a smile on my face and got me thinking about John Maynard Keynes. I’ve written about Keynes before noting that while he is recognized as the most influential economist of the 20^th century, few people realize that he was also one the greatest traders of all time. Unlike most pointy headed academicians, Keynes understood that markets - and for that matter all business activity - were controlled more by emotion rather than reason.

Rather than trying to construct complex mathematical solutions, Keynes produced a psychological model to explain the dynamics of the market. It is quite bittersweet to see the accuracy of his approach in light of the fact that so many “brilliant” quantitative hedge funds chuck full of “the smartest people on earth” relying on some of the most complex financial algorithms ever created, experienced double digit losses this month. One of the more famous of those funds, Goldman Sachs’ Alpha fund is located in the same building on Wall Street as our company and as I came in to work this week, looking at the signatures of Goldman traders on the building’s sign-in ledger I often wondered what they must be thinking now.

Perhaps they would have been better off reading a bit of Keynes who had a decidedly non-academic view on how the markets worked. Keynes likened the markets to a beauty contest. It was the traders job to find and identify the contestant that the majority of the audience would find the most beautiful. Setting the anachronistic sexism of the metaphor aside, let’s focus on what Keynes actually meant by this idea. Note that Keynes specifically emphasized that the trader should not judge contestants by the trader’s personal standards of beauty, but rather try to figure out how the crowd would make its choice. This was Keynes’ great insight into trading, teaching us that our view does not matter. Only the market’s opinion matters. As speculators it is our job to figure out how the majority will feel on any given day and then construct a trade based upon that hypothesis.

In the currency market, there was only one question to answer this week. Risk or no risk? Depending on how well you handicapped that question on any given day resulted in whether you won or lost. It was almost immaterial what currency pair you chose to trade. During moments of risk aversion yen rose and all other majors declined against the dollar and during periods of risk assumption the reverse dynamic ruled true. Fortunately we were correct in our assessment two out of three times catching EURCHF for 57 points and EURUSD for 52 points.

Indeed reduced to their Keynesian terms, the markets are actually quite easy to comprehend. “Understand the story, understand the trade,” is the catchy little phrase we often use in our trading seminars, It is, of course easier said than done. Stories can turn on a dime as unexpected news changes the crowd’s opinion. Still as traders this approach offers us the best chance for success. It also helps us to properly deal with losing trades. Instead of viewing those trades as some signs of our personal inadequacy we should accept them for what they really are – occasional mistakes in our ability to gauge crowd behavior. Looked from that perspective stops are then not some sort of moral transgressions but rather proper expressions of mature decisions making. After all, the key to being a well developed, grown up individual is our ability to accept mistakes graciously. Is there anything more pathetic and infantile than an adult man or woman who refuse to see the error of their ways throwing an emotional temper tantrum in the process?

If nothing else, Keynes “beauty pageant” model teaches us to not take the markets too seriously which in turn provides us the proper distance to make mature, adult like decisions with respect to each trade.

Have a great weekend.

We’ll be back next week with more trade ideas.

B & K

posted by BKTrader  # 8/26/2007 05:24:00 AM 0 comments

Direction and Amplitude

Novice traders often think that finding proper direction is the most difficult aspect of trading. No doubt getting direction right is a challenge, but with experience that task can be mastered. After some time in the markets many traders can accurately forecast direction as much 60% to 70% of the time. However in order to succeed, a trader must no only predict direction but also the amplitude of the move. Put simply we need to accurately forecast not only if the instrument will go up or down but by how much it will do so. And amplitude can be maddeningly hard to estimate. Every time we see a moving average crossover, a Ballinger band breakout or an event risk reaction we can never be sure if the move will last for 10 pips or for 100.

