dont trade like tony montana

8/3/2019 Dont Trade Like Tony Montana

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BKFOREX ADVISORS LLC

Dont Trade Like Tony

MontanaAdventures in FX TradingBoris Schlossberg

1/1/2012


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For the past three years I have been writing a weekly column for traders chronicling my day to day battles

with the currency market. What follows are the best and most useful parts of my work that can help youunderstand some of the psychological and tactical challenges of day trading FX.

I have divided this anthology into 2 parts. Trading Psychology and Trading Strategies. I hope you have as

much fun reading these pieces as I had writing them. As always if you have any questions or comments

feel free to email me [email protected].

May you always be in the know and in the flow.

Boris Schlossberg

Managing Director BKForex LLC

@fxflow
mailto:[email protected]:[email protected]:[email protected]:[email protected]


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Trading Psychology

Dont Trade Like Tony MontanaPage 4

Win By LosingPage 5

Why Trading is Not like Any Other JobPage 7

A Trade Is Not Your Spouse!Page 8

Why We Pull StopsPage 9

Superstition WorksPage 10

What Business Are We In?Page 11

Do You Want to Stay Angry, or Do You Want to Win?Page 12

Why Trade?Page 13


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Dont Trade Like Tony Montana

Fly on any JetBlue flight from New York to FortLauderdale and a curious thing will happen. Ifone of the Direct TV channels happens to beplaying Scarface, every seat with a man in it willturn to that channel within5 minutes until the wholeplane is watching themovie. Guys love TonyMontana - the swaggering,psychotic gangsterimmortalized by Al Pacino.

Who amongst us can

forget that final scenewhen Pacino faces acrowd of assassinsscreaming Say hello to myleeeetle friend! as he fires off his bazooka whilehe takes a shot after shot refusing to go down.Despite the comic book violence, and thepsychopathology of the main character, mostguys view Tony Montana with a no small dollopof romanticism. He represents our universaldesire to take on the world on our own terms nomatter the cost. But the cost matters, because inthe end of course Tony Montana gets blown tosmithereens.

Ive been thinking about the Tony Montanacharacter lately, realizing that I sometimes do abizarre imitation of the say-hello-to-my-leeetle-friend scene when I fight the tape in FX. Didyou stop me out as tried to short the top? Noproblem I can take it. Here is another order tosell. Another stop? Give it to me. More? Goahead Ill take it all - I am stronger than themarket, I can take it all. In any case you get theidea. After a while your trading account starts tolook like Tony Montanas body and you begin torealize that maybe this is not such a good idea.

This weeks moves in risk FX had many tradersacting like mini Al Pacinos with euro shortsrefusing to accept the fact that the currency wasnot going to implode anytime soon. The short

covering rally was one of themost vicious spikes in recentmemory, but if youve been in themarkets for a while you knew thatit wasnt that unusual. When themarkets want to roll you can jointhem or get out of the way. If youchose to make a stand you willalmost always be leveled to the

ground.

Sun Tzu once said He whoknows when he can fight and

when he cannot, will be victorious. This isperhaps some of the greatest advice that we canabsorb as traders. Very often we trade not to winbut satisfy our ego. Taking on the world, or themarket is a romantic idea that weve all beentaught, but in finance that is a very expensiveway to conduct your business. As guys we mayall yearn to release our inner Tony Montana, butas traders we should mature enough to knowbetter.


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Win By Losing

I've missed more than 9000 shots inmy career. I've lost almost 300

games. 26 times, I've been trusted totake the game winning shot andmissed. I've failed over and over andover again in my life. And that is whyI succeed.

Michael Jordan


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To trade well you must learn to lose. That maysound like an unusual advice from a guy who

throws more temper tantrums than a teethingbaby any time a trade doesnt go his way, but itis nevertheless the most fundamental truth ofthis business. Trading at its core is the art ofmanaging failure.

Of course that is not how most retail tradersapproach this game. Subconsciously we expectto win every single time we open a position andseveral losses in a row often send us into a nearcatatonic state of despair. Ive often suspectedthat the reason most people quit trading has lessto do with their ability to read the market and

much more to do with the psychological shock oflosing money on a near daily basis. After all,there are very few areas of life where weconfront failure every single day.

In civilian life we are always preconditioned forsuccess. We expect the trains to run on time,our computers and Internet connections to workflawlessly, our clothes to be perfectly pressedwhen we pick them up from the dry cleaners anda million other mundane tasks that we take forgranted. Indeed, the purpose of civilization is toconstantly engineer failure out of existence byproviding us with better tools to handle all oflifes many challenges.

Even in highly complex and risky professionssuch as emergency medicine we have becomemuch more proficient at eliminating failure. ERdoctors face a multitude of medical problems,most of which they are able to control. In anindustrialized country, it is almost unheard of foran emergency doctor to lose a patient everysingle day, unless there are some specialcircumstances such as a mass accident or thespread of a virulent virus. On the other hand ifyou are trading FX, a losing trade every day is

the rule rather than the exception.

I make this analogy not to trivialize medicine

which is a far nobler and clearly more valuablecalling than speculation, but rather to make apoint about expectations. The reason whytrading is so difficult is because it stands outsideour normal frame of reference. As modern dayhuman beings we are just not used to dealingwith constant failure as a way of life. Mosttraders will accept one or two losses in a row,but few realize that even an 80% accuratestrategy can generate a string of five or sixconsecutive stop outs.

There is no perfect way to combat this problem

but a trick of the trade that Ive found useful is tosimply run your strategy manually on a pricechart to see how well it performs during randomperiods of time. Many traders of course back testtheir strategies and many computer programsoffer very sophisticated analytical tools to showyou how the trades have performed. However,while computer back testing is a nice tool, it isvirtually useless in helping you trade. Reams ofcomputer driven reports can provide you with anstatistical analysis of your trading methodology,but none of them will offer you the psychologicaltruth that comes from actually feeling the tradesas they occur on the chart. There is somethingincredibly powerful about marking your wins andlosses by hand that makes you absorb thedynamics of your strategy in the most primal andeffective way. We may be highly evolvedmammals, but we are mammals nonethelessand as such we are still tactile animals. Ivefound that by just working out my strategy on achart, seeing all those wins and losses clusterand spread out over various time frames, I wasable to trade much better in real time because Iunderstood the likely outcomes and was not asperturbed by a string of several stop outs in arow.


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Why Trading is Not like Any OtherJob

One of the maddening aspects of trading is thatit resists any and all attempts to turn it into aregular business activity. For most of us, ourgreatest desire as traders is to achieve steadyand positive returns that compound on a daily

basis. But trading is not and will never be a jobwith the predictability of a bi-weekly paycheckbecause Mr. Market is unlike any boss you willever have.

In the normal world of salaried employees weget paid irrespective of whether we are having agood day or bad one. In fact many of us caneven play hooky, or call in sick and do no workat all and still get paid. At worst, if we arecommission based employees like salespeople,we simply do not get any cash if we performpoorly on any given day. Mr. Market however is

a much more insidious boss. Not only does henot pay you on any day that you do not work, buthe actually goes into your bank account andpulls out money that you already posses, themoment you make a mistake.

Thats a very disturbing reality for most tradersto accept. In the real economy, only selfemployed business owners ever face thatdynamic and even they experience it very rarely.For example if you were to run a coffee shop,your day to day business would be relativelypredictable. It is almost inconceivable for acoffee shop owner to have 1000 customers oneday and zero customers the next. The flow ofbusiness in the regular economy is generallysteady. In the financial markets however the flowof returns is much lumpier.

This notion became crystal clear to me when Iwas looking through a back test of an intradayflow strategy that I trade. No matter what filters Iapplied there were just some months when the

methodology did not work and it lost money. Inother months it just printed pips with barely abad trade in the batch. In fact I realized that thebest you can hope for when you are trading is tosimply dampen your losses as much as you can

when the markets are not cooperating whilestaying in the game long enough to enjoy thewinning streaks. Make no doubt about it,financial markets are very streaky. Most of thetime prices bounce around in a state ofindecision until a dominant theme developsgenerating strong directional flows. Furthermore,because it only takes the press of a button tochange your mind, the financial economy ismuch more volatile than the real one. Thats whya famous analyst once quipped that the USstock market predicted 9 out of the last 4recessions.

