Ever wondered why US dollars are always occupying the hot seat of base currency. However, there are exceptions for the mention analyses, these constitute of primarily four other major currencies apart from US dollars that act as driving force for the trades operated in forex. Forex has five major currencies against which other currency are generally speculated, these are,
1) US dollars symbolized as USD.
2) EURO symbolized as EURO.
3) Japanese Yen symbolized as JPY.
4) Pound sterling symbolized as GBP.
5) Swiss Frank symbolized as CHF.
These five currencies together syndicate as majors on forex and the other currencies traded against them or for them are called crosses.
Among them US dollar occupies the prime position as more than 80% of the forex trade in the market are speculated against it. New York stock exchange has been trading around 50billion US dollar per day in the forex market and no wonder dollar has become the most sought after currency on the global forex markets.
Hypothetically it can be assumed that the bases for their major role are derived from their financial organization or the inventions and discoveries which have catered to their economic progress. We are all aware of the famous Swiss bank and its might. It is rumored and believed that bank of England holds much of the known gold as its reserves and can influence the stock and forex markets in a wink of an eye. Japanese technology and electronic tycoons have already over taken the world by storm. Ever since the conjunction of European union, the combined currency EURO has emerged as a formidable adversary for other currencies in the forex arena to recon with. Eventually the mighty United Sates of America which is indeed the most powerful nation of the globe and its political head the president, the most influential person known in the present era, US is not only mighty on the military front, but they have evolved as a nation which has capitalized every giant business ventures and opportunities present on our planet.
However, there are still other agencies present which can influence the exchange rate of the majors present in the forex markets. Following is the list of some of these agencies which can prove to be a driving force behind the scenes for a particular currency and can be held directly or indirectly of its upsurge or its upheavals.
1) Central banks and governments: - forex is a huge markets necessitating tremendous amount of money in fact, the foreign exchange market derives its force with the liquid capital. Central banks and government of a country can play an extremely significant role for influencing a particular currency and there by improving their economy. For instance, India can gain tremendous advantage with its foreign exchange reserves of millions of dollars. By having the foreign exchange reserve of a currency even a developing country like India can be a proud faction of the US economy and can have a rampant advantage derived indirectly via the growth of US economy.
2) Banks: - banks are playing a crucial role on the global front by investing millions or billions of dollars into the forex markets to gain monetary increments for their share holders. In other cases their clients may employ banks as brokers for investing huge amount of capital in the forex markets.
3) Funds:- visualizing the upheaval of stock markets all around the globe, many funds have turned their heads towards forex and since time is not a boundation and leverage is also enormous, which can range from 100:1 to 50:1 maximum, not found in the primary stock markets. These funds are investing huge multitudes of capital in the forex markets to gain tremendously out of extreme volatility of the forex market.
4) Corporate:- mammoth business corporate organizations who are done with the primary markets are now moving towards a much volatile forex markets which offers more opportunities for deriving monetary profits.
5) Travel and outsourcing:- another factor which has recently evolved as a guiding hot spot for a a currency exchange rate and determining the literal value for it is the industry of travel and tourism with contemporary modern, technological advancements in the field of transportation there are millions of tourist and business man traveling from one part to the other. The most frequently visited country will achieve an elevated leverage for its currency as it will be frequently exchanged for other currencies. The global competition has given rise to the modest operands of outsourcing. Thousands and millions of US dollars are paid to employees working in the developing nations for MNC’s based in developed countries, these dollars are finally exchanged for the currencies of the developing nations, this has proved as one global trade which has in variable influence over the currencies in pairs meant for exchange.
Monday, August 31, 2009
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Concerns or questions about this privacy policy can be directed to http://forexworlduk.blogspot.com for further clarification.
Routine Information Collection
All web servers track basic information about their visitors. This information includes, but is not limited to, IP addresses, browser details, timestamps and referring pages. None of this information can personally identify specific visitors to this site. The information is tracked for routine administration and maintenance purposes.
Cookies and Web Beacons
Where necessary, How To Trade Forex? uses cookies to store information about a visitor's preferences and history in order to better serve the visitor and/or present the visitor with customized content.
Advertising partners and other third parties may also use cookies, scripts and/or web beacons to track visitors to our site in order to display advertisements and other useful information. Such tracking is done directly by the third parties through their own servers and is subject to their own privacy policies.
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Note that you can change your browser settings to disable cookies if you have privacy concerns. Disabling cookies for all sites is not recommended as it may interfere with your use of some sites. The best option is to disable or enable cookies on a per-site basis. Consult your browser documentation for instructions on how to block cookies and other tracking mechanisms. This list of web browser privacy management links may also be useful.
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Concerns or questions about this privacy policy can be directed to http://forexworlduk.blogspot.com for further clarification.
Rool Overs -Where Uk Dominates USA
Although much of the transactions executed on forex markets are against dollars, which is a currency of United States of America, most of the spot deals are done on London foreign exchange and hence are executed according to GMT which is 21:59 at which 1 business day climaxes any deals done at this eleventh hour are automatically rolled over to the next session which starts at the same price the deals were left at 21:59 the previous day.
Q) What is a spot deal?
A) Spot deal is also known as T+2 deals, it is a deal in which the buyer agrees to take the delivery of the currency in two days after the deal is executed for a particular currency and day.
It is a common practice these days by brokers if you opened a trade and continued to hold it uncertain of converting it to the other currency, then brokers rollover your deal for the next day or for two days. If you wonder why your broker was so considerate, then you should know that your broker charged a nominal fee on your account as rollover fee.
The T+2 formula for rollover comes into practice when you hold your trade at the end of the session and make a spot deal, in two days your deal will be finalized to the rates quoted or held at the time of spot deal. The broker will charge you on the difference between the two prices on the final day which will be either loss or profits incurred by you on your spot deal. For instance, if you opened the trade on Monday, and held your position for a spot deal, then on Wednesday you will have to take the delivery of the currency you made the spot deal for and you will be required to open your deal on the price of spot deal made on Monday. Some brokers charge on the over night basis, while the others charge you for the difference in pips between the spot deal day and the actual deal day.
Rollovers is a common practice in forex markets, to comprehend it we need to take a closer look at our primary stock markets where futures and options has become a general practice. Rollovers on forex and futures on stock markets are some what similar and are operated in a similar fashion. But unlike stock market, where malpractices by gigantic broking firms or organizations yet need to be addressed, forex already has a pre meditated solution. Like stock markets there are huge banks which practice enormous volume of trading in currencies in context with rollovers in order to influence the price band of a particular currency, it is at this time that the federal banks step in to check the bear’s garden. An awkward increment or depreciation in the price band of a currency at an untimely manner is one of the signs where federal banks play their significant role, but as far as dollar which is the currency of America is concerned, the government of United State has led the tide take its time. In other words the US government has left the monetary evaluation of its currency on the sea saw of the market dynamics.
Rollover has become a prudent and an opulent practiced for many organization and individuals who do not wish to take the delivery on the trading session. The reasons may vary according to the essentials and the situation and demand. Sometimes due to lack of funds available as in the case of leverage account, rollover is practiced in order to buy some time to accumulate essential funds requisite for taking the delivery. Another reason for rollover might be speculative in nature and has originated through your tippers who have a confirmed information that the dollars is going to gain grounds in the coming two days, you might be tempted and hold your line for the spot deal and wait for two days only to get a pleasant surprise on the actual day of the deal that dollar indeed has gained grounds. You open the deal at a lower rate (you buy) when the dollar is hitting at all time high.
Rollover is a facility in forex, which is commonly practiced by government, banks and mammoth financial organization. You can do little wonder with leverage accounts in case you rolled over and the tide has turned against you, since a standard forex slot come at around $100000 which is literally a good amount of capital involved for just a single slot and for those who have their financial resources restrained taking the delivery on the second day will be an extremely harsh experience as huge some of liquid capital will be involved and essential.
Rollover should be practiced with extreme caution and after due analysis, as forex is a play ground for two gladiators, one who is skilled in experience and the other who has a lot of financial backing. It is best suggested for novice traders on forex markets to take the delivery at the end of the session rather than wait for the next forex quote for the currency. Since, the global market is filled with extreme volatility, rest assured if you do take the delivery, your price intended for selling and converting into your paramount requisite currency will come by the end of a day or two.
Q) What is a spot deal?
A) Spot deal is also known as T+2 deals, it is a deal in which the buyer agrees to take the delivery of the currency in two days after the deal is executed for a particular currency and day.
It is a common practice these days by brokers if you opened a trade and continued to hold it uncertain of converting it to the other currency, then brokers rollover your deal for the next day or for two days. If you wonder why your broker was so considerate, then you should know that your broker charged a nominal fee on your account as rollover fee.
The T+2 formula for rollover comes into practice when you hold your trade at the end of the session and make a spot deal, in two days your deal will be finalized to the rates quoted or held at the time of spot deal. The broker will charge you on the difference between the two prices on the final day which will be either loss or profits incurred by you on your spot deal. For instance, if you opened the trade on Monday, and held your position for a spot deal, then on Wednesday you will have to take the delivery of the currency you made the spot deal for and you will be required to open your deal on the price of spot deal made on Monday. Some brokers charge on the over night basis, while the others charge you for the difference in pips between the spot deal day and the actual deal day.
Rollovers is a common practice in forex markets, to comprehend it we need to take a closer look at our primary stock markets where futures and options has become a general practice. Rollovers on forex and futures on stock markets are some what similar and are operated in a similar fashion. But unlike stock market, where malpractices by gigantic broking firms or organizations yet need to be addressed, forex already has a pre meditated solution. Like stock markets there are huge banks which practice enormous volume of trading in currencies in context with rollovers in order to influence the price band of a particular currency, it is at this time that the federal banks step in to check the bear’s garden. An awkward increment or depreciation in the price band of a currency at an untimely manner is one of the signs where federal banks play their significant role, but as far as dollar which is the currency of America is concerned, the government of United State has led the tide take its time. In other words the US government has left the monetary evaluation of its currency on the sea saw of the market dynamics.
Rollover has become a prudent and an opulent practiced for many organization and individuals who do not wish to take the delivery on the trading session. The reasons may vary according to the essentials and the situation and demand. Sometimes due to lack of funds available as in the case of leverage account, rollover is practiced in order to buy some time to accumulate essential funds requisite for taking the delivery. Another reason for rollover might be speculative in nature and has originated through your tippers who have a confirmed information that the dollars is going to gain grounds in the coming two days, you might be tempted and hold your line for the spot deal and wait for two days only to get a pleasant surprise on the actual day of the deal that dollar indeed has gained grounds. You open the deal at a lower rate (you buy) when the dollar is hitting at all time high.
Rollover is a facility in forex, which is commonly practiced by government, banks and mammoth financial organization. You can do little wonder with leverage accounts in case you rolled over and the tide has turned against you, since a standard forex slot come at around $100000 which is literally a good amount of capital involved for just a single slot and for those who have their financial resources restrained taking the delivery on the second day will be an extremely harsh experience as huge some of liquid capital will be involved and essential.
Rollover should be practiced with extreme caution and after due analysis, as forex is a play ground for two gladiators, one who is skilled in experience and the other who has a lot of financial backing. It is best suggested for novice traders on forex markets to take the delivery at the end of the session rather than wait for the next forex quote for the currency. Since, the global market is filled with extreme volatility, rest assured if you do take the delivery, your price intended for selling and converting into your paramount requisite currency will come by the end of a day or two.
The Best Hours To Trade
If you want to earn extra cash aside from the cash you earn from your regular job or your business, maybe it’s time to you to enter the financial market. One kind of financial market that made a lot of people earn a lot of money is the Forex market.
Aside from the fact that the Forex market can give you an opportunity to earn a lot of money, you should also know that Forex is the largest and the most liquid financial market in the world with trade exchanges that amounts up to trillions of dollars each day.
Forex also operates 24 hours a day and therefore making it the most liquid market in the world. However, Forex is also a very risky market. Besides that fact that it generated a lot of people to become rich, it also made a lot of people lose large amounts of money. Therefore, you should consider that you should think twice before entering this financial market. You should have enough knowledge and skills before you enter this market. Part of the knowledge that you should know the best time you should enter this very liquid and very large market.
Sure you know how to trade, you know what currency pairs to trade, and you even know how to read charts. Perhaps, you also know one or two strategy when trading in the Forex market. However, you should also consider the fact that because the Forex market operates 24 hours a day, you need to know when you should trade.
Every minute in the Forex market counts. One minute you notice a currency is increasing in value, the next you notice that the same kind of currency you noticed a minute ago is decreasing in value. This is why you should consider the fact that Forex market is a very dynamic market with lots of price oscillations.
Minute by minute events are very important in order for you to be successful. Because of this feature that is found in the Forex market, you, as a Forex trader, can enter the market a number of times a day. This will allow you to earn some profits after every number of trades you do and perhaps maybe even lose one if you made the wrong trading decision.
Firstly, you have to remember that the Forex market beings at Sunday at 5PM EST to Friday at 4PM EST then it beings again at 5PM EST. Trading begins in Forex at New Zealand next at Australia followed by Asia, in the Middle East, Europe and ends in America. The major markets in Forex are London, Tokyo and New York with trading activities the heaviest when major markets overlap.
Basing from the times, you will see that there will always be someone anywhere in the world who is buying and selling currencies. You will see that when one market closes, another market opens. Trading in the Forex market is 24 hours a day.
Forex market transaction volume is always high during the whole day. However, it peaks the highest when the Asian market, the European market and the US market opens at the same time.
