Let
me quote from one of the classics in literature for traders – Alexander Elder's
"How to Play and Win on the Market":
"If
a friend of yours with very little experience in farming comes to you and says
that he is planning on feeding himself from what he can grow on a quarter acre
plot, you'll know that he is going to be going hungry. We all have a sense of
what can be gotten out of a plot of that size. But in the world of trading,
full-grown adults allow themselves to harbor such fantasies."
As
soon as an amateur gets roughed up a few times and has a few margin calls, he
loses his assertiveness, becomes more timid and begins formulating all manner
of frightening ideas about financial markets. Losers on the market buy, sell or
stay on the sidelines all as result of their fantasies. They are like children
who are afraid to walk through a cemetery or peek under the bed for fear that
there could be ghosts lurking. The unstructured nature of financial markets is
fertile ground for fantasy to take flight.
And
our fantasies can affect our behavior even when we don't realize we have them.
A successful trader must first recognize his fantasies and then rid himself of
them.
Fly-by-night
Dealers and Other Myths about How Brokers Actually Work
There
are three ways a dealing center can operate.
1.
Not a single client position is hedged with an external counteragent. In this case
it is in the dealer's interest that the client lose – otherwise, the client is
paid out of the dealer's own pocket. In Russia, the prevalence of such dealers
in the 1990s let to industry players adopting a pejorative slang word, kukhnya
(translated as "kitchen") to describe such low-budget, fledgling
dealers. It is true that many dealing companies operate according to this model
in the first years of their existence because they don't have enough trading
volume to hedge their clients' net positions in the interbank Forex market (a
standard lot being 0.5 mln). Less well-established dealers run the risk that
one of their clients will win big and the company won't be able to meet its
obligations. In order to reduce the risk of this happening, such dealers often
take measures to "help" their clients lose, a practice which damages
the reputation of the industry at large.
At
the end of the 1990s there were very few dealing centers in Russia and most of
those that were operating didn't have enough clients to properly hedge client
positions on the larger market. As a result, to minimize clients profiting at
the expense of the company's bottom line, many dealers began throwing wrenches
in their clients' trading. "Slippage", filling orders at a price
slightly less profitable for the client, was one of any number of methods
dealers used to subtlety sabotage their clients. But time doesn't stand still.
Dealers who got their start in the 90s and survived have managed to acquire a
large client base. And since larger companies generally aren't willing to risk
their reputations to make a quick buck at their clients' expense, shady dealing
practices have generally been relegated to the ever-shifting world of
low-budget, fly-by night dealing centers.
When
a dealer has acquired a critical mass of clients and is able to take the
training wheels off, certain things become clear:
·
Over the long run the profit of
"fly-by-night" operations (who are trading against their clients)
turns out to be essentially the same as if they were just earning based on the
spread (due to the fact that the company's winnings and loses against the
client will even out over the long haul). In the end a larger client base is
the only way to make progress – and that depends largely on the reputation of
the company.
·
A good reputation and long-term clients is ultimately
more profitable than short-term profit from the losses of clients. Because of
this, even those dealers who still process everything internally eventually
move beyond unethical practices (poor execution, swooping up stop losses,
etc.), that characterize the fly-by-night types.
·
The company has come to be more valuable and
management doesn't want to lose it all because of a few lucky clients.
·
Client accounts are getting larger (a sure sign of a
good reputation) and even some much larger clients are showing up, most of whom
are generally successful due to having more professional experience and better
training.
As
a dealing center grows, management starts thinking about hedging client
position, and as a result, moves to the second business model.
2.
Hedge the net client position on the interbank market. This means
that the net client position (of a certain previously agreed upon size) is
hedged on the main market. This removes any motive for the company to trade
against the client. Now, highly successful clients no longer put the company on
the verge of ruin.
3.
Hedging every client position on the interbank market. From the
client's perspective this model carries no advantage compared the one listed
above. Among its drawbacks:
·
Large account balance and minimum trade requirements
·
Slower execution
When
this article was written, Alpari had more than 7,200 clients, which allows the
company to use the second dealing model.
The
Myth That It's Impossible to Make Money on Forex
It's
often been said that 90% of those who trade with leverage on financial markets
end up losing their money. Unfortunately, this is true. Let's see if we can
make sense of why that is. If we analyze how the "90%" go about
trading, we can come to a few conclusions as to what the unsuccessful trader
does wrong:
·
Doesn't have a grasp of the basics of analysis: Unsuccessful
traders make poor use of technical and fundamental analysis.
