Foreword
·
Currency trading is an art and the people who
are good at it are artists
·
The market is non-stationary and the rules
constantly change
Chapter 1: Introduction
·
Currency markets are huge, 5 trillion dollars
are transacted a day.
·
Trading is a test of self-discipline,
self-control. It is an endless emotional rollercoaster, frequent
disappointment, sudden euphoria, and unbearable periods of crushing self-doubt.
PART 1: Understand
the Foreign Exchange Market (EX 101)
Chapter 2: A Very Brief History of FX
·
WW II marked the end of British pound as
dominant global reserve currency and the ascent of the US dollar.
·
Bretton Woods agreement – countries kept their
currencies fixed to the US dollar.
·
International balances were settled in dollars
using a fixed conversion rate of $35/ounce of gold.
·
On Aug 15, 1971, Richard Nixon announced the end
of gold standard.
·
By 1973 – exchange rates were flexible and
currency trading began.
·
System of floating currencies backed only by
faith in the issuing country with no intrinsic backing is called fiat currency
system.
o Fiat:
a format authorization or proposition, a decree, an arbitrary order
·
The Telex Era (1971 – 1981)
o Trading
was conducted over telex machines and telephone lines.
o Only
a small group of bank traders, corporations & HNW individuals traded.
·
Direct Dealing Era (1981 – 1992)
o 1981
– Reuters launched computerized dealing service that streamlined the FX trading
·
Electronic Era (1992 – 2001)
o 1992
– Reuters launched Dealing 2000, online trading platform.
o EBS
(Electronic Brokerage Services), now Nex was launched.
·
The
Algo Era (2001 to present)
o There
is now more volume done by algos than by humans in the FX market (est. 60/40)
Chapter 3: Currency Trading Basics
·
Currency Pair X/Y – it takes Y units to buy 1
unit of X
·
If you hold a currency past 5PM, you must pay
one day’s interest on the currency you are short and you earn one day’s
interest on the currency you are long.
·
88% of all trades use the USD in the pair
·
Better for short-term traders to focus on
most-liquid pairs:
o EURUSD,
GBPUSD, USDJPY, AUDUSD, EURGBP, USDCAD
·
PIP
o Smallest
trading increment in a currency. Eg. USDCAD, 1.2833 to 1.2834 = 1 pip move
(0.0001)
o USDJPY
110.55 to 110.44 = 11 pips (0.01 a pip)
·
TWAP – time weighted average price
·
VWAP – volume weighted average price
·
Calculating P&L
o P&L
are reported in the denominator currency
o USD
as base: P&L = (Position Size x Price change)
o Non-USD
as base:
§ Eg.
USDCAD bought 10000 units, at 1.3100 and sold at 1.3150
§ 50
pips = 0.0050 x 10000 = 50 CAD
§ 50
/ 1.3150 = $38.02 USD
Chapter 4: Understand Market Structure
·
Every currency has its own personality
·
The “Majors” refers to EURUSD, GBPUSD, USDJPY,
AUDUSD, USDCHF, USDCAD
·
Commodity currencies: AUD, CAD, NZD, BRL, ZAR,
& CLP – these are commodity exporting nations whose currencies are heavily
influenced by commodity prices
·
Eg. AUD is influenced by copper, gold, &
iron ore. CAD is driven my crude oil & natural gas
·
Currency yield: “Carry”. E.g if AUD yields 4%
& USD yields 1%, you will earn a net of 3% for holding a long position in
AUDUSD
·
High yielding currencies go up slowly and down
quickly.
·
USD;
o Tends
to rally when the US economy is ripping and the Fed is hiking.
o Also
rallies during US recessions.
o Sells
off in periods of moderate growth.
·
Volatility & Liquidity
o Volatility
matters as it directly relates to position sizing. You cannot trade a large
position if the asset is volatile as the risk of ruin is larger
o Liquidity
is important as you increase the transaction size and/or frequency.
o V&L
depends on the time of day. FX majors are active when London & NY overlaps
between 6.00AM & 11.00AM NY time.
o Key
times:
§ 8.30
AM NY, most economic data are released
§ 10.00
AM NY, when options expire (and 2nd tier economic data released)
§ 11.00
AM NY, WMR fix (rate setting that takes place every day 4.00PM LDN)
§ Month-end
4.00PM LND (11.00 AM NYT) fix is the largest volume timing
§ USDCAD:
Noon has high volume
§ 3.00
Pm NYT also is active time.