This week was a good case in point. We had two long term trades that initially moved our way but ultimately reversed and hit the stops. Our short EURGBP stayed very quiet while the rest of the market was caught in a whirlwind of activity. The trade even slowly moved 10 pips our way as our forecast of stronger UK Retail Sales and therefore more bullish cable posture proved accurate. Bu the move was short lived. The market this week wasn’t paying attention to economic news – it was strictly trading off risk aversion theme as carry trades were liquidated wholesale. The EURGBP got caught in the cross fire of volatility as the 1000 point declines in GBPJPY ultimately pushed the pound lower.

In the GBPUSD trade we had a different dynamic but similar results. We bet on the fact that after Thursday’s massive sell off the high yielders would be due for a bounce. Going long GBPUSD into the Asian open we were right from the start and the trade moved 40 points our way. But when the Nikkei opened for Friday trade, panicked Japanese investors sold stocks at a frantic pace pushing the index –800 points. The pressure was just too much for the currency market and the pound buckled hitting our stop and falling for another 100 points lower before finding some support.

Some of you took us to task for letting a winner turn into a loser and rightly so. Generally we trade with two units so that when 1 unit moves into profit we take a small profit and move the rest of the position to break even. This, in fact, is the only practical solution to the direction/amplitude problem. Since you never know whether the move is good for 10 or 100 points you take some money off the table and look to ride the second unit to a much larger profit. However, we decided that using two units on our long term trades exposes subs to too much risk. A typical 100 point stop could generate a 200 point loss on two units of trade. Therefore we prefer using only one unit. The trade off for assuming less risk is that we will sometimes miss banking small profits. Of course some of you chose to use 2 units even on long term trade recommendations and wrote to us that you’ve been able to bank profits that way. You are more than welcome to do so. In fact the most successful BK subs are those that use our ideas but adapt them to their own trading style. For our part we will try to manage these trades tighter and will trail our stops to or near breakeven once they move in the money in order to minimize risk.

Overall the market continues to be dominated by themes rather than event risk and therefore we will maintain more of our focus on longer term trades rather than news ideas. We expect volatility to continue for at least another week as investors try to assess the magnitude of last weeks damage, We also have Category 5 hurricane Dean barreling into the Gulf of Mexico which may wreck havoc with oil markets and impact financial markets as well. All in all it promises to be another exciting week in the markets and we will be back to you with fresh trading ideas.

posted by BKTrader  # 8/18/2007 10:53:00 AM 0 comments

Variation on the Theme Part II

This week we introduced our first long term trade and were able to bank 31 points out of the USDCAD short. At one point we had a 60 point profit and were hoping to milk it for more but the release of Ivey PMI which printed much weaker than expected forced us to change plans and cover sooner which proved prudent as the pair traded higher for the rest of the day. Overall, we’ve received overwhelmingly positive responses from subscribers on the long term ideas. They clearly allow for a more leisurely approach to trade entry and management and we will definitely continue to produce more of them as part of our repertoire as BKForexAdvisor.

On the short term trade front, we saw lots of heat, but little light this week as some of our better trade ideas were negated by offsetting news factors. For example we were dead right in calling for weaker Japanese Overall Household spending, but the trade was sabotaged by better labor figures that came out at the same time. Similarly US ISM Manufacturing was weaker just as we forecast, but US Pending Homes Sales (a notoriously manipulated figure by the NAHB) printed far better than expectations and took the string out of the dollar bearish ISM news. Alas, these are the vagaries of the market. These certainly weren’t the first obstacles to trading event risk, nor will they be the last, but as you saw we stayed very disciplined in our approach keeping our drawdown on the short term trades to a very manageable –40 points in what were very challenging conditions. One positive trade should erase most of those losses and two will put us square in the black. This is the essence of our trade approach – which is to keep our losses very contained so that they may be made up with only one or two good trades.

This week, I wanted to continue our discussion of various ways to trade event risk by sharing with you an exert from an article I wrote for the upcoming November issue of SFO magazine (www.sfomag.com). It deals with variety of approaches to trading event risk and I share it with you in the spirit of offering you some alternative methods to trading the news. Note that we do not follow this particular methodology with BKForexadvisor because collectively the logistics of pre- and post positioning are just too difficult to accomplish due to fast markets, but on an individual basis this may be an interesting idea to consider.