The best we can hope for when we trade is toremain at breakeven for most of the time andmake money during the few months when themarkets are trending. In finance unlike in reallife, the payouts are lumpy and you need to learnhow to take your lumps if you want to succeed.


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A Trade Is Not Your Spouse!

Do you take this woman to be your lawfullywedded wife, to love and to cherish? In sicknessand in health? For better or for worse? Untildeath do you part? How many times have all of

us heard those words? We all know them byheart and can repeat them in our sleep.No doubt marriage vows possess enormousemotional power for most of us, but in tradingthose few simple sentences can be the deadliesttrap ever made. Although men are oftenportrayed as irredeemable Lotharios with zeroability to commit, the truth is that the concept ofloyalty and fidelity is ingrained in boys from earlychildhood. From Never rat on your mate, toNeverhit on your buddys ex-girlfriend to thecry of Semper Fi! of US Marines men areinculcated with the idea that loyalty is the highestvalue in life.

Unfortunately in trading loyalty will ultimately getyou killed, or at the very least bankrupt. A tradeis not your spouse and you should never marryit, because if you do, 99 out of 100 times therelationship will end in tears. The average manis extraordinarily monolithic in his approach tolife. We like simple, logical, belief patterns thatwe apply universally. Once taught that Quittersnever win and winner never quit we tend toapproach everything with the same nose-to-thegrindstone attitude.Women on the other hand understand that

fidelity in one arena does not necessarily requirefidelity in another. Thats why women tend to bemuch better traders than men. They can cut theirlosses ruthlessly with all the cold calculation of amercenary. Women generally do not invest theirego into trading and tend not to view theoutcome of each trade as a moral judgment ontheir character.

One of the reasons why men become so vestedin each trade, stubbornly refusing to admit theirmistakes is because they lose sight of the endgoal. Whats the object of trading? Is it to win

each and every time? No. The goal is togenerate a positive return at the end of eachyear. If thats the purpose, then each trade isimmaterial. At BK - a relatively staid signalservice - we execute 100 trades each year. Inmy own personal account I do approximately1500 over the same period of time. Many of youwho trade short term probably do even morevolume than that.

Is it really necessary to destroy your accountover one or even ten incorrect trades? Of coursenot. In real life, fidelity may be valued, but intrading promiscuity is the far better path. A trade

is not your spouse and when it becomes difficultor unpleasant, your attitude should beNEEEXT!


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Why We Pull Stops

In their book Sway, authors Ori and RomBrafman describe the series of eventssurrounding the worst airline crash in Dutchhistory. Piloted by one of the most accomplishedand experienced aviators in the world CaptainJacob Van Zanten, KLM Flight4805 was on its way to CanaryIslands. However, a bombexplosion a flower shop closed theLas Palmas airport, and KLM 4805along with several other planeswas diverted to the island ofTenerife about 50 miles away. As

the authors describe it, Tenerifewas a tiny airport with a singlerunway not meant to supportjumbo jets.

Sitting on the runway in Tenerife Captain VanZanten realized that the crew was running intomandated rest period which under Dutchaviation laws was actually a crime punishable by

jail time. Becoming more anxious by the minutethe Captain agitated to resume the flight before itwould have to be grounded on Tenerife whichhad no accommodations for the passengers.The air traffic control on the laid back island

however, was listening to a soccer match andwas in no hurry to move the planes. Finally justwhen it looked like the plane was ready to leavethe airport became enmeshed in fog. Thecaptain, utterly frustrated by this point decided totake matters into his own hands, put the engineat full throttle and decided to gun it down therunway despite the fact that he had no clearancefor takeoff from the tower. What happened nextwas as tragic as it was predictable. As the fogcleared and the KLM plane was about to lift offthe captain suddenly saw a Pan Am 747 parkedat the end of the runway (it was in the wrong

spot because of the fog). The captaindesperately tried to lift the planes nose to clearthe 747 but the underside of the fuselage rippedthrough the top of 747 and the whole crew and584 passengers lost their lives.

The accident of KLM 4805 is a stark reminder ofjust how powerful and destructive the humaninstinct for loss aversion can be. Despite hisyears of experience the Captain was ultimately

driven to his irrational behavior by his desire toavoid the massive delay and the inconvenienceand loss of reputation that an overnight stay atTenerife would entail. The end result washorrendous, but to those of us who trade it was

not entirely unfamiliar.

How many times have we astraders seen the following set ofevents occur? We wake up, stillgroggy look at the FX market andwithout much thought put on atrade that promptly stops us out.

Annoyed, we try again only tohave the market dip to take us outonce more and then reversedirection in our favor. Now getting

really angry, we accidentally sell when we meanto buy and watch in disgust as we get taken outagain. Now we double up the position and onlysucceed in buying the absolute top of the movewatching in dismay as prices retrace and stop usout once more. Prices finally stabilize and wedecide to buy one last time. We get long only tosee prices drift lower once again. But this timewe decide that the market will not play us for asucker. We wont get shaken out again, so we

make the ultimate mistake we lift the stop fromthe trade and let it float in the marketunprotected.

At this point the ending is just too predictable.The account crashes much like the KLM flightalbeit with far less horrific consequences.However, the failure in both cases is due to ourhuman instinct to avoid loss at any cost. Intrading in order to win you must learn how tolose. No matter how painful, no matter howannoying, no matter how frustrating the processmay be, you have to have a hard stop on every

trade. A stop is an insurance policy againstbankruptcy. As long as youve preserved aportion of your capital you can always comeback. Ironically enough our basic instinct toprotect us from loss will often lead us to theultimate catastrophe of losing it all. As traderswe should always be mindful of this trap if wewant to succeed in the game


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Superstition Works

My sister just came back from mainland China

and upon her return to Florida wasshocked to see the contrast betweenthe obese Americans and therelatively thin Chinese. This is ofcourse a common observation andoften leads to a never ending lamentabout the dominance of Americanfast food that has essentially turnedthis nation into a land of fat people. Icertainly agree with the criticism ofthe American food culture but I think the obesityepidemic is also a signal of something elsemuch more positive.

First, Americans are no longer unique in theirfatness. The Brits are becoming fatter by the dayand so for that matter are the French. A recentstudy of overweight teens from across the worldbasically shows a huge geographical skew withNorth America and Western Europe producingmarkedly fatter children while Eastern Europeremains relatively slim.

At its core the obesity epidemic in theindustrialized world is a sign of mans totaltriumph over nature. The advances intechnology have made food so cheap in theWest that we can stuff ourselves full of caloriesat almost no cost. This near pornographicabundance of food is a testament to sciencesability to conquer the environment. No moreneed for the rain dance. No more offerings to thegods. We control the future.

This belief in control has become the philosophyof the modern age. As societies and asindividuals we now approach every new problemwith an engineering mindset. There is no crisisthat we cannot engineer away. From electricalengineering, to financial engineering, to

behavioral engineering at its core the glory ofmodern civilization is really the worship ofengineering.

Unfortunately, when it comes to trading,engineering fails miserably. The irony of tradingis that it is a discipline that relies on the mostmodern of technologies yet contains all of thechaos, uncertainty and superstition of the

ancient world. As I sit at my desk surrounded by

six screens, multiple computers and instantmedia feeds from around the globe, I stillcannot with any degree of certainty know ifmy trade will turn out to be profitable. Thatswhy the engineering or to put in tradingterms the algorithmic approach has nevermade money in the long run. Look at themost successful hedge funds over the pasttwenty years and they are all discretionary innature. Soros, Jones, Steve Cohen all

managers that have never relied on any roboticmodel to make their trading decisions. The onlyexception to that rule is Jim Simmons

Renaissance fund, but the public version of thatfund which claims to use the same algorithmictechniques has performed so poorly that itmakes me believe that for all of his hundreds ofPhds sequestered in Long Island, Simmons isdoing something less than scientific to garner hisreturns.

At its core trading is always more art thanscience. Furthermore, the unpredictable natureof the game quickly turns the most modern ofmen into the most superstitious of our ancestors.When we feel we cannot control the future wequickly seek psychological crutches.

I for example developed a maddening new beliefthat our trades will not hit our target if I amstaring at the screen. Therefore, when priceaction comes within several pips of the target Ileave the computer, go for walk, go get a cup ofcoffee, go work out anything but watch theprice action. Ive dubbed this my pipdance .While I completely understand the absurdity ofmy actions, I refuse to change them, which Iactually think is ok. Surrounded by all thistechnology we are fooled by the illusion andarrogance of control. Having some superstitions

in our life infuses us with some humility servesas reminder of the volatile and primitive forcesthat truly rule this game.


