BK Trader FX Weekly - Revenge of the Machines 11/1-7/08

November 1, 2008

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—————–The Key to Winning—————

Warren Buffet’s number one rule of investing is very simple. Don’t lose money. His number two rule is don’t ever forget rule number one. A while back I showed how Buffet’s success can be directly attributed to this one key variable. From 1999 - 2007 Warren Buffet actually made less money than the S&P index 5 out of 7 years, but he outperformed the index by a wide margin because in the disaster years of 2001 and 2002 he only lost several percent while the index was down by double digits each year. for us as traders the key to winning lies in Warren Buffet’s formula for investing.

————–FX Market Outlook————–

On Thursday night as I was having drinks atop the beautiful Jumeirah Beach hotel in Dubai, Patti Domm from CNBC called me. It was still day time in New York and the euro was going crazy, having first traded to 1.32 and then dropped to 1.27 in a period of a few hours. What’s going on? She wanted to know. What was the reason for such tremendous volatility?

Instead of fabricating some fundamental excuse, I decided to level with her. The fact of the matter was that there was nothing major happening news wise. The Fed had cut rates the day before as expected. Euro skyrocketed on a massive short covering rally and then collapsed just as quickly when it reached resistance at 1.3200. Algorithmic trading, I told her, has really exaggerated the recent moves in the FX market.

Algorithmic trading is simply a fancy way of saying computer driven trading. Much like the equity market, the FX market has seen a vast increase in computer based model trading over the past several years. The advent of electronic hubs like Currinex has made it much easier to run computer based models that often trade 200-300 times per day.

Most computer algorithms are moment based - they buy when prices are rising and sell when they are falling. The net effect is that volatility, which is already extremely high in today’s markets is amplified even more by the action of the robots. Ironically enough, the cold, calculating machines are now actually exaggerating rather than tempering the human emotion behind the price flow.

As I noted last week, this dynamic is unlikely to change anytime soon. Price ranges will remain wide, especially next week with the US election and US unemployment numbers due to report. Although an Obama win looks increasing likely, a McCain upset cannot be ruled out and should it occur the price reaction might be quite violent as markets generally hate surprises. In this environment there are only three strategies to use.

1. Stay out of the market and let the volatility compress as it eventually will
2. Trade very small and very wide using almost no leverage and enormously large stops
3. Trade frequently, staying glued to the screen while keeping your risk/reward ratio no worse than 1:1 and hope than when the dust settles your winners will outnumber the losers

Whatever you choose, be careful out there, its likely to be another historic week of incredible volatility.

—————–The Key to Winning—————

The math is devastatingly simple, but as traders we tend to always forget its impact. If you lose 50% of your money you need to make 100% just to break even and 200% to achieve a 50% return. If you lose 75% you need to make 400% just to get back your original capital and a whopping 800% just to make a 50% on your money. The road to profit become increasingly more difficult the more ground you cede to losses.

Yet you can’t win unless you play. Aversion of losses cannot turn into a fear of them. As traders we are only paid when we participate in the game. We cannot avoid risk we can only control it. That is why i always turn apoplectic when I hear other trading professionals dismiss the importance of stops. No one likes stops, just like no one like push ups and sit ups, but if you want to be in shape physically and financially you must do both. Stops are the only sure fire way to limit your losses. You can make a thousand mistakes and still preserve a portion of your capital to try to make a comeback if you use stops. You only need to make one terminally bad decision to lose everything if you don’t use stops. History is littered with examples of failed hedge funds and investment banks that did not follow Mr. Buffett’s advice.

Perhaps all of this confusion regarding stops is due to the misunderstanding between investing and trading. Investors do not necessarily need to use stops but traders must. As an investor you can build a portfolio of 40 diversified non leveraged positions and even if one idea goes to 0 another idea may appreciate by 200% and produce a positive blended return. This is in fact what many stock investors and venture capitalists actually do. They make a lot of different bets fully expecting some to blow up, but hope that a few other others will soar in value offsetting the losses. In long only positions when your downside is limited and your upside is infinite such a strategy can work well over a long perid of time.

However, as traders we do not have the luxury of time. We are trading highly levered instruments from both the long and the short side. Our objective is absolute positive return regardless of whether the markets are bullish or bearish and our goal is always to limit our losses so that we may trade another day. Stops are the only way we can accomplish that task.

No video this week due to travel

Posted in Boris Schlossberg, FX Weekly Reports