BKFOREX ADVISORS LLC

Dont Trade Like Tony Montana

Adventures in FX Trading
Boris 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 you understand 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 at bktrader@gmail.com . May you always be in the know and in the flow.

Boris Schlossberg Managing Director BKForex LLC @fxflow

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At BK Weve Made Money 4 years in a row* We Made Money in 2008 in 2009 in 2010 and 2011. Now We Are Making BK Even Better In 2012 We Give You Three Distinct Ways to Trade the Currency Market 1. BK Classic Trades Our Twice/Week Trading Calls with EXACT Entry, Stop and Limit Instructions 2. Kathys Calendar Calls Our Daily Calls on Global Economic Data that Provide You with the Edge to Position Yourself Ahead of the News 3. Boriss Flow Trades Our Daily Trades in the EUR/USD with EXACT Entry, Stop and Limit Instructions that Work in both Up and Down Markets. Sign Up Now and Receive Two Free Reports Kathys How to Trade News like a Pro Boriss How to Trade Flow like a Pro as Our Thank You Gift to You http://www.bkforexadvisors.com/subscription-special/

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Trading Psychology
Dont Trade Like Tony Montana Page 4 Win By Losing Page 5 Why Trading is Not like Any Other Job Page 7 A Trade Is Not Your Spouse! Page 8 Why We Pull Stops Page 9 Superstition Works Page 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 Fort Lauderdale and a curious thing will happen. If one of the Direct TV channels happens to be playing Scarface, every seat with a man in it will turn to that channel within 5 minutes until the whole plane is watching the movie. Guys love Tony Montana - the swaggering, psychotic gangster immortalized by Al Pacino. Who amongst us can forget that final scene when Pacino faces a crowd of assassins screaming Say hello to my leeeetle friend! as he fires off his bazooka while he takes a shot after shot refusing to go down. Despite the comic book violence, and the psychopathology of the main character, most guys view Tony Montana with a no small dollop of romanticism. He represents our universal desire to take on the world on our own terms no matter the cost. But the cost matters, because in the end of course Tony Montana gets blown to smithereens. Ive been thinking about the Tony Montana character lately, realizing that I sometimes do a bizarre imitation of the say-hello-to-my-leeetlefriend scene when I fight the tape in FX. Did you stop me out as tried to short the top? No problem I can take it. Here is another order to sell. Another stop? Give it to me. More? Go ahead Ill take it all - I am stronger than the market, I can take it all. In any case you get the idea. After a while your trading account starts to look like Tony Montanas body and you begin to realize that maybe this is not such a good idea. This weeks moves in risk FX had many traders acting like mini Al Pacinos with euro shorts refusing to accept the fact that the currency was not going to implode anytime soon. The short covering rally was one of the most vicious spikes in recent memory, but if youve been in the markets for a while you knew that it wasnt that unusual. When the markets want to roll you can join them or get out of the way. If you chose to make a stand you will almost always be leveled to the ground. Sun Tzu once said He who knows when he can fight and when he cannot, will be victorious. This is perhaps some of the greatest advice that we can absorb as traders. Very often we trade not to win but satisfy our ego. Taking on the world, or the market is a romantic idea that weve all been taught, but in finance that is a very expensive way to conduct your business. As guys we may all yearn to release our inner Tony Montana, but as traders we should mature enough to know better.

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Win By Losing

I've missed more than 9000 shots in my career. I've lost almost 300 games. 26 times, I've been trusted to take the game winning shot and missed. I've failed over and over and over again in my life. And that is why I succeed. Michael Jordan

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To trade well you must learn to lose. That may sound like an unusual advice from a guy who throws more temper tantrums than a teething baby any time a trade doesnt go his way, but it is nevertheless the most fundamental truth of this business. Trading at its core is the art of managing failure. Of course that is not how most retail traders approach this game. Subconsciously we expect to win every single time we open a position and several losses in a row often send us into a near catatonic state of despair. Ive often suspected that the reason most people quit trading has less to do with their ability to read the market and much more to do with the psychological shock of losing money on a near daily basis. After all, there are very few areas of life where we confront failure every single day. In civilian life we are always preconditioned for success. We expect the trains to run on time, our computers and Internet connections to work flawlessly, our clothes to be perfectly pressed when we pick them up from the dry cleaners and a million other mundane tasks that we take for granted. Indeed, the purpose of civilization is to constantly engineer failure out of existence by providing us with better tools to handle all of lifes many challenges. Even in highly complex and risky professions such as emergency medicine we have become much more proficient at eliminating failure. ER doctors face a multitude of medical problems, most of which they are able to control. In an industrialized country, it is almost unheard of for an emergency doctor to lose a patient every single day, unless there are some special circumstances such as a mass accident or the spread of a virulent virus. On the other hand if you 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 valuable calling than speculation, but rather to make a point about expectations. The reason why trading is so difficult is because it stands outside our normal frame of reference. As modern day human beings we are just not used to dealing with constant failure as a way of life. Most traders will accept one or two losses in a row, but few realize that even an 80% accurate strategy can generate a string of five or six consecutive stop outs. There is no perfect way to combat this problem but a trick of the trade that Ive found useful is to simply run your strategy manually on a price chart to see how well it performs during random periods of time. Many traders of course back test their strategies and many computer programs offer very sophisticated analytical tools to show you how the trades have performed. However, while computer back testing is a nice tool, it is virtually useless in helping you trade. Reams of computer driven reports can provide you with an statistical analysis of your trading methodology, but none of them will offer you the psychological truth that comes from actually feeling the trades as they occur on the chart. There is something incredibly powerful about marking your wins and losses by hand that makes you absorb the dynamics of your strategy in the most primal and effective way. We may be highly evolved mammals, but we are mammals nonetheless and as such we are still tactile animals. Ive found that by just working out my strategy on a chart, seeing all those wins and losses cluster and spread out over various time frames, I was able to trade much better in real time because I understood the likely outcomes and was not as perturbed by a string of several stop outs in a row.

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Why Trading is Not like Any Other Job

One of the maddening aspects of trading is that it resists any and all attempts to turn it into a regular business activity. For most of us, our greatest desire as traders is to achieve steady and positive returns that compound on a daily basis. But trading is not and will never be a job with the predictability of a bi-weekly paycheck because Mr. Market is unlike any boss you will ever have. In the normal world of salaried employees we get paid irrespective of whether we are having a good day or bad one. In fact many of us can even play hooky, or call in sick and do no work at all and still get paid. At worst, if we are commission based employees like salespeople, we simply do not get any cash if we perform poorly on any given day. Mr. Market however is a much more insidious boss. Not only does he not pay you on any day that you do not work, but he actually goes into your bank account and pulls out money that you already posses, the moment you make a mistake. Thats a very disturbing reality for most traders to accept. In the real economy, only self employed business owners ever face that dynamic and even they experience it very rarely. For example if you were to run a coffee shop, your day to day business would be relatively predictable. It is almost inconceivable for a coffee shop owner to have 1000 customers one day and zero customers the next. The flow of business in the regular economy is generally steady. In the financial markets however the flow of returns is much lumpier. This notion became crystal clear to me when I was looking through a back test of an intraday flow strategy that I trade. No matter what filters I applied there were just some months when the