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What Business Are We In?

What business do you think AMC Cinema isin? How about Cinemark or Regencyentertainment? If you said the moviebusiness you would be dead wrong. All thecinema chains in the United States, and forthat matter the world over, are actually in thefood business. Movies are a very low profitbusiness for most cinema houses. In US,they have to pay out 70% of the first weeksgross to the distributor. That share ratiobecomes more equitable the longer themovies stay in distribution. But since only afew films have the staying power to play

more than two weeks, the movie revenues arebasically a scratch for movie theaters. Movietheaters make most of their money on popcornand soda which run 90% profit margins.

So given the fact that theater owners are reallyin the food business you would think that theywould do a better job of servicing the customer.You would think that instead of hiring lazy andglassy eyed high school kids to man the counterand to process orders at the pace of a postaloffice clerk they would invest in self vendingmachines that would cut the line times in half

and offer a variety of cool products likecustomized sodas and gourmet popcorn. Thetechnology is there, but movie houses still thinkthey are in the movie business and thats whymost of them suck.

The mistake of misunderstanding your businessis a common one and certainly not limited to thehapless movie house sector. In the 1930s and1940s US train companies thought they were inthe train business rather than the transportationbusiness and were promptly destroyed by carsand airplanes. In Contrast, high speed rail inboth Europe and Asia connects major cities in

comfort and style. Ever taken an Amtrak trainthrough the US Northeast corridor? It makes a 7hour traffic jam on I-95 feel like a pleasurableexperience.

So why am I suddenly so concerned with thequestion of understanding what business we arein? Because when it comes to trading most of us(and I put myself at the head of this list) think

that we are in the prediction business. Most ofus think we are in the being right business.We are not. In trading we are in the makingmoney business and making money comesfrom properly reading the mind of the market.So our opinion doesnt matter. Only theopinion of the market matters. There are onlytwo reasons for why we lose money in ourtrades.

1. We are dead wrong in our analysis ofmarket opinion.

2. We are early.

In both cases we are losing money which meansthat we are not practicing our business properlyand we must cut our losses and look for a newidea or a better time to enter the trade. Once weclarify the question of what business we are in,the question of being right becomes a lot lessrelevant and we can hopefully learn to trademore effectively.


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Do You Want to Stay Angry, or DoYou Want to Win?

On my flight to Dubai I lost my Blackberry on theplane. While there I managed to blow out thetransformer to my laptop. When I came back, the

super in my apartment building forgot to plasterthe walls of my bedroom, so I had to endure thesmell of paint (something I despise) for severaldays.

Despite all of these annoyances I never gotangry. This is after all just the normal ebb andflow of life and mishaps happen all the time. Yethow many of us bring the same laissez-faireattitude to our trading? I certainly did not. Manysmashed computer screens and keyboards havebeen victims of my wrath when my trades did notgo as planned.

Its taken me a long time, but I have finallyunderstood that anger is the single greatestenemy of successful trading. There will be timeswhen you hit the buy button when you meant tohit sell. There will be times when you walk awayfrom the screen for 2 minutes only to come backand see that the trade went to within 1 pip ofyour target only to trade back below your entry.Or you will watch as the trade quickly dips toyour stop, takes you out and then rall ies in yourdirection while you are left with nothing butlosses. You will have your platform go down justat the moment when critical news createsmassive opportunity for profit and you will sitthere trying to login in vain. Or, as just happenedtoday, Reuters will make a mistake in its newsrelease causing prices to plummet and then justas quickly reverse wreaking havoc with yourpositions.

All of this will happen to anyone who tradesactively and more importantly it will continue to

happen for as long as you trade. This is after alljust the normal ebb and flow of life and mishapshappen all the time. Yet if we get angry, if we rail

at the unfairness of it all, if we throw a tempertantrum like a two year old toddler we risk losingsomething much more than money. We risklosing control.

Once you lose control as a trader, you loseeverything. The money is just an afterthought.As sure as day follows night, if you lose controlthe equity in your account will be gone as youbegin the wild orgy of revenge trading trying toshow the market who is boss. Meanwhile, themarket will simply stand there like a bemusedblack belt champion and methodically strip you

of all your money as you make one desperatetrade after another.

Dont get me wrong. I am not a robot. I still getupset anytime a trade moves against me, andyou can even argue that my heart bleeds withevery negative pip. But over the years I havelearned that getting angry is a waste of my time.The market couldnt care less. The market is likea referee at a soccer match it will neverchange its mind. So the only question you needto ask yourself is, Do I want to stay angry, or doI want to win?

Think about that the next time you are temptedto punch your flat screen monitor.


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Why Trade?Unlike my partner I am no foodie. I am not onthe first name basis with Harold from Perilla, Idont know the coolestnew bistro in town and Inever consult Yelp for mydinner selections. Andalthough I like a fine mealonce in a while and cancook a few Italian disheswith the skill of a pro, Iwould much rather enjoythe warm comfort of agrilled cheese sandwichand fries than some tiny slice of lamb drenchedin a puddle of raspberry reduction.

I do however love Anthony Bourdains NoReservations show on the Travel channel. In factI have every episode he ever made saved intomy ITunes library on my computer and I oftenwatch them over and over. Not only do I likeBourdains snarky attitude, his wonderful ear forthe English language and the shows awardwinning cinematography, but I also appreciatethe mad obsessive-compulsive characters thatpopulate the show.

People who cook food almost universally do itfor passion rather than money. To achieve the

perfect pizza dough, the perfect steak, theperfect risotto you never think about profitmargins, efficiency protocols or labor savings.You think about ingredients, presentation,texture and taste. To be a great chef is to seekbut never quite attain perfection and therefore topractice the Greek ideal for living a trulysatisfying life.

To watch the guests on No Reservations is tomarvel at how completely absorbed and contentthey are in their profession despite its clearphysical and emotional challenges. No cubicleennui here. No middle management angst.People in the restaurant business are happy inthe deepest sense of the word because theyhave passion and purpose.

Surprisingly enough many traders share thesame attributes. After all trading is anunbelievably frustrating and emotionally drainingtask that requires constant concentration andenormous will power to succeed. No matter how

much you plan, no matter how well you analyze,no matter how well you time your entry, markets

can trip you up and stop youout at any given moment.Yet most of us arecompletely obsessed andpassionate about taming thebeast. Although trading isostensibly about makingmoney, what actually drivestraders everyday is theintellectual challenge offiguring out what comes

next. The art of a well executed trade is aspleasing as the profits it brings.

Whether theyve had a winning or a losing weekIve never once heard a trader moan, Oh no! ItsMonday, I dont want to go to work! In fact formost hardcore traders the weekend is anuisance that stands between them and themarkets. Jack Schwager, in his seminal bookMarket Wizards, talks about the golden days ofpit based trading and notes that most of theChicago traders he interviewed could not wait forMonday to start. How many other professionsinspire such intensity?

Very few.

Which is why just like true restaurateurs, tradersnever have any reservations about their chosencraft despite its relentless challenges.


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14

Trading Strategy

The Arrogance of Counter TrendPage 15

All Strategies SuckPage 16

Day Trade like Warren Buffet

Page 17

The False Glory of Demo BillionsPage 18

Price Lies All the TimePage 19

Trading is GamblingPage 20

My Best Trading Advice to YouPage 21

Why Leverage is a DrugPage 22

The Key to Every Winning ModelPage 23

Why Chasing Price WorksPage 24

The Round Number TradePage 25

Surviving IS WinningPage 26

An Edge is Not a WinPage 27

3 Simple Qs For Your NexxtTrade

Page 28

The Great Advantage of RetailTrade

Page 29

The Long Term is RandomPage 30

Four Ways to Beat the MarketPage 31

Be a Coward like Patton andMacArthur

Page 32

Trade like the HousePage 33


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15

The Arrogance of Counter Trend

By all accounts Steve Jobs was a horrid human

being. He abandoned his out of wedlock child.He browbeat his employees and cast them asideafter years of loyalty. He told his just pregnantgirlfriend that he preferred his former girlfriendand spent months thereafter asking friendswhich one they thought was prettier. He evenparked in handicapped spaces because he hadno patience to look for an open spot.

