INVESTOR SOPHISTICATION 10

Reading Market Wizards, by Jack D. Schwager for the first time, it’s
difficult not to notice that most, if not all, of the successful traders use
computerized systems.  These traders realize the importance of doing solid
research, system building, and testing in an environment without trading
stress.  And they realize the importance of implementing those systems in
a computerized environment.
Of course, working at Solomon Brothers or Fidelity has its perks, and these
traders all have access to massive IT budgets and staffs.  What about the
individual trader?  In recent years, a number of traders have sought to
automate their systems by hiring software developers.  Too often, the
trader didn’t know enough about software to make the system work
correctly.
In other attempts, software developers have tried to create automated
trading systems that could run on the trader’s computer.  These attempts
were also flawed, since the software engineer was not likely to have
sufficient trading knowledge.  Beyond that, software programs installed on
a home or office based computer are susceptible to power and bandwidth
outages, and a number of other serious deficiencies.
FX Engines was created to solve all of these problems.  Our service is an
automated trading platform with all of the sophistication of the
institutions, designed by a trader with software experience, implemented
by a group of software experts, and hosted in one of the world’s most
advanced, secure, redundant data centers.

FX Engines is designed to create sophisticated investors, which is another
way of saying: FX Engines helps traders succeed.  We invite you to visit us
at http://www.fxengines.com to check out our service with a 15 day free
trial, after which you may still use the basic service free of charge.  Live
trading will be available soon, so get started building and testing today.

A C T I O N

The sophisticated investor understands the six forces of forex.  They
operate with awareness of their environment, and that awareness informs
their trading plan.  To succeed in forex trading, you must become a
sophisticated investor.

Figure 8: The Trader’s Min

The trader goes through an enormous array of emotions and thoughts
during a trade.  Some are good, some are bad, but it is rare to find a trader
who consistently applies his plan.

Emotion, or lack of discipline, is the greatest enemy of every trader.  This
is so true that one could argue that discipline is a more precious trading
commodity than capital itself, since capital can only be sustained with
discipline.
This is not to say that the trader does not have value to bring – he does.  In
moments of clear, objective contemplation, many traders – even novices –
can be builders of excellent trading systems.  These systems can take
advantage of their understanding of the forces of forex and test out
incredibly.  Once live, however, the system falls apart.  Why?
The simple reason is that emotion has no place in trading.  Emotion causes
the trader to act differently following large wins or losses.  Emotion causes
the trader to act irrationally when large moves occur.  Emotion causes the
trader to apply his trading system inconsistently.  
If you took a survey of successful traders you would find many similarities.
The traders would understand and apply all of the forces of forex.  They
would usually trade incredibly simple trading systems. They would trade
using conservative, well thought out money management philosophies,
and they would trade with absolute consistency.
For the institutional investor, absolute consistency is not a problem, since
they have an array of personnel and resources at their disposal.  For
individual investors, there are three groups.  Those who trade without
consistency, those who trade with manual consistency, and those who
trade with automated consistency.  The novice, of course, is the trader who
thrashes from trade to trade.  The individual investor who uses consistent
discipline or automation as the foundation of his trading activity
maximizes his level of sophistication.

Figure 7: When to Trade - P

The markets sleep when London and New York are off.

One of the best ways to validate a technical indicator is volume.  When
volume is strong, indicators tend to be more accurate.  Unfortunately,
there is no volume data available for the forex markets.  Using trading
ranges is the next best thing.
Having this data in hand, the trader can more carefully evaluate when to
trade.  Not only will technical indicators generally have more accuracy at
different points of the day, but there is both more profit potential and less
loss potential at other times of the day.
Consider a trade in EURUSD at 10 AM EST vs. one at 10 PM EST.  The
first has an average trading range of 30 pips, the second, 10 pips.  Entering
the market during the morning trade creates some interesting possibilities
– the market may go against you or with you, but you should be prepared
for a ride in either case.  On the other hand, if the market goes against you
10 pips at 10 PM, how concerned should you be?  Probably not as much as
if it was 4 AM.

For a more in-depth discussion of when to trade, including trend, days of
the week, and other metrics, register for your free trial at FX Engines.  All
FX Engines users receive our periodic Case Studies which highlight
automated trading strategies.
Anybody can trade based on technical indicators.  The novice, in
particular, ignores the importance of “when” as he makes trading choices.
The sophisticated investor is the one who uses timing to his advantage –
creating profit opportunities and limiting losses by observing the market
with more perspective.
HOW
Once an understanding of the external elements of trading is completed,
the hard work begins: the trader must understand his own mind.  The
external elements are easy – they are usually rational, factual, consistent,
and ordered.  The trader’s mind, however, is far from all of that.

Figure 6: When to Trade - A

Give yourself a chance!  Trade when the market is most likely to help you.
Take a look at the average trading ranges for the four majors below.

Figure 5: What to Trad

Understanding the major components of a trading plan is a prerequisite
for successful trading.

All of these factors work together.  Trading a high spread currency using
short interval entry signals and highly leveraged positions will probably be
a failing strategy.  Conversely, trading a tight spread currency using mid-
to long-interval entry signals and little leverage has a better chance of
success.  
In the final analysis, the currency, signals, and money management
approach must all gel together and exist without contradictions.  Novice
investors make critical errors by trying to patch together strategies from
various sources, rather than systematically building, testing, and deploying
a comprehensive trading plan.  The sophisticated investor, who does this
difficult work, operates with a complementary trading plan that creates
consistent profit opportunities.
WHEN
Forex is a 24/7 market – but is the market action the same at all times?  Of
course not, but not many traders stop to consider the impact of this fact on
their trades.  Studying historical price data reaching back to January
2000, the impact is clear, as shown in Figures 6 & 7.

Figure 4: The Dealer Comparison Matri

Comparing different dealers using common metrics helps to clarify where
each dealer’s strength lies.  Armed with that information, the trader is
ready to choose the dealer who best fits his trading style.

Which dealer would you choose?  Novice traders will often choose the
dealer with the best marketing, simply because it’s the one they know.

They learn about the dealer, visit the site, register for a demo, then scale
the learning curve to grow comfortable trading with that dealer, using
their charts, etc.
Frequently, the dealer with the best marketing is not the best dealer for the
trader, or perhaps, for any trader.  Traders use systems that work in the
short term, mid term, or long term, with varying holding times and
strategies.  The type of dealer needed for each approach is quite different.
For every trader there is an optimal dealer.  For many, the path of least
resistance leads to the dealer who makes first contact, not the dealer who
will provide the best trading outcome.  The sophisticated investor
optimizes returns by matching his trading style to his dealer.
WHAT
A comprehensive trading plan is framed by three main elements: the
trading vehicle, or currency pair, the events that trigger market entry and
exit, and the overall approach to trade management.

Figure 3: The Leverage-Loss Matri

What’s the ultimate worst case scenario?  Consecutive losses.  Knowing
how many consecutive losses your system is likely to sustain is the key to
capital conservation. Examples of leverage: 1:1 = one $100K contract per
$100K in capital.  20:1 = 20 $100K contracts per $100K in capital

Convenience
The fact that you need to go to bed or spend time with your family does not
stop the forex markets from operating.  In other markets you can trade a
specific window that usually lasts 6-10 hours, which is physically
manageable.  Forex, on the other hand, demands 24 hour monitoring.
That can be accomplished through automated trading systems or, less
optimally, through pre-set stop and limit orders or physical monitoring of
a trade.
Cost
“No commission trading” is a marketing slogan many dealers offer as a
perceived benefit of forex.  But the fact that there is no commission does
not change the high level of transaction costs paid to dealers through the
bid-ask spread.

There is no doubt that the liquidity, leverage, convenience, and transaction
costs found in the forex markets are great tools for investors – but not
always.  Just as easily as these tools can be used for wealth creation, they
can be misused for wealth destruction.  The novice investor destroys
wealth, and the sophisticated investor creates it.
WHERE
It is one thing to choose a dealer, and quite another to choose the correct
dealer.  Dealers’ service offerings can take many forms, and each dealer
usually has one or two major features that they highlight above all others.
When analyzing dealers, first understand and rank all of their service
offerings, then apply those findings to your trading style to arrive at your
optimal dealer.

Figure 2: The Who’s Who of Fore

They key difference among these market participants is their level of 

sophistication, where the elements of sophistication include: 

ƒ Money management techniques 

ƒ Profit objectives 

ƒ Level of computerization 

ƒ Quantitative abilities 

ƒ Research abilities 

ƒ Level of discipline

Of course there are sophisticated and non-sophisticated banks, 

governments, corporations, investment funds, and traders.  But among 

these segments it is the individual trader who has the least amount of 

external governance.  Whereas governments, banks, corporations, and 

investment funds adhere to regulations and restrictions (to a certain 

extent), traders are only restricted by their level of capital. 

In the absence of these external restrictions, traders fall into two groups: 

those who can impose internal restrictions – discipline - on their trading 

strategies and those who cannot: the fence-swingers, et al.   

Those who can impose this discipline we will call the sophisticated 

investor.  In the zero-sum game of forex trading, the sophisticated investor 

uses tools and strategies that emulate those of the highly sophisticated 

institutional participants to extract profits from the novice participant.  It 

is only the sophisticated investor who has the ability to extract positive 

returns from the forex markets. 

WHY 

Forex trading has surged in recent years, as more individuals earn their 

living trading and the popularity of riskier investment vehicles like hedge 

funds has increased.  The bottom line for these investors is superior 

returns, and in foreign exchange four major factors create a unique 

investment environment: 

ƒ Liquidity  

ƒ Leverage  

ƒ Convenience  

ƒ Cost  

In no other market can you find a playing field that is so biased to the 

investor, at least on the surface.  But to take advantage of these factors you 

have to be constantly aware of their downside. 

Liquidity 

In a liquid market there is a high degree of transparency, even when large 

transactions change hands.  The sophisticated investor understands what 

this means: forex attracts huge players.  As a trader grows in 

sophistication, they understand that these huge players have significant 

price impact, and watch for their market entry. 

Leverage 

The low margin requirements in the forex markets make everyone’s whatif analysis yield forecasts with 1000% growth annually.  What those 

forecasts fail to account for is the multiplying effect of leverage during 

periods of consecutive losses

Figure 1: The Forex Vortex

Natural selection takes on a whole new meaning in the forex markets,
where survival of the fittest is the only rule, and market action ruthlessly
eliminates anyone who has not uncovered the context of the game.

WHO
Far more important than knowing who trades forex is knowing who trades
forex successfully, and how they do it.  The players in the forex markets
operate with widely varying perspectives.  When one of these players
enters the market, a force is created that is proportional to the perspective
of the trade initiator.  That force can play a role in the short term, creating
radical price changes, and it can play a long term role, defining trends.
Figure 2 shows the major perspectives in the forex markets.