methodology did not work and it lost money. In other months it just printed pips with barely a bad trade in the batch. In fact I realized that the best you can hope for when you are trading is to simply dampen your losses as much as you can when the markets are not cooperating while staying in the game long enough to enjoy the winning streaks. Make no doubt about it, financial markets are very streaky. Most of the time prices bounce around in a state of indecision until a dominant theme develops generating strong directional flows. Furthermore, because it only takes the press of a button to change your mind, the financial economy is much more volatile than the real one. Thats why a famous analyst once quipped that the US stock market predicted 9 out of the last 4 recessions. The best we can hope for when we trade is to remain at breakeven for most of the time and make money during the few months when the markets are trending. In finance unlike in real life, the payouts are lumpy and you need to learn how 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 lawfully wedded wife, to love and to cherish? In sickness and in health? For better or for worse? Until death do you part? How many times have all of us heard those words? We all know them by heart and can repeat them in our sleep. No doubt marriage vows possess enormous emotional power for most of us, but in trading those few simple sentences can be the deadliest trap ever made. Although men are often portrayed as irredeemable Lotharios with zero ability to commit, the truth is that the concept of loyalty and fidelity is ingrained in boys from early childhood. From Never rat on your mate, to Never hit on your buddys ex-girlfriend to the cry of Semper Fi! of US Marines men are inculcated with the idea that loyalty is the highest value in life. Unfortunately in trading loyalty will ultimately get you killed, or at the very least bankrupt. A trade is not your spouse and you should never marry it, because if you do, 99 out of 100 times the relationship will end in tears. The average man is extraordinarily monolithic in his approach to life. We like simple, logical, belief patterns that we apply universally. Once taught that Quitters never win and winner never quit we tend to approach everything with the same nose-to-the grindstone attitude. Women on the other hand understand that fidelity in one arena does not necessarily require fidelity in another. Thats why women tend to be much better traders than men. They can cut their losses ruthlessly with all the cold calculation of a mercenary. Women generally do not invest their ego into trading and tend not to view the outcome of each trade as a moral judgment on their character.

One of the reasons why men become so vested in each trade, stubbornly refusing to admit their mistakes is because they lose sight of the end goal. Whats the object of trading? Is it to win each and every time? No. The goal is to generate a positive return at the end of each year. If thats the purpose, then each trade is immaterial. At BK - a relatively staid signal service - we execute 100 trades each year. In my own personal account I do approximately 1500 over the same period of time. Many of you who trade short term probably do even more volume than that. Is it really necessary to destroy your account over one or even ten incorrect trades? Of course not. In real life, fidelity may be valued, but in trading promiscuity is the far better path. A trade is not your spouse and when it becomes difficult or unpleasant, your attitude should be NEEEXT!

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Why We Pull Stops

In their book Sway, authors Ori and Rom Brafman describe the series of events surrounding the worst airline crash in Dutch history. Piloted by one of the most accomplished and experienced aviators in the world Captain Jacob Van Zanten, KLM Flight 4805 was on its way to Canary Islands. However, a bomb explosion a flower shop closed the Las Palmas airport, and KLM 4805 along with several other planes was diverted to the island of Tenerife about 50 miles away. As the authors describe it, Tenerife was a tiny airport with a single runway not meant to support jumbo jets. Sitting on the runway in Tenerife Captain Van Zanten realized that the crew was running into mandated rest period which under Dutch aviation laws was actually a crime punishable by jail time. Becoming more anxious by the minute the Captain agitated to resume the flight before it would have to be grounded on Tenerife which had no accommodations for the passengers. The air traffic control on the laid back island however, was listening to a soccer match and was in no hurry to move the planes. Finally just when it looked like the plane was ready to leave the airport became enmeshed in fog. The captain, utterly frustrated by this point decided to take matters into his own hands, put the engine at full throttle and decided to gun it down the runway despite the fact that he had no clearance for takeoff from the tower. What happened next was as tragic as it was predictable. As the fog cleared and the KLM plane was about to lift off the captain suddenly saw a Pan Am 747 parked at the end of the runway (it was in the wrong spot because of the fog). The captain desperately tried to lift the planes nose to clear the 747 but the underside of the fuselage ripped through the top of 747 and the whole crew and 584 passengers lost their lives. The accident of KLM 4805 is a stark reminder of just how powerful and destructive the human instinct for loss aversion can be. Despite his years of experience the Captain was ultimately driven to his irrational behavior by his desire to avoid the massive delay and the inconvenience and loss of reputation that an overnight stay at Tenerife would entail. The end result was horrendous, but to those of us who trade it was not entirely unfamiliar. How many times have we as traders seen the following set of events occur? We wake up, still groggy look at the FX market and without much thought put on a trade that promptly stops us out. Annoyed, we try again only to have the market dip to take us out once more and then reverse direction in our favor. Now getting really angry, we accidentally sell when we mean to buy and watch in disgust as we get taken out again. Now we double up the position and only succeed in buying the absolute top of the move watching in dismay as prices retrace and stop us out once more. Prices finally stabilize and we decide to buy one last time. We get long only to see prices drift lower once again. But this time we decide that the market will not play us for a sucker. We wont get shaken out again, so we make the ultimate mistake we lift the stop from the trade and let it float in the market unprotected. At this point the ending is just too predictable. The account crashes much like the KLM flight albeit with far less horrific consequences. However, the failure in both cases is due to our human instinct to avoid loss at any cost. In trading in order to win you must learn how to lose. No matter how painful, no matter how annoying, no matter how frustrating the process may be, you have to have a hard stop on every trade. A stop is an insurance policy against bankruptcy. As long as youve preserved a portion of your capital you can always come back. Ironically enough our basic instinct to protect us from loss will often lead us to the ultimate catastrophe of losing it all. As traders we should always be mindful of this trap if we want 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 was shocked to see the contrast between the obese Americans and the relatively thin Chinese. This is of course a common observation and often leads to a never ending lament about the dominance of American fast food that has essentially turned this nation into a land of fat people. I certainly agree with the criticism of the American food culture but I think the obesity epidemic is also a signal of something else much more positive. First, Americans are no longer unique in their fatness. The Brits are becoming fatter by the day and so for that matter are the French. A recent study of overweight teens from across the world basically shows a huge geographical skew with North America and Western Europe producing markedly fatter children while Eastern Europe remains relatively slim. At its core the obesity epidemic in the industrialized world is a sign of mans total triumph over nature. The advances in technology have made food so cheap in the West that we can stuff ourselves full of calories at almost no cost. This near pornographic abundance of food is a testament to sciences ability to conquer the environment. No more need for the rain dance. No more offerings to the gods. We control the future. This belief in control has become the philosophy of the modern age. As societies and as individuals we now approach every new problem with an engineering mindset. There is no crisis that we cannot engineer away. From electrical engineering, to financial engineering, to behavioral engineering at its core the glory of modern civilization is really the worship of engineering. Unfortunately, when it comes to trading, engineering fails miserably. The irony of trading is that it is a discipline that relies on the most modern of technologies yet contains all of the chaos, uncertainty and superstition of the ancient world. As I sit at my desk surrounded by six screens, multiple computers and instant media feeds from around the globe, I still cannot with any degree of certainty know if my trade will turn out to be profitable. Thats why the engineering or to put in trading terms the algorithmic approach has never made money in the long run. Look at the most successful hedge funds over the past twenty years and they are all discretionary in nature. Soros, Jones, Steve Cohen all managers that have never relied on any robotic model to make their trading decisions. The only exception to that rule is Jim Simmons Renaissance fund, but the public version of that fund which claims to use the same algorithmic techniques has performed so poorly that it makes me believe that for all of his hundreds of Phds sequestered in Long Island, Simmons is doing something less than scientific to garner his returns. At its core trading is always more art than science. Furthermore, the unpredictable nature of the game quickly turns the most modern of men into the most superstitious of our ancestors. When we feel we cannot control the future we quickly seek psychological crutches. I for example developed a maddening new belief that our trades will not hit our target if I am staring at the screen. Therefore, when price action comes within several pips of the target I leave the computer, go for walk, go get a cup of coffee, go work out anything but watch the price action. Ive dubbed this my pipdance. While I completely understand the absurdity of my actions, I refuse to change them, which I actually think is ok. Surrounded by all this technology we are fooled by the illusion and arrogance of control. Having some superstitions in our life infuses us with some humility serves as reminder of the volatile and primitive forces that truly rule this game.

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What Business Are We In?