§ Currency
markets close at 5.00 PM NYT. Liquidity dries up at around 3.00 PM. Holding it
after Friday is subject to potential significant gap risk
§ Equity
Open/Close: currencies sometimes are correlated to equity markets. There can be
surges around the open and closing
§ Twilight
Zone: 5.00 PM to 6.00 PM NY. Liquidity is absolute worse and not advisable to
trade in this period. When some major news comes out, the price moves can be
dramatic as liquidity is close to non-existent
§ Keep
your trades within the 4/5-hour LND/NY overlap timing 6.00 AM to 11.00 AM
PART 2: Trade
the Foreign Exchange Market
Chapter 5: Understand Fundamental Analysis
·
“In the short run the market is a voting
machine. In the long run it is a weighing machine.”
·
You need to understand the macro backdrop no
matter how short your trading horizon is.
·
Fundamental Analysis (FA) – study of
macro-economic factors that drive markets
·
Long-term FX valuation
o Purchasing
Power Parity (PPP) – backet of goods in one country should cost the same in
another country. “Big Mac Index”.
·
Global currency drivers:
o 1.
Global growth
§ When
strong, exporters like China, Korea, Brazil tend to do well. And when week,
money flows into safe havens like JPY, USD, CHF
o 2.
Commodity prices – exporters benefit from the price strength
o 3.
Risk aversion – when markets are nervous, traders flock to safe haven
currencies like CHF & JPY & USD
o 4.
Geopolitics
·
Domestic Drivers:
o 1.
Monetary policy
§ a.
Interest Rates
·
hawkish: central banks desire for higher
interest rates. Dovish: desire for lower interest rates
·
“Buy the rumor. Sell the fact” – the currency
trends in a particular direction based on central banks statements about
changing rates. The traders keep anticipating. By the time the central bank
actually changes the rate, the anticipation is over and traders close positions
to take profits.
·
Higher rates attract capital and lower rates
trigger outflow of capital.
·
Yield Curve – a chart showing the interest rates
at different tenors.
o Normal
and steep curve is bullish for currency
o Inverted
yield curve, suggests central bank is holding short term rates higher, and that
future economic outlook is uncertain.
o IYC
tends to precede recession.
·
Always important to compare rates from one
country to another in the currency pair.
·
Bullish for currency- High rates, rising rates,
steep/steepening yield curve
·
Bearish for currency- Low rates, falling rates,
flat/flattening/inverted yield curve
o
§ b.
Balance sheet size
§ c.
Growth – higher grown good for currency
§ d.
Inflation
·
can be good or bad
·
we have to observe how central bank reacts to
changing inflation.
§ e.
Central Bank preference for weak or strong currency
·
Signaling – it is expensive and risky for
central banks to intervene directly, so a common approach is for the CB to
signal a desire for a stronger or weaker currency and hope the market does the
work for them.
o 2.
Capital flows
o 3.
Trade Balance
·
US Economic Data Releases
o When
it comes to trading economic data, the only thing the market cares about is how
the numbers compare to expectations.
o Non-farm
Payrolls (importance 5*) – 1st Friday of the month
o Initial
Claims (3*) – Every Thursday
o GDP
(5*) – Quarterly
§ Advance,
Preliminary & Final. Advance is most important
o Core
PCE (2*) – same time as GDP
§ Personal
Consumption Expenditures
§ Fed’s
preferred measure of inflation.
o Consumer
Confidence (CCI) (3.5*) – Monthly (mid-month)
§ Health
of the economy from the perspective of the consumer.
o ISM
Manufacturing & Non-Manufacturing (4*) – 1st business day of
every month
o CPI
(3*) – Monthly (mid-month)
§ Consumer
Price Index – measure of change in price for the average consumer.
o University
of Michigan Confidence (2*) – Monthly
o Durable
Goods Orders (3*) – Monthly
o Housing
Indicators (2* to 4*) – Monthly
§ Building
permits
§ Housing
Starts
§ Pending
Home Sales
§ New
Home Sales
§ NAHB
Housing Index
·
HMI – Housing Market Index is based on monthly
survey of NAHB members
o Industrial
Production (3*) – Monthly
o Retail
Sales (3.5*) – Monthly
o Chicago
PMI, Philly Fed, & Empire State (3*) – Monthly
§ These
are regional business surveys, also highly correlated to one another and the
national number
·
Global Economic releases – it is also important
to pay attention to similar numbers in each country whose currency you are
trading in the currency pair.