The portrait of Steve Jobs the person isdiametrically opposite to that of Steve Jobs thebusinessman. As a businessman Steve Jobsremains lionized. He is seen as a great innovatorwho radically simplified the computerexperience. Yet the very same skills thatpropelled him to the top of the business worldmay have also been responsible for his death.

By now we have all read the story of how hedelayed cancer surgery for 9 months relyinginstead on diets and visualization exercisesinstead of medicine. In his greatest moment ofneed Steve Jobs turned to the power of magicalthinking and wish fulfillment acting like a shamanin some primitive tribe in the Amazon rather thanthe CEO of the most technologically advancedcompany in the world. Steve Jobs has always

succeeded by challenging conventional wisdom,but sometimes conventional wisdom is deadright and his last attempt at bucking the trendkilled him.

I was thinking about Steve Jobs a lot this week,as well as about John Paulson - another guy thathas been deified in the press for having calledthe housing bubble, only to lose more than 45%

of investors money this year - a track record that

the most amateurish of FX traders would have ahard time making worse. These two guys madeall of their money by essentially trading countertrend. (Making computers more expensive, wheneveryone was slashing prices, shorting CDOswhen everyone was long, etc.) Counter trendcan certainly be an incredibly profitableapproach in both business and markets.However, the danger of counter trend is that youget arrogant. After beating the system so manytimes you begin to feel invincible and you losethe humility to appreciate your mistakes.Sometimes that results in losing money andsometimes it results in death.

Ive often remarked that for all the talk of trendtrading very few retail traders actually pursue thestrategy - which ironically enough is why mosttraders fail. Trend trading represents the veryheart of conventional thinking and for most of us(myself front and center) is an anathema to theway we view ourselves. All of us like to beviewed as creative and original, but the truth ofthe matter is that often the most original move inthe markets is to follow the crowd.

Anti-trend trading teaches you arrogance, whiletrend trading teaches you humility. You tell mewhich one works better in the long run.


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16

All Strategies Suck

What do traders love most? Strategies,strategies, strategies. Just one great idea, onewell-functioning algo and we are in heaven. Wealways think that strategies are the path to tradernirvana. But lets admit it - all strategies suck. Infact there are really only three types of tradingstrategies in existence.

1. Breakout strategies which are based onprice momentum and velocity anddepend on continuation for theirsuccess.

2. Mean reversion strategies which arebased on fundamental value ortemporary extremes in price conditionsand depend on price reversal for theirsuccess.

3. And finally what I call cheating strategiesthat depend on technical, regulatory, orcapital arbitrage opportunities that takeadvantage of certain market peculiarities

available only to a few privilegedplayers.

Once you understand this fact you realize thatno strategy is bullet proof. Momo strategies failmiserably in choppy markets. Mean reversionstrategies get decimated in strongly trendingenvironments, and cheating strategieseventually become obsolete as more and moreplayers attempt to exploit the particularloopholes in the market.

Dont get me wrong. Strategies are veryimportant. They provide the framework foreverything you do. But the longer I trade themore I realize that it is not the specific strategiesthat matter but the general rules of trade youemploy every day.

What leverage do you use? Do you double down on your positions? Do you ignore your own setup rules in

the heat of the battle?

Do you pull your stops when the markettrades against you?

These are much more important questions toconsider than whether to use a simple or anexponential moving average when evaluating atrade. All strategies suck and all strategies aregreat depending on the market environment.

What distinguishes success from failure is muchmore a function of your own behavior rather thanthe clever little algo you just created.


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17

Day Trade like Warren Buffet

Warren Buffet once said that "In the short run,the market is a voting machine. In the long run,it's a weighing machine." What he meant is thatultimately, in the financial markets just as in reallife, action talks and baloneywalks. No matter how ridiculous,how illogical, how utterly insaneprices become, they alwayscorrect to their intrinsic value.Witness the Nikkei in 1980s,Internet stocks in the 1990s, UShousing market in 2000s.

Mr. Buffets maxim holds true forinvestors, but it can be a coldcomfort for speculators like us whotrade the most fickle market in theworld. Ostensibly, the currencymarket exists for corporations tohedge their foreign exchange exposure, but fully97% of the volume (last measured at $4 Trillionper day) is driven by speculators such as banks,hedge funds and retail trade. The dirty littlesecret of FX is that everyone speculates - eventhe corporates and the central banks.

The history of the market is littered with tragicstories of Fortune 1000 corporations whoseTreasury departments lost millions andsometimes even billions of their shareholderscapital in badly managed FX trades that hadnothing to do with the core business of thecompany. Even Mr. Buffet dropped a cool billionat the start of this century when his bet on thecollapse of the dollar turned out to be woefullywrong.

So how do you think about value in a marketwhere sentiment reigns supreme? After allequities at least had some semblance of net

worth because they represent hard assets of thecorporations that issue them. Currencies on theother hand are a completely abstract conceptbacked only by the full faith and credit of thesovereign entities. Money is just a blur ofelectronic bits on a computer screen.

Therefore as speculators we must operatedifferently. In order for us to heed Mr. Buffets

advice we must make sure that the market isoperating as both a voting anda weighingmachine at the same time. What that means inplain English is that in order to succeed we must

make sure thatfundamentals and priceaction are in alignment.Those of you who followme on Twitter (@fxflow)know that my ideal flowtrades are always drivenby a combination of pricemomentum off some

fundamental trigger. Intrading flow, it is notenough to be on the rightside of the news - priceaction must confirm youranalysis. Only then do you

have a high probability trade.

The longer I trade flow, the more I am convincedof the efficacy of this approach. Whenever Ideviate from my method, by trying to fight eitherthe price action or the news flow, I inevitablylose. Mr. Buffet is right. The market is both a

voting and a weighing machine and it is our dutyas traders to make sure they align beforeentering the fray.


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18

The False Glory of Demo Billions

Conventional advice in the currency marketstates that as a novice you should only trade ademo account until you become comfortablewith the whole trading process. I couldntdisagree more. First of all you will never getcomfortable with the process. A trading life, toparaphrase Thomas Hobbes, is nasty, brutishand short. Markets are never predictable andeven lifelong veterans of speculation areconstantly challenged by the game. The bestway to learn how to trade is to just dive right inand practice over and over and over again- justlike with every other endeavor in life

The demo account is useful only for a fewdistinct tasks.

Learn how to place a trade. Learn how to attach a stop and a limit

order. Learn how to configure charts and news. Learn how to read the trade settlement

report.Thats it. Once you are familiar with themechanics of the platform there is no more needfor a demo.

Many trading coaches argue that by using ademo you can test out a variety of strategieswithout risking capital, but that is bogus advice.The very essence of trading is not to become

adroit at a single strategy whose value willdissipate over time but to master the art of takingon risk the very thing that demo accountsavoid. Thats the reason so many demo traderscan run $50,000 demo dollars to $1 million butfail miserably when they start trading $5,000dollars of real money.

As a demo trader here is what you will neverexperience. Youll never experience the dealerslowing down the order entry platform at time ofmaximum volatility just when you need to enteror exit the market the most. Youll neverexperience spreads suddenly widening just asyour take profit target is about to be hit. Youllnever experience a platform outage, or the veryuncomfortable deer in the headlights feelingthat comes from selling a currency pair whenyou meant to buy it. In short, trading a demo hasnothing to do with real life trading. Its thedifferences between practicing basketball freethrows in a quiet gym versus trying to sink agame winning basket as thousands of rabid fans

scream at the top of their lungs and sway backand forth trying to make you miss.

Start with small account, trade mini lots andlearn the trading game with real money. There isno glory in being a demo billionaire.


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19

Price Lies All the Time

At the FX expo in Las Vegas, I found myself inthe unusual position of being in the audiencerather than on stage as my friend Todd Gordonhosted a panel on the joys and tribulations of FXtrading. Instead of pontificating as always, Ilistened for change and walked away with somegreat insights into the game.

Although the event was sponsored by a broker,the majority of the panelists were not associatedwith any broker dealer firm and as a result thecrowd received an unvarnished and quiterealistic view of the business. No one on thepanel claimed that you could trade your way to asix figure income with ease or promised thatthey could show you a way to print money. Infact everyone was quite sober and realisticabout the actual returns that you could achievefrom trading. The consensus view was that 15%-20% per year was the best you could do if youbecame especially proficient at the game. Thiswas hardly the turn-ten-thousand-dollars-into-a-million pitch that many had expected to hear, but

I think most in the audience appreciated thecandor of the message.