What business do you think AMC Cinema is in? How about Cinemark or Regency entertainment? If you said the movie business you would be dead wrong. All the cinema chains in the United States, and for that matter the world over, are actually in the food business. Movies are a very low profit business for most cinema houses. In US, they have to pay out 70% of the first weeks gross to the distributor. That share ratio becomes more equitable the longer the movies stay in distribution. But since only a few films have the staying power to play more than two weeks, the movie revenues are basically a scratch for movie theaters. Movie theaters make most of their money on popcorn and soda which run 90% profit margins. So given the fact that theater owners are really in the food business you would think that they would do a better job of servicing the customer. You would think that instead of hiring lazy and glassy eyed high school kids to man the counter and to process orders at the pace of a postal office clerk they would invest in self vending machines that would cut the line times in half and offer a variety of cool products like customized sodas and gourmet popcorn. The technology is there, but movie houses still think they are in the movie business and thats why most of them suck. The mistake of misunderstanding your business is a common one and certainly not limited to the hapless movie house sector. In the 1930s and 1940s US train companies thought they were in the train business rather than the transportation business and were promptly destroyed by cars and airplanes. In Contrast, high speed rail in both Europe and Asia connects major cities in comfort and style. Ever taken an Amtrak train through the US Northeast corridor? It makes a 7 hour traffic jam on I-95 feel like a pleasurable experience. So why am I suddenly so concerned with the question of understanding what business we are in? 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 of us think we are in the being right business. We are not. In trading we are in the making money business and making money comes from properly reading the mind of the market. So our opinion doesnt matter. Only the opinion of the market matters. There are only two reasons for why we lose money in our trades. 1. We are dead wrong in our analysis of market opinion. 2. We are early. In both cases we are losing money which means that we are not practicing our business properly and we must cut our losses and look for a new idea or a better time to enter the trade. Once we clarify the question of what business we are in, the question of being right becomes a lot less relevant and we can hopefully learn to trade more effectively.

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

On my flight to Dubai I lost my Blackberry on the plane. While there I managed to blow out the transformer to my laptop. When I came back, the super in my apartment building forgot to plaster the walls of my bedroom, so I had to endure the smell of paint (something I despise) for several days. Despite all of these annoyances I never got angry. This is after all just the normal ebb and flow of life and mishaps happen all the time. Yet how many of us bring the same laissez-faire attitude to our trading? I certainly did not. Many smashed computer screens and keyboards have been victims of my wrath when my trades did not go as planned. Its taken me a long time, but I have finally understood that anger is the single greatest enemy of successful trading. There will be times when you hit the buy button when you meant to hit sell. There will be times when you walk away from the screen for 2 minutes only to come back and see that the trade went to within 1 pip of your target only to trade back below your entry. Or you will watch as the trade quickly dips to your stop, takes you out and then rallies in your direction while you are left with nothing but losses. You will have your platform go down just at the moment when critical news creates massive opportunity for profit and you will sit there trying to login in vain. Or, as just happened today, Reuters will make a mistake in its news release causing prices to plummet and then just as quickly reverse wreaking havoc with your positions. All of this will happen to anyone who trades actively and more importantly it will continue to

happen for as long as you trade. This is after all just the normal ebb and flow of life and mishaps happen all the time. Yet if we get angry, if we rail at the unfairness of it all, if we throw a temper tantrum like a two year old toddler we risk losing something much more than money. We risk losing control. Once you lose control as a trader, you lose everything. The money is just an afterthought. As sure as day follows night, if you lose control the equity in your account will be gone as you begin the wild orgy of revenge trading trying to show the market who is boss. Meanwhile, the market will simply stand there like a bemused black belt champion and methodically strip you of all your money as you make one desperate trade after another. Dont get me wrong. I am not a robot. I still get upset anytime a trade moves against me, and you can even argue that my heart bleeds with every negative pip. But over the years I have learned that getting angry is a waste of my time. The market couldnt care less. The market is like a referee at a soccer match it will never change its mind. So the only question you need to ask yourself is, Do I want to stay angry, or do I want to win? Think about that the next time you are tempted to punch your flat screen monitor.

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Why Trade?
Unlike my partner I am no foodie. I am not on the first name basis with Harold from Perilla, I dont know the coolest new bistro in town and I never consult Yelp for my dinner selections. And although I like a fine meal once in a while and can cook a few Italian dishes with the skill of a pro, I would much rather enjoy the warm comfort of a grilled cheese sandwich and fries than some tiny slice of lamb drenched in a puddle of raspberry reduction. I do however love Anthony Bourdains No Reservations show on the Travel channel. In fact I have every episode he ever made saved into my ITunes library on my computer and I often watch them over and over. Not only do I like Bourdains snarky attitude, his wonderful ear for the English language and the shows award winning cinematography, but I also appreciate the mad obsessive-compulsive characters that populate the show. People who cook food almost universally do it for passion rather than money. To achieve the perfect pizza dough, the perfect steak, the perfect risotto you never think about profit margins, efficiency protocols or labor savings. You think about ingredients, presentation, texture and taste. To be a great chef is to seek but never quite attain perfection and therefore to practice the Greek ideal for living a truly satisfying life. To watch the guests on No Reservations is to marvel at how completely absorbed and content they are in their profession despite its clear physical and emotional challenges. No cubicle ennui here. No middle management angst. People in the restaurant business are happy in the deepest sense of the word because they have passion and purpose. Surprisingly enough many traders share the same attributes. After all trading is an unbelievably frustrating and emotionally draining task that requires constant concentration and enormous 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 you out at any given moment. Yet most of us are completely obsessed and passionate about taming the beast. Although trading is ostensibly about making money, what actually drives traders everyday is the intellectual challenge of figuring out what comes next. The art of a well executed trade is as pleasing as the profits it brings. Whether theyve had a winning or a losing week Ive never once heard a trader moan, Oh no! Its Monday, I dont want to go to work! In fact for most hardcore traders the weekend is a nuisance that stands between them and the markets. Jack Schwager, in his seminal book Market Wizards, talks about the golden days of pit based trading and notes that most of the Chicago traders he interviewed could not wait for Monday to start. How many other professions inspire such intensity? Very few. Which is why just like true restaurateurs, traders never have any reservations about their chosen craft despite its relentless challenges.

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Trading Strategy
The Round Number Trade Page 25 Surviving IS Winning Page 26 An Edge is Not a Win Page 27 3 Simple Qs For Your Nexxt Trade Page 28 The Great Advantage of Retail Trade Page 29 The Long Term is Random Page 30 Four Ways to Beat the Market Page 31

The Arrogance of Counter Trend Page 15 All Strategies Suck Page 16 Day Trade like Warren Buffet Page 17 The False Glory of Demo Billions Page 18 Price Lies All the Time Page 19 Trading is Gambling Page 20 My Best Trading Advice to You Page 21 Why Leverage is a Drug Page 22 The Key to Every Winning Model Page 23 Why Chasing Price Works Page 24

Be a Coward like Patton and MacArthur Page 32 Trade like the House Page 33

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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 aside after years of loyalty. He told his just pregnant girlfriend that he preferred his former girlfriend and spent months thereafter asking friends which one they thought was prettier. He even parked in handicapped spaces because he had no patience to look for an open spot. The portrait of Steve Jobs the person is diametrically opposite to that of Steve Jobs the businessman. As a businessman Steve Jobs remains lionized. He is seen as a great innovator who radically simplified the computer experience. Yet the very same skills that propelled him to the top of the business world may have also been responsible for his death. By now we have all read the story of how he delayed cancer surgery for 9 months relying instead on diets and visualization exercises instead of medicine. In his greatest moment of need Steve Jobs turned to the power of magical thinking and wish fulfillment acting like a shaman in some primitive tribe in the Amazon rather than the CEO of the most technologically advanced company in the world. Steve Jobs has always succeeded by challenging conventional wisdom, but sometimes conventional wisdom is dead right and his last attempt at bucking the trend killed him. I was thinking about Steve Jobs a lot this week, as well as about John Paulson - another guy that has been deified in the press for having called the 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 a hard time making worse. These two guys made all of their money by essentially trading counter trend. (Making computers more expensive, when everyone was slashing prices, shorting CDOs when everyone was long, etc.) Counter trend can certainly be an incredibly profitable approach in both business and markets. However, the danger of counter trend is that you get arrogant. After beating the system so many times you begin to feel invincible and you lose the humility to appreciate your mistakes. Sometimes that results in losing money and sometimes it results in death. Ive often remarked that for all the talk of trend trading very few retail traders actually pursue the strategy - which ironically enough is why most traders fail. Trend trading represents the very heart of conventional thinking and for most of us (myself front and center) is an anathema to the way we view ourselves. All of us like to be viewed as creative and original, but the truth of the matter is that often the most original move in the markets is to follow the crowd.