“If proactive trading is too volatile and reactive trading is too limited is there a better way to trade event risk? There is. The solution is really a fusion of the two techniques along with an assist from Jesse Livermore. Jesse Livermore, one of the greatest speculators of all time was well known for his probative approach to trading. Instead of committing to a position all at once Livermore would test out the waters by sending small orders into the market to see if his directional analysis was proven right. If the initial trade made money he would add to the position trying to pyramid his gains.

By adding to winners rather than adding to losers, the Livermore approach stands in stark contrast with the typical way most traders trade. Scaling up rather than scaling down into position is clearly the better money management technique as it minimizes losses while amplifying gains. However, the Livermore methodology is extremely difficult to implement because it requires the trader to forsake near term profits for the potential of much larger albeit more infrequent long term gains. There is perhaps nothing more frustrating to the average retail trader than watching profits turn into losses which happens quite often under the Livermore technique as prices retrace their initial gains. That is why most people do the exact opposite of what most trading professionals recommend – they allow their losses to run wild but cut their profits short.

However, the retrace risk which sabotages so many scale up trades can be generally avoided during news trades if the surprise is significantly large. Let’s use the EURUSD pair and the US Durable Goods report as an example. For purposes of illustration let’s assume that the EURUSD is presently trading at 1.3700 and the Durable Goods Number is expected to print at 1%. We are bullish the US Durable Good number and will therefore sell the EURUSD (a dollar bullish position since we are getting short euros and long dollars by selling EURUSD) a few minutes before the release. Just as we expected the Durables Goods number prints at 2% - much better than forecast and EURUSD immediately trades down to 1.3670. Our position is now 30 points in the money. We short another unit of EURUSD for the reactive part of our trade, move the stop on the whole position to breakeven and target 1.3655 as our profit target on the trade. A few minutes later as the news disseminates through the market, the EURUSD is pushed lower and our target is hit. Total profit on the trade is 60 points (45 points on our proactive position plus an additional 15 points on the reactive part). Why so little profit on the reactive part? Remember that most of the price adjustment had already taken place and we are looking only for a limited follow through. Nevertheless by making even a small amount of additional profit on the second unit we’ve been able to increase our gain from 45 to 60 points or nearly 33%!

What happens if the analysis is wrong? This is perhaps the best feature of the strategy. Often you are able to exit the position with only a 5 or 10 point loss before market prices fully react to the news. But suppose that the price adjustment is abrupt and the stop of –20 is hit. No problem. The loss is still minimized because you are only using 1 unit for your initial entry and are not adding to a losing position. Therefore, in the best case scenario the trade yields 60 points of profit when you are right. When you are wrong you are able to exit with 5 or 10 point loss most of the time and occasionally you get hit with –20 point stop. Overall that is a very favorable risk reward spectrum. You only need to be right 3 out 10 times to be net profitable. That’s the kind of margin of error that most traders could accept. However, very few traders can trade this way because most human beings cannot accept multiple losses in a row even they are very small. And make no doubt about it, news trading is a volatile strategy. Yet when practiced properly it can also be quite profitable. There are only three rules that the trader must follow in order to achieve success.

1. Exit trades immediately if there is no surprise in your direction

2. Add a second unit to your trade on those rare occasions when you are correct in your analysis and price has moved at least 30 points in the money.

3. Don’t be greedy and take quick profits as price continuation is often limited. “

I hope you’ve found this variation on the theme of interest. One final note. We are now in the dog days of summer and both K and I will be traveling next week, so there will be no weekly issue. But fear not we will have both short and long term trade ideas this week and will be back in touch in two weeks.

Wishing you best

B & K

posted by BKTrader  # 8/05/2007 07:30:00 AM 0 comments