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