The most interesting story however was told byDerek Frey who is a frequent contributor to FXStreet. Once every few months Derek createswhat he calls his lottery account. He funds afive thousand dollar account that he trades veryaggressively. This is capital that he is perfectly

willing to lose, but nevertheless he tries to makeevery effort to stick to a particular strategy. A fewmonths ago Derek opened a new account andimmediately proceeded to hit the worst tradingstreak of his life. He made 11 losing trades in arow and saw the account decline to 1800 dollars.

Difficult as it was for him to maintain hisdiscipline in the face of such negative results hecontinued to take signals from his strategy andas markets improved he was able not only torecover his losses but trade the account tonearly ten thousand dollars by the time he cameto the expo.

Dereks experience is a great reminder to all ofus that in order to achieve long term success weneed to trust the process not the price. Price canbe very capricious and as sure as day followsnight the only certainty of the markets is that youwill eventually hit a nasty drawdown that willtempt you to abandon your set up. Those pointsof abject bleakness separate winning traders

from losing ones. The losers quit, but thewinners persist and when markets become moreamenable to their strategy, their accountrecovers. This is perhaps the most valuabletrading lesson of all and thanks to Derek forsharing it with all of us in Vegas.


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20

Trading is Gambling

One of the greatest comedic bits ever written isa piece by George Carlin in which he takes onthe hypocrisy of the English language, especiallyas it relates to war. Carlin notes that in WorldWar I the words for the stress of combat wereShell Shock. In WWII the term was changed toBattle Fatigue, in the Korean War it becameOperational Exhaustion until finally in Vietnamit was reduced to the clinically sounding PostTraumatic Stress Disorder.

Still eight syllables, notes Carlin, but we'veadded a hyphen! And the pain is completelyburied under jargon. Post-Traumatic StressDisorder. I'll bet you if we would have been stillcalling it Shell Shock, some of those Vietnamveterans might have gotten the attention theyneeded at the time. I'll betcha. I'll betcha."

When it comes to finance we have oureuphemisms to hide exactly what we do. My

favorite is risk taking. That sounds admirableand progressive but in fact I think it is high timewe called trading for what it really is - gambling.Every time we trade we play a game of chancewhich is in fact a form of gambling.

Contrary to popular belief, gambling is not apejorative term in my opinion. You can of coursebet blindly with no rhyme or reason in whichcase you are indeed the prototypical losergambler - a sucker in Vegas parlance. But youcan also approach the business as aprofessional. Professional gamblers differ from

amateurs in two distinct ways - they have a verygood idea of the odds facing them each timethey bet and they do not get emotional whenthey are beaten.

Aside from winning one dollar from a slotmachine at the Barbary Coast casino I havenever gambled in my life. I have no confidencein my ability to read people or count cards and Ifind the whole process relatively boring. I would

much rather try to handicap market psychologyas it relates to economic and geo-politicalevents. Nevertheless, I am more than will ing toadopt the best practices of successful gamblersto my own trading routine.

Once you have a viable trading strategy -especially one with fixed targets and stops it isreally no different from a game of blackjack.Every trade is just a bet. Just as in 21,sometimes you will get a very nasty run of cardseven when the odds are in your favor. In poker,thats known as a bad beat and it is an everpresent fact of life.

Professional gamblers just like professionaltraders constantly experience draw-downs, butthey rarely complain about the market. Theyaccept the game as it is. If we choose to viewtrading from the prism of a professional gamblerwe will undoubtedly assume a much healthier

and more accurate attitude towards trading andhopefully improve our performance in theprocess.


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21

My Best Trading Advice to You

I would like to share with you some tricks of thetrade that can help you minimize the stress ofday to day trading and hopefully keep you calm,focused, and on plan.

Open Two SeparateTrading Accounts.

Lets face it. Most of uswill never stick to ourtrading plan. Moreoverthere is no good reason

for why we should.Experimentation iscritical to creativity andcreativity is absolutelyvital to survival in themarkets. Marketsconstantly change andthe only way we candiscern those changesis by interacting withprice action in new and hopefully profitableways. The critical mistake that most of us makeis that we often commingle our experimental

trading with our core setup trading in oneaccount. The net result is that losses from ourexperimental trading almost always lead us toabandon the discipline of our core setup.

I used to believe that having two accounts at thesame broker would help you solve that problem,but I no longer think that this is a good idea. Itstoo easy to transfer money to and from twoadjoining accounts at the same broker and youbasically wind up sending good money after bad.Instead, it is much better to open accounts attwo separate brokers.

For your junk account you should choose abroker with lowest possible spreads andsmallest possible size executable, so that you

can experiment trading lots as little as 1000units. This is effectively your play account andyou should open it first thing each day to satisfyyour urge to trade and participate in the market.

Your serious accountshould be held at a brokerwho has the best possibleexecution rather narrowestpossible spreads.Ask yourself thesequestions.

Does my broker

widen spreads inordinatelyduring newsannouncements, making itimpossible to enter themarket at reasonable cost?

Does my brokerfrequently reject limit entriesduring periods of volatility?

Does my brokeroften lag its price feed

behind the market?If the answer is yes to any of those questions,then that brokerage is not the place for your

serious account. Yourserious account shouldbe traded only at a reputable broker with gooddealing capabilities and top notch customersupport.

Once you have set up this structure you mustmake a solemn promise to yourself that you willnever, ever, ever ever, ever, ever trade anythingbut your prescribed setup in your seriousaccount. Irrespective of whether you are losingor winning you cannot pollute your setup tradeswith experimental trades. Thats what the junkaccount is for. Having separation of purpose willhopefully create peace of mind and allow you toadhere to your trading plan with 100%consistency.


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22

Why Leverage is a Drug

Drug dealers often use an insidious strategy toobtain new customers. They provide freesamples of their wares to children in the form ofa lollipop or candy bar. A few licks of the sweetdrug and the kids are hooked, frequently for life.Speculative markets can operate much in thesame manner except in finance the drug of

choice is leverage.

How many times do we see advertisements onthe web enticing traders with ridiculous leverageoffers of 100:1, 200:1, 300:1 even 500:1? Thelure is incredibly tempting - turn $1000 into$100,000 within weeks! Take $10,000 and ride itto a million! Just like a drug high, leverage highpromises you perpetual bliss but delivers mostlyagony and pain. The truth of the matter is that inhighly levered speculative markets it is far morecommon to see $100,000 accounts shrivel downto $1000 rather than the other way around.

Leverage, just like narcotics, takes control out ofyour hands. The more leverage you use themore vulnerable you become. How many timeshave you been taken out of a trade thateventually recovered simply because you wereover-leveraged? The margin call is the marketssecret weapon. It is the easiest way for themarket to take away your money because it

forces you to liquidate your position at the worstpossible time, often at the absolute bottom if youare long or absolute top if you are short.

My trading improved astronomically when Idrastically reduced my leverage. At present mymaximumleverage is 5:1. Most FX traders may

consider that laughably small, yet I am tradingmore than ever and enjoying the smallestdrawdowns of my career.

Reduced leverage is not the reason I am killing itin the market. My flow analysis has simply beenmuch sharper and more on target. However, thefact that my analytics have been better thismonth has everything to do with my lowleverage. By trading small I naturally execute myplan, taking stops quickly instead of letting losersrun. Small stops are psychologically easier toaccept and also a lot easier to recoup. Bytrading on relatively small leverage I tend totrade much more professionally, managing myrisk without emotion since I am not vulnerable toa highly levered loss.

Just like a junkie who has kicked his habit andenjoys clean living, I have weaned myself offleverage. The net result is that both my mindand my trading account are much better off.


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23

The Key to Every Winning Model

When I spent the summer of my junior year incollege at Sorbonne, I used to play a game inthe streets of Paris whenever I was bored. Idlook out at the swarming crowds at Champs-Elyses or Rive Gauche and see how quickly Icould spot a fellow American. I became so goodthat it often took me less than half a second toidentify my target. I did not even need to see theflash of the white athletic socks, or theunmistakable combination of shorts and golfshirts to know I was dead on. I could spot myfellow citizens just by their gait.