·
Doesn't understand the philosophy behind trading: I'll explain
with an example from my own experience. Once when I was a young technical
analyst I was analyzing a currency, let's say the Yen. I look at the
"week" chart, the indicators are all pointing down, the day chart –
same thing, four-hour chart – same thing, 5-minute – same. Great, I think,
everything's pointing in one direction. I open a position. The result?
Miserable. My faith in technical analysis was shaken to the core. I ran to get
a beer and thought a lot about what had just happened. I realized that it isn't
technical analysis that's at fault, but me. The week and day charts were
showing that the overall trend was down. The shorter timeframes showed that
movement in the direction of the trend was already happening and had apparently
bottomed out. The ideal moment to sell would have been if the week and day
charts were down but the 4-hour was bullish (bouncing off the bottom) and the
hour chart is showing that the upwards movement has ended (for example, when
the bulls are divided).
·
Doesn't follow the rules of Money Management:
o
Doesn't set stop losses at all.
o
Sets stop losses too close to the entry price. A stop
loss order on the Forex market should not be less than 40-50 pips from the
entrance price. Stop losses that are placed closer are likely doomed to get
triggered due to the fact that you are very unlikely to catch the top or bottom
when you enter the market (i.e. even if you are correct in your analysis, there
could be some initial price movement against you). This could be 10-15 pips.
Plus 5 pips of spread. And if you count market noise (10-15 pips), a stop loss
order placed less than 40-50 pips off the entry price has an unacceptably high
chance of getting picked up.
o
Doesn't maintain a profit/loss ratio of 2/1.
o
Tries to record a profit of 5 pips but is willing to
ride a bad trade down to a 100 or more pip loss. In this case you would need 20
profitable trades just to cancel out the loss sustained in the one bad trade.
This would mean a success rate of over 95% -- something that not even Soros
could pull off. Professional analysts are right 75-80% of the time.
o
etc.
·
Base their trading on too small fluctuations: I think that
the market reflects about 10 pips of noise (a large order is placed to a bank
which bumps the price up or down by 5 pips after which the price returns to its
previous level. Also, different market-makers show slightly different prices).
Let's take this as an axiom (it can't be proven). That means:
o
Analysis of a 1-minute time-frame allows you to catch
a movement of 15 pips. 66% of that is market noise (10 pips).
o
Analysis of a 5-minute time-frame allows you to catch
a movement of 30 pips. 33% of that is market noise.
o
Analysis of an hour time-frame allows you to catch a
movement of 100 pips. 10% of that is market noise.
o
Analysis of a day time-frame allows you to catch a
movement of 500 pips. 2% of that is market noise.
·
These numbers are hypothetical. It's the concept
that's important. As it works out, a lot of the time we end up just trying to
predict market noise when analyzing short periods of time. Market noise is
unpredictable. The market, however, is predictable, which is why we should
concentrate more on longer periods of time.
·
If you haven't been having success trading on Forex,
take a careful look at what I have laid out above and draw your own conclusions
about what you need to do better. To be successful on the Forex market, you
need certain knowledge but you also need to understand how to follow certain
guidelines, notably those related to money management.
Myth:
There aren't enough brokers in brokerage firms, otherwise why does it take so
long for my trade to be executed during periods of greater price fluctuation?
A
delay can be caused the following:
·
Software or network is unable to handle increased
traffic during periods of greater price movement.
·
Broker insufficiently staffed.
The
question remains, however, why do brokers that don't suffer from either of the
above-mentioned shortcomings still sometimes experience delays when processing
orders?
The
most common business model in larger companies is # 2 (see above) – the company
hedges client positions with an external counteragent. When the market is calm
the broker is able to process the client's trade almost instantaneously and
then worry about hedging it in the larger market (if need be). There's no
reason to hurry and the broker might even be able to jump in a couple of pips
better than the client had.
But
everything is different during a volatile market. The client's position needs
to be hedged immediately or else the market could move quickly and the broker
could get left with a loss. As a result, client orders are filled at the same
time that the company is attempting to hedge the positions on the larger
market. Naturally, client orders will take longer to fill. But this should be
seen as the price to pay for working with a reputable company that isn't
working against the client.
The
Myth about Not Having Enough Capital
I
will once again quote Elder:
"A
lot of unsuccessful traders think that they would be more successful if they
had more money at their disposal. Most such traders were thrown out of the game
after a particularly bad stretch or perhaps even just one unsuccessful trade.
It also happens often that as soon as the amateur has closed all his positions,
the market moves in the direction that he had been anticipating. The hapless
trader is either furious at himself or at his broker, "If I had been able
to hold out for just another week, I would have made a fortune."