Chapter 6: Understand Technical Analysis I
·
Study of chart patterns to forecast future price
movements
·
Author says “TA should be used as a tactical and
risk-management tool and not as a trade selection tool”
·
TA is highly subject to confirmation bias – “if
you are bullish on some security, you will tend to find a pattern that confirms
your bullish view”
·
TA Branches
o 1.
Traditional TA – trend, breakouts, cycles, retracements, momentum, support,
resistance, moving averages, overbought, oversold etc.
o 2.
Candlestick charting
o 3.
Elliot Wave & cycle analysis
·
Using Moving Average as support & resistance
o General
rule – be long when the spot is above the MA and short when below
o Golden
Cross: when the 50 period MA crosses above 200 period MA
o Death
Cross: when the 50 crosses below 200
·
Sometimes it is redundant to use multiple
momentum indicators
·
Parabolic SAR (Stop & Reverse) – it is a
lagging trend indicator to find potential reversals.
o Parabola
below the price is generally bullish, while above is bearish.
o One
usage: use SAR to establish the trend direction. Then using a different
indicator like Directional Index to determine the strength of the trend.
o Gives
a clear stop loss level
o TIP:
Any trend-following indicator will give you approximately the same message, so
don’t clutter up your chart.
o Just
pick one or two trend and one or two momentum.
·
Candlesticks
o Doji
– shows market’s indecision
o Hammers
are useful, if your preferred style is going against the trend.
o Long
Wicks – indicate uncertainty, should pay attention to these. Shows price
attempted to enter a new equilibrium zone but was quickly rejected.
·
Ichimoku
o Gives
a clear view of the trend with one look and provides firm entry and exit points
o If
price is above the cloud it is bullish. Buy near the top of the cloud and stop
loss when price falls out the bottom of the cloud
·
Market Profile
o Organizing
price & time
o Gives
the ability to quickly identify equilibrium zones.
·
Never worry about missing it. There will always
be another trade.
o Most
good traders are right 50% to 60% of the time.
o Being
wrong is part of the business
o You
should be upset at yourself when you fail to follow the plan or when you show
bad discipline. Not when you watch a great idea crash.
·
Range-about markets are the most difficult to
trade
o Not
always perfectly defined
o By
the time you realize it’s a range, the range is ready to break.
o Characterized
by many false breaks
·
Trending markets are easier to trade
o Two
ways to trade trend
§ Trade
Pullbacks – identify the trend and then simply pick a MA and trade the trend as
it pulls back
§ Put
your stop loss below the slower MA
o Breakouts
and continuation patterns
§ TIP:
use a stop loss of approximately, average daily range x 1.5
§ Advantage
– you are with the directional momentum
§ Disadvantage
– you are most often buying high and selling low
o Continuation
patterns:
§ 1.
Flag Pattern
·
Formed when there is rapid price movement in one
direction
·
Buy a break of the top of the flag. Take profit
at flagpole length added to levels that define the bottom and top of the flag.
§ 2.
Pennants – similar to flags but are triangular instead of rectangular
§ 3.
Triangle – similar to pennants except they have no flagpole.
o Reversal
patterns:
§ Double
top, Triple top.
Chapter 7: Understand Technical Analysis II (The Seven
Deadly Setups)
·
1.Slingshot Reversal
·
2. Shooting starts & hammers
·
3. Extreme deviation from a moving average, aka
the Deviation
·
4. Volume spike at a price extreme
·
5. Broken triangles
·
6. Double & Triple top
·
7. Sunday Gaps
·
Slingshot Reversal
o False
breakout and reversal. Occurs when an important support or resistance level
breaks temporarily but fails to hold.
o It
must happen around a level of very high importance, that many people are
watching the level and orders are clustered around it
o 1.
Identify crucial resistance level
o 2.
Wait for it to break and place a stop entry(sell) 10 pips below the key level
o 3.
Once stop sell order triggered, place a stop loss 10 pips above the new high
o 4.
Add a reasonable take profit (1.5 or 2X) of average daily range.
·
Shooting Starts & Hammers
o Gives
you a strong reversal signal and a clear exit point. Look for these when you
have a strong countertrend.