American men walk like upright gorillas. Ourshoulders slightly hunched forward, our feetpounding the pavement with the force of anelephant. Unschooled in the balletic grace ofsoccer, Americans do not glide through space,they barrel through it like the linebackers andrunning backs that so many of us were in highschool.

In Paris I was practicing the simple art of patternrecognition. I became so adept at it that I wouldoften amuse my French friends winning a fewfrancs in the process.

Pattern recognition is a fundamental human traitand is at heart of every trading model that hasever been designed. The underlying assumptionof every trading setup be it a simple movingaverage crossover or a complex multi-variablealgorithm is that prices move in patterns andthose patterns repeat themselves with enoughfrequency to give the trader an edge. If priceaction was truly random, no one could extractany profit out of the market over a sustainableperiod of time. There has never been a rouletteplayer that has won thirty years in a row, yet we

know plenty of hedge fund managers that havemade billions of dollars over the past severaldecades by speculating in financial markets.Whether these traders formally acknowledge itor not all of their activity is based on some sortof pattern that they continue to exploit.

Patterns however are not enough to succeed intrading. Exploitation of patterns is only effective

when trades are executed within a propercontext. To appreciate the value of context,consider the following story. A few years backWashington Post wanted to see what wouldhappen if they put Joshua Bell, a world famousviolin virtuoso, into a metro station to play forspare change during the morning rush hour. Mr.Bell held nothing back that morning andperformed with the same skill and passion thathe brought to his many recitals across the world.For most of his performance Mr. Bell wasroundly ignored by the busy commuters rushing

to work. Mind you, this was the same performerwho later on that night would be paid thousandsof dollars for his sold-out concert with theNational Symphony. His gross earnings from thegig in the metro? Thirty two dollars andseventeen cents. Context IS everything.

The experiment with Mr. Bell answers a verycommon question that many traders pose. Ifyour model is so good, how come I always losemoney when I use it? The truth of the matter isthat almost all trading models fail when usedindiscriminately. For example I find that mostsuccessful equity traders that employmomentum models trade only the opening andclosing hours of the day when liquidity is highest.This makes perfect sense because of the law oflarge numbers. Momentum works best whencrowd behavior is monolithic. Crowds tend tobehave with much greater homogeneity thelarger their size. Human beings are socialanimals and they will tend to mimic each otherwith greater intensity as people join in. Just try towalk slowly next time you are caught in a crowdrushing into a pre-Christmas sale at Toys R Us(or worse yet remain calm during a sample salefor women designer shoes at some tony

showroom in New York).

Patterns and context are the key factors of everywinning model ever traded. Of course neither iseasy to discern which is what makes tradingsuch a challenge.


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24

Why Chasing Price Works

When I had a chance to meet Jack Schwagerseveral years ago, I told him that I read MarketWizards more than 25 times over my life.Schwager was clearly impressed at mydedication to his tome, but the truth of the matteris that I have never been able to put the ideas ofMW to much use in my own trading.

Until now.

I hadnt read Wizards in more than five years,

but over the Christmas vacation a vaguerecollection of a quote from Larry Hite poppedinto my head and took my scalping to a wholenew level. Larry Hite is one of the legendarytraders profiled by Schwager who generated30% annual returns for 13 years running beforeretiring in 1993. This is what he said, When amarket makes a historic high, it is telling yousomething. No matter how many people tell youwhy the market shouldnt be that high, or whynothing has changed, the mere fact that theprice is at a new high tells you something haschanged.

As I scanned hundreds of intra-day charts overmy vacation I realized that Larrys observationwas just as applicable on a short term basis as itwas on a longer term time frame. Granted, thesession breakouts that I looked at often hadminuscule follow through, and you had to beextremely disciplined in both your entries andexits in order to take proper advantage of theprice action, but the underlying idea remained

valid. New highs and new lows ARE telling ussomething even if on occasion we do not want tohear it.

How many times have we seen a currency pairtrade opposite to the just released fundamentalnews often taking out the days highs or lowsand continuing on its merry way? On thoseoccasions something else is going on in themarket that we may not necessarily understandbut must respect. Often the true story surfaces

several hours later, but by that time the bulk ofthe move is done

One of the greatest ironies of trading is that ashuman beings we are naturally averse tochasing tops or bottoms when in reality theyprovide us with some of the highest probabilityentries in the game. My intraday scalpingimproved immeasurably ever since I took LarryHites observation to heart and I can finally saythat after 25 readings of Market Wizards I finallylearned something valuable.


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25

The Round Number Trade

Those of you who have followed my writings andvideos for a while know that I am obsessed withthe round number trade. The round numbertrade postulates that all conditions being equaltrades in the currency market will run stopstowards the round number figure such as the

1.3700, 1.3800, 1.3900 in EUR/USD or the85.00, 84.00, 83.00 handle in USD/JPY. Ofcourse all conditions are rarely equal so the 00setup can be a lot more difficult than it initiallyappears. However an interesting confirmation ofthis phenomenon of human behavior comessurprisingly enough from baseball, courtesy ofthe Big Picture blog from Barry Ritholtz.

Baseball, for most non-Americans is anunbelievably boring spectator sport where 90%of the time most players appear stand aroundand do nothing more than scratch themselves. Infact I would venture to say that baseball is asboring a spectator sport most non-Americans(Japanese are the big exception) as soccer(football) is to most Americans. Fortunately I wasborn in Europe, but raised in America so I havean appreciation for both games. I will try toexplain to our non-American subscribers thegoal of baseball which is nothing more thanhitting a very hard leather ball with a wooden bat(stick). This act is so hard to accomplish thatthose athletes who are able to connect just 3 outof 10 times are considered superstars of thesport and are known as the .300 hitters.

Here is where round number issue takes aninteresting turn. Above all baseball is a sport ofstatistics. I could make a legitimate argumentthat baseball generates as many statisticsamongst its rabid fans as the US economy itself.

According to the latest statistical study, thoseplayers who come into the final day of theseason sporting a batting average within 3 basispoints (.003) of the .300 mark are inordinatelymotivated to get a hit and will do so at a rate fargreater than mere chance could explain.

Here is the clip from Barrys blog that describesthe dynamic in detail.

Two economists at the Wharton School of theUniversity of Pennsylvania, while investigatinghow round numbers influence goals, examinedthe behavior of major league hitters from 1975 to2008 who entered what became their final plateappearance of the season with a batting averageof .299 or .300 (in at least 200 at-bats).They found that the 127 hitters at .299 or .300batted a whopping .463 in that final at-bat,demonstrating a motivation to succeed wellbeyond normal (and in what was usually anotherwise meaningless game).

What does this mean to us as traders? It meansthat round numbers are special. In the 1970sand early 1980s the Dow Jones IndustrialAverage approached the 1000 barrier 17 timesbefore it finally broke through for good, but whenit did it ushered in a two decade long bull runthat went through 10,000 and beyond. In the FXmarket we see the pull of the round numberseveryday. This weeks run in the Euro to 1.4000and the consequent pullback from that level is a

dynamic that repeats itself over and over.Human beings are naturally attracted to theorder of round numbers and as traders weshould always be aware of that behavioralmarker to help us properly position our trades.


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26

Surviving IS Winning

When studying money managers, academicsalways note the presence of survivorship bias.Survivorship bias amongstmany other things is the ideathat if you flip a coin oftenenough any monkey cansucceed at this job. Basicallyin any given pool of applicantsa very small percentage canflip ten heads in a row andthus produce 10 consecutiveyears of good performancethrough sheer luck rather than

skill. Survivorship bias is areal problem when it comes to evaluating theperformance of investment managers and youshould be keenly aware of this dynamic whenyou evaluate their long term records.

However, when it comes to short term trading,survivorship bias plays a far less important roleas the law of large numbers quickly grinds downall the lucky participants into dust leaving onlythose who are truly skilled behind. Why? Simplyput it is much harder to generate 100 winningdays in a row than it is to generate 10 and

harder still to generate 1000. FX, which is ahighly levered market, is the ultimate Darwinianproving ground. Those few who survive to tradeit for more than several years with their originalstake in tact are truly skilled in my opinion.

In fact I would go so far as to say that survivingIS winning when it comes to short term trading.Amongst the hundreds of traders Iveinterviewed in my lifetime Ive never met anysuccessful trader who did not blow up his or hertrading account at least once and in most casesthree or four times before they finally mastered

the craft. In fact it was only after they learned topreserve their capital that most of those traders

started to succeed. Thats whyrisk control is so much moreimportant than any tradingstrategy you choose. WoodyAllen once said that 90% ofsuccess in life is just showingup. When it comes to tradingthe markets I couldnt agreemore. Hang out long enoughand you will eventuallydiscover a setup that you can

exploit, but only if you havecapital left to trade it.