These are the trading hours in the Forex market you have to trade in, in order to get the highest possible trades. This are the hours that are also the most profitable.
Here are the open market times that you can use as reference:
• New York – 8am to 4pm EST
• London – 2am to 12nn EST
• Great Britain – 3am to 11am EST
• Tokyo – 8pm to 4am EST
• Australia – 7pm to 3am EST
If you look at the schedule and study it, you will see that there are two instances where two of the major markets overlap on trading hours. These are between 2am and 4am EST with Asian and European markets and 8am to 12pm EST with European and North American.
These are the things you should remember when trading in the Forex market. It is not only important that you know how to trade and know some strategies on Forex trading, But, you should also know when is the best time to trade in this very large and very liquid market.
If you follow all these, you can be sure that you can earn a potentially higher profit than on other trading times
Aside from the fact that the Forex market can give you an opportunity to earn a lot of money, you should also know that Forex is the largest and the most liquid financial market in the world with trade exchanges that amounts up to trillions of dollars each day.
Forex also operates 24 hours a day and therefore making it the most liquid market in the world. However, Forex is also a very risky market. Besides that fact that it generated a lot of people to become rich, it also made a lot of people lose large amounts of money. Therefore, you should consider that you should think twice before entering this financial market. You should have enough knowledge and skills before you enter this market. Part of the knowledge that you should know the best time you should enter this very liquid and very large market.
Sure you know how to trade, you know what currency pairs to trade, and you even know how to read charts. Perhaps, you also know one or two strategy when trading in the Forex market. However, you should also consider the fact that because the Forex market operates 24 hours a day, you need to know when you should trade.
Every minute in the Forex market counts. One minute you notice a currency is increasing in value, the next you notice that the same kind of currency you noticed a minute ago is decreasing in value. This is why you should consider the fact that Forex market is a very dynamic market with lots of price oscillations.
Minute by minute events are very important in order for you to be successful. Because of this feature that is found in the Forex market, you, as a Forex trader, can enter the market a number of times a day. This will allow you to earn some profits after every number of trades you do and perhaps maybe even lose one if you made the wrong trading decision.
Firstly, you have to remember that the Forex market beings at Sunday at 5PM EST to Friday at 4PM EST then it beings again at 5PM EST. Trading begins in Forex at New Zealand next at Australia followed by Asia, in the Middle East, Europe and ends in America. The major markets in Forex are London, Tokyo and New York with trading activities the heaviest when major markets overlap.
Basing from the times, you will see that there will always be someone anywhere in the world who is buying and selling currencies. You will see that when one market closes, another market opens. Trading in the Forex market is 24 hours a day.
Forex market transaction volume is always high during the whole day. However, it peaks the highest when the Asian market, the European market and the US market opens at the same time.
These are the trading hours in the Forex market you have to trade in, in order to get the highest possible trades. This are the hours that are also the most profitable.
Here are the open market times that you can use as reference:
• New York – 8am to 4pm EST
• London – 2am to 12nn EST
• Great Britain – 3am to 11am EST
• Tokyo – 8pm to 4am EST
• Australia – 7pm to 3am EST
If you look at the schedule and study it, you will see that there are two instances where two of the major markets overlap on trading hours. These are between 2am and 4am EST with Asian and European markets and 8am to 12pm EST with European and North American.
These are the things you should remember when trading in the Forex market. It is not only important that you know how to trade and know some strategies on Forex trading, But, you should also know when is the best time to trade in this very large and very liquid market.
If you follow all these, you can be sure that you can earn a potentially higher profit than on other trading times
Getting Started
Step 1. Open a demo account.
You can apply your knowledge in a real-life environment without risking your money.
Demo accounts are used for:
* Developing and testing trading strategies;
* Gaining confidence and familiarity of the trading platform;
* Applying your Risk Management rules to get an understanding of how they work.
Download MetaTrader 4
* Download trading platform. MetaTrader 4 User Guide.
* Open a FREE DEMO account.
* Free MetaTrader 4 for PDAs and for mobile phones.
* Free MetaTrader 4 MultiTerminal for money managers.
We recommend that you open a demo account prior to trading the live markets.
Step 2. Learn to forecast which way a market is expected to trend.
It is up to you what to choose: Fundamental Analysis, Technical Analysis, Elliot Wave theory, Candlesticks, Tomas Demark Theory, Chaos Theory or any other. Whatever you choose try to get as much experience as possible and never stop studying.
Step 3. Develop and test your trading strategy.
As with all trading, timing is critical. Sometimes it is not enough to know which trend prevails in the market. You need to learn how to determine the moment when it is more profitable to open/close a position because the difference in a few minutes can mean the difference between being a winner or a loser.
Step 4. Develop and test your risk management rules.
Follow your rules of risk management and know exactly how much you are ready to commit to the trade. If you do apply risk management rules correctly this could help you to increase your profit and at the same time to limit your losses.
Step 5. Be less emotional.
Try to make rational not emotional decisions. If you follow your emotions you are more inclined to make wrong and therefore unprofitable decisions. Make your trading plans before you open positions. Decide on your objectives, entry and exit points.
Step 6. Open a live account.
Start trading on the live account with a strategy that you've proven to yourself. Analyze your good trades and your bad ones. You can continue to develop your trading skills by testing your trading strategies on your demo account.
You can apply your knowledge in a real-life environment without risking your money.
Demo accounts are used for:
* Developing and testing trading strategies;
* Gaining confidence and familiarity of the trading platform;
* Applying your Risk Management rules to get an understanding of how they work.
Download MetaTrader 4
* Download trading platform. MetaTrader 4 User Guide.
* Open a FREE DEMO account.
* Free MetaTrader 4 for PDAs and for mobile phones.
* Free MetaTrader 4 MultiTerminal for money managers.
We recommend that you open a demo account prior to trading the live markets.
Step 2. Learn to forecast which way a market is expected to trend.
It is up to you what to choose: Fundamental Analysis, Technical Analysis, Elliot Wave theory, Candlesticks, Tomas Demark Theory, Chaos Theory or any other. Whatever you choose try to get as much experience as possible and never stop studying.
Step 3. Develop and test your trading strategy.
As with all trading, timing is critical. Sometimes it is not enough to know which trend prevails in the market. You need to learn how to determine the moment when it is more profitable to open/close a position because the difference in a few minutes can mean the difference between being a winner or a loser.
Step 4. Develop and test your risk management rules.
Follow your rules of risk management and know exactly how much you are ready to commit to the trade. If you do apply risk management rules correctly this could help you to increase your profit and at the same time to limit your losses.
Step 5. Be less emotional.
Try to make rational not emotional decisions. If you follow your emotions you are more inclined to make wrong and therefore unprofitable decisions. Make your trading plans before you open positions. Decide on your objectives, entry and exit points.
Step 6. Open a live account.
Start trading on the live account with a strategy that you've proven to yourself. Analyze your good trades and your bad ones. You can continue to develop your trading skills by testing your trading strategies on your demo account.
Daily Loss Limit Key To Long Term Survival
Last week, I received an email from a student asking my advice on whether I feel it is good practice to stop trading if one has lost a predefined daily amount.
In his email, he goes on to explain that he had been adhering to a "daily loss limit'' rule for some time. And the days he did lose the prescribed amount, he switched to simulator mode for the remainder of the trading day. Interestingly, he found that once he began his simulated trading, he would often make up his losses, and then some (in monopoly money). He also revealed that on one occasion, he transgressed, and ended up losing more than twice his allotted amount. This in turn caused him such emotional discomfort that it took him some time to get his mind back in the game. Since he was making up his losses after he stopped trading live, he was struggling with the idea that he should continue trading, and deal with the potential of incurring bigger loses.
This brings up several issues that are quite common to traders, particularly neophytes. One is the "could have, would have, and should have" conflict, which is where traders lament what they didn't do, or could have done differently. Quite often - if not forgotten quickly – this conflict can lead traders down the path of impulsive trading and a negative feedback loop that can be hard to squelch.
Similarly, when traders put themselves in a hole early in the trading day, the natural inclination is to want to recover all their losses, which in and of itself is fine. However, for some traders, the eagerness to gain back what they have lost elicits reckless behavior and excessive trading. Ironically, this only ends up exacerbating the loss.
If you've ever been in the aforementioned situation - and who hasn't at some point in their trading career - you know that sound judgment is clouded by the extreme need to get back the money we've lost. Moreover, traders that are only looking to break even after they've lost, more often than not, do just that.
Now, it goes without saying that you will not grow your account very much by breaking even on the majority of your trades; therefore, one should treat every single trade completely independent from the prior; without regard to whether it was a winning or losing trade.
This can only be done by having a rule that defines the maximum loss that can be sustained per trading day. The amount will vary depending on a trader's account size, and more importantly his or her tolerance for risk.
To make my point about how everyone has to have their own personal daily loss limit, when I'm teaching, I often joke that there are some folks in the room, who will lose a thousand bucks on any given day, and not even give it a second thought. Conversely, others will lose the same thousand dollars, and as a result, will have to take a Zoloft (anti-depression drug) to deal with the loss. Nevertheless, setting a daily stop loss is critical to survival in the longer term.
Along the same vein, it is also prudent to have weekly stop losses. One protocol I strictly adhere to is when my daily loss limit is triggered for three consecutive days, I cease my trading activity indefinitely. I take the time to clear my mind, diagnose whatever challenges I might be faced with, and begin the corrective process. Once I feel confident this has been achieved, I resume trading.
All in all, the response I wrote to the student was that having a daily loss limit far outweighs the psychological damage that he would endure if he were to take another big loss. Instead, he should focus on better execution and perhaps more patience.
Let's move on to a completely different topic. In last week's newsletter, I posted a chart of the S&P 500 in which I indicated was trading roughly 33% below its 200-day moving average. I remarked that it was a very rare occurrence, which in the past had preceded sharp rallies. By shear coincidence, the article was posted on Tuesday March 10, the day the S&P had one of its biggest rallies since November. As a result, I received several emails asking me for my prognostication of the market going forward.
The question on everyone's mind is whether Tuesday's rally marked the bottom, or just another bear market rally. The truth is, no one knows for sure, but I will go out on a limb and say that the preponderance of data certainly favors the odds that indeed the market is poised for - what I would deem - a tradable rally.
Let me explain: In the last two weeks, pessimism among investors reached levels that we haven't seen since the market crash of 1987. Furthermore, most so-called overbought–oversold indicators by most measures became grossly oversold. Additionally, company executives (insiders), who are considered by most "the smart money," are busy buying millions of shares in their respective companies. All the while, most investors are fleeing the stock market in droves. The government may also lend a hand in the rally argument, as they are likely to reinstate the uptick rule.
From a technical perspective, in the hourly chart of the ES (E-mini S&P) below, we see a change of trend clearly beginning to emerge.
Figure 1
Lastly, and perhaps the clincher, one of the major business news networks featured an article this week dedicated to showing investors how to profit from inverse EFT's (bear funds). In case you're not familiar with these products, they are closed-end funds that trade just like common stock, and produce gains as the market declines. Go figure, the market is down over 50%, and now they want to help investors with ways to short the market.
These are the primary reasons, in my view, that tilt the probabilities in favor of a short-term recovery for the market.
Until next time, I hope everyone has a profitable week.
If you have questions, comments, or you would like a specific topic covered, please email me at http://forexworlduk.blogspot.com
In his email, he goes on to explain that he had been adhering to a "daily loss limit'' rule for some time. And the days he did lose the prescribed amount, he switched to simulator mode for the remainder of the trading day. Interestingly, he found that once he began his simulated trading, he would often make up his losses, and then some (in monopoly money). He also revealed that on one occasion, he transgressed, and ended up losing more than twice his allotted amount. This in turn caused him such emotional discomfort that it took him some time to get his mind back in the game. Since he was making up his losses after he stopped trading live, he was struggling with the idea that he should continue trading, and deal with the potential of incurring bigger loses.
This brings up several issues that are quite common to traders, particularly neophytes. One is the "could have, would have, and should have" conflict, which is where traders lament what they didn't do, or could have done differently. Quite often - if not forgotten quickly – this conflict can lead traders down the path of impulsive trading and a negative feedback loop that can be hard to squelch.
Similarly, when traders put themselves in a hole early in the trading day, the natural inclination is to want to recover all their losses, which in and of itself is fine. However, for some traders, the eagerness to gain back what they have lost elicits reckless behavior and excessive trading. Ironically, this only ends up exacerbating the loss.
If you've ever been in the aforementioned situation - and who hasn't at some point in their trading career - you know that sound judgment is clouded by the extreme need to get back the money we've lost. Moreover, traders that are only looking to break even after they've lost, more often than not, do just that.
Now, it goes without saying that you will not grow your account very much by breaking even on the majority of your trades; therefore, one should treat every single trade completely independent from the prior; without regard to whether it was a winning or losing trade.
This can only be done by having a rule that defines the maximum loss that can be sustained per trading day. The amount will vary depending on a trader's account size, and more importantly his or her tolerance for risk.
To make my point about how everyone has to have their own personal daily loss limit, when I'm teaching, I often joke that there are some folks in the room, who will lose a thousand bucks on any given day, and not even give it a second thought. Conversely, others will lose the same thousand dollars, and as a result, will have to take a Zoloft (anti-depression drug) to deal with the loss. Nevertheless, setting a daily stop loss is critical to survival in the longer term.