Unsuccessful
traders interpret this as a confirmation of their methods. So they put their
hard-earned (or borrowed) money into opening another account. But the same
story happens again. The trader is wiped out and watches from the sidelines as
the market again heads in his direction, again proving his analysis, albeit too
late. This is about where the fantasy "if I had a bigger account, I would
stay alive longer and actually be able to make money" takes flight.
Some
traders talk relatives into funding their next venture, showing them the charts
as proof that they know what they're doing. But poor traders hardly fare better
with well-funded accounts than they had before.
The
biggest problem for the losing trader isn't a lack of capital but a lack of
understanding of how to trade. A weak trader can run through a large account
almost as quickly as a small one. He overplays his hand and his money
management fails. Poor traders often take overly risky market positions even
with larger accounts. Regardless of how well a trader's overall strategy is,
subjecting one's account to excessive risk can be a recipe for disaster – if a
couple of big trades go against you, you could be wiped out.
I
am often asked how much money you need to get started trading. They want to
have enough to survive a down period. They think that they will lose a bunch of
money before they start making anything. It's like an engineer who plans on
constructing a couple of bridges that will end up collapsing before building
his masterpiece. Can a surgeon kill a few patients before becoming an expert at
curing appendicitis?
The
amateur doesn't think that he will suffer losses and isn't prepared to handle
such a situation. The conviction that your failures are due to
under-capitalization is a trap that makes it more difficult to notice two
unpleasant things: lack of discipline and the lack of a realistic plan for
managing one's funds.
One
advantage of a larger account is that the start-up costs are smaller relative
to your account. If you are managing a fund with a million dollars and spend
$10,000 on computers and seminars, you only have to earn 1% to cover those
expenses. But if you only have $20,000, those same expenses constitute 50% of
your entire account.
The
Myth about Autopilot
Let's
assume that a stranger comes up to you while you're in your garage and tries to
sell you a fully automated driving system, "for just a couple hundred
dollars, you can get this computer chip which will drive your car for
you." You can just sit and sleep while you are being driven to work. You
would probably laugh at such an offer. But would you laugh if someone offered
you an automated system for investing in the markets?
Traders
who believe in the "autopilot" myth think that making money can be
automated. Some try to create automated systems themselves, others try to buy
ready-made ones. People who spend years crafting their trades as lawyers,
doctors, or business then turn around and try to buy the equivalent of years
worth of experience in the form of an automated trading system. These types are
generally ruled by greed, laziness and profound misconceptions about
mathematics.
In
the old days, such systems were written down on scraps of paper; now they are
on protected disks. Some are very primitive, others are quite complex with
built-in optimizers and rules for money management. Many traders are looking
for magic – a way to turn a few lines of code into an endless stream of money.
Those who pay for automated trading systems are reminiscent of knights from the
middle ages who paid alchemists for the secret of turning simple metals into
gold.
Human
behavior, with all of its complexity, doesn't allow itself to be automated.
Computer programs haven't replaced teachers and computer-based accounting
systems hasn't led to mass unemployment among accountants. Most human
activities require the ability to make decisions – something computers can help
with but can never fully replace humans.
If
you had managed to get a hold of an automated system, you could retire to
Tahiti and live the rest of your days in luxury, picking up a never-ending
stream of checks from your broker. But so far the only people who have made
money from automated trading systems are the people who sell them. They have
created a small but quite attractive little niche for themselves. If their
systems worked, why would they sell them? Instead of hawking their systems,
they could have long ago themselves retired to Tahiti. Of course such salesmen
have an answer ready. Some say that they like programming more than trading on
the market. Others say they are selling their system just to acquire capital
for making further investment.
But
the market is always changing and what worked yesterday may not work today. A
good trader is always correcting his methods when he sees that things are changing.
An automated system will be unable to make the necessary adjustment and will
inevitably crash and burn.
Take
the airlines. Even though they all have autopilot systems in their airplanes,
they all nevertheless continue to pay pilots rather large salaries. This is
because the pilot, unlike the computer, can deal with an unexpected situation.
When a plane flying over the Pacific suffers damage to the fuselage and needs
to execute an emergency landing or when a plane flying over Canada unexpectedly
runs out of fuel, only a human can deal with such a situation. Trusting your
money to an autopilot system is a good way to have your account destroyed by
the first unexpected event.
There
are good systems out there but they have to be managed and their trades have to
be watched. You can't simply turn it on and let it go.