Anti-trend trading teaches you arrogance, while trend trading teaches you humility. You tell me which one works better in the long run.

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All Strategies Suck

What do traders love most? Strategies, strategies, strategies. Just one great idea, one well-functioning algo and we are in heaven. We always think that strategies are the path to trader nirvana. But lets admit it - all strategies suck. In fact there are really only three types of trading strategies in existence. 1. Breakout strategies which are based on price momentum and velocity and depend on continuation for their success. 2. Mean reversion strategies which are based on fundamental value or temporary extremes in price conditions and depend on price reversal for their success. 3. And finally what I call cheating strategies that depend on technical, regulatory, or capital arbitrage opportunities that take advantage of certain market peculiarities available only to a few privileged players. Once you understand this fact you realize that no strategy is bullet proof. Momo strategies fail miserably in choppy markets. Mean reversion strategies get decimated in strongly trending environments, and cheating strategies eventually become obsolete as more and more players attempt to exploit the particular loopholes in the market. Dont get me wrong. Strategies are very important. They provide the framework for everything you do. But the longer I trade the more I realize that it is not the specific strategies that matter but the general rules of trade you employ 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 market trades against you?

These are much more important questions to consider than whether to use a simple or an exponential moving average when evaluating a trade. All strategies suck and all strategies are great depending on the market environment. What distinguishes success from failure is much more a function of your own behavior rather than the clever little algo you just created.

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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 that ultimately, in the financial markets just as in real life, action talks and baloney walks. No matter how ridiculous, how illogical, how utterly insane prices become, they always correct to their intrinsic value. Witness the Nikkei in 1980s, Internet stocks in the 1990s, US housing market in 2000s. Mr. Buffets maxim holds true for investors, but it can be a cold comfort for speculators like us who trade the most fickle market in the world. Ostensibly, the currency market exists for corporations to hedge their foreign exchange exposure, but fully 97% of the volume (last measured at $4 Trillion per day) is driven by speculators such as banks, hedge funds and retail trade. The dirty little secret of FX is that everyone speculates - even the corporates and the central banks. The history of the market is littered with tragic stories of Fortune 1000 corporations whose Treasury departments lost millions and sometimes even billions of their shareholders capital in badly managed FX trades that had nothing to do with the core business of the company. Even Mr. Buffet dropped a cool billion at the start of this century when his bet on the collapse of the dollar turned out to be woefully wrong. So how do you think about value in a market where sentiment reigns supreme? After all equities at least had some semblance of net worth because they represent hard assets of the corporations that issue them. Currencies on the other hand are a completely abstract concept backed only by the full faith and credit of the sovereign entities. Money is just a blur of electronic bits on a computer screen. Therefore as speculators we must operate differently. In order for us to heed Mr. Buffets advice we must make sure that the market is operating as both a voting and a weighing machine at the same time. What that means in plain English is that in order to succeed we must make sure that fundamentals and price action are in alignment. Those of you who follow me on Twitter (@fxflow) know that my ideal flow trades are always driven by a combination of price momentum off some fundamental trigger. In trading flow, it is not enough to be on the right side of the news - price action must confirm your analysis. Only then do you have a high probability trade. The longer I trade flow, the more I am convinced of the efficacy of this approach. Whenever I deviate from my method, by trying to fight either the price action or the news flow, I inevitably lose. Mr. Buffet is right. The market is both a voting and a weighing machine and it is our duty as traders to make sure they align before entering the fray.

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The False Glory of Demo Billions

Conventional advice in the currency market states that as a novice you should only trade a demo account until you become comfortable with the whole trading process. I couldnt disagree more. First of all you will never get comfortable with the process. A trading life, to paraphrase Thomas Hobbes, is nasty, brutish and short. Markets are never predictable and even lifelong veterans of speculation are constantly challenged by the game. The best way to learn how to trade is to just dive right in and practice over and over and over again- just like with every other endeavor in life The demo account is useful only for a few distinct 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 the mechanics of the platform there is no more need for a demo. Many trading coaches argue that by using a demo you can test out a variety of strategies without risking capital, but that is bogus advice. The very essence of trading is not to become

adroit at a single strategy whose value will dissipate over time but to master the art of taking on risk the very thing that demo accounts avoid. Thats the reason so many demo traders can run $50,000 demo dollars to $1 million but fail miserably when they start trading $5,000 dollars of real money. As a demo trader here is what you will never experience. Youll never experience the dealer slowing down the order entry platform at time of maximum volatility just when you need to enter or exit the market the most. Youll never experience spreads suddenly widening just as your take profit target is about to be hit. Youll never experience a platform outage, or the very uncomfortable deer in the headlights feeling that comes from selling a currency pair when you meant to buy it. In short, trading a demo has nothing to do with real life trading. Its the differences between practicing basketball free throws in a quiet gym versus trying to sink a game winning basket as thousands of rabid fans scream at the top of their lungs and sway back and forth trying to make you miss. Start with small account, trade mini lots and learn the trading game with real money. There is no glory in being a demo billionaire.

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Price Lies All the Time

At the FX expo in Las Vegas, I found myself in the unusual position of being in the audience rather than on stage as my friend Todd Gordon hosted a panel on the joys and tribulations of FX trading. Instead of pontificating as always, I listened for change and walked away with some great insights into the game. Although the event was sponsored by a broker, the majority of the panelists were not associated with any broker dealer firm and as a result the crowd received an unvarnished and quite realistic view of the business. No one on the panel claimed that you could trade your way to a six figure income with ease or promised that they could show you a way to print money. In fact everyone was quite sober and realistic about the actual returns that you could achieve from trading. The consensus view was that 15%20% per year was the best you could do if you became especially proficient at the game. This was hardly the turn-ten-thousand-dollars-into-amillion pitch that many had expected to hear, but I think most in the audience appreciated the candor of the message. The most interesting story however was told by Derek Frey who is a frequent contributor to FX Street. Once every few months Derek creates what he calls his lottery account. He funds a five thousand dollar account that he trades very aggressively. This is capital that he is perfectly

willing to lose, but nevertheless he tries to make every effort to stick to a particular strategy. A few months ago Derek opened a new account and immediately proceeded to hit the worst trading streak of his life. He made 11 losing trades in a row and saw the account decline to 1800 dollars. Difficult as it was for him to maintain his discipline in the face of such negative results he continued to take signals from his strategy and as markets improved he was able not only to recover his losses but trade the account to nearly ten thousand dollars by the time he came to the expo. Dereks experience is a great reminder to all of us that in order to achieve long term success we need to trust the process not the price. Price can be very capricious and as sure as day follows night the only certainty of the markets is that you will eventually hit a nasty drawdown that will tempt you to abandon your set up. Those points of abject bleakness separate winning traders from losing ones. The losers quit, but the winners persist and when markets become more amenable to their strategy, their account recovers. This is perhaps the most valuable trading lesson of all and thanks to Derek for sharing it with all of us in Vegas.

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Trading is Gambling

One of the greatest comedic bits ever written is a piece by George Carlin in which he takes on the hypocrisy of the English language, especially as it relates to war. Carlin notes that in World War I the words for the stress of combat were Shell Shock. In WWII the term was changed to Battle Fatigue, in the Korean War it became Operational Exhaustion until finally in Vietnam it was reduced to the clinically sounding Post Traumatic Stress Disorder. Still eight syllables, notes Carlin, but we've added a hyphen! And the pain is completely buried under jargon. Post-Traumatic Stress Disorder. I'll bet you if we would have been still calling it Shell Shock, some of those Vietnam veterans might have gotten the attention they needed at the time. I'll betcha. I'll betcha." When it comes to finance we have our euphemisms to hide exactly what we do. My favorite is risk taking. That sounds admirable and progressive but in fact I think it is high time we called trading for what it really is - gambling. Every time we trade we play a game of chance which is in fact a form of gambling. Contrary to popular belief, gambling is not a pejorative term in my opinion. You can of course bet blindly with no rhyme or reason in which case you are indeed the prototypical loser gambler - a sucker in Vegas parlance. But you can also approach the business as a professional. Professional gamblers differ from amateurs in two distinct ways - they have a very good idea of the odds facing them each time they bet and they do not get emotional when they are beaten. Aside from winning one dollar from a slot machine at the Barbary Coast casino I have never gambled in my life. I have no confidence in my ability to read people or count cards and I find the whole process relatively boring. I would

much rather try to handicap market psychology as it relates to economic and geo-political events. Nevertheless, I am more than willing to adopt the best practices of successful gamblers to my own trading routine. Once you have a viable trading strategy especially one with fixed targets and stops it is really 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 cards even when the odds are in your favor. In poker, thats known as a bad beat and it is an ever present fact of life. Professional gamblers just like professional traders constantly experience draw-downs, but they rarely complain about the market. They accept the game as it is. If we choose to view trading from the prism of a professional gambler we will undoubtedly assume a much healthier and more accurate attitude towards trading and hopefully improve our performance in the process.

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My Best Trading Advice to You

I would like to share with you some tricks of the trade that can help you minimize the stress of day to day trading and hopefully keep you calm, focused, and on plan. Open Two Separate Trading Accounts. Lets face it. Most of us will never stick to our trading plan. Moreover there is no good reason for why we should. Experimentation is critical to creativity and creativity is absolutely vital to survival in the markets. Markets constantly change and the only way we can discern those changes is by interacting with price action in new and hopefully profitable ways. The critical mistake that most of us make is that we often commingle our experimental trading with our core setup trading in one account. The net result is that losses from our experimental trading almost always lead us to abandon the discipline of our core setup. I used to believe that having two accounts at the same broker would help you solve that problem, but I no longer think that this is a good idea. Its too easy to transfer money to and from two adjoining accounts at the same broker and you basically wind up sending good money after bad. Instead, it is much better to open accounts at two separate brokers. For your junk account you should choose a broker with lowest possible spreads and smallest possible size executable, so that you can experiment trading lots as little as 1000 units. This is effectively your play account and you should open it first thing each day to satisfy your urge to trade and participate in the market. Your serious account should be held at a broker who has the best possible execution rather narrowest possible spreads. Ask yourself these questions. Does my broker widen spreads inordinately during news announcements, making it impossible to enter the market at reasonable cost? Does my broker frequently reject limit entries during periods of volatility? Does my broker often 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. Your serious account should be traded only at a reputable broker with good dealing capabilities and top notch customer support. Once you have set up this structure you must make a solemn promise to yourself that you will never, ever, ever ever, ever, ever trade anything but your prescribed setup in your serious account. Irrespective of whether you are losing or winning you cannot pollute your setup trades with experimental trades. Thats what the junk account is for. Having separation of purpose will hopefully create peace of mind and allow you to adhere to your trading plan with 100% consistency.

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Why Leverage is a Drug

Drug dealers often use an insidious strategy to obtain new customers. They provide free samples of their wares to children in the form of a lollipop or candy bar. A few licks of the sweet drug and the kids are hooked, frequently for life. Speculative markets can operate much in the same manner except in finance the drug of choice is leverage. How many times do we see advertisements on the web enticing traders with ridiculous leverage offers of 100:1, 200:1, 300:1 even 500:1? The lure is incredibly tempting - turn $1000 into $100,000 within weeks! Take $10,000 and ride it to a million! Just like a drug high, leverage high promises you perpetual bliss but delivers mostly agony and pain. The truth of the matter is that in highly levered speculative markets it is far more common to see $100,000 accounts shrivel down to $1000 rather than the other way around. Leverage, just like narcotics, takes control out of your hands. The more leverage you use the more vulnerable you become. How many times have you been taken out of a trade that eventually recovered simply because you were over-leveraged? The margin call is the markets secret weapon. It is the easiest way for the market to take away your money because it

forces you to liquidate your position at the worst possible time, often at the absolute bottom if you are long or absolute top if you are short. My trading improved astronomically when I drastically reduced my leverage. At present my maximum leverage is 5:1. Most FX traders may consider that laughably small, yet I am trading more than ever and enjoying the smallest drawdowns of my career. Reduced leverage is not the reason I am killing it in the market. My flow analysis has simply been much sharper and more on target. However, the fact that my analytics have been better this month has everything to do with my low leverage. By trading small I naturally execute my plan, taking stops quickly instead of letting losers run. Small stops are psychologically easier to accept and also a lot easier to recoup. By trading on relatively small leverage I tend to trade much more professionally, managing my risk without emotion since I am not vulnerable to a highly levered loss. Just like a junkie who has kicked his habit and enjoys clean living, I have weaned myself off leverage. The net result is that both my mind and my trading account are much better off.

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The Key to Every Winning Model

When I spent the summer of my junior year in college at Sorbonne, I used to play a game in the streets of Paris whenever I was bored. Id look out at the swarming crowds at ChampsElyses or Rive Gauche and see how quickly I could spot a fellow American. I became so good that it often took me less than half a second to identify my target. I did not even need to see the flash of the white athletic socks, or the unmistakable combination of shorts and golf shirts to know I was dead on. I could spot my fellow citizens just by their gait. American men walk like upright gorillas. Our shoulders slightly hunched forward, our feet pounding the pavement with the force of an elephant. Unschooled in the balletic grace of soccer, Americans do not glide through space, they barrel through it like the linebackers and running backs that so many of us were in high school. In Paris I was practicing the simple art of pattern recognition. I became so adept at it that I would often amuse my French friends winning a few francs in the process. Pattern recognition is a fundamental human trait and is at heart of every trading model that has ever been designed. The underlying assumption of every trading setup be it a simple moving average crossover or a complex multi-variable algorithm is that prices move in patterns and those patterns repeat themselves with enough frequency to give the trader an edge. If price action was truly random, no one could extract any profit out of the market over a sustainable period of time. There has never been a roulette player that has won thirty years in a row, yet we know plenty of hedge fund managers that have made billions of dollars over the past several decades by speculating in financial markets. Whether these traders formally acknowledge it or not all of their activity is based on some sort of pattern that they continue to exploit. Patterns however are not enough to succeed in trading. Exploitation of patterns is only effective when trades are executed within a proper context. To appreciate the value of context, consider the following story. A few years back Washington Post wanted to see what would happen if they put Joshua Bell, a world famous violin virtuoso, into a metro station to play for spare change during the morning rush hour. Mr. Bell held nothing back that morning and performed with the same skill and passion that he brought to his many recitals across the world. For most of his performance Mr. Bell was roundly ignored by the busy commuters rushing to work. Mind you, this was the same performer who later on that night would be paid thousands of dollars for his sold-out concert with the National Symphony. His gross earnings from the gig in the metro? Thirty two dollars and seventeen cents. Context IS everything. The experiment with Mr. Bell answers a very common question that many traders pose. If your model is so good, how come I always lose money when I use it? The truth of the matter is that almost all trading models fail when used indiscriminately. For example I find that most successful equity traders that employ momentum models trade only the opening and closing hours of the day when liquidity is highest. This makes perfect sense because of the law of large numbers. Momentum works best when crowd behavior is monolithic. Crowds tend to behave with much greater homogeneity the larger their size. Human beings are social animals and they will tend to mimic each other with greater intensity as people join in. Just try to walk slowly next time you are caught in a crowd rushing into a pre-Christmas sale at Toys R Us (or worse yet remain calm during a sample sale for women designer shoes at some tony showroom in New York). Patterns and context are the key factors of every winning model ever traded. Of course neither is easy to discern which is what makes trading such a challenge.

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Why Chasing Price Works

When I had a chance to meet Jack Schwager several years ago, I told him that I read Market Wizards more than 25 times over my life. Schwager was clearly impressed at my dedication to his tome, but the truth of the matter is that I have never been able to put the ideas of MW to much use in my own trading. Until now. I hadnt read Wizards in more than five years, but over the Christmas vacation a vague recollection of a quote from Larry Hite popped into my head and took my scalping to a whole new level. Larry Hite is one of the legendary traders profiled by Schwager who generated 30% annual returns for 13 years running before retiring in 1993. This is what he said, When a market makes a historic high, it is telling you something. No matter how many people tell you why the market shouldnt be that high, or why nothing has changed, the mere fact that the price is at a new high tells you something has changed. As I scanned hundreds of intra-day charts over my vacation I realized that Larrys observation was just as applicable on a short term basis as it was on a longer term time frame. Granted, the session breakouts that I looked at often had minuscule follow through, and you had to be extremely disciplined in both your entries and exits in order to take proper advantage of the price action, but the underlying idea remained

valid. New highs and new lows ARE telling us something even if on occasion we do not want to hear it. How many times have we seen a currency pair trade opposite to the just released fundamental news often taking out the days highs or lows and continuing on its merry way? On those occasions something else is going on in the market that we may not necessarily understand but must respect. Often the true story surfaces several hours later, but by that time the bulk of the move is done One of the greatest ironies of trading is that as human beings we are naturally averse to chasing tops or bottoms when in reality they provide us with some of the highest probability entries in the game. My intraday scalping improved immeasurably ever since I took Larry Hites observation to heart and I can finally say that after 25 readings of Market Wizards I finally learned something valuable.

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The Round Number Trade

Those of you who have followed my writings and videos for a while know that I am obsessed with the round number trade. The round number trade postulates that all conditions being equal trades in the currency market will run stops towards the round number figure such as the 1.3700, 1.3800, 1.3900 in EUR/USD or the 85.00, 84.00, 83.00 handle in USD/JPY. Of course all conditions are rarely equal so the 00 setup can be a lot more difficult than it initially appears. However an interesting confirmation of this phenomenon of human behavior comes surprisingly enough from baseball, courtesy of the Big Picture blog from Barry Ritholtz. Baseball, for most non-Americans is an unbelievably boring spectator sport where 90% of the time most players appear stand around and do nothing more than scratch themselves. In fact I would venture to say that baseball is as boring a spectator sport most non-Americans (Japanese are the big exception) as soccer (football) is to most Americans. Fortunately I was born in Europe, but raised in America so I have an appreciation for both games. I will try to explain to our non-American subscribers the goal of baseball which is nothing more than hitting a very hard leather ball with a wooden bat (stick). This act is so hard to accomplish that those athletes who are able to connect just 3 out of 10 times are considered superstars of the sport and are known as the .300 hitters. Here is where round number issue takes an interesting turn. Above all baseball is a sport of statistics. I could make a legitimate argument that baseball generates as many statistics amongst its rabid fans as the US economy itself.

According to the latest statistical study, those players who come into the final day of the season sporting a batting average within 3 basis points (.003) of the .300 mark are inordinately motivated to get a hit and will do so at a rate far greater than mere chance could explain. Here is the clip from Barrys blog that describes the dynamic in detail. Two economists at the Wharton School of the University of Pennsylvania, while investigating how round numbers influence goals, examined the behavior of major league hitters from 1975 to 2008 who entered what became their final plate appearance of the season with a batting average of .299 or .300 (in at least 200 at-bats). They found that the 127 hitters at .299 or .300 batted a whopping .463 in that final at-bat, demonstrating a motivation to succeed well beyond normal (and in what was usually an otherwise meaningless game). What does this mean to us as traders? It means that round numbers are special. In the 1970s and early 1980s the Dow Jones Industrial Average approached the 1000 barrier 17 times before it finally broke through for good, but when it did it ushered in a two decade long bull run that went through 10,000 and beyond. In the FX market we see the pull of the round numbers everyday. This weeks run in the Euro to 1.4000 and the consequent pullback from that level is a dynamic that repeats itself over and over. Human beings are naturally attracted to the order of round numbers and as traders we should always be aware of that behavioral marker to help us properly position our trades.

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Surviving IS Winning
When studying money managers, academics always note the presence of survivorship bias. Survivorship bias amongst many other things is the idea that if you flip a coin often enough any monkey can succeed at this job. Basically in any given pool of applicants a very small percentage can flip ten heads in a row and thus produce 10 consecutive years of good performance through sheer luck rather than skill. Survivorship bias is a real problem when it comes to evaluating the performance of investment managers and you should be keenly aware of this dynamic when you evaluate their long term records. However, when it comes to short term trading, survivorship bias plays a far less important role as the law of large numbers quickly grinds down all the lucky participants into dust leaving only those who are truly skilled behind. Why? Simply put it is much harder to generate 100 winning days in a row than it is to generate 10 and harder still to generate 1000. FX, which is a highly levered market, is the ultimate Darwinian proving ground. Those few who survive to trade it for more than several years with their original stake in tact are truly skilled in my opinion. In fact I would go so far as to say that surviving IS winning when it comes to short term trading. Amongst the hundreds of traders Ive interviewed in my lifetime Ive never met any successful trader who did not blow up his or her trading account at least once and in most cases three or four times before they finally mastered the craft. In fact it was only after they learned to preserve their capital that most of those traders started to succeed. Thats why risk control is so much more important than any trading strategy you choose. Woody Allen once said that 90% of success in life is just showing up. When it comes to trading the markets I couldnt agree more. Hang out long enough and you will eventually discover a setup that you can exploit, but only if you have capital left to trade it. The following rules are what I consider to be the inviolable principles of short term trading. 1. 2. 3. 4. Always trade with a stop Never average down Stop trading for the day if you hit three consecutive losers Dont take wildly asymmetrical risks (bet 50 to make 10)

Although simple, these rules are incredibly difficult to follow. I have broken every one of them many, many times. In fact I can trace ALL of my failures in trading to disobeying these four simple precepts rather to any inability on my part to analyze the market properly. I would bet that for many of you the same experience applies. Thats why our true control of the market will come only when we learn to master ourselves. Thats the beauty of trading - unlike most other professions we cannot hide our incompetence so we must learn to accept responsibility in order to succeed in the long run.

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An Edge is Not a Win

I can bankrupt you in five easy trades with a setup thats 95% accurate. Suppose I gave you a trading strategy that wins 95 times out of a 100 with an even 1:1 risk/reward ratio. Most traders would sacrifice an appendage for such an edge. But watch how quickly things can go wrong. If you trade with 10:1 leverage and risk 2% on each trade (20% levered) 5 consecutive losers which are well within the statistical realm of possibility will wipe out your whole account. But statistics and leverage are not the only problems we face as traders. The whole notion of an edge should be taken with a barrel of salt because trading is a social, rather than a hard science and any conclusions that we draw from our research into price behavior are therefore highly suspect. Allow me to elaborate. One of the great advantages of hard sciences like physics or chemistry is that we can replicate their experiments one million times in a row and achieve the same result. When Galileo dropped two unequal balls from the Leaning Tower of Pisa and observed that they hit the ground at the same time, he was able to refute 2000 years of Aristotelian logic. Furthermore, if each one of us chose to repeat the experiment we would arrive at the same results over and over and over again. Thats because in our universe, the laws of gravity remain constant allowing us to draw the proper cause and effect conclusions that we can extrapolate to the world at large. Lets move on to medicine where double blind tests on human subjects will often yield good but hardly universally positive results. Why doesnt medicine work equally well on all of us? Because every human being is genetically unique (twins excluded) and the variations in our personal biology and anatomy make it impossible for scientists to keep all other conditions constant and replicate the experiment with 100% accuracy. When we perform a clinical trial, we can safely conclude that this particular drug has been effective on these particular individuals and we assign some probability(50%, 60%, 80%) that it will be efficacious on the population as a whole. Generally, those conclusions are accurate, but as anyone who finds himself allergic to penicillin or immune to a particular therapy knows, medical treatments are far from uniformly effective. Now lets take a look at trading which is in essence a social activity and can therefore be studied as a behavioral science. Anyone with a teenage daughter at home can attest that consistency is not the hallmark of human behavior. In fact if we were to be honest with ourselves our own behavior is hardly a bastion of stability. Very often we will react in polar opposite ways to the same set of stimuli depending on our mood. The markets are of course the same way. Thats why any strategies based on historical price patterns which are in fact strategies based on human behavior should not be trusted fully. Mark Twain once said that history does not repeat itself but it rhymes. Alas, the variations in those rhymes can turn a profit into a loss. In a recent interview Jack Schwager noted that irrespective of whether we are fundamentalists or technicians as traders we all trade patterns. Ultimately thats all we can do given the nature of this game. However, no matter how much we love our setups we should never 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 is a place on Lincoln Road called Nexxt. There is nothing special about this restaurant. It is just another meeting place for the Miami glitterati where the well tanned and the well toned boys and girls come to see and be seen. Its menu is composed 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 perfectly charred and moist and tender. The rice is fluffy but not sticky and the sauces are neither too sweet nor too salty. Nexxt knows exactly what it is a simple American caf with every dish executed to perfection. I often think about Nexxt when I am trading because thats the standard I want to emulate. If you are anything like me very few of your trades are executed perfectly. A perfect trade is not necessarily one that is a winner. Losing trades can be perfect and winning trades can be an awful mess of conjecture and sheer dumb luck. A perfect trade is one that can answer three simple questions. 1. Does this trade comply with my strategy? 2. Am I in this trade at my proper entry point? 3. Will I hold this trade to the end of my plan? 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 of more than 50 points in one direction. The premise is that flow is more dominant than fade and over many sample periods continuation will triumph over retrace. Do I always follow my rules? No. Like everyone else I try to buy bottoms and sell tops. Answer to question number one not always. My set up also has very rigorous entry points. I enter on a limit order of a break of the 00 or 50 level. Do I always do that? Again no. Sometimes, I chase price especially when I am not paying attention, and the trade has already moved past my entry criteria. Answer to question number two not by a long shot. My trade plan calls for very specific stop and limit exits. Do I generally honor my stops? Yes. Years of ignoring that rule has taught me to never pull the stop no matter how painful it is to take two, three or four losses in a row. But do I exit early? You bet. The fear of losing my profits will often push me out before my limit gets hit cutting my profits and skewing my risk/ reward edge. Answer to number three not even close. So, when you review your account this weekend ask yourself with all honesty. How many perfect trades have you made? If the answer is not many then make a vow to make your next trade as good as the meal at Nexxt.

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The Great Advantage of Retail Trade

A book that I am currently reading (The Quants, by Scott Patterson) follows the classic path of a Greek tragedy. Man full of hubris (in this case due to his intellectual prowess) believes he has discovered the Truth. Drunk with arrogance from his ability to extract billions upon billions of profits from the financial markets he ignores the dangerous signs of the greatest credit bubble in the history of mankind and winds up nearly destroying the global financial system with his greed and megalomania. Its difficult to fathom that some of the smartest mathematical minds in the world could become subject to the basest human emotions of a degenerate gambler, but the protagonists of this book do indeed begin to behave exactly like roulette junkies doubling down continuously until their bankroll is nearly exhausted. One of the key takeaways from the Quants is that despite the multi-regression factor analysis, despite cupola functions and Gaussian curves, despite elegant algorithms that constantly play mean reversion between momentum and value financial markets are at their core not logical at all, but rather psychological. In times of fear human beings will be afraid to bid a penny for a multibillion dollar company and in times of greed they will part with their last dollar on a stock that has negative net worth. Yet the true lesson that I learned from the book is that size and leverage kill. The real reason most of these quant hedge funds got into so much trouble is that the massive scale of their positions along with the very high lever factor up to 30:1 setting them up for a colossal failure. Like dinosaurs that ruled the earth they were nearly wiped out from one cataclysmic event the collapse of the US housing market. In many ways their predicament made me appreciate my position as a retail trader. My exit strategy is not dependent on liquidation of thousands of securities. One click of a button and I can be in cash within seconds. This is a much underappreciated benefit that many of us take for granted. Unless we are trading more than 50M notional value of currency, our size will not impact the market allowing us unimpeded entry and exit from our trade. Of course, platforms will go down, quotes will freeze and brokers will be unable to execute our orders but those are permanent risks of trading FX and a big reason for why you should have several accounts. In the grander scheme of things however our ability to float like a butterfly, sting like a bee is a huge asset. In trading being small and swift is a plus. The other lesson from the Quants is the double edged danger of leverage. Basically anything above 10:1 is ultimately financial suicide. Leverage is a wonderful drug when the trade moves in your direction but it is pure poison when the market is aligned against you. The Achilles heel of all of the quants profiled in the book wasnt their finely tuned analytics. It was their massive leverage that forced them to cough up their positions at the worst possible time. When Bob Pisani walks the floor of the NYSE screaming that there is non-fundamental seller in a stock he is referring to margin liquidation a time when your ability to choose is taken away from you. The quants were the victims of that very dynamic and not even the most sophisticated algos in the world could help them out of their predicament.

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The Long Term is Random

In the latest book I am reading (The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty by Sam Savage) the author briefly takes the reader on a trip back in time to World War II and the work done at Princeton University by a group of a mathematicians and statisticians to help with the war effort. In an almost throw away passage, Mr. Savage writes, Ted Anderson currently an emeritus professor of statistics and economics at Stanford University, was a research associate there. One of their projects involved the evaluation of longrange weather forecasts. We found that there was very little accuracy beyond two days, Ted recalls. I stared at this paragraph in the book for a long time wondering why it resonated with me so much and then I finally remembered a meeting I had with a Russian hedge fund a few years back that had its offices in a very tony Fifth avenue building and housed more computer power than the Pentagon. The Russians had done an enormous amount of research on price behavior across almost all asset markets and concluded that at any given point of time directionality completely degraded within 72 hours from the start of observation. Essentially, market forecasts and weather forecasts have something in common our ability to predict either beyond the next 48 hours is no better than a guess. Thats the reason that

whenever I am on Squawk and the hosts try to get me to forecast the value of the dollar in the next twelve months I squirm in my seat and protest that I am only good for the next day or two. Chaotic systems such as markets and weather patterns are notoriously volatile and projecting their direction far out in time can be exercise in futility. But does that mean that all long term investing is not possible? Not necessarily. Warren Buffet is a testament to the fact that the turtle can sometimes decimate the hare in the race to generate alpha. The key with the long term view is that investors must expand their margin of error. Portfolio managers who trade stocks will rarely allocate more than 2% of their equity to one idea - this way even a 50% decline in price of the security only results in a 1% loss to their overall holdings. Contrast that approach with what we do in FX where we regularly trade at 10 times leverage. Under those conditions an adverse move of just 1% in our position results in a 10% haircut to our account. Both ways are perfectly legitimate forms of investing as long as we acknowledge what we are doing upfront. Too often short term traders become investors as price moves against them. If you are trading for the short term and you are holding the position for more than 72 hours you may as well buy a lottery ticket. Your chance of success will probably be better.