Along the same vein, it is also prudent to have weekly stop losses. One protocol I strictly adhere to is when my daily loss limit is triggered for three consecutive days, I cease my trading activity indefinitely. I take the time to clear my mind, diagnose whatever challenges I might be faced with, and begin the corrective process. Once I feel confident this has been achieved, I resume trading.
All in all, the response I wrote to the student was that having a daily loss limit far outweighs the psychological damage that he would endure if he were to take another big loss. Instead, he should focus on better execution and perhaps more patience.
Let's move on to a completely different topic. In last week's newsletter, I posted a chart of the S&P 500 in which I indicated was trading roughly 33% below its 200-day moving average. I remarked that it was a very rare occurrence, which in the past had preceded sharp rallies. By shear coincidence, the article was posted on Tuesday March 10, the day the S&P had one of its biggest rallies since November. As a result, I received several emails asking me for my prognostication of the market going forward.
The question on everyone's mind is whether Tuesday's rally marked the bottom, or just another bear market rally. The truth is, no one knows for sure, but I will go out on a limb and say that the preponderance of data certainly favors the odds that indeed the market is poised for - what I would deem - a tradable rally.
Let me explain: In the last two weeks, pessimism among investors reached levels that we haven't seen since the market crash of 1987. Furthermore, most so-called overbought–oversold indicators by most measures became grossly oversold. Additionally, company executives (insiders), who are considered by most "the smart money," are busy buying millions of shares in their respective companies. All the while, most investors are fleeing the stock market in droves. The government may also lend a hand in the rally argument, as they are likely to reinstate the uptick rule.
From a technical perspective, in the hourly chart of the ES (E-mini S&P) below, we see a change of trend clearly beginning to emerge.
Figure 1
Lastly, and perhaps the clincher, one of the major business news networks featured an article this week dedicated to showing investors how to profit from inverse EFT's (bear funds). In case you're not familiar with these products, they are closed-end funds that trade just like common stock, and produce gains as the market declines. Go figure, the market is down over 50%, and now they want to help investors with ways to short the market.
These are the primary reasons, in my view, that tilt the probabilities in favor of a short-term recovery for the market.
Until next time, I hope everyone has a profitable week.
If you have questions, comments, or you would like a specific topic covered, please email me at http://forexworlduk.blogspot.com
A Basic Understanding Of Forex Market
A couple weeks ago I wrote a piece that compared the Spot Forex market to the Forex Futures. It recently dawned on me that the piece was really written to an audience that already has some knowledge of Forex. Today, let's discuss the basics of this very opportunistic market.
The foreign currency (Forex) market is where global exchange rates are derived for everyone including market speculators and end users of currency. People and companies buy and sell currency much like you would buy and sell anything else. Strong economies have strong currencies. When we trade the Forex markets, we are trading economies. Therefore, supply and demand for currency depends on the current and expected perceived health of a country's economy.
Example:
A Brief History
Foreign Currency (Forex) trading traces its history centuries back before the Babylonians. While they were the ones credited with the first use of paper notes and receipts, forms of currency had existed for quite some time already.
In the beginning, the value of goods and services was expressed in terms of other goods and services, also called "the barter system." Limitations of this system were the catalyst for establishing more generally accepted mediums of exchange. In the early days, primitive economies used items such as teeth, feathers, and stones as means of payment. In time, a more structured value system using Gold and Silver was created. After this came government paper money like we use today. Over the past few decades, foreign exchange trading (Forex) has developed into the world's largest global market. Restrictions on capital flows have been removed in most countries, leaving the market forces free to adjust foreign exchange rates according to their perceived values based on pure supply and demand for currency.
Why Trade Forex
* Leverage – Low capital requirements. Forex traders can start with much smaller amounts of money than you need for Day Trading equities.
* Time – Forex traders can trade when they have time. The Forex market is open and moving 24 hours a day, 5 ½ days a week. Trading occurs in all time zones in the world and can be a part-time or full-time occupation.
* Opportunity – The Forex markets are fantastic trending markets. They are also made up of markets that are not moving in the same direction. This provides rare non–correlated opportunity. Also, traders can profit in up and down trends by buying long or selling short. There are no short-selling rules.
How Does a Trade Work
First off, a "PIP" means Percentage In Points. For example, a move in the Euro vs. Dollar from .9050 to .9051 = 1 PIP. At $10.00 a PIP, let's calculate a trade setup much like we do in the Extended Learning Track (XLT) Forex class. Trading a 1 lot, if we have a protective stop loss that is 10 PIP's away from entry and a target for profit that is 30 PIP's away from entry, we would be risking $100 to make $300, 10 PIP's to make 30, or a 1:3 reward to risk ratio.
The key to getting involved in Forex trading is to first get educated and keep things simple. Next, trade a demo account until your numbers suggest you should trade real money. Once that is accomplished, you can trade mini Spot Forex at $1.00 a PIP. Once your numbers suggest you are doing well, which means you are consistently making at least two or three times what you are losing on each trade along with a decent win/loss ratio, then go to the $10.00 a PIP market and trade your successful plan. Never put your hard-earned money at risk until you are quite certain you have a plan that leads to consistent profits. You will only know this after your education leads to a trading plan that leads to consistent demo and mini Spot Forex trading. From my experience in the trading and trading education world, those who don't think this way typically lose their accounts to those who do.
Have a good day.
The foreign currency (Forex) market is where global exchange rates are derived for everyone including market speculators and end users of currency. People and companies buy and sell currency much like you would buy and sell anything else. Strong economies have strong currencies. When we trade the Forex markets, we are trading economies. Therefore, supply and demand for currency depends on the current and expected perceived health of a country's economy.
Example:
Example: |
|
|---|---|
Company "A" | Company "B" |
Strong earnings | Weak earnings |
Strong management | Weak management |
Strong market share | Weak market share |
High Stock Valuation | Low Stock Valuation |
Example 2: |
|
|---|---|
Country "A" | Country "B" |
Strong economy | Weak economy |
Low taxes | High taxes |
Growing GDP | Declining GDP |
High Currency Valuation | Low Currency Valuation |
A Brief History
Foreign Currency (Forex) trading traces its history centuries back before the Babylonians. While they were the ones credited with the first use of paper notes and receipts, forms of currency had existed for quite some time already.
In the beginning, the value of goods and services was expressed in terms of other goods and services, also called "the barter system." Limitations of this system were the catalyst for establishing more generally accepted mediums of exchange. In the early days, primitive economies used items such as teeth, feathers, and stones as means of payment. In time, a more structured value system using Gold and Silver was created. After this came government paper money like we use today. Over the past few decades, foreign exchange trading (Forex) has developed into the world's largest global market. Restrictions on capital flows have been removed in most countries, leaving the market forces free to adjust foreign exchange rates according to their perceived values based on pure supply and demand for currency.
Why Trade Forex
* Leverage – Low capital requirements. Forex traders can start with much smaller amounts of money than you need for Day Trading equities.
* Time – Forex traders can trade when they have time. The Forex market is open and moving 24 hours a day, 5 ½ days a week. Trading occurs in all time zones in the world and can be a part-time or full-time occupation.
* Opportunity – The Forex markets are fantastic trending markets. They are also made up of markets that are not moving in the same direction. This provides rare non–correlated opportunity. Also, traders can profit in up and down trends by buying long or selling short. There are no short-selling rules.
How Does a Trade Work
First off, a "PIP" means Percentage In Points. For example, a move in the Euro vs. Dollar from .9050 to .9051 = 1 PIP. At $10.00 a PIP, let's calculate a trade setup much like we do in the Extended Learning Track (XLT) Forex class. Trading a 1 lot, if we have a protective stop loss that is 10 PIP's away from entry and a target for profit that is 30 PIP's away from entry, we would be risking $100 to make $300, 10 PIP's to make 30, or a 1:3 reward to risk ratio.
The key to getting involved in Forex trading is to first get educated and keep things simple. Next, trade a demo account until your numbers suggest you should trade real money. Once that is accomplished, you can trade mini Spot Forex at $1.00 a PIP. Once your numbers suggest you are doing well, which means you are consistently making at least two or three times what you are losing on each trade along with a decent win/loss ratio, then go to the $10.00 a PIP market and trade your successful plan. Never put your hard-earned money at risk until you are quite certain you have a plan that leads to consistent profits. You will only know this after your education leads to a trading plan that leads to consistent demo and mini Spot Forex trading. From my experience in the trading and trading education world, those who don't think this way typically lose their accounts to those who do.
Have a good day.
How To Trade In Forex
Okay, so things are rough out there. Bear Stearns, Lehman Brothers, Washington Mutual, American International Group, B&B, Freddy and Fannie and the rest of the gang have all either gone to that Big Vault in the Sky, or are on life support. The proverbial "other shoe" has dropped so many times that we've all lost count – and the carnage isn't yet complete. But just because the world is facing financial Armageddon, and long-term investments are falling apart faster than the New York Mets in September, that doesn't mean your trading account has to suffer. In fact, some traders thrive in this rock 'em, sock 'em environment. Just take a look at the volatility in the Great Britain Pound – U.S. Dollar currency pair (symbol GBP/USD). Note how the candles on the left side of the chart are much bigger than on the right, indicating that the daily range has expanded dramatically. Also, take a look at the Average True Range indicator (ATR), which shows us that the average daily range of GBP/USD over the past 14 trading days now exceeds 300 pips! (See figure 1).
Figure 1: GBP/USD's average daily volatility has risen to over 300 pips. Source: Saxo Bank
This level of volatility hasn't been seen since the year 2000, and the type of wild action it creates will be welcomed by some traders and avoided by others. Here are three key thoughts to help you trade safely and securely during these challenging and historic times.
Nimble – Things are happening quickly out there, and the wide swings in volatility are causing markets to move faster and farther than before. In fact, volatility in the currency markets is at its highest point since the year 2000. What's a trader to do? Traders looking for quick intraday moves need to keep their finger on the trigger at all times – especially when they are already in a trade. The game changes quickly, so be ready for action at a moment's notice. Put your mouse cursor directly above the exit button, and keep your finger poised above the mouse. That way, you'll never be taken by surprise, and you'll always be ready to close your position.
Pip Slip – Prepare for slippage, as fast moving markets may cause some surprising fills. This is a common occurrence in the stock markets, but currency traders have been largely immune to slippage - that is, until the recent spike in volatility changed the game and turned the trading world upside down. How to deal with this problem? Plan ahead and don't be surprised when you get a bad fill; in fact, make it part of your game plan. When performing your calculations, assume that the price you receive for both buys and sells will be slightly worse than you would normally anticipate. Not only will you be prepared for a bad fill, but you may find yourself pleasantly surprised when you get a good one!
Park It - Trading in this fast-paced environment isn't meant for those with a nervous stomach. In fact, many of us would be better served by simply staying out of the trade and watching from the sidelines until the markets settle down. Always remember that part of our jobs as traders is to know when to avoid trading. The truth is you should never feel as if you absolutely have to place a trade, and you should only place trades when you feel that the odds are in your favor. Selectivity is the key; you will make more money from one good trade than you will from ten mediocre trades, so maintain your focus and only take the best trading opportunities.
Question of the Week
Q) Ed, I keep hearing about LIBOR in connection with the bailout but I'm not familiar with this term. Can you please explain what it means and why it is important to traders?
Ed Ponsi) Thank you for your question. LIBOR is short for London Interbank Offered Rate, and it represents the cost of borrowing dollars overnight in London. On September 30th, the last day of the third quarter and the day after the bailout plan first failed to pass through Congress, LIBOR spiked an incredible 431 basis points to 6.88%. Let's think about that for a minute; banks are charging each other an annual rate of 6.88% for overnight loans! They must be pretty frightened to charge such a high rate, perhaps because no bank wants to lend money, only to find out later that the borrower has evaporated.
In a way, you could say that LIBOR is a "fear gauge", and it is telling us right now that banks do not want to lend money to other banks except at ridiculous rates. This is despite the fact that the Fed and other central banks are constantly pumping liquidity into the system, jamming the banks full of cash so that they'll be more willing to lend. Many of the banks are just hoarding this added capital for their own needs instead of lending it out to others, defeating the purpose of the Fed's actions.
Right now we are seeing strength in the U.S. dollar, and that is because the USD tends to perform well when fear is high. But this will pass; fear is a temporary condition, and as bad as it may seem right now, things will eventually get better. When they do, watch out – the bill will come due for this mess, and when it does, it will weigh heavily on the greenback. Enjoy the USD rally while it lasts.
Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.
Figure 1: GBP/USD's average daily volatility has risen to over 300 pips. Source: Saxo Bank
This level of volatility hasn't been seen since the year 2000, and the type of wild action it creates will be welcomed by some traders and avoided by others. Here are three key thoughts to help you trade safely and securely during these challenging and historic times.
Nimble – Things are happening quickly out there, and the wide swings in volatility are causing markets to move faster and farther than before. In fact, volatility in the currency markets is at its highest point since the year 2000. What's a trader to do? Traders looking for quick intraday moves need to keep their finger on the trigger at all times – especially when they are already in a trade. The game changes quickly, so be ready for action at a moment's notice. Put your mouse cursor directly above the exit button, and keep your finger poised above the mouse. That way, you'll never be taken by surprise, and you'll always be ready to close your position.
Pip Slip – Prepare for slippage, as fast moving markets may cause some surprising fills. This is a common occurrence in the stock markets, but currency traders have been largely immune to slippage - that is, until the recent spike in volatility changed the game and turned the trading world upside down. How to deal with this problem? Plan ahead and don't be surprised when you get a bad fill; in fact, make it part of your game plan. When performing your calculations, assume that the price you receive for both buys and sells will be slightly worse than you would normally anticipate. Not only will you be prepared for a bad fill, but you may find yourself pleasantly surprised when you get a good one!
