Forex Trader Mentor

Newsletter  # 12

11th January 2006

Hi and a Happy New Year. I hope that you had a successful 2005. In this issue, you can read my opinion of what 2006 may bring, broker tricks, using TraderMetrics to improve your trading and  first part of my take on the psychology of trading.

It is not to late to late to participate in the broker survey. I had thought of releasing the results in this newsletter, but you know how it is when you're busy?

http://www.forextradermentor.com/survey/brokersurvey.htm

This survey is about whether you as a trader believe that your broker has an influence on your trading results.

Predictions for 2006

Currency forecasters are notorious at getting the longer term forecasts wrong. At the end of 2004, they were predicting the dollar to weaken to 1.45 against the Euro. What happened? On the 31st December 2004, the EUR/USD reached a high of 1.3664 and then did nothing but fall away apart from a couple of rallies, reaching a low of 1.1638 on 15th November. So what is the prediction this year and what is happening?

I am pretty convinced that the greenback's strength at the latter end of 2005 was due to the Homeland Investment Act. JP Morgan Chase has estimated that $100 billion of foreign currency could have been repatriated, including $60 billion of Euro. It has been estimated that US corporations had about $500 billion of profits that could have been repatriated.

Is this year going to be a reverse of the last? Certainly the first move was negative and the economic data so far has been poor for the dollar, such as the release of poor employment data on 6th January, showing 100,000 new jobs instead of the 200,000 forecast. This follows poor manufacturing data and lower inflation information which indicates that the economy may be slowing. This would infer that the Fed will not tighten further in March.

On the other side of the Atlantic, the ECB thinks that fighting inflation takes priority over economic growth and seems likely to strangle any chance of a recovery by perhaps tightening a further 25 basis points, this closing the interest rate gap. There could be signs that the economies will pick up, as the new German Government is determined to succeed in this area.

As usual, the pundits talk of a currency crisis in the coming year. They have done so for several years now, but each year we manage to escape such a crisis, despite wars, energy price shocks, current account deficits and trade imbalances. Is this year any different? Will there be a dollar collapse caused by the US consumer and the government spending beyond their means while saving nothing? The current account deficit just gets larger - $800 billion in 2005 and probably $900 billion in 2006. The holders of US debt, in other words the nations with trade surpluses with the US, have no interest seeing a weaker dollar, because their dollar-denominated assets will decrease in value. But what if someone jumps ship now? Will that cause a rout?

On the other hand, the crisis could be in Euroland. In 2005, there were mumblings in Italy that being in the Euro was not particularly good for Italy's economy. What if it left the Euro? Again, an unlikely event short term, but markets are good at forcing hands sometimes.

Whatever happens, I think we will have an interesting year. Remember that when a real currency crisis starts, it is normally a one way bet. They used to occur every 18 months or so, and we haven't had one for a while. Like an earthquake, we are one overdue.

How can you take advantage of this if you are a short-term trader? One way is to buy a Euro call 'far out of the money' 6 months or further forward (If you foresee a dollar collapse). If you can get a price, that is. Some would say that this is not a good idea because you are paying for the time value of the option, which will rapidly decrease in value as you get near maturity. However, if the Euro strengthens, after a certain point (a so-called 25% delta), the value can rise quite fast, until the stage where the option is 'in the money', when it will be increasing in value at virtually the same pace as the point increase. By this time, you can sell the option to protect the remaining time value of the option.

I did this once and had almost forgotten that I had bought an option, until there was a crisis that caused a great rate move. The market maker called me and said that I was no 'in the money', what did I want to do? I sold it for a windfall profit!

They Don't Like It Up 'em

Recently, I have been speaking to various parties about creating a virtual forex market using TraderMetrics, our forex simulation. I spoke to a couple of broking firms, explaining that one of the options was to allow players to become market-makers. One broker said 'There is no way that we would want our clients to learn about market makers!" Another was more subtle:

"I am impressed by the quality of the product you have clearly made.   I am sure it is an excellent means by which real Forex Traders learn how to quote for customer flow, which is in fact a step more developed than our client-base, who merely speculate upon an independently-moving market.
 