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Four Ways to Beat the Market

Can you beat the market? Many academics will tell you no. The markets are just too efficient in the long run. Those who appear to be winning are simply lucky fools who will get their comeuppance eventually. Are the efficient theory proponents right? I really dont know. Certainly the challenges are daunting. In any given year only 10-20% of all market participants manage to beat the averages. Still, regardless of whether the professors are correct, traders will continue to trade for the very same reason that climbers continue to climb Mount Everest the human spirit 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 to most traders in the market informational and behavioral. (For now lets forget all about execution edge because most retail traders will never have it) Informational edge is simply what we call fundamental analysis and most retail traders ignore it at their own risk. Fundamentals are the primary drivers of price action. To trade without knowledge of fundamentals is like driving blindfolded by feeling the curves of the road. Chances of a crash are almost assured. The second edge is behavioral which is simply another way of saying know your technicals. Technical analysis despite its fancy geometry and mathematical indicators is nothing more than an attempt to handicap human behavior. I believe that technicals work better on ultra short term time frames when price action is not subject to ever changing news flow, but thats a matter for debate. Whats incontrovertible is that techs are an important compliment to fundamentals. At BK we always trade in alignment with both and that approach provides us with our edge. Recognize that ALL edges will disappear over time as more and more traders attempt to exploit them. That why the search for edge is a never ending process. 2. Dont be greedy I know that the standard trading advice is: make your winners bigger than your losers, but I have never had success with that approach. Markets are generally not that generous. The standard refrain is that you need to be correct 50% of the time on a 2-1 reward/risk trade to make money in the long run, but in my experience the market produces strict 2 to 1 payoffs only 30% of the time making that strategy a loser. Floating profits are just that - floating. They can hit an iceberg anytime. Thats why Ive never found a better way to manage risk than to take partial profits early and try to ride the rest to glory. When it comes to trading a bird in the hand IS worth two in the bush 3. Be Humble It is incredibly seductive to pound your chest when you are winning and proclaim you are the Greaaatest, but Mr. Market will bitch slap you mercilessly just when you think you have it all figure out. K and I are blazing hot right now, but we spend most of our time ruthlessly challenging each others assumptions and come up with many more reasons to rule OUT trades rather than to rule them IN. Having done this for a long time we are the biggest skeptics of our own hype. We know just how tough this game really is. This brings me to my final point. 4. Trade One Pip at a Time The best way to make a millions in trading is to never try. Novice traders always approach trading with a hidden desire of hitting it big. The marketing literature of our business is littered with take $10,000 to $1 Million in Just one year pitches. Thats not trading thats the lottery. The real business, as many of you who have been with us for several years know, is remarkably prosaic. Two steps forward, one step back. Every basis point of return is a cold calculated battle with the market. In the end wealth, like all things in life, is built one brick at a time. Perhaps the reason why so few people make money from trading is because most simply dont have the patience or the equanimity to withstand Mr. Markets inevitable blows. But if you really like the game, the intellectual and financial rewards are well worth the challenge.

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Be a Coward like Patton and MacArthur

This week K and I attended the Bloomberg FX conference and aside from getting a tremendous ego boost when we found out that that we have an enthusiastic following on the institutional as well as the retail side, we also got to spend the day with some of the smartest currency traders in the world. The lessons learned last Thursday were immensely valuable, but none more so than the message from Jim Haskel from Bridgewater Associates. Bridgewater is one of the preeminent hedge funds in the world and Jim is responsible for assessing risk in the overall portfolio. He was clearly one of the sharpest guys in the room but his message was deceptively simple - above all else stay alive. Haskel recounted how Bridgewater was able to weather the post Lehman financial storm by essentially not trading for a while. Its much better to miss an opportunity than to assume unnecessary risk. Listening to Haskel, I suddenly remembered the great opening scene of Patton where George C. Scott stands in front of a massive American flag gently swaying behind him and barks at the camera, No dumb son-of-a-bitch ever won a war by dying for his own country but by having the other dumb son-of-a-bitch die for his country. I found this fascinating because even Patton, who was the most reckless military leader in WWII, understood instinctively that self preservation was paramount for victory. MacArthur, the other great general of the war, was also famous for never engaging the enemy at their point of strength. MacArthurs philosophy was to bypass the toughest Japanese military installations and attack only the weakest. Although the reality of these great military leaders contrasts sharply with our romantic view of charge-atall-costs war hero, it offers tremendous lessons to us as traders. Whether in war or on markets the first rule of the game is to simply survive. For those of us engaged in the day to day combat with price action it is sometimes difficult to remember that winning is not always an option and sometimes just staying alive is good enough. I cant remember how many times in my trading career, Ive let my ego get the better of me only to be saved by stop losses (every trade I make automatically carries one) thus preventing a total blow up of my account. In markets, there will always be tomorrow and there will always be chances to make fresh profits, but only if you have capital left to trade. From the best traders in the world to the greatest military commanders in history, we learn that we must always pick our battles carefully and make sure to stay alive to fight another day.

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Trade like The House

The longer I trade the more I come to the conclusion that you have to trade like a casino or an insurance company. No, I dont mean that you should start thinking about setting up your own blackjack table or begin offering life insurance products, but rather that you should only trade the risks that you understand and stand aside the rest of the time. The house edge in blackjack using liberal Las Vegas rules is only a miniscule 28 basis points. In baccarat it is 1.06% if you are the banker. In video poker it is just 46 basis points. The numbers are ridiculously small, yet they are enough to allow Steve Winn to buy Picassos, Warhols and Van Goghs and graciously display them in his art museum. The story is the same with life insurance. If you are in you mid-thirties to mid-forties, a nonsmoker, are not overweight and have no chronic medical conditions, it takes only about $1000 per year to obtain a $1M term life insurance policy. That seems incredibly cheap and you may wonder how insurance companies are able to offer such low cost protection. Do they just run a massive Bernie Madoff Ponzi scheme and refuse to pay off when you die? Well this being insurance some do, but generally they dont have to. The odds of them paying out a claim on the type of cohort I described is just 1 in 60,000 which means they can expect to bank $59M each year from every 60,000 policies they sell. Not a bad gig. Of course both insurance and casinos are basically fixed odds systems. Under the law of large numbers the payoffs are practically guaranteed. Trading is not as neatly forecastable by statistics. Unlike casino games the outcomes in markets are much more difficult

to predict. Investment returns suffer from what is known as fat tails events that under normal conditions would happen only once in every 10,000 years, occur in markets once every decade. Thats why in trading it becomes even more important to follow the casino and life insurance model and assume only the risks you can afford. Suppose youve been playing blackjack for a while in Vegas and you are up 1M on the house. What happens? Do the pit bosses glower at you? Do dealers looks at you in fear and disgust? Quite the opposite. The waitresses offer you free drinks and ask if you would like a Kobe burger brought to the table all courtesy of the house. The pit boss approaches you and congratulates you on your recent winnings and suggests that as a gesture of goodwill the casino would be glad to put you up at their $10,000 night penthouse suite for as long as you like and will be happy to attend to your every need. What the hell is going on here? Why is the casino being so nice? Because they know that the longer you stay at the table, the greater the chances that you will give all your winnings back. Now imagine you belly up to the blackjack table and place 100M worth of chips on a single bet. Do you think any casino would take your business? Of course not. Although casinos know that over the long run the edge is theirs, on any given hand the odds could easily favor the player and the prospect of 100M loss is much too great a risk to the safety of their business, Casinos trade only the risks that they know and stand down against everything else. If only we as traders could follow such steely discipline.

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