Park It - Trading in this fast-paced environment isn't meant for those with a nervous stomach. In fact, many of us would be better served by simply staying out of the trade and watching from the sidelines until the markets settle down. Always remember that part of our jobs as traders is to know when to avoid trading. The truth is you should never feel as if you absolutely have to place a trade, and you should only place trades when you feel that the odds are in your favor. Selectivity is the key; you will make more money from one good trade than you will from ten mediocre trades, so maintain your focus and only take the best trading opportunities.
Question of the Week
Q) Ed, I keep hearing about LIBOR in connection with the bailout but I'm not familiar with this term. Can you please explain what it means and why it is important to traders?
Ed Ponsi) Thank you for your question. LIBOR is short for London Interbank Offered Rate, and it represents the cost of borrowing dollars overnight in London. On September 30th, the last day of the third quarter and the day after the bailout plan first failed to pass through Congress, LIBOR spiked an incredible 431 basis points to 6.88%. Let's think about that for a minute; banks are charging each other an annual rate of 6.88% for overnight loans! They must be pretty frightened to charge such a high rate, perhaps because no bank wants to lend money, only to find out later that the borrower has evaporated.
In a way, you could say that LIBOR is a "fear gauge", and it is telling us right now that banks do not want to lend money to other banks except at ridiculous rates. This is despite the fact that the Fed and other central banks are constantly pumping liquidity into the system, jamming the banks full of cash so that they'll be more willing to lend. Many of the banks are just hoarding this added capital for their own needs instead of lending it out to others, defeating the purpose of the Fed's actions.
Right now we are seeing strength in the U.S. dollar, and that is because the USD tends to perform well when fear is high. But this will pass; fear is a temporary condition, and as bad as it may seem right now, things will eventually get better. When they do, watch out – the bill will come due for this mess, and when it does, it will weigh heavily on the greenback. Enjoy the USD rally while it lasts.
Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.
Why Investors Fail?
Like all the children from Lake Wobegon, I am sure all my readers are above-average investors. But I am also sure you have friends who are not, so in this chapter we will look at the reasons why they fail at investing, and how they should analyze funds and determine risk. Hopefully this will give you some ways to help them. I will show you a simple way to put yourself in the top 20% of investors. This should make it easier to go to family reunions and listen to your brother-in-law's stories.
A big part of successful Bull's Eye Investing is simply avoiding the mistakes that the large majority of investors make. I can give you all the techniques, trading tips, fund recommendations, forecasts, and so on; but you must still keep away from the patterns which are typical of failed investors.
What I want to do in this section is give you an "aha!" moment: that insight which helps you understand something about the mysteries of the marketplace. We will look at a number of seemingly random ideas and concepts, and then see what conclusions we can draw. Let's jump in.
Investors Behaving Badly
The Financial Research Corporation released a study prior to the [2001-02] bear market which showed that the average mutual fund's three-year return was 10.92%, while the average investor in those same periods gained only 8.7%. The reason was simple: investors were chasing the hot sectors and funds.
If you study just the last three years, my guess is those numbers will be worse. "The study found that the current average holding period was around 2.9 years for a typical investor, which is significantly shorter than the 5.5-year holding period of just five years ago.
[While the research below is from a few years ago, recent studies show exactly the same, if not worse, results. Investors in general are not getting any better.]
"Many investors are purchasing funds based on past performance, usually when the fund is at or near its peak. For example, $91 billion of new cash flowed into funds just after they experienced their "best performing" quarter. In contrast, only $6.5 billion in new money flowed into funds after their worst performing quarter." (from a newsletter by Dunham and Associates)
I have seen numerous studies similar to the one above. They all show the same thing: that the average investor does not get average performance. Many studies show statistics which are much worse.
The study also showed something I had observed anecdotally, for which there was no evidence. Past performance was a good predictor of future relative performance in the fixed-income markets and international equity (stock) funds, but there was no statistically significant way to rely on past performance in the domestic (US) stock equity mutual funds. I will comment on why I believe this is so later on.
"The oft-repeated legal disclosure that past performance is no guarantee of future results is true at two levels:
1. Absolute returns cannot be guaranteed with any confidence. There is too much variability for each broad asset class over multiple time periods. Stocks in general may provide 5-10% returns during one decade, 10-20% during the next decade, and then return back to the 5-10% range.
2. Absolute rankings also cannot be predicted with any certainty. This is caused by too much relative variability within specific investment objectives. #1 funds can regress to the average or fall far below the average over subsequent periods, replaced by funds that may have had very low rankings at the start. The higher the ranking and the more narrowly you define that ranking (i.e. #1 vs. top-decile [top 10%] vs. top quartile [top 25%] vs. top half), the more unlikely it is that a fund can repeat at that level. It is extremely unlikely to repeat as #1 in an objective with more than a few funds. It is very difficult to repeat in the top decile, challenging to repeat in the top quartile, and roughly a coin toss to repeat in the top half." (Financial Research Center)
This is in line with a study from the National Bureau of Economic Research. Only a very small percentage of companies can show merely above-average earnings growth for 10 years in a row. The percentage is not more than you would expect from simply random circumstances.
The chances of you picking a stock today that will be in the top 25% of all companies every year for the next ten years are 1 in 50 or worse. In fact, the longer a company shows positive earnings growth and outstanding performance, the more likely it is to have an off year. Being on top for an extended period of time is an extremely difficult feat.
Yet, what is the basis for most stock analysts' predictions? Past performance and the optimistic projections of a management that gets compensated with stock options. What CEO will tell you his stock is overpriced? His staff and board will kill him, as their options will be worthless. Analysts make the fatally flawed assumption that because a company has grown 25% a year for five years that it will do so for the next five. The actual results for the last 50 years show the likelihood of that happening is very small.
Tails You Lose, Heads I Win
I cannot recommend highly enough a marvelous book by Nassim Nicholas Taleb, called Fooled by Randomness. The sub-title is "The Hidden Role of Chance in the Markets and in Life." I consider it essential reading for all investors, and would go so far as to say that you should not invest in anything without reading this book. He looks at the role of chance in the marketplace. Taleb is a man who is obsessed with the role of chance, and he gives us a very thorough treatment. He also has a gift for expressing complex statistical problems in a very understandable manner. I intend to read the last half of this book at least once a year to remind me of some of these principles. Let's look at just a few of his thoughts.
Assume you have 10,000 people who flip a coin once a year. After five years, you will have 313 people who have come up with heads five times in a row. If you put suits on them and sit them in glass offices, call them a mutual or a hedge fund, they will be managing a billion dollars. They will absolutely believe they have figured out the secret to investing that all the other losers haven't discerned. Their seven-figure salaries prove it.
The next year, 157 of them will blow up. With my power of analysis, I can predict which one will blow up. It will be the one in which you invest!
Ergodicity
In the mutual fund and hedge fund world, one of the continual issues of reporting returns is something called "survivorship bias." Let's say you start with a universe of 1,000 funds. After five years, only 800 of those funds are still in business. The other 200 had dismal results, were unable to attract money, and simply folded.
If you look at the annual returns of the 800 funds, you get one average number. But if you add in the returns of the 200 failures, the average return is much lower. The databases most statistics are based upon only look at the survivors. This sets up false expectations for investors, as it raises the average.
Taleb gave me an insight for which I will always be grateful. He points out that because of chance and survivorship bias, investors are only likely to find out about the winners. Indeed, who goes around trying to sell you the losers? The likelihood of being shown an investment or a stock which has flipped heads five times in a row are very high. But chances are, that hot investment you are shown is a result of randomness. You are much more likely to have success hunting on your own. The exception, of course, would be my clients. (Note to regulators: that last sentence is a literary device called a weak attempt at humor. It is not meant to be taken literally.)
That brings us to the principle of Ergodicity, "...namely, that time will eliminate the annoying effects of randomness. Looking forward, in spite of the fact that these managers were profitable in the past five years, we expect them to break even in any future time period. They will fare no better than those of the initial cohort who failed earlier in the exercise. Ah, the long term." (Taleb)
Why Investors Fail
While the professionals typically explain their problems in very creative ways, the mistakes that most of us make are much more mundane. First and foremost is chasing performance. Study after study shows the average investor does much worse than the average mutual fund, as they switch from their poorly performing fund to the latest hot fund, just as it turns down.
Mark Finn of Vantage Consulting has spent years analyzing trading systems. He is a consultant to large pension funds and Fortune 500 companies. He is one of the more astute analysts of trading systems, managers, and funds that I know. He has put more start-up managers into business than perhaps anyone in the fund management world. He has a gift for finding new talent and deciding if their "ideas" have investment merit.
He has a team of certifiable mathematical geniuses working for him. They have access to the best pattern-recognition software available. They have run price data through every conceivable program, and come away with this conclusion:
Past performance is not indicative of future results.
Actually, Mark says it more bluntly: Past performance is pretty much worthless when it comes to trying to figure out the future. The best use of past performance is to determine how a manager behaved in a particular set of prior circumstances.
Yet investors read that past performance is not indicative of future results, and then promptly ignore it. It is like reading statements at McDonalds that coffee is hot. We don't pay attention.
Chasing the latest hot fund usually means you are now in a fund that is close to reaching its peak, and will soon top out. Generally that is shortly after you invest.
What do Finn and his team tell us does work? Fundamentals, fundamentals, fundamentals. As they look at scores of managers each year, the common thread for success is how they incorporate some set of fundamental analysis patterns into their systems.
This is consistent with work done by Dr. Gary Hirst, one of my favorite analysts and fund managers. In 1991, he began to look at technical analysis. He spent huge sums on computers and programming, analyzing a variety of technical analysis systems. Let me quote him on the results of his research:
"I had heard about technical analysis and chart patterns, and looking at this stuff I would say, what kind of voodoo is this? I was very, very skeptical that technical analysis had value. So I used the computers to check it out, and what I learned was that there was, in fact, no useful reality there. Statistically and mathematically all these tools -- stochastics, RSI, chart patterns, Elliot Wave, and so on -- just don't work. If you code any of these rigorously into a computer and test them they produce no statistical basis for making money; they're just wishful thinking. But I did find one thing that worked. In fact almost all technical analysis can be reduced to this one thing, though most people don't realize it: the distributions of returns are not normal; they are skewed and have "fat tails." In other words, markets do produce profitable trends. Sure, I found things that work over the short term, systems that work for five or ten years but then fail miserably. Everything you made, you gave back. Over the long term, trends are where the money is."
Becoming a Top 20% Investor
Over very long periods of time, the average stock will grow at about 7% a year, which is GDP growth plus dividends plus inflation. This is logical when you think about it. How could all the companies in the country grow faster than the total economy? Some companies will grow faster than others, of course, but the average will be the above. There are numerous studies which demonstrate this. That means roughly 50% of the companies will outperform the average and 50% will lag.
The same is true for investors. By definition, 50% of you will not achieve the average; 10% of you will do really well; and 1% will get rich through investing. You will be the lucky ones who find Microsoft in 1982. You will tell yourself it was your ability. Most of us assign our good fortune to native skill and our losses to bad luck.
But we all try to be in the top 10%. Oh, how we try. The FRC study cited at the beginning shows how most of us look for success, and then get in, only to have gotten in at the top. In fact, trying to be in the top 10% or 20% is statistically one of the ways we find ourselves getting below-average returns over time. We might be successful for a while, but reversion to the mean will catch up.
Here is the very sad truth. The majority of investors in the top 10-20% in any given period are simply lucky. They have come up with heads five times in a row. Their ship came in. There are some good investors who actually do it with sweat and work, but they are not the majority. Want to make someone angry? Tell a manager that his (or her) fabulous track record appears to be random luck or that they simply caught a wave and rode it. Then duck.
By the way, is it luck or skill when an individual goes to work for a start-up company and is given stock in their 401k which grows at 10,000%? How many individuals work for companies where that didn't happen, or their stock options blew up (Enron)? I happen to lean toward Grace, rather than luck or skill, as an explanation; but this is not a theological treatise.
Read The Millionaire Next Door. Most millionaires make their money in business and/or by saving lots of money and living frugally. Very few make it simply by investing skill alone. Odds are that you will not be that person.
But I can tell you how to get in the top 20%. Or better, I will let FRC tell you, because they do it so well:
"For those who are not satisfied with simply beating the average over any given period, consider this: if an investor can consistently achieve slightly better than average returns each year over a 10-15 year period, then cumulatively over the full period they are likely to do better than roughly 80% or more of their peers. They may never have discovered a fund that ranked #1 over a subsequent one- or three-year period. That "failure," however, is more than offset by their having avoided options that dramatically underperformed. Avoiding short-term underperformance is the key to long-term outperformance.
"For those that are looking to find a new method of discerning the top ten funds for 2002, this study will prove frustrating. There are no magic short-cut solutions, and we urge our readers to abandon the illusive and ultimately counterproductive search for them. For those who are willing to restrain their short-term passions, embrace the virtue of being only slightly better than average, and wait for the benefits of this approach to compound into something much better..."
That's it. You simply have to be only slightly better than average each year to be in the top 20% at the end of the race. It is a whole lot easier to figure out how to do that than chase the top ten funds.
Of course, you could get lucky (or Blessed) and get one of the top ten funds. But recognize it for what it is and thank God (or your luck if you are agnostic) for His blessings.