Unfortunately, we do not currently have a use for such a product.  We are very happy with the sort of business our clients currently do, and shifting them onto any other kind of business model is likely to actually diminish our revenues"

The message is that the brokers have their customers exactly where they want them; namely, in the dark. Along with hypnotizing clients into trading a certain way with no idea of money management makes it a one-way game for the brokers.

Stop Losses

Take stop losses. A neccessary cost of doing business? Yes, to a degree. When you enter a trade, you have to pre-define your risk and reward, and obviously these have to be in proportions that will lead to profit in the long term. Doing this means that you can be emotionally detached from the trade. That is, you put on the trade and you know that one of two things will happen; it will reach the target and you will make a profit, or you will hit the stop and make a loss. Losses are a part of this business, therefore a cost of doing business.

Many traders don't understand this relationship of risk and reward, often putting on a very short term trade with a 20 point stop, looking for a 5 point profit. Let me make one point absolutely clear: You will NEVER make a profit with this strategy.

Imagine for a moment that you are a broker. Your job is to provide the facility by which your client can trade the forex markets. You do this by extending credit (leverage) and the means to put on and exit trades. The idea is that you as a broker will make a small 'turn' on each trade between the spread received from a 'market-maker' (typically a bank) and the client.

A typical client opens an account and puts on a trade with 100:1 leverage. This automatically forces a fairly close stop loss order and at the same time a short-term strategy. Given that the market short term is a random walk, the price fluctuates a lot. Does the client take a 'small' profit? Yes, if he can, but regardless of the system, the client will be stopped out as many times as he takes the 'small' profit. Additionally, many clients have no idea where to take the profit, regardless of the 'system'.

My client has given away the strategy as soon as the trade has been placed by nature of the leverage and the stop. Why should I bother to 'turn' the trade with the market-maker when I know that my client is stupid. In addition, if I am on commission, I can get greedy and 'spike' my client, to deliberately trigger the stop. Why not? Where is the evidence if the client complains?

What can you do as a client. First of all, try and find a 'fair' broker. Follow the surveys, such as on the go-forex web site. Secondly, forget the high-leverage short term trades. Don't play into the hands of the broker. Select a 'do-able' risk reward ratio, preferably between 2 and 3:1. Base your system on a longer time frame. Stake the same amount on each trade. Now here is another area where the brokers refuse to accommodate the speculator. To risk the same amount each trade implies that you will vary the trade size; however, many brokers only allow a lot size of multiples of 100k.

Can you run without stops? You need rock solid discipline. Most traders don't have this and want someone else to take the responsibility (i.e. the broker) to do this. The stop loss was originally applied in spot forex by traders who wanted protection when they were away from the desk. When trading in a bank, I never set a stop loss, because I never had a trade open when I was away from the desk.

Trading Psychology

As some of you probably know, I am a great fan of Mark Douglas. He has written a couple of books on trading psychology and in this article, I would like to put some of his points into a forex context.

What does it really take to become a good trader?

Market knowledge? A good system? A lot of capital? Yes, all these, but the most important factor is you. It is your attitude and state of mind that will determine your success.

There are thousands of 'experts' out there on the Internet today, selling you a dream based on superior market analysis or a trading system. But they are only telling you are fraction of the story. For example, many unsuspecting people are conned into paying $4000 or more for a system that shows a green light to buy and a red light to sell, without realizing that it is their subsequent series of actions that are going to dictate a profit or a loss - not the signals!

First of all, let us ask the question:

Who are the good traders?

They are the few who have confidence in their own trades and trust themselves to do without hesitation what needs to be done.

They are not afraid of the unpredictable and erratic behaviour of the market. They concentrate on the information that provides opportunities for profit and not the information that bolsters their fears.

They have learned that trading has nothing to do with being right or wrong with any particular trade.

They are confident but never reckless and are not prone to euphoria or depression. They have cut out the emotional risk of trading, because they have no expectation about what the market might do at any particular point of time or situation.

They are aware that they don't need to know what happens next to make money, that anything can happen and every market moment is unique - a trade either works or it doesn't.

Unfortunately, there is a belief that by throwing financial resources into becoming a trader, the problem will be solved. Not true - the forex market is a psychological phenomena because it is made up of people, making decisions on whether to get in, get out or do nothing in the market.