·
Extreme Deviation from the MA
o When
trading overbought/oversold, you must understand that you are going against the
trend. Things that are overbought/sold can be so for extended periods.
o USDCAD
is a good pair for mean-reversion. Good candidate for overbought/sol trades.
·
Volume Spike at a Price Extreme
o Most
FX volumes are not readily available.
o Futures
markets are an acceptable proxy for the overall FX volume
o Volume
spike at price extreme is an indication of capitulation as market transacts
high volumes in a short span.
o Trading
the spike – stay out until the dust settles. After 2 or 3 bars, go long with a
stop loss below the lows.
·
Broken Triangles
o Sometimes
the triangle breakout in one direction can immediately reverse and pierce the
triangle and go the other direction. Need to watch out for that.
·
Double & Triple Top
·
Sunday Gaps
o This
arises when there is a major news over the weekend and market open at a new
level on Sunday.
o Stunning
feature of Sunday Gaps is that they almost always fully reverse within 48
hours. (approx. 85%)
o Extremely
difficult, but highly profitable. Not for the faint of heart.
·
Combo Setups
o The
more setups that happen simultaneously, the better.
o Sometimes
some indicators are bullish, if you dig deeper, there may be few bearish. This
is referred to as “Crosswinds”. Better to avoid such scenarios.
Chapter 8: Understand Correlation & Intermarket Relationships
·
Correlations between FX & other asset
classes jumped toward 1.0 in 2007-2008.
·
predicting a movement of one asset class using
the movement of other is called Cross-market, or intermarket, or cross-asset
analysis.
·
Ask yourself:
o Does
the correlation make econometric/logical sense?
o Is
the correlation likely to continue into the future?
o Is
there a third variable influencing the movement of the other two?
·
Correlation of one Currency pair vs another
o Eg.
If EURUSD, GBPUSD, & NZDUSD rally, the odds are greater for AUDUSD to go up
and USDCAD to go down.
·
Correlation of Currency pair vs interest rates
o Investors
tend to favor currencies that pay higher interest (high yield). So a move
higher in rates is often a good predictor of an upcoming move higher in the
currency
o Important
to not that, while direction of move matches, the magnitude may not. There may
be leads and lags.
·
Correlation with Commodities
o Eg.
Canada is a stable supplier of crude. Hence oil prices are correlated with
USDCAD. Same with Norway. Hence CAD and NOK are called “Petrocurrencies”
o Higher
milk prices tend to benefit NZD
o Also
be cautions that the correlations me come and go and also fade
·
Correlation with Equity Index
o Nikkei
vs USDJPY tends to be highly correlated
o Another
way is to look at relative performance of two equity indices to determine
possible direction for those two currencies
·
Correlation with Single Name equities or ETFs
o Eg.
USDCAD with crude producers like Suncor, Encana, & Cenovus
·
Trading correlations
o Create
a group of overlay charts
·
TIP: Continuous reading and listening to all
news stories and FX analysts is important
·
Timeframes
o Be
consistent with your choice of scales otherwise you will fall prey to
confirmation bias as you are attempting to find the answer you want.
o If
using hourly charts, use scale between 21 to 42 days (500 to 1000 hours)
·
Common correlations:
o Stock
market vs FX
o Indices
o Commodities
o Interest
rates
o Other
currencies
Chapter 9 – Understand Behavioral Finance
·
Positioning & Sentiment
o Positioning
– a metric that measures actual positions
o Sentiment
– eg. DSI Daily Sentiment Index, a daily survey of retail futures traders.
Guage of how people view the market
o A
market can be extremely bearish, but not heavily positioned.
§ Is
primed to go down
o A
market can be extremely bearish and extremely short positioned
§ Is
more at risk of a short squeeze or reversal
o Why
would a market see extreme sentiment but no extreme positioning?
§ Sentiment
moves faster, and it generally leads positioning
§ TIP:
identify moments where the market has a very strong view but does not have the
position yet because they are waiting for an upcoming event to pass. You can
profit by simply putting on the position faster than others once the event is
out of the way
§ Time
of year – as we get close to end of year, traders like to reduce risk and book
profits
§ Position
clear-outs – when the traders hold the macro view, they cannot afford to hold
the positions any longer. So, they cut the positions. Called as stop loss run.
o Positioning
§ Positioning
indicators – eg. Commitment of Traders (COT) report from Chicago Mercantile
exchange (CME).