I should point out that it takes a lot of work to be in the top 50% consistently. But it can be done. I don't see it as much as I would like, but I do see it.
Investing in a stock or a fund should not be like going to Vegas. When you put money with a manager or a fund, you should think as if you are investing in their management company. Ask yourself, "Is this someone I want to be in business with? Do I want him running my company? Does this company have a reasonable business objective? What is their edge that makes me think they will be above average? What is the reason I would think they could discern the difference between randomness and good management?"
When I meet a manager, and all he wants to do is talk about his track record, I find a way to quickly close the conversation. When they tell me they are trying to make the most they can, I head for the door. Maybe they are the real deal, but my experience says the odds are against it.
It's about not settling for being mediocre. Statistics and experience tell us that simply being consistently above average is damn hard work. When a fund is the number one fund, that is random. They had a good run or a good idea and it worked. Are they likely to repeat? No.
But being in the top 50% every year for ten years? That is NOT random. That is skill. That type of consistent solid management is what you should be looking for.
By the way, I mentioned at the beginning that past performance was statistically useful for ascertaining relative performance of certain types of funds like bond funds and international funds. In the fixed-income markets (bonds) everyone is dealing with the same instruments. Funds with lower overhead and skilled traders who aggressively watch their trading costs have an edge. That management skill shows up in consistently above-average relative returns.
Likewise, funds which do well in international investments tend to stay in the top brackets. That is because the skill set for international fund management is rare and the learning cost is high. In that world, local knowledge of the markets clearly adds value.
But in the US stock market, everybody knows everything everybody else does. Past performance is a very bad predictor of future results. If a fund does well in one year, it is possibly because they took some extra risks to do so, and eventually those risks will bite them and their investors. Maybe they were lucky and had two of their biggest holdings really go through the roof. Finding those monster winners is a hard thing to do for several years in a row. Plus, the US stock market is very cyclical, so that what goes up one year or even longer in a bubble market will not do well the next.
Investors Behaving Badly
Gavin McQuill of the Financial Research Center sent me his rather brilliant $5,000 report called "Investors Behaving Badly." He was the author and he did a great job. I read it over one weekend, and refer to it again from time to time.
Earlier we looked at a report which showed that over the last decade investors chased the hot mutual funds. The higher the markets went, the less likely it was that they would buy and hold. Investors consistently bought high and sold low. Investors made significantly less than the average mutual fund did.
McQuill focused on six emotions that cause investors to make these mistakes. You should read these and see whether some of them are familiar.
1. "Fear of Regret - An inability to accept that you've made a wrong decision, which leads to holding onto losers too long or selling winners too soon." This is part of a whole cycle of denial, anxiety, and depression. As with any difficult situation, we first deny there is a problem, and then get anxious as the problem does not go away or gets worse. Then we go into depression because we didn't take action earlier, and hope that something will come along and rescue us from the situation.
2. "Myopic loss aversion (a.k.a. as 'short-sightedness') - A fear of losing money and the subsequent inability to withstand short-term events and maintain a long-term perspective." Basically, this means we attach too much importance to day-to-day events, rather than looking at the big picture. Behavioral psychologists have determined that the fear of loss is the most important emotional factor in investor behavior.
Like investors chasing the latest hot fund, a news story or a bad day in the market becomes enough for the investor to extrapolate the recent event as the new trend which will stretch far into the future. In reality, most events are unimportant, and have little effect on the overall economy.
3. "Cognitive dissonance - The inability to change your opinion after new evidence contradicts your baseline assumption." Dissonance, whether musical or emotional, is uncomfortable. It is often easier to ignore the event or fact producing the dissonance rather than deal with it. We tell ourselves it is not meaningful, and go on our way. This is especially easy if our view is the accepted view. "Herd mentality" is a big force in the market.
4. "Overconfidence - People's tendency to overestimate their abilities relative to individuals possessing greater expertise." Professionals beat amateurs 99% of the time. The other 1% is luck. The famous Clint Eastwood line, "Do you feel lucky, punk? Well, do you?" comes to mind.
In sports, most of us know when we are outclassed. But as investors, we somehow think we can beat the pros, will always be in the top 10%, and any time we win it is because of our skills and good judgement. It is bad luck when we lose.
Commodity brokers know that the best customers are those who strike it rich in their first few trades. They are now convinced they possess the gift or the Holy Grail of trading systems. These are the people who will spend all their money trying to duplicate their initial success, in an effort to validate their obvious abilities. They also generate large commissions for their brokers.
5. "Anchoring - People's tendency to give too much credence to their most recent experience and to show reluctance to adjust their current beliefs." If you believe that NASDAQ stocks are the place to be, that becomes your anchor. No matter what new information comes your way, you are anchored in your belief. Your experience in 1999 shows you were right.
As Lord Keynes said so eloquently when forced to acknowledge a shift in a previous position he had taken, "Sir, the fact have changed, and when the facts change, I change. What do you do, sir?"
We expect the current trend to continue forever, and forget that all trends eventually regress to the mean. That is why investors still plunge into index funds, believing that stocks will go up over the long term. They think long term is two years. They do not understand that it will take years - maybe even a decade - for the process of reversion to the mean to complete its work.
6. "Representativeness - The tendency of people to see patterns within random events." Eric Frye did a great tongue-in-cheek article in The Daily Reckoning, a daily investment letter (www.dailyreckoning.com). He documented that each time Sports Illustrated used a model for the cover of their swimsuit issue who came from a new country that had never been represented on the cover before, the stock market of that country had always risen over a four-year period. This year, it is time to buy Argentinian stocks. Frye evidently did not do a correlation study on the size of the swimsuit against the eventual rise in the market. However, I am sure some statistician with more time on his hands than I do will brave that analysis.
Investors assume that items with a few similar traits are likely to be associated or identical, and start to see a pattern. McQuill gives us an example. Suzy is an English and environmental studies major. Most people, when asked if it is more likely that Suzy will become a librarian or work in the financial services industry, will choose librarian. They will be wrong. There are vastly more workers in the financial industry than there are librarians. Statistically, the probability is that she will work in the financial services industry, even though librarians are likely to be English majors.
I hope you enjoy your week.
A big part of successful Bull's Eye Investing is simply avoiding the mistakes that the large majority of investors make. I can give you all the techniques, trading tips, fund recommendations, forecasts, and so on; but you must still keep away from the patterns which are typical of failed investors.
What I want to do in this section is give you an "aha!" moment: that insight which helps you understand something about the mysteries of the marketplace. We will look at a number of seemingly random ideas and concepts, and then see what conclusions we can draw. Let's jump in.
Investors Behaving Badly
The Financial Research Corporation released a study prior to the [2001-02] bear market which showed that the average mutual fund's three-year return was 10.92%, while the average investor in those same periods gained only 8.7%. The reason was simple: investors were chasing the hot sectors and funds.
If you study just the last three years, my guess is those numbers will be worse. "The study found that the current average holding period was around 2.9 years for a typical investor, which is significantly shorter than the 5.5-year holding period of just five years ago.
[While the research below is from a few years ago, recent studies show exactly the same, if not worse, results. Investors in general are not getting any better.]
"Many investors are purchasing funds based on past performance, usually when the fund is at or near its peak. For example, $91 billion of new cash flowed into funds just after they experienced their "best performing" quarter. In contrast, only $6.5 billion in new money flowed into funds after their worst performing quarter." (from a newsletter by Dunham and Associates)
I have seen numerous studies similar to the one above. They all show the same thing: that the average investor does not get average performance. Many studies show statistics which are much worse.
The study also showed something I had observed anecdotally, for which there was no evidence. Past performance was a good predictor of future relative performance in the fixed-income markets and international equity (stock) funds, but there was no statistically significant way to rely on past performance in the domestic (US) stock equity mutual funds. I will comment on why I believe this is so later on.
"The oft-repeated legal disclosure that past performance is no guarantee of future results is true at two levels:
1. Absolute returns cannot be guaranteed with any confidence. There is too much variability for each broad asset class over multiple time periods. Stocks in general may provide 5-10% returns during one decade, 10-20% during the next decade, and then return back to the 5-10% range.
2. Absolute rankings also cannot be predicted with any certainty. This is caused by too much relative variability within specific investment objectives. #1 funds can regress to the average or fall far below the average over subsequent periods, replaced by funds that may have had very low rankings at the start. The higher the ranking and the more narrowly you define that ranking (i.e. #1 vs. top-decile [top 10%] vs. top quartile [top 25%] vs. top half), the more unlikely it is that a fund can repeat at that level. It is extremely unlikely to repeat as #1 in an objective with more than a few funds. It is very difficult to repeat in the top decile, challenging to repeat in the top quartile, and roughly a coin toss to repeat in the top half." (Financial Research Center)
This is in line with a study from the National Bureau of Economic Research. Only a very small percentage of companies can show merely above-average earnings growth for 10 years in a row. The percentage is not more than you would expect from simply random circumstances.
The chances of you picking a stock today that will be in the top 25% of all companies every year for the next ten years are 1 in 50 or worse. In fact, the longer a company shows positive earnings growth and outstanding performance, the more likely it is to have an off year. Being on top for an extended period of time is an extremely difficult feat.
Yet, what is the basis for most stock analysts' predictions? Past performance and the optimistic projections of a management that gets compensated with stock options. What CEO will tell you his stock is overpriced? His staff and board will kill him, as their options will be worthless. Analysts make the fatally flawed assumption that because a company has grown 25% a year for five years that it will do so for the next five. The actual results for the last 50 years show the likelihood of that happening is very small.
Tails You Lose, Heads I Win
I cannot recommend highly enough a marvelous book by Nassim Nicholas Taleb, called Fooled by Randomness. The sub-title is "The Hidden Role of Chance in the Markets and in Life." I consider it essential reading for all investors, and would go so far as to say that you should not invest in anything without reading this book. He looks at the role of chance in the marketplace. Taleb is a man who is obsessed with the role of chance, and he gives us a very thorough treatment. He also has a gift for expressing complex statistical problems in a very understandable manner. I intend to read the last half of this book at least once a year to remind me of some of these principles. Let's look at just a few of his thoughts.
Assume you have 10,000 people who flip a coin once a year. After five years, you will have 313 people who have come up with heads five times in a row. If you put suits on them and sit them in glass offices, call them a mutual or a hedge fund, they will be managing a billion dollars. They will absolutely believe they have figured out the secret to investing that all the other losers haven't discerned. Their seven-figure salaries prove it.
The next year, 157 of them will blow up. With my power of analysis, I can predict which one will blow up. It will be the one in which you invest!
Ergodicity
In the mutual fund and hedge fund world, one of the continual issues of reporting returns is something called "survivorship bias." Let's say you start with a universe of 1,000 funds. After five years, only 800 of those funds are still in business. The other 200 had dismal results, were unable to attract money, and simply folded.
If you look at the annual returns of the 800 funds, you get one average number. But if you add in the returns of the 200 failures, the average return is much lower. The databases most statistics are based upon only look at the survivors. This sets up false expectations for investors, as it raises the average.
Taleb gave me an insight for which I will always be grateful. He points out that because of chance and survivorship bias, investors are only likely to find out about the winners. Indeed, who goes around trying to sell you the losers? The likelihood of being shown an investment or a stock which has flipped heads five times in a row are very high. But chances are, that hot investment you are shown is a result of randomness. You are much more likely to have success hunting on your own. The exception, of course, would be my clients. (Note to regulators: that last sentence is a literary device called a weak attempt at humor. It is not meant to be taken literally.)
That brings us to the principle of Ergodicity, "...namely, that time will eliminate the annoying effects of randomness. Looking forward, in spite of the fact that these managers were profitable in the past five years, we expect them to break even in any future time period. They will fare no better than those of the initial cohort who failed earlier in the exercise. Ah, the long term." (Taleb)
Why Investors Fail
While the professionals typically explain their problems in very creative ways, the mistakes that most of us make are much more mundane. First and foremost is chasing performance. Study after study shows the average investor does much worse than the average mutual fund, as they switch from their poorly performing fund to the latest hot fund, just as it turns down.
Mark Finn of Vantage Consulting has spent years analyzing trading systems. He is a consultant to large pension funds and Fortune 500 companies. He is one of the more astute analysts of trading systems, managers, and funds that I know. He has put more start-up managers into business than perhaps anyone in the fund management world. He has a gift for finding new talent and deciding if their "ideas" have investment merit.
He has a team of certifiable mathematical geniuses working for him. They have access to the best pattern-recognition software available. They have run price data through every conceivable program, and come away with this conclusion:
Past performance is not indicative of future results.
Actually, Mark says it more bluntly: Past performance is pretty much worthless when it comes to trying to figure out the future. The best use of past performance is to determine how a manager behaved in a particular set of prior circumstances.
Yet investors read that past performance is not indicative of future results, and then promptly ignore it. It is like reading statements at McDonalds that coffee is hot. We don't pay attention.
Chasing the latest hot fund usually means you are now in a fund that is close to reaching its peak, and will soon top out. Generally that is shortly after you invest.
What do Finn and his team tell us does work? Fundamentals, fundamentals, fundamentals. As they look at scores of managers each year, the common thread for success is how they incorporate some set of fundamental analysis patterns into their systems.