The biggest contribution to your success in this business is your self-discipline and self-trust. To gain these qualities, you will have to change your belief systems. Very few, if any of us have those systems ready available here and now. You have been socially conditioned to prepare you for anything BUT trading forex.

In very simple terms, what you need to have as a forex trader, is a system that can give you better odds than merely randomly buying or selling, capital enough to allow you to get a result from the system allowing for the losses that all systems produce, the ability to think in probabilities, detach yourself from the need to be 'right' and learn to accept a loss.

What about those belief systems? We are all brought up in a structured environment where we are controlled by a power greater than ourselves. Be it our parents, school, company rules or the law of the land. In the forex market, you are the one in control of yourself. You have the freedom of expression, of creation, to enter, remain in and exit the market whenever you want and create the ability to give yourself the money you deserve.

That includes your ability to give your money to other traders! But you have to bear in mind all the time the market cannot 'do' you anything. It does not care!

There are not many of us who have learnt how to handle this freedom to express our creativeness in the absence of an external structure. You have the potential to make unlimited profits with every trade at the same time face the risk of losing everything.

If you work from a mental framework based on an external structure with its limitations and expectations, it will cause you emotional distress that will lead to financial disaster.

Fear is your worst enemy, because it distorts reality. Your mental baggage will cause your to try to avoid the pain of making losses instead of looking for opportunities. Getting it wrong and being afraid to lose money will be your main motivation to act (or not to act) and you will only be open to receiving information that will validate your fear.

Take spiders. Do you like spiders? My wife hates them, to the degree that she freezes in panic whenever she sees one. We didn't buy a house with a cellar, much to my disappointment. Has our life has been affected by these little creatures? No, by my wife's fear. Do the spiders care? Not in the least. Just think of the things my wife may have missed out on because of this fear of spiders. If there is a spider around, she cannot do anything.

That is the same as a trader being afraid of losing money - he is paralysed.

Unfortunately terms such as 'self-discipline' and 'emotional control' are vague and abstract, so bear with me, please!

Think of emotions such as 'fear' and 'confidence' as being on the same scale, like a temperature gauge showing 'cold' and 'hot'. In other words, it is the same thing separated by degrees.

Big lesson 1: Learn to accept a loss. First of all, you have to have enough trading capital to accept a loss. So don't trade with limited capital or money that you cannot afford to lose (like on your credit card). Choose a contract that suits your capital size (mini contracts)

Learn to accept your loss with no guilt, shame or self-punishment! Losses happen, even with the best systems; as long as your system has better than even odds over a longer period.

You will need to work at two mental components to get this skill. The first is to work on your understanding of why it is necessary to confront the possibility of a loss. The 2nd is your willingness to change your own opinions of what a loss means, such as changing the idea that losses diminish you as a person.

Confronting and accepting the inevitability of a loss is a trading skill.

Predefine a loss in every trade you look at entering into. Note what the market has to look like to tell you that this trade no longer looks like an opportunity within the time frame of your system.

Doesn't trading look simple? It seems that it goes up or it goes down and all you have to do is get on the right side. If it is that easy, how come 90% fail? The fact is that once you are in (made a trade), it is like being in an earthquake zone. The ground under your feet is unstable. This is not a static environment. It is perpetual movement- and seemingly perpetual motion at that. Could you imagine your neighbourhood being in the state of a constant earthquake. What would that do for your sense of security? Not a lot, I should think!

What about winning? I guess you want to win BIG in forex. To many, winning big becomes a compulsion combined with a fear at the same time of devastating loss. One heluva environment to think objectively, don't you agree?

How is your attitude to making money without working for it, especially in a very short time-span? Does your upbringing support that notion? My Father used to say that you don't get anything without working for it. Luckily, I have overcome that stigma, but it took some time. Imagine a bunch of people came to your door and offered you a lot of money. How would you feel about that? You are probably saying 'I'd take it', but I don't think you would, because social conditioning means that you would feel that you didn't deserve it because you didn't work for it.

Many traders, when they have made a 'windfall' profit (that is, a large unexpected profit), usually end up giving it back to the market in one way or another. A typical ploy is 'Wow, I am on a roller' and the increase the size of their trades because they think they are indefeatable. They come unstuck!

to be continued

Take a look at Mark Douglas's books (click on the image for more info)

The Disciplined Trader

Trading in the Zone