§ It
is generally more profitable to go with COT positioning, not go against it.
§ You
can get an idea of positioning from Twitter feeds and market analyst BUY/SELL
recommendations, reading blogs, media reports and taking to other traders.
§ Sense
of positioning improves with experience
·
Cognitive Bias
o 1.
Confirmation Bias
§ Humans
tend to absorb and internalize information that confirms their beliefs and
ignore or discount information that contradicts their views/beliefs/hypothesis.
§ “you
believe what you want to believe”
§ Rule
#7: Flat is the strongest position. When in doubt, get out.
o 2.
Overconfidence Bias
§ Being
overconfident may blind your weakness and overestimate your edge.
o 3.
Extrapolation Bias (Recency Bias)
§ Assuming,
whatever is happening right now will continue to happen in the future.
o 4.
Asymmetric Loss Aversion
§ Research
shows humans feel more pain from losses than they feel joy from wins in the
ratio of 2:1
§ Humans
will take more risk to avoid loss than they will take to avoid gains
§ traders
find it hard to exit losing positions because once they exit the positions, the
loss becomes crystalized in their mind
o 5.
Emotions: Greed and Fear
§ G
& F can create feedback loops between news and price as news causes price
to move and then price moves cause new behavior as traders react to the news.
o 6.
Anchoring
§ Entering
a trade at one price, and when the price goes against the direction of your
trade, you assume that the price will return to your level. You end up making
huge losses.
§ “I’ll
just wait to get back to flat”. Not a good idea. Just get out.
o 7.
Round Number Bias
§ Humans
just prefer round numbers
o 8.
Favorite/Longshot Bias
§ Success
comes from repeatedly executing trades with high expected value, not from the
occasional monster trade
o 9.
Herding Bias
§ Most
people feel safer to be wrong with the crowd that to try to be right on their
own.
§ If
you are an economist forecasting an economic data, you want to be on the
ballpark of every other economist. If your forecast is way different then the
rest and when the actuals come out and you are right, then you are a start. But
if its wrong, you are an idiot.
o Anecdotal
Evidence
§ Example,
the cover of Magazines can be reversal indicators.
§ Business
Week Aug 1979: “Death of Equities”. Bull market started after that.
§ The
Economist 1999: “Drowning in Oil” – Oil shot up after that.
§ Time
2000: Jeff Bezos person of the year. After that the Tech bubble came
§ Time
2007: Putin person of the year. After that the Russian economy collapsed.
o The
Skyscraper Indicator
§ Skyscrapers
are built at the high of the bull market. There may an impending reversal.
o The
Cheer Hedge
§ When
someone around you cheers in celebration of a winning position – go the other
way. It usually works.
§ When
you find yourself counting how much BIG money you are going to make in a
direction that is going crazy in favor of you, chances are it will reverse
quickly. Better to take some profits in this scenario
o The
WTF Indicator
§ When
many people are asking “WTF” about a move, they are most likely in the wrong
side and it has further to run in that direction. It’s a good sentiment indicator.
o The
IPO Indicator
§ The
only time a market will absorb a very large IPO is when sentiment is bullish
and the market is trading extremely well. But this may be the late stage of the
bull market and a reversal may be impending.
Chapter 10: Trading the News
·
CRITICAL CONCEPT: Understand what is priced in
o The
reaction to an event (such as rate hike) that was priced in, is the opposite of
what the macroeconomic textbooks might suggest, because those who have been
buying on the anticipation of the event sell on the day of the event to take
profits
·
CRITICAL CONCEPT: Buy the Rumor/Sell the Fact
o The
market prices in an event in advance and then reverses after the anticipated
event takes place.
o BR/SF
is applicable only for highly anticipated events, and the result comes in as
expected and the market has been moving on the direction of the pricing that
specific outcome.
·
Trade the Extreme Data
o Beat
the algos – going the other way after economic data
o Reversal
for a good reason
o Reversal
for no reason
·
Understanding the Central Banks
o If
you want to trade FX, need to understand CB nuances very well
o CB’s
thinking is communicated via speeches and official statements and you need to
read every single one.
o The
longer you follow, the more of a feel you get for their biases, tactics, &
communication strategy
o Variables
controlled by CB: Interest Rates, Balance sheet management, & Forward
guidance
o Balance
Sheet:
§ Quantitative
Easing (QE) is a tool to increase the size of the balance sheet
§ QE
should:
·
Push a currency lower
·
Drive bond yields lower
·
Drive stock market higher
·
Increase inflation
o Construct
a simple Expected Value (EV) diagram to determine the value of your position
based on your probability estimate.
o Rule
#9: Never fade unexpected central bank moves. Jump on them!
o When
CB cuts rates unexpectedly, it is a huge opportunity. jump in fast &
aggressive
o CB
Speeches are minor, Meetings are major
§ Can
get clue from speech titles eg. “Currency implications for monitory policy”
PART 3: Understand
Risk Management
Chapter 11: Understand Free Capital
·
How money can you afford to lose?
·
Set Goals
o Need
targets for returns and volatility. These targets plus your free capital
determine the amount of risk you can take any day, month, or year
o Rule
#10: Making money is hard. Keeping it is harder.
o Example:
§ Monthly
chunks of risk management
§ Goal:
$10 MM a year
§ Drawdown
limit: $5 MM
§ Free
capital - $10 - $5 = $5
§ Jan
stop loss = 10% of year’s free capital = $500K
§ Jan
P&L target (take profit): 2X stop loss = $1 MM
§ End
of January
·
Profit: $2 MM
·
Now free capital for Feb = 5+2 = $7 MM
·
Free capital = 10% = $0.7 MM
·
P&L target (2X FC) for Feb = $1.4 MM
§ If
you hit stop loss, then stop trading and take a mental reset
·
Track & Analyze your P&L
o Create
a spreadsheet with Open, High, Low, & Close P&L for each day
o Create
a chart of your daily & YTD data
o Monthly
P&L – Monthly view eliminates noise and give a good picture of your
performance.
o Yearly
P&L – ultimate measure of long-term performance.
o Win
% - # Days Up / # Days Traded. Most traders are 45% to 60%
o Average
Gain/Loss
§ Most
important ration in your P&L
§ If
your avg G/L ratio is falling M/M, then it means you are probably cutting your
winners too early or riding your loss for too long.
§ Big
Up days and small Down days are the key to success
§ Rule
#11: Successful traders make more money on up days than they lose on down days
o Sharpe
Ratio
§ If
an investor receives same returns from two different investments, he will
prefer the one with lower volatility
§ Eg.
·
Trader A: +250 + 120 – 500 + 400 + 50 = 320
·
Trader B: 50 + 100 + 100 + 0 = 300
·
Looking at total amount Trader A seems to have
done better.
·
But looking at the trades, Trader B made the
best winning streak. Trader B will perform well in the long run
·
Trader A has too much
volatility/variance/randomness
·
Sharpe Ratio = (Return – risk-free rate/Standard
Deviation)
·
A ratio of 2 or above is outstanding
o Fat
Tails & Risk of Ruin
§ Rule
#12: Anything can happen
§ Rule
#1: Don’t blow-up. Avoid risk of ruin above all else.
§ Tail
risk can come from sudden change in policy. And “Flash crashes” can come from
nowhere
·
Eg. GBPUSD in Oct 2016
·
EURCHF on Jan 15, 2015
§ Avoid
pegged currencies
o Rolling
Drawdown
§ A
chart of current P&L minus YTD High P&L
§ Gives
a visual representation of downside volatility over time.
o P&L
by time of day
§ For
the author:P&L consistently rose from 7:00 AM to 11:00 AM, then it came off
gradually until end of day.
§ Your
data should help you decide which time of day, week, month works best for you
and finetune your trading style
o Keep
a trading Journal
§ A
mush
§ Helps
track the evolution of your trading and captures emotions, themes, &
thoughts throughout the process.
§ By
writing down each trade along with a rationale and thought process, you can
pick up recurring errors, themes, & leaks in your trading.
§ Rule
#13: keep a trading journal. Thoughts are abstract and fuzzy. Writing is
concrete and solid.
§ Also
helps to identify bias
§ TIP:
Bad discipline often comes from having no plan whatsoever and just hitting the
buy & sell keys in response to random market stimuli.
§ TIP:
A plan written down has 100 times the value of a plan loosely formulated in
your head.
Chapter 12: Understanding Position Sizing
·
Position size as % of capital
o 4
primary factors
§ 1.
How much free capital you have?
§ 2.
How confident are you on this trade?
§ 3.
How volatile is the currency pair?
§ 4.
Where is your stop loss?
o Develop
a % of free capital you are will to bet on a trade based on the quality of your
setup.
§ Rate
your setup as:
·
3 Star trade setup – 1% of free capital bet
·
4 Star trade setup – 3% of free capital bet
·
5 Star trade setup – 6% of free capital bet
o Rule
#14: there is a time and place to go big
o Dynamic
sizing (using simple Excel template) can help automatically adjust your
position based on your performance
o Rule
#15: Good traders vary bet size
o Different
currencies have different volatility profiles. Need to adjust position
according to volatility of the currency pair.
o https://www.investing.com/tools/forex-volatility-calculator
o Don’t
have more then 2 or 3 trades at a time. It will complicate your risk management
o Traits
of a 5-Star set-up
§ 1.
Fundamentals are improving/worsening. But not reflected in the price yet
§ 2.
Cross-market signals – correlated variables proving good signals
§ 3.
Positioning – sentiment and positioning support
§ 4.
Technicals – chart pattern supports. But wait for a good entry point.
§ 5.
Gut feel. Your confidence level.
o Kelly
Criterion
§ %
of Capital to Risk = Win% - ((1- Win%)/Avg Win/Avg Loss))
§ Used
to determine optimal bet size. It can be applied to gambling & trading,
provided you have a good estimate of the probability of winning.
·
Determine Position Size
o Position
Size = ($ AtRisk) / (Loss per Unit if stop triggers)
·
Common Errors in Position Sizing
o 1.
Position are too big
§ You
need to size the position so that you can survive the volatility if and when
you are temporarily wrong
o 2.
Position is too small
§ It
won’t blow you up but it can lead to a slow death by 1000 cuts
o 3.
Trading the same size of Position
§ When
expected value (EV) of a trade is high, trade big. When less confident trade
small
·
Stop Losses
o You
will be wrong a lot. So, manage your risk using stop losses
o Where
to Put your Stop Loss
§ 1.
Use technical analysis to determine the stop loss level and add 20% of a day’s
range as extra room.
§ 2.
Using Average Daily Range to set stop loss.
·
There should be a relationship between your stop
and your time horizon.
·
Short term: Stop loss = Current price + (1.2 X
ADR)
·
Medium-term: Stop Loss = Current price + (2.5 X
ADR)
§ 3.
Trailing Stop Losses – as trade moves further into the money, you move your
stop loss in your favor ensuring to lock-in some profits.
·
Understand Risk/Reward
o It
is very important to estimate the Expected Value (EV) before placing a trade.
o To
calculate EV, you need to have a good estimate of Probability of Win and Loss.
o For
that you will have to maintain a trading journal and collect as much data as
possible
o Rules
to follow:
§ 1.
Always record your SL treat it with importance
§ 2.
Don’t keep changing your SL level by finding excuses to let a losing trade run.
§ 3.
Automate your SL process.
·
Take Profits
o Rule
#16: It always looks bid at the highs. It always looks heavy at the lows.
·
Rule #17: You control the process but you do not
control the outcome.
·
Rule #18: Each trade is a drop of water. The
market is an ocean.
Part 4: Understand
Yourself
·
90% of the game is half mental – Yogi Berra
·
Learning the rules is easy. Following them is
hard.
·
Trading is more about psychology and channeling mental
chaos than it is about charts and macro and behavioral analysis.
Chapter 13: Characteristics of a Successful Trader
·
Finds the balance between risky behavior and
discipline
·
Thinks independently
o Read
an absorb as much as you can. But trade your own view
·
Knows their edge
o Rule
#19: Know your edge.
o FX
is a negative-sum game due to transaction costs
·
Trades One Time horizon
o FX
is the most liquid market in the world. Hence it is suited for short-term
trading.
o Stick
to one time horizon. Mixing time zones is a recipe for disaster.
o Author:
most of his trades are 3 hours to 7 days. Vast majority: 1 day to 3 days.
o Rule
#20: Know your time horizon
o There
are great opportunities every single day.
·
Controls Emotion/Acts like a Robot/Self-aware
o Emotion
kills. Be unemotional as possible.
o If
feeing emotional take a step back. Reduce position size.
·
Implements a Consistent Daily Routine
o Rule
#21: Good traders have a plan. They may not always stick to the plan but they
always have one.
o Create
a brief written plan before starting. This simple practice will make you a
better trader.
·
Happy to be Flat
o Have
the patience & will power to wait for good opportunities.