This is consistent with work done by Dr. Gary Hirst, one of my favorite analysts and fund managers. In 1991, he began to look at technical analysis. He spent huge sums on computers and programming, analyzing a variety of technical analysis systems. Let me quote him on the results of his research:
"I had heard about technical analysis and chart patterns, and looking at this stuff I would say, what kind of voodoo is this? I was very, very skeptical that technical analysis had value. So I used the computers to check it out, and what I learned was that there was, in fact, no useful reality there. Statistically and mathematically all these tools -- stochastics, RSI, chart patterns, Elliot Wave, and so on -- just don't work. If you code any of these rigorously into a computer and test them they produce no statistical basis for making money; they're just wishful thinking. But I did find one thing that worked. In fact almost all technical analysis can be reduced to this one thing, though most people don't realize it: the distributions of returns are not normal; they are skewed and have "fat tails." In other words, markets do produce profitable trends. Sure, I found things that work over the short term, systems that work for five or ten years but then fail miserably. Everything you made, you gave back. Over the long term, trends are where the money is."
Becoming a Top 20% Investor
Over very long periods of time, the average stock will grow at about 7% a year, which is GDP growth plus dividends plus inflation. This is logical when you think about it. How could all the companies in the country grow faster than the total economy? Some companies will grow faster than others, of course, but the average will be the above. There are numerous studies which demonstrate this. That means roughly 50% of the companies will outperform the average and 50% will lag.
The same is true for investors. By definition, 50% of you will not achieve the average; 10% of you will do really well; and 1% will get rich through investing. You will be the lucky ones who find Microsoft in 1982. You will tell yourself it was your ability. Most of us assign our good fortune to native skill and our losses to bad luck.
But we all try to be in the top 10%. Oh, how we try. The FRC study cited at the beginning shows how most of us look for success, and then get in, only to have gotten in at the top. In fact, trying to be in the top 10% or 20% is statistically one of the ways we find ourselves getting below-average returns over time. We might be successful for a while, but reversion to the mean will catch up.
Here is the very sad truth. The majority of investors in the top 10-20% in any given period are simply lucky. They have come up with heads five times in a row. Their ship came in. There are some good investors who actually do it with sweat and work, but they are not the majority. Want to make someone angry? Tell a manager that his (or her) fabulous track record appears to be random luck or that they simply caught a wave and rode it. Then duck.
By the way, is it luck or skill when an individual goes to work for a start-up company and is given stock in their 401k which grows at 10,000%? How many individuals work for companies where that didn't happen, or their stock options blew up (Enron)? I happen to lean toward Grace, rather than luck or skill, as an explanation; but this is not a theological treatise.
Read The Millionaire Next Door. Most millionaires make their money in business and/or by saving lots of money and living frugally. Very few make it simply by investing skill alone. Odds are that you will not be that person.
But I can tell you how to get in the top 20%. Or better, I will let FRC tell you, because they do it so well:
"For those who are not satisfied with simply beating the average over any given period, consider this: if an investor can consistently achieve slightly better than average returns each year over a 10-15 year period, then cumulatively over the full period they are likely to do better than roughly 80% or more of their peers. They may never have discovered a fund that ranked #1 over a subsequent one- or three-year period. That "failure," however, is more than offset by their having avoided options that dramatically underperformed. Avoiding short-term underperformance is the key to long-term outperformance.
"For those that are looking to find a new method of discerning the top ten funds for 2002, this study will prove frustrating. There are no magic short-cut solutions, and we urge our readers to abandon the illusive and ultimately counterproductive search for them. For those who are willing to restrain their short-term passions, embrace the virtue of being only slightly better than average, and wait for the benefits of this approach to compound into something much better..."
That's it. You simply have to be only slightly better than average each year to be in the top 20% at the end of the race. It is a whole lot easier to figure out how to do that than chase the top ten funds.
Of course, you could get lucky (or Blessed) and get one of the top ten funds. But recognize it for what it is and thank God (or your luck if you are agnostic) for His blessings.
I should point out that it takes a lot of work to be in the top 50% consistently. But it can be done. I don't see it as much as I would like, but I do see it.
Investing in a stock or a fund should not be like going to Vegas. When you put money with a manager or a fund, you should think as if you are investing in their management company. Ask yourself, "Is this someone I want to be in business with? Do I want him running my company? Does this company have a reasonable business objective? What is their edge that makes me think they will be above average? What is the reason I would think they could discern the difference between randomness and good management?"
When I meet a manager, and all he wants to do is talk about his track record, I find a way to quickly close the conversation. When they tell me they are trying to make the most they can, I head for the door. Maybe they are the real deal, but my experience says the odds are against it.
It's about not settling for being mediocre. Statistics and experience tell us that simply being consistently above average is damn hard work. When a fund is the number one fund, that is random. They had a good run or a good idea and it worked. Are they likely to repeat? No.
But being in the top 50% every year for ten years? That is NOT random. That is skill. That type of consistent solid management is what you should be looking for.
By the way, I mentioned at the beginning that past performance was statistically useful for ascertaining relative performance of certain types of funds like bond funds and international funds. In the fixed-income markets (bonds) everyone is dealing with the same instruments. Funds with lower overhead and skilled traders who aggressively watch their trading costs have an edge. That management skill shows up in consistently above-average relative returns.
Likewise, funds which do well in international investments tend to stay in the top brackets. That is because the skill set for international fund management is rare and the learning cost is high. In that world, local knowledge of the markets clearly adds value.
But in the US stock market, everybody knows everything everybody else does. Past performance is a very bad predictor of future results. If a fund does well in one year, it is possibly because they took some extra risks to do so, and eventually those risks will bite them and their investors. Maybe they were lucky and had two of their biggest holdings really go through the roof. Finding those monster winners is a hard thing to do for several years in a row. Plus, the US stock market is very cyclical, so that what goes up one year or even longer in a bubble market will not do well the next.
Investors Behaving Badly
Gavin McQuill of the Financial Research Center sent me his rather brilliant $5,000 report called "Investors Behaving Badly." He was the author and he did a great job. I read it over one weekend, and refer to it again from time to time.
Earlier we looked at a report which showed that over the last decade investors chased the hot mutual funds. The higher the markets went, the less likely it was that they would buy and hold. Investors consistently bought high and sold low. Investors made significantly less than the average mutual fund did.
McQuill focused on six emotions that cause investors to make these mistakes. You should read these and see whether some of them are familiar.
1. "Fear of Regret - An inability to accept that you've made a wrong decision, which leads to holding onto losers too long or selling winners too soon." This is part of a whole cycle of denial, anxiety, and depression. As with any difficult situation, we first deny there is a problem, and then get anxious as the problem does not go away or gets worse. Then we go into depression because we didn't take action earlier, and hope that something will come along and rescue us from the situation.
2. "Myopic loss aversion (a.k.a. as 'short-sightedness') - A fear of losing money and the subsequent inability to withstand short-term events and maintain a long-term perspective." Basically, this means we attach too much importance to day-to-day events, rather than looking at the big picture. Behavioral psychologists have determined that the fear of loss is the most important emotional factor in investor behavior.
Like investors chasing the latest hot fund, a news story or a bad day in the market becomes enough for the investor to extrapolate the recent event as the new trend which will stretch far into the future. In reality, most events are unimportant, and have little effect on the overall economy.
3. "Cognitive dissonance - The inability to change your opinion after new evidence contradicts your baseline assumption." Dissonance, whether musical or emotional, is uncomfortable. It is often easier to ignore the event or fact producing the dissonance rather than deal with it. We tell ourselves it is not meaningful, and go on our way. This is especially easy if our view is the accepted view. "Herd mentality" is a big force in the market.
4. "Overconfidence - People's tendency to overestimate their abilities relative to individuals possessing greater expertise." Professionals beat amateurs 99% of the time. The other 1% is luck. The famous Clint Eastwood line, "Do you feel lucky, punk? Well, do you?" comes to mind.
In sports, most of us know when we are outclassed. But as investors, we somehow think we can beat the pros, will always be in the top 10%, and any time we win it is because of our skills and good judgement. It is bad luck when we lose.
Commodity brokers know that the best customers are those who strike it rich in their first few trades. They are now convinced they possess the gift or the Holy Grail of trading systems. These are the people who will spend all their money trying to duplicate their initial success, in an effort to validate their obvious abilities. They also generate large commissions for their brokers.
5. "Anchoring - People's tendency to give too much credence to their most recent experience and to show reluctance to adjust their current beliefs." If you believe that NASDAQ stocks are the place to be, that becomes your anchor. No matter what new information comes your way, you are anchored in your belief. Your experience in 1999 shows you were right.
As Lord Keynes said so eloquently when forced to acknowledge a shift in a previous position he had taken, "Sir, the fact have changed, and when the facts change, I change. What do you do, sir?"
We expect the current trend to continue forever, and forget that all trends eventually regress to the mean. That is why investors still plunge into index funds, believing that stocks will go up over the long term. They think long term is two years. They do not understand that it will take years - maybe even a decade - for the process of reversion to the mean to complete its work.
6. "Representativeness - The tendency of people to see patterns within random events." Eric Frye did a great tongue-in-cheek article in The Daily Reckoning, a daily investment letter (www.dailyreckoning.com). He documented that each time Sports Illustrated used a model for the cover of their swimsuit issue who came from a new country that had never been represented on the cover before, the stock market of that country had always risen over a four-year period. This year, it is time to buy Argentinian stocks. Frye evidently did not do a correlation study on the size of the swimsuit against the eventual rise in the market. However, I am sure some statistician with more time on his hands than I do will brave that analysis.
Investors assume that items with a few similar traits are likely to be associated or identical, and start to see a pattern. McQuill gives us an example. Suzy is an English and environmental studies major. Most people, when asked if it is more likely that Suzy will become a librarian or work in the financial services industry, will choose librarian. They will be wrong. There are vastly more workers in the financial industry than there are librarians. Statistically, the probability is that she will work in the financial services industry, even though librarians are likely to be English majors.
I hope you enjoy your week.
Forget The Fundamentals
I am writing this article on a 20 hour flight back to the States after spending a spectacular week in Singapore. I would first like to thank the staff at Online Trading Academy Singapore for their hospitality and also congratulate them on their work at the Asian Trader and Investor's Conference. I had a unique opportunity while in Singapore to be a guest on CNBC Asia's Cash Flow program. I was asked to weigh in on the technicals of the Asian markets as well as individual stocks (the video clips of the show should be available at http://forexworlduk.blogspot.com soon). I was bombarded with emails from viewers from Australia to Tokyo.
At one point, the anchor of the show, Maura Fogerty, asked me to describe technical analysis which I did. She then asked an interesting question which got me thinking. She asked if technical analysis can be used by itself to analyze the markets. I answered that technical analysis could be used to analyze the markets and individual securities and that I was able to make accurate predictions of future prices on securities I know nothing about. The simple fact is that we do not trade currencies, futures, or companies. We trade people's perceptions of those securities and their emotions. Technical analysis gives us the ability to recognize predictable patterns in those behaviors and therefore minimize our risk and even create profits.
However, after the show, I was thinking about my own trading style. I am a technical trader but I also have a good understanding of the fundamentals of the markets and the economy if not the individual securities I trade. This understanding allows me to anticipate changing perceptions of the masses and how they may be directed to either accumulate or sell off certain positions. I realized that if I was to be a great trader, I cannot forget the fundamentals. The news in the financial arena is currently centered around a possible recession and even stagflation in the US economy. How many of us know what that truly means? More importantly, do you know what sectors or asset classes will have the most risk and therefore should be avoided? Do you know what sectors and asset classes will benefit from the slumping American economy?
I have been fortunate to have studied fundamental analysis and economic theory and it is something I inject into the classes I teach. Nearly all of Online Trading Academy's classes have a portion that focuses on analyzing the markets from a fundamental standpoint. If you do not have a strong background in how the economy works, I suggest you visit your local Online Trading Academy Center and learn. There is a rocky road ahead for the economy both in the US and the world. Let's face it, we live in a global economy and no country will be immune. Even the BRIC countries (Brazil, Russia, India, and China) are feeling the effect. China announced this week they will take measures to fight rampant inflation in their economy. Seems to be more than Big Ben is doing.
So as you plan for your assault on the markets and draw your squiggly lines all over your charts, don't forget to see how you can minimize your risk by understanding the fundamental factors that will drive the global economy. The money you save could be your own!
At one point, the anchor of the show, Maura Fogerty, asked me to describe technical analysis which I did. She then asked an interesting question which got me thinking. She asked if technical analysis can be used by itself to analyze the markets. I answered that technical analysis could be used to analyze the markets and individual securities and that I was able to make accurate predictions of future prices on securities I know nothing about. The simple fact is that we do not trade currencies, futures, or companies. We trade people's perceptions of those securities and their emotions. Technical analysis gives us the ability to recognize predictable patterns in those behaviors and therefore minimize our risk and even create profits.
However, after the show, I was thinking about my own trading style. I am a technical trader but I also have a good understanding of the fundamentals of the markets and the economy if not the individual securities I trade. This understanding allows me to anticipate changing perceptions of the masses and how they may be directed to either accumulate or sell off certain positions. I realized that if I was to be a great trader, I cannot forget the fundamentals. The news in the financial arena is currently centered around a possible recession and even stagflation in the US economy. How many of us know what that truly means? More importantly, do you know what sectors or asset classes will have the most risk and therefore should be avoided? Do you know what sectors and asset classes will benefit from the slumping American economy?
I have been fortunate to have studied fundamental analysis and economic theory and it is something I inject into the classes I teach. Nearly all of Online Trading Academy's classes have a portion that focuses on analyzing the markets from a fundamental standpoint. If you do not have a strong background in how the economy works, I suggest you visit your local Online Trading Academy Center and learn. There is a rocky road ahead for the economy both in the US and the world. Let's face it, we live in a global economy and no country will be immune. Even the BRIC countries (Brazil, Russia, India, and China) are feeling the effect. China announced this week they will take measures to fight rampant inflation in their economy. Seems to be more than Big Ben is doing.