The following rules are what I consider to be theinviolable principles of short term trading.

1. Always trade with a stop2. Never average down3. Stop trading for the day if you hit three

consecutive losers4. Dont take wildly asymmetrical risks (bet

50 to make 10)

Although simple, these rules are incrediblydifficult to follow. I have broken every one ofthem many, many times. In fact I can trace ALLof my failures in trading to disobeying these foursimple precepts rather to any inability on my partto analyze the market properly. I would bet thatfor many of you the same experience applies.Thats why our true control of the market willcome only when we learn to master ourselves.Thats the beauty of trading - unlike most otherprofessions we cannot hide our incompetenceso we must learn to accept responsibility in orderto succeed in the long run.


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27

An Edge is Not a Win

I can bankrupt you in five easytrades with a setup thats 95%accurate. Suppose I gave you atrading strategy that wins 95times out of a 100 with an even1:1 risk/reward ratio. Mosttraders would sacrifice anappendage for such an edge.But watch how quickly thingscan go wrong. If you trade with10:1 leverage and risk 2% on each trade (20%levered) 5 consecutive losers which are wellwithin the statistical realm of possibility will

wipe out your whole account.But statistics and leverage are not the onlyproblems we face as traders. The whole notionof an edge should be taken with a barrel of saltbecause trading is a social, rather than a hardscience and any conclusions that we draw fromour research into price behavior are thereforehighly suspect. Allow me to elaborate. One ofthe great advantages of hard sciences likephysics or chemistry is that we can replicatetheir experiments one million times in a row andachieve the same result.

When Galileo dropped two unequal balls fromthe Leaning Tower of Pisa and observed thatthey hit the ground at the same time, he wasable to refute 2000 years of Aristotelian logic.Furthermore, if each one of us chose to repeatthe experiment we would arrive at the sameresults over and over and over again. Thatsbecause in our universe, the laws of gravityremain constant allowing us to draw the propercause and effect conclusions that we canextrapolate to the world at large.

Lets move on to medicine where double blindtests on human subjects will often yield good but

hardly universally positive results. Why doesntmedicine work equally well on all of us?Because every human being is geneticallyunique (twins excluded) and the variations in ourpersonal biology and anatomy make itimpossible for scientists to keep all other

conditions constant andreplicate the experimentwith 100% accuracy. Whenwe perform a clinical trial,we can safely conclude thatthis particular drug hasbeen effective on theseparticular individuals and weassign someprobability(50%, 60%, 80%)

that it will be efficacious on the population as awhole. Generally, those conclusions areaccurate, but as anyone who finds himself

allergic to penicillin or immune to a particulartherapy knows, medical treatments are far fromuniformly effective.

Now lets take a look at trading which is inessence a social activity and can therefore bestudied as a behavioral science. Anyone with ateenage daughter at home can attest thatconsistency is not the hallmark of humanbehavior. In fact if we were to be honest withourselves our own behavior is hardly a bastionof stability. Very often we will react in polaropposite ways to the same set of stimuli

depending on our mood. The markets are ofcourse the same way. Thats why any strategiesbased on historical price patterns which are infact strategies based on human behavior shouldnot be trusted fully. Mark Twain once said thathistory does not repeat itself but it rhymes. Alas,the variations in those rhymes can turn a profitinto a loss. In a recent interview Jack Schwagernoted that irrespective of whether we arefundamentalists or technicians as traders we alltrade patterns. Ultimately thats all we can dogiven the nature of this game. However, nomatter how much we love our setups we shouldnever assume that they will last in perpetuity and

we should never forget that an edge is not a win.


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3 Simple Qs For Your Nexxt Trade

One of my favorite restaurants in South Beach isa place on Lincoln Road called Nexxt. There isnothing special about this restaurant. It is justanother meeting place for the Miami glitteratiwhere the well tanned and the well toned boysand girls come to see and be seen. Its menu iscomposed of utterly conventional American

bistro food. It does however, do one thing well.Every dish on its menu is perfectly made.

The salads are created with only the freshest,crispiest ripe vegetables. The steak is perfectlycharred and moist and tender. The rice is fluffybut not sticky and the sauces are neither toosweet nor too salty. Nexxt knows exactly what itis a simple American caf with every dishexecuted to perfection.

I often think about Nexxt when I am tradingbecause thats the standard I want to emulate. Ifyou are anything like me very few of your tradesare executed perfectly. A perfect trade is notnecessarily one that is a winner. Losing tradescan be perfect and winning trades can be anawful mess of conjecture and sheer dumb luck.A perfect trade is one that can answer threesimple questions.

1. Does this trade comply with mystrategy?

2. Am I in this trade at my proper entrypoint?

3. Will I hold this trade to the end of myplan?

Lets use my 00 setup as test of these questions.My setup is based on the idea of momentum. I

define momentum as an uninterrupted move ofmore than 50 points in one direction. Thepremise is that flow is more dominant than fadeand over many sample periods continuation willtriumph over retrace.

Do I always follow my rules? No. Like everyone

else I try to buy bottoms and sell tops. Answer toquestion number one not always.

My set up also has very rigorous entry points. Ienter on a limit order of a break of the 00 or 50level. Do I always do that? Again no.Sometimes, I chase price especially when I amnot paying attention, and the trade has alreadymoved past my entry criteria. Answer to questionnumber two not by a long shot.

My trade plan calls for very specific stop andlimit exits. Do I generally honor my stops? Yes.Years of ignoring that rule has taught me tonever pull the stop no matter how painful it is totake two, three or four losses in a row. But do Iexit early? You bet. The fear of losing my profitswill often push me out before my limit gets hitcutting my profits and skewing my risk/ rewardedge.

Answer to number three not even close.So, when you review your account this weekendask yourself with all honesty. How many perfecttrades have you made? If the answer is notmany then make a vow to make your next tradeas good as the meal at Nexxt.


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The Great Advantage of Retail Trade

A book that I am currentlyreading (The Quants, byScott Patterson) followsthe classic path of aGreek tragedy. Man full ofhubris (in this case due tohis intellectual prowess)believes he hasdiscovered the Truth.Drunk with arrogancefrom his ability to extractbillions upon billions ofprofits from the financial

markets he ignores the dangerous signs of thegreatest credit bubble in the history of mankindand winds up nearly destroying the globalfinancial system with his greed andmegalomania.

Its difficult to fathom that some of the smartestmathematical minds in the world could becomesubject to the basest human emotions of adegenerate gambler, but the protagonists of thisbook do indeed begin to behave exactly likeroulette junkies doubling down continuously untiltheir bankroll is nearly exhausted.

One of the key takeaways from the Quants isthat despite the multi-regression factor analysis,despite cupola functions and Gaussian curves,despite elegant algorithms that constantly playmean reversion between momentum and value financial markets are at their core not logical atall, but rather psychological. In times of fearhuman beings will be afraid to bid a penny for amultibillion dollar company and in times of greedthey will part with their last dollar on a stock thathas negative net worth.

Yet the true lesson that I learned from the book

is that size and leverage kill. The real reasonmost of these quant hedge funds got into somuch trouble is that the massive scale of theirpositions along with the very high lever factor upto 30:1 setting them up for a colossal failure.Like dinosaurs that ruled the earth they were

nearly wiped out from onecataclysmic event thecollapse of the US housingmarket.

In many ways theirpredicament made meappreciate my position as aretail trader. My exit strategyis not dependent onliquidation of thousands ofsecurities. One click of abutton and I can be in cash

within seconds. This is a much underappreciatedbenefit that many of us take for granted. Unlesswe are trading more than 50M notional value ofcurrency, our size will not impact the marketallowing us unimpeded entry and exit from ourtrade. Of course, platforms will go down, quoteswill freeze and brokers will be unable to executeour orders but those are permanent risks oftrading FX and a big reason for why you shouldhave several accounts. In the grander scheme ofthings however our ability to float like a butterfly,sting like a bee is a huge asset. In trading beingsmall and swift is a plus.