·
Understands Tight/Aggressive
o Rule
#22: Tight/Aggressive
o Don’t
involve in many trades, but when you are involved in just a few that are good,
be aggressive.
·
Self-understanding and Metacognition
o Do
more of what works and less of what does not.
o Constantly
assess your state of mind
·
Loves Trading
o If
you are trading just for the money, you can’t win.
·
Learns and Adapts
·
Gut vs Head: Two very different decision-making
systems
o Head:
Logic and analysis system
o Gut:
past experience and intuition.
o Strongest
views come when head and gut are in sync
o The
longer you have been trading, the more you can trust your gut.
o All
head, No gut – pause and do some deep thinking why your head says yes but gut
says no.
o All
gut, No head – no logical foundation to your idea. Then start doing your
analysis to confirm the gut feeling.
Chapter 14: Common Weaknesses in Trading
·
Poor Risk Management, Bad Discipline, &
Negative Risk/Reward
·
Trading for the Wrong reasons- Overtrading,
gambling, entertainment, & addiction
·
To Feel smarter than anyone else
·
FOMO (Fear of Missing Out)
o Rule
#23: Be flexible. Don’t get married to a view.
·
Waiting for the perfect trade – there is no
perfect trade. Try to keep a good pace of trading.
·
Invincibility/Overconfidence
·
Woulda, Coulda, Shoulda Syndrome – extract
lessons from the past failed trades but don’t brood over it
·
Directional Bias - If you are a short-term
trader, you should be flexible to trade every currency from both long and short
side
Chapter 15: The Voice of Experience
·
Don’t let random trades bleed you
o Too
many random trades done out of boredom or poor discipline can drown out the
P&L from your good ideas
o Rule
#24: Do not let random, low-conviction trades kill you.
·
How to avoid overtrading
o Try
having a trade quota
o Try
trading only on specific times
o Write
down your rules and follow them
o If
you cannot control, try reducing your position size to minimum.
·
Trading Slumps
o Square
up – cut existing positions
o Trade
smaller
o Take
a break and do some reading or research
·
Get some perspective
o Every
loss is a lesson
o Many
world class traders are only right 50%-55% of the time
·
Rule #25: Have fun. If you don’t enjoy it, what’s
the point?
Brent Donnelly’s 25 Rules of Currency Trading:
Rule #1: Don’t blow-up. Avoid risk of ruin above all else.
Rule #2: Adapt or Die
Rule #3: Do the work. Read the speeches. Analyze, read and
study
Rule #4: If you look hard enough, you can always find a tech
level to justify a bad trade!
Rule #5: "It's a big level!" is not a good enough
reason to put on a trade
Rule #6: No mo' FOMO. Never worry about missing it. There
will always be another trade.
Rule #7: Flat is the strongest position. When in doubt, get
out.
Rule #8: It doesn't always have to make sense.
Rule #9: Never fade unexpected central bank moves. Jump on
them!
Rule #10: Making money is hard. Keeping it is harder.
Rule #11: Successful traders make more money on up days than
they lose on down days
Rule #12: Anything can happen
Rule #13: keep a trading journal. Thoughts are abstract and
fuzzy. Writing is concrete and solid
Rule #14: there is a time and place to go big
Rule #15: Good traders vary bet size
Rule #16: It always looks bid at the highs. It always looks
heavy at the lows.
Rule #17: You control the process but you do not control the
outcome.
Rule #18: Each trade is a drop of water. The market is an
ocean.
Rule #19: Know your edge
Rule #20: Know your time horizon
Rule #21: Good traders have a plan. They may not always
stick to the plan but they always have one
Rule #22: Tight/Aggressive
Rule #23: Be flexible. Don’t get married to a view
Rule #24: Do not let random, low-conviction trades kill you.
Rule #25: Have fun. If you don’t enjoy it, what’s the point?
Some Reading Recommendations in the book:
·
Mind over Matter: Power Trading with Market
Generated Information – by Dalton, James, Eric Jones, & Robert Dalton
·
Thinking Fast & Slow, Daniel Kahneman
·
Behavioral Trading: Methods for measuring
investor confidence and Exceptions and Market Trends, Woody Dorsey
·
Willpower: Rediscovering the Greatest Human
Strength, Roy Baumeister
Websites:
·
https://www.investing.com/tools/forex-volatility-calculator