So as you plan for your assault on the markets and draw your squiggly lines all over your charts, don't forget to see how you can minimize your risk by understanding the fundamental factors that will drive the global economy. The money you save could be your own!
Introduction To Vertical Spreads
When you hear the term "vertical spread," the first thing that comes to the mind for many is something you might do while standing up. In the world of options, there is a slightly different interpretation – which is somewhat less fun, but occasionally profitable.
Today we'll explore vertical spreads. Basically, a vertical option spread is the purchase of one option and the sale of another with both options having the same expiration month. It is a directional strategy and a vertical spread can be done with either puts or calls, depending on your opinion of where the stock will move. If you're using calls, and you would be if you are bullish, this particular vertical spread is called a "bull call spread." By the same token, if you are bearish, you can use puts to create a vertical "bear put spread."
Why use a spread instead of just buying a call? Good question. Glad I asked it. Using a vertical spread instead of a strait option purchase gives the trader more flexibility. Let's look at some examples from the option chain below.
Apple is trading at $64.02. If you look at a daily chart of AAPL, you'll see that there is resistance at about $70.
If someone was bullish and wanted to buy a call on AAPL, he has a number of choices. Look at the red arrows near the "ask" column.
1) A $60 call would cost $5.90 – with $4.02 of intrinsic value and $1.88 of time value. The delta of the $60 call option is about 74. If you just purchased the $60 call option, your total risk would be the $5.90. That's a lot of money. You can reduce your risk by selling an option at a higher strike price.
Remember, the resistance is near $70. So, there's a reasonable chance that, even if AAPL makes it to $70, it will bounce off resistance and head back down. If you sold the $70 call, you could take in $.95. What have you accomplished? You have just reduced your risk from $5.90 to $4.95.
The price you pay for receiving the $.95 is that you have capped your potential profits. With your $60/$70 vertical spread, the most you can possibly make now is the difference between the strike prices $10) -- if AAPL finishes above $70 at expiration. You would bring in $10 – and your cost for the spread position was $4.95. Your profit would then be $5.05 ($10 less $4.95) – about a 1-1 risk reward ratio.
What is your breakeven on the $60/$70 bull call spread? Since you spent $4.95 for the position, AAPL must, at expiration, be at $64.95 before you will have made any money. It would require a relatively small move of $.93 to reach the breakeven point.
2) Look at the chain again. For this second alternative, let's buy the $65 call – for $2.80. That's less than half of the $60 call in #1 above. So, the risk is less – only $2.80. But, let's create another vertical spread ($65/$70) by selling the $70 call and taking in the $.95. Our new cost basis, and total risk, for this position is only $1.85 ($2.80 less $.95). That's pretty reasonable.
How is this different from #1 above? Calculate the breakeven point. The $65 call is all time value. It has NO intrinsic value and has a delta of only 47. Add your risk of $1.85 to the $65 strike price and you have a break even point of $66.85. That requires a $2.83 move of AAPL stock.
If AAPL would close over $70, the profit would be more appealing than #1. You, the trader, would bring in the $5.00 difference between the two strike prices ($65/$70). Your cost of establishing this trade is only $1.85. Therefore, you would pocket the difference -- $3.15 ($5.00 less $1.85). Not bad. But remember that you are asking more of AAPL stock.
3) Let's take the vertical spread a step further. This example may sound familiar. Not that long ago I heard a seminar company boasting that it has a strategy in which you can be wrong four times, right once, and still make a profit? For a mere $3,000 they will pass along this pearl of wisdom.
Most people think to themselves, "Hey, I can be wrong five times. And the law of averages says I'll be right the sixth time. If I can still make a profit after all that, then I NEED TO KNOW that strategy."
Well, my loyal students, I'll save you the $3,000 – and it's not even Christmas!!
Look at the AAPL option chain again. Let's create another vertical spread. This time let's buy the $70 call (for $1.05) and sell the $75 call (for $.25). Our total out-of-pocket for this five point vertical bull call spread is $.80 ($1.05 less $.25). Our break even point is $70.80 ($70 plus $.80). Our potential profit is the $5.00 difference between the strikes less our $.80 cost – which equals a whopping $4.20. That's one hell-of-a risk reward ratio.
How many times can we be wrong and then be right one time and still be profitable? If we lost $.80 five times, it would cost us $4.00. Then, if we were right the sixth time and made $4.20, that would make up the $4.00 from the previous five tries and leave us a profit of $.20.
Obviously, the further out of the money (away from where the asset it trading) the higher the profit can be. The only catch is that your chances of AAPL moving from $64.02 to $75 in the next five weeks is almost as good as the odds of me losing 30 pounds in the next five weeks. In other words, don't hold your breath. And don't get sucked in to these "pot-of-gold at the end of the rainbow" promotions – if you value your money. Reality sometimes sucks, but it's real and needs to be dealt with as such. There isn't a holy grail when it comes to option trading. There's only understanding strategies and putting as many of the odds in your favor as possible.
4) Do you want good odds? Try this on for size. Look at our option chain again. What if we were to put on a vertical spread that's already ITM (in-the-money)? Let's buy the $60 call for $5.90 and then sell the $62.50 call for $4.10. Our cost for this vertical spread is $1.80. The difference between the $60 and $62.50 strike prices is $2.50. Our potential profit is $.70 ($2.50 less $1.80) – if AAPL closes above $62.50 at expiration.
Think about this. The risk ($1.80) / reward ($.70) ratio isn't as pretty as our previous examples. It's true that we've certainly sacrificed a chunk of profit. But, in return, we now have a much better chance of success. Why? Because, with AAPL trading at $64.02 – well beyond the $62.50 short option. To be profitable, AAPL doesn't have to move up at all. As a matter of fact, it can move up, stay the same and it even has a $1.52 cushion to the downside and the position will remain profitable.
As I've said before, options are simply tools. If you learn how to use them properly, you can increase your odds and put yourself in a position to be profitable.
Missed Any Columns?
Hey, this is good stuff – especially if you're serious about learning options. The Pulitzer people won't likely be knocking at my door soon, but I've taught a lot of people how to conservatively and consistently make money – and they're still making money to this day. I hope you'll become one of them.
So, if you missed any of my previous columns, click on the following link and, hopefully, they will magically appear. http://forexworlduk.blogspot.com
Who Is This Guy? --
Mike Parnos has "been there and done that" – plenty! Known as "Online Trading Academy's Options Therapist," Mike has been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders. Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."
Today we'll explore vertical spreads. Basically, a vertical option spread is the purchase of one option and the sale of another with both options having the same expiration month. It is a directional strategy and a vertical spread can be done with either puts or calls, depending on your opinion of where the stock will move. If you're using calls, and you would be if you are bullish, this particular vertical spread is called a "bull call spread." By the same token, if you are bearish, you can use puts to create a vertical "bear put spread."
Why use a spread instead of just buying a call? Good question. Glad I asked it. Using a vertical spread instead of a strait option purchase gives the trader more flexibility. Let's look at some examples from the option chain below.
Apple is trading at $64.02. If you look at a daily chart of AAPL, you'll see that there is resistance at about $70.
If someone was bullish and wanted to buy a call on AAPL, he has a number of choices. Look at the red arrows near the "ask" column.
1) A $60 call would cost $5.90 – with $4.02 of intrinsic value and $1.88 of time value. The delta of the $60 call option is about 74. If you just purchased the $60 call option, your total risk would be the $5.90. That's a lot of money. You can reduce your risk by selling an option at a higher strike price.
Remember, the resistance is near $70. So, there's a reasonable chance that, even if AAPL makes it to $70, it will bounce off resistance and head back down. If you sold the $70 call, you could take in $.95. What have you accomplished? You have just reduced your risk from $5.90 to $4.95.
The price you pay for receiving the $.95 is that you have capped your potential profits. With your $60/$70 vertical spread, the most you can possibly make now is the difference between the strike prices $10) -- if AAPL finishes above $70 at expiration. You would bring in $10 – and your cost for the spread position was $4.95. Your profit would then be $5.05 ($10 less $4.95) – about a 1-1 risk reward ratio.
What is your breakeven on the $60/$70 bull call spread? Since you spent $4.95 for the position, AAPL must, at expiration, be at $64.95 before you will have made any money. It would require a relatively small move of $.93 to reach the breakeven point.
2) Look at the chain again. For this second alternative, let's buy the $65 call – for $2.80. That's less than half of the $60 call in #1 above. So, the risk is less – only $2.80. But, let's create another vertical spread ($65/$70) by selling the $70 call and taking in the $.95. Our new cost basis, and total risk, for this position is only $1.85 ($2.80 less $.95). That's pretty reasonable.
How is this different from #1 above? Calculate the breakeven point. The $65 call is all time value. It has NO intrinsic value and has a delta of only 47. Add your risk of $1.85 to the $65 strike price and you have a break even point of $66.85. That requires a $2.83 move of AAPL stock.
If AAPL would close over $70, the profit would be more appealing than #1. You, the trader, would bring in the $5.00 difference between the two strike prices ($65/$70). Your cost of establishing this trade is only $1.85. Therefore, you would pocket the difference -- $3.15 ($5.00 less $1.85). Not bad. But remember that you are asking more of AAPL stock.
3) Let's take the vertical spread a step further. This example may sound familiar. Not that long ago I heard a seminar company boasting that it has a strategy in which you can be wrong four times, right once, and still make a profit? For a mere $3,000 they will pass along this pearl of wisdom.
Most people think to themselves, "Hey, I can be wrong five times. And the law of averages says I'll be right the sixth time. If I can still make a profit after all that, then I NEED TO KNOW that strategy."
Well, my loyal students, I'll save you the $3,000 – and it's not even Christmas!!
Look at the AAPL option chain again. Let's create another vertical spread. This time let's buy the $70 call (for $1.05) and sell the $75 call (for $.25). Our total out-of-pocket for this five point vertical bull call spread is $.80 ($1.05 less $.25). Our break even point is $70.80 ($70 plus $.80). Our potential profit is the $5.00 difference between the strikes less our $.80 cost – which equals a whopping $4.20. That's one hell-of-a risk reward ratio.
How many times can we be wrong and then be right one time and still be profitable? If we lost $.80 five times, it would cost us $4.00. Then, if we were right the sixth time and made $4.20, that would make up the $4.00 from the previous five tries and leave us a profit of $.20.
Obviously, the further out of the money (away from where the asset it trading) the higher the profit can be. The only catch is that your chances of AAPL moving from $64.02 to $75 in the next five weeks is almost as good as the odds of me losing 30 pounds in the next five weeks. In other words, don't hold your breath. And don't get sucked in to these "pot-of-gold at the end of the rainbow" promotions – if you value your money. Reality sometimes sucks, but it's real and needs to be dealt with as such. There isn't a holy grail when it comes to option trading. There's only understanding strategies and putting as many of the odds in your favor as possible.
4) Do you want good odds? Try this on for size. Look at our option chain again. What if we were to put on a vertical spread that's already ITM (in-the-money)? Let's buy the $60 call for $5.90 and then sell the $62.50 call for $4.10. Our cost for this vertical spread is $1.80. The difference between the $60 and $62.50 strike prices is $2.50. Our potential profit is $.70 ($2.50 less $1.80) – if AAPL closes above $62.50 at expiration.
Think about this. The risk ($1.80) / reward ($.70) ratio isn't as pretty as our previous examples. It's true that we've certainly sacrificed a chunk of profit. But, in return, we now have a much better chance of success. Why? Because, with AAPL trading at $64.02 – well beyond the $62.50 short option. To be profitable, AAPL doesn't have to move up at all. As a matter of fact, it can move up, stay the same and it even has a $1.52 cushion to the downside and the position will remain profitable.
As I've said before, options are simply tools. If you learn how to use them properly, you can increase your odds and put yourself in a position to be profitable.
Missed Any Columns?
Hey, this is good stuff – especially if you're serious about learning options. The Pulitzer people won't likely be knocking at my door soon, but I've taught a lot of people how to conservatively and consistently make money – and they're still making money to this day. I hope you'll become one of them.
So, if you missed any of my previous columns, click on the following link and, hopefully, they will magically appear. http://forexworlduk.blogspot.com
Who Is This Guy? --
Mike Parnos has "been there and done that" – plenty! Known as "Online Trading Academy's Options Therapist," Mike has been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders. Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."
Simplifying Your Trading
Some traders like structure. The more hard and fast rules you can give them, the better they like it. On the other hand, there are creative thinkers – traders who take concepts and experiment until they find a method that fits their personality.
Since we're still a little wet behind the ears in the experience department, let's leave creativity for a future discussion. Today, let's focus on the questions you need to answer that will help determine whether or not a trade is viable.
We've all heard Jim Cramer or some other analyst (notice the first four letters of analyst) howling about the next "hot" stock that's about to move. In the excitement of getting what people think is "inside" information, new traders tend to rush over to the computer and start hitting the buy button. Think about it. If the trade goes bad and they lose money, they can blame Jim Cramer instead of themselves (where it belongs) – an easy out. Their money is still gone, but it wasn't their fault.