The other lesson from the Quants is the doubleedged danger of leverage. Basically anythingabove 10:1 is ultimately financial suicide.Leverage is a wonderful drug when the trademoves in your direction but it is pure poisonwhen the market is aligned against you. TheAchilles heel of all of the quants profiled in thebook wasnt their finely tuned analytics. It wastheir massive leverage that forced them to coughup their positions at the worst possible time.When Bob Pisani walks the floor of the NYSEscreaming that there is non-fundamental seller ina stock he is referring to margin liquidation a

time when your ability to choose is taken awayfrom you. The quants were the victims of thatvery dynamic and not even the mostsophisticated algos in the world could help themout of their predicament.


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The Long Term is Random

In the latest book I am reading (The Flaw ofAverages: Why We Underestimate Risk in theFace of Uncertainty by Sam Savage) the authorbriefly takes the reader on a trip back in time toWorld War II and the work done at PrincetonUniversity by a group of a mathematicians andstatisticians to help with the war effort.

In an almost throw away passage, Mr. Savagewrites, Ted Anderson currently an emeritusprofessor of statistics and economics at StanfordUniversity, was a research associate there. One

of their projects involved the evaluation of long-range weather forecasts. We found that therewas very little accuracy beyond two days, Tedrecalls.

I stared at this paragraph in the book for a longtime wondering why it resonated with me somuch and then I finally remembered a meeting Ihad with a Russian hedge fund a few years backthat had its offices in a very tony Fifth avenuebuilding and housed more computer power thanthe Pentagon. The Russians had done anenormous amount of research on price behavior

across almost all asset markets and concludedthat at any given point of time directionalitycompletely degraded within 72 hours from thestart of observation.

Essentially, market forecasts and weatherforecasts have something in common ourability to predict either beyond the next 48 hoursis no better than a guess. Thats the reason that

whenever I am on Squawk and the hosts try toget me to forecast the value of the dollar in thenext twelve months I squirm in my seat andprotest that I am only good for the next day ortwo.

Chaotic systems such as markets and weatherpatterns are notoriously volatile and projectingtheir direction far out in time can be exercise infutility. But does that mean that all long terminvesting is not possible? Not necessarily.Warren Buffet is a testament to the fact that the

turtle can sometimes decimate the hare in therace to generate alpha. The key with the longterm view is that investors must expand theirmargin of error. Portfolio managers who tradestocks will rarely allocate more than 2% of theirequity to one idea - this way even a 50% declinein price of the security only results in a 1% lossto their overall holdings.

Contrast that approach with what we do in FXwhere we regularly trade at 10 times leverage.Under those conditions an adverse move of just1% in our position results in a 10% haircut to our

account. Both ways are perfectly legitimateforms of investing as long as we acknowledgewhat we are doing upfront. Too often short termtraders become investors as price movesagainst them. If you are trading for the shortterm and you are holding the position for morethan 72 hours you may as well buy a lotteryticket. Your chance of success will probably bebetter.


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Four Ways to Beat the MarketCan you beat the market? Many academics willtell you no. The markets are just too efficient inthe long run. Those who appear to be winningare simply lucky fools who will get theircomeuppance eventually. Are the efficient theoryproponents right? I really dont know. Certainlythe challenges are daunting. In any given yearonly 10-20% of all market participants manageto beat the averages. Still, regardless of whetherthe professors are correct, traders will continueto trade for the very same reason that climberscontinue to climb Mount Everest the humanspirit will always try to master a challenge.

So if you are going to try to play the game here

are my rules that I call the Tao of Trading.

1. Have an edge.There are only two types of edges available tomost traders in the market informational andbehavioral. (For now lets forget all aboutexecution edge because most retail traders willnever have it) Informational edge is simply whatwe call fundamental analysis and most retailtraders ignore it at their own risk. Fundamentalsare the primary drivers of price action. To tradewithout knowledge of fundamentals is like drivingblindfolded by feeling the curves of the road.

Chances of a crash are almost assured. Thesecond edge is behavioral which is simplyanother way of saying know your technicals.Technical analysis despite its fancy geometryand mathematical indicators is nothing morethan an attempt to handicap human behavior. Ibelieve that technicals work better on ultra shortterm time frames when price action is notsubject to ever changing news flow, but thats amatter for debate. Whats incontrovertible is thattechs are an important compliment tofundamentals. At BK we always trade inalignment with both and that approach providesus with our edge.

Recognize that ALL edges will disappear overtime as more and more traders attempt to exploitthem. That why the search for edge is a neverending process.

2. Dont be greedy

I know that the standard trading advice is: makeyour winners bigger than your losers, but I havenever had success with that approach. Marketsare generally not that generous. The standardrefrain is that you need to be correct 50% of thetime on a 2-1 reward/risk trade to make moneyin the long run, but in my experience the marketproduces strict 2 to 1 payoffs only 30% of thetime making that strategy a loser. Floating profitsare just that - floating. They can hit an iceberganytime. Thats why Ive never found a betterway to manage risk than to take partial profitsearly and try to ride the rest to glory. When itcomes to trading a bird in the hand IS worth twoin the bush

3. Be HumbleIt is incredibly seductive to pound your chestwhen you are winning and proclaim you are theGreaaatest, but Mr. Market will bitch slap youmercilessly just when you think you have it allfigure out. K and I are blazing hot right now, butwe spend most of our time ruthlessly challengingeach others assumptions and come up withmany more reasons to rule OUT trades ratherthan to rule them IN. Having done this for a longtime we are the biggest skeptics of our ownhype. We know just how tough this game really

is. This brings me to my final point.

4. Trade One Pip at a TimeThe best way to make a millions in trading is tonever try. Novice traders always approachtrading with a hidden desire of hitting it big. Themarketing literature of our business is litteredwith take $10,000 to $1 Million in Just one yearpitches. Thats not trading thats the lottery.The real business, as many of you who havebeen with us for several years know, isremarkably prosaic. Two steps forward, one stepback. Every basis point of return is a coldcalculated battle with the market. In the endwealth, like all things in life, is built one brick at atime. Perhaps the reason why so few peoplemake money from trading is because mostsimply dont have the patience or the equanimityto withstand Mr. Markets inevitable blows. But ifyou really like the game, the intellectual andfinancial rewards are well worth the challenge.


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Be a Coward like Patton and

MacArthur

This week K and I attendedthe Bloomberg FX conferenceand aside from getting atremendous ego boost whenwe found out that that wehave an enthusiastic followingon the institutional as well asthe retail side, we also got to

spend the day with some ofthe smartest currency tradersin the world. The lessonslearned last Thursday wereimmensely valuable, but nonemore so than the messagefrom Jim Haskel fromBridgewater Associates.

Bridgewater is one of thepreeminent hedge funds inthe world and Jim isresponsible for assessing risk in the overallportfolio. He was clearly one of the sharpestguys in the room but his message wasdeceptively simple - above all else stay alive.Haskel recounted how Bridgewater was able toweather the post Lehman financial storm byessentially not trading for a while. Its muchbetter to miss an opportunity than to assumeunnecessary risk.

Listening to Haskel, I suddenly remembered thegreat opening scene of Patton where George C.Scott stands in front of a massive American flaggently swaying behind him and barks at thecamera, No dumb son-of-a-bitch ever won a

war by dying for his own country but by havingthe other dumb son-of-a-bitch die for hiscountry. I found this fascinating because evenPatton, who was the most reckless military

leader in WWII, understoodinstinctively that selfpreservation was paramountfor victory.

MacArthur, the other greatgeneral of the war, was alsofamous for never engaging

the enemy at their point ofstrength. MacArthursphilosophy was to bypass thetoughest Japanese militaryinstallations and attack onlythe weakest.

Although the reality of thesegreat military leaderscontrasts sharply with ourromantic view of charge-at-all-costs war hero, it offers

tremendous lessons to us as traders. Whether inwar or on markets the first rule of the game is tosimply survive. For those of us engaged in theday to day combat with price action it issometimes difficult to remember that winning isnot always an option and sometimes just stayingalive is good enough.

I cant remember how many times in my tradingcareer, Ive let my ego get the better of me onlyto be saved by stop losses (every trade I makeautomatically carries one) thus preventing a totalblow up of my account. In markets, there willalways be tomorrow and there will always bechances to make fresh profits, but only if you

have capital left to trade. From the best tradersin the world to the greatest military commandersin history, we learn that we must always pick ourbattles carefully and make sure to stay alive tofight another day.


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