Why should a trader bother to think for himself when someone else has already done it for them? It's uncanny how many people spend countless thousands of dollars in search of the Holy Grail. They typically end up with charting software full of little green arrows and red arrows pointing hither and yon as buy and sell signals. If that stuff really worked, we wouldn't need teachers to explain the "whys" and "hows" of trading. We'd only need people to sit and help us count the massive profits we'd all be making while we're out shopping for more swampland in Florida.
In this week's column I've enclosed a checklist (see below) of sorts. This checklist is for those who are considering the purchase or sale of an option. It may take a few minutes to fill out the checklist, but, once you do, you'll know if you have a viable trade.
It should be a simple matter to copy and paste the checklist into a MS Word file. Then, you can print out as many copies as you need to help you with your decision making. Punch three holes and keep them in a loose-leaf and you'll have a convenient way to track your trades.
It's often recommended that traders keep a journal of their trades. That's an excellent idea, but writing your notes and thoughts onto the checklist will is an organized and efficient way of accomplishing the same thing. As we progress, I will publish a new checklist for most of the strategies we will discuss.
Option Purchase or Sale Checklist
Stock / Index:
Current Price:
Option (Put or Call)
Option Symbol:
Action: (Purchase or Sale)
Expiration Month / Strike Price:
Option Price: (Bid & Ask)
Option Undervalued or Overvalued
Delta / Implied Volatility:
Number of Contracts:
Purchase / Sale Price (Bid or Ask):
Total Investment:
Stock Target Price:
Option Target Price:
EXIT PLAN:
Support Levels 1 & 2
10 Day EMA / 50 Day EMA
Cut Loss Exit Price:
Stop Loss Order @:
Actual Exit Price:
Profit / Loss:
Reason for Entering Trade:
Notes:
Your Assignment
In the next week, come up with some trades. Fill out the checklist and see what trades you can generate. Use the day's closing prices. It's a little easier to calculate when the market isn't bouncing around. It's OK to use puts, too. Some of the best trades you'll ever make are to the downside. Remember, just because you would like to make a trade, you may not find one that meets the criteria you've established for a viable trade.
Don't compromise!! That's when you can get into big trouble. Make sure that you maintain the standards you've set. It's very easy to rationalize a few points here and there – and using an overpriced option, etc. It's like rationalizing that extra piece of cake – pretending that those extra calories don't exist.
Follow Up
In our July 20, 2006 column, we went, step-by-step, through the trade selection process. We ended up with an August $25 long call position on EBAY. The trade was hypothetical, but it was based on current prices. At the time, EBAY was trading at $25.93. The call cost $2.40.
We had an exit strategy to sell our option if/when EBAY closed below $25. The very next day, EBAY closed at $24.66. It's been inching down steadily ever since. We would have been stopped out and our option would have been sold for about $1.25. That's an estimate, but it's close enough.
What did we accomplish? Hypothetically, when EBAY's support level didn't hold, we admitted that we were wrong, closed the position and conserved our trading capital. That's the name of the game. We're going to have losses, but keeping them under control will allow us to continue trading and to possibly become profitable in the future.
Could EBAY rebound before August expiration? Sure, it's possible. But the odds are against it. You don't want to get caught puffing on that hopium. It's dangerous. If you want to bet on a long-shot, go to the track. The odds are better.
Picking directions when trading options is a difficult task, to say the least. You have to be right about three things: 1) the direction; 2) the size of the move; and 3) how long it will take for it to get there. The rewards can be substantial -- if you guess right. Use the checklist above. It will help.
Missed Any Columns?
Hey, this is good stuff – especially if you're serious about learning options. The Pulitzer people won't likely be knocking at my door soon, but I've taught a lot of people how to conservatively and consistently make money – and they're still making money to this day. I hope you'll become one of them.
So, if you missed any of my previous columns, click on the following link and, hopefully, they will magically appear. http://forexworlduk.blogspot.com
Who Is This Guy? --
Mike Parnos has "been there and done that" – plenty! Known as "Online Trading Academy's Options Therapist," Mike has been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders. Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."
Disclaimer: Mike Parnos is an options instructor and mentor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.
Since we're still a little wet behind the ears in the experience department, let's leave creativity for a future discussion. Today, let's focus on the questions you need to answer that will help determine whether or not a trade is viable.
We've all heard Jim Cramer or some other analyst (notice the first four letters of analyst) howling about the next "hot" stock that's about to move. In the excitement of getting what people think is "inside" information, new traders tend to rush over to the computer and start hitting the buy button. Think about it. If the trade goes bad and they lose money, they can blame Jim Cramer instead of themselves (where it belongs) – an easy out. Their money is still gone, but it wasn't their fault.
Why should a trader bother to think for himself when someone else has already done it for them? It's uncanny how many people spend countless thousands of dollars in search of the Holy Grail. They typically end up with charting software full of little green arrows and red arrows pointing hither and yon as buy and sell signals. If that stuff really worked, we wouldn't need teachers to explain the "whys" and "hows" of trading. We'd only need people to sit and help us count the massive profits we'd all be making while we're out shopping for more swampland in Florida.
In this week's column I've enclosed a checklist (see below) of sorts. This checklist is for those who are considering the purchase or sale of an option. It may take a few minutes to fill out the checklist, but, once you do, you'll know if you have a viable trade.
It should be a simple matter to copy and paste the checklist into a MS Word file. Then, you can print out as many copies as you need to help you with your decision making. Punch three holes and keep them in a loose-leaf and you'll have a convenient way to track your trades.
It's often recommended that traders keep a journal of their trades. That's an excellent idea, but writing your notes and thoughts onto the checklist will is an organized and efficient way of accomplishing the same thing. As we progress, I will publish a new checklist for most of the strategies we will discuss.
Option Purchase or Sale Checklist
Stock / Index:
Current Price:
Option (Put or Call)
Option Symbol:
Action: (Purchase or Sale)
Expiration Month / Strike Price:
Option Price: (Bid & Ask)
Option Undervalued or Overvalued
Delta / Implied Volatility:
Number of Contracts:
Purchase / Sale Price (Bid or Ask):
Total Investment:
Stock Target Price:
Option Target Price:
EXIT PLAN:
Support Levels 1 & 2
10 Day EMA / 50 Day EMA
Cut Loss Exit Price:
Stop Loss Order @:
Actual Exit Price:
Profit / Loss:
Reason for Entering Trade:
Notes:
Your Assignment
In the next week, come up with some trades. Fill out the checklist and see what trades you can generate. Use the day's closing prices. It's a little easier to calculate when the market isn't bouncing around. It's OK to use puts, too. Some of the best trades you'll ever make are to the downside. Remember, just because you would like to make a trade, you may not find one that meets the criteria you've established for a viable trade.
Don't compromise!! That's when you can get into big trouble. Make sure that you maintain the standards you've set. It's very easy to rationalize a few points here and there – and using an overpriced option, etc. It's like rationalizing that extra piece of cake – pretending that those extra calories don't exist.
Follow Up
In our July 20, 2006 column, we went, step-by-step, through the trade selection process. We ended up with an August $25 long call position on EBAY. The trade was hypothetical, but it was based on current prices. At the time, EBAY was trading at $25.93. The call cost $2.40.
We had an exit strategy to sell our option if/when EBAY closed below $25. The very next day, EBAY closed at $24.66. It's been inching down steadily ever since. We would have been stopped out and our option would have been sold for about $1.25. That's an estimate, but it's close enough.
What did we accomplish? Hypothetically, when EBAY's support level didn't hold, we admitted that we were wrong, closed the position and conserved our trading capital. That's the name of the game. We're going to have losses, but keeping them under control will allow us to continue trading and to possibly become profitable in the future.
Could EBAY rebound before August expiration? Sure, it's possible. But the odds are against it. You don't want to get caught puffing on that hopium. It's dangerous. If you want to bet on a long-shot, go to the track. The odds are better.
Picking directions when trading options is a difficult task, to say the least. You have to be right about three things: 1) the direction; 2) the size of the move; and 3) how long it will take for it to get there. The rewards can be substantial -- if you guess right. Use the checklist above. It will help.
Missed Any Columns?
Hey, this is good stuff – especially if you're serious about learning options. The Pulitzer people won't likely be knocking at my door soon, but I've taught a lot of people how to conservatively and consistently make money – and they're still making money to this day. I hope you'll become one of them.
So, if you missed any of my previous columns, click on the following link and, hopefully, they will magically appear. http://forexworlduk.blogspot.com
Who Is This Guy? --
Mike Parnos has "been there and done that" – plenty! Known as "Online Trading Academy's Options Therapist," Mike has been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders. Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."
Disclaimer: Mike Parnos is an options instructor and mentor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.
Two Species Of Trader Which Are You?
In the wide world of directional trading there are basically two species – trend followers and contrarians. Trend followers take the "hitch your wagon to a star" kind of approach. When they see a stock moving in a particular direction, they figure that someone smarter than they are must know something. So, they jump in the fray and hope for the best. Whether they profit or not depends largely on when they have this epiphany. If they get in early in the trend, they may make a few bucks.
If they come late to the dance, all the pretty girls are already dancing and the song is almost over. So, you either dance with a Linda Tripp look-a-like -- or you go home. You've lost your pride, the cover charge, and then some. A few stiff drinks may make your Linda Tripp look like Brittany Spears, but when you sober up, the reality is there (ugghhh), and your money is still gone.
Contrarians are a different breed. They believe that when too many people agree on a direction, they're simply confused, don't understand the situation and are in for a rude financial awakening. Contrarians believe that an overwhelming majority of retail traders tend to buy high and sell low.
Instead of jumping on a bandwagon (trend), contrarians try to determine when the euphoria will end and then short the herd of traders who will be scrambling to get out. There are a number of mutual funds who use contrarian strategies to take advantage of the follies of retail traders.
A Contrarian Story
My son is a daytrader – a very successful one. At the office where he plies his craft, there are currently five other traders. They are the few survivors. Years ago, when the market was hot, there were four or five daytrading offices in metropolitan Detroit. Each office had 15 to 20 traders, plastered to computers, making money hand over fist. But, remember, that was in the day when monkeys throwing darts at the Wall Street Journal stock pages outperformed analysts and an embarrassing number of professional traders.
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When the irrational market hit the wall and fell like ton of manure, so did the mass of irrational daytraders. They only knew one style of trading, couldn't make the adjustment, and watched in amazement as they gave back most, or all, of what they made.
An occasional visitor to the office is a former daytrader named Little Richard. A great guy, about 5'6", he was affectionately known as their "contrarian indicator."
There are some people in this world who have the Midas touch. Whatever they touch turns to gold. Then there are those who, whatever they touch turns to something you wouldn't want to step in. Well, Little Richard was the latter.
Whenever Little Richard would enthusiastically announce that he just bought 500 shares of XYZ stock, the other traders in the office would immediately short XYZ stock. It worked about 80% of the time. Notice I said Little Richard is a "former" daytrader.
Identifying A Trend
Lotsa luck!! It ain't easy. Technical analysis may give you some guidance. But, the question is, once you've identified the trend, how much trend is left? That's the $64,000 question.
Look at the trend line. The steeper the trend line, the more powerful the trend may be. Some traders look for crossing moving average lines or other momentum indicators.
Throw a few support and/or resistance lines on the chart. Then, add some moving averages. Toss in another an oscillator and, before you know it, the chart looks like last night's spaghetti. A good knowledge of technical analysis can make some sense of it. Some say it gives traders an edge.
Both the momentum and/or contrarian approaches can work. It all depends on the trading skill, the chart reading skills and self-discipline of the individual trader. Developing these skills is not like Minute Rice. It takes time, effort, practice and a commitment. The market is a non-forgiving animal that eats up traders for lunch and spits out what little is left. You don't want to take a knife to a gunfight. Be prepared.
The Online Trading Academy offers probably the best and most comprehensive technical analysis and trading courses in the industry. When you complete the Online Trading Academy courses, you will have the information you'll need to give you an edge in identifying trends as well as evaluating and selecting directional, non-directional, short and long term strategies.
Missed Any Columns?
Hey, this is good stuff – especially if you're serious about learning options. The Pulitzer people won't likely be knocking at my door soon, but I've taught a lot of people how to conservatively and consistently make money – and they're still making money to this day. I hope you'll become one of them.
So, if you missed any of my previous columns, click on the following link and, hopefully, they will magically appear. http://forexworlduk.blogspot.com
Who Is This Guy? --
Mike Parnos has "been there and done that" – plenty! Known as "Online Trading Academy's Options Therapist," Mike has been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders. Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."
If they come late to the dance, all the pretty girls are already dancing and the song is almost over. So, you either dance with a Linda Tripp look-a-like -- or you go home. You've lost your pride, the cover charge, and then some. A few stiff drinks may make your Linda Tripp look like Brittany Spears, but when you sober up, the reality is there (ugghhh), and your money is still gone.
Contrarians are a different breed. They believe that when too many people agree on a direction, they're simply confused, don't understand the situation and are in for a rude financial awakening. Contrarians believe that an overwhelming majority of retail traders tend to buy high and sell low.
Instead of jumping on a bandwagon (trend), contrarians try to determine when the euphoria will end and then short the herd of traders who will be scrambling to get out. There are a number of mutual funds who use contrarian strategies to take advantage of the follies of retail traders.
A Contrarian Story
My son is a daytrader – a very successful one. At the office where he plies his craft, there are currently five other traders. They are the few survivors. Years ago, when the market was hot, there were four or five daytrading offices in metropolitan Detroit. Each office had 15 to 20 traders, plastered to computers, making money hand over fist. But, remember, that was in the day when monkeys throwing darts at the Wall Street Journal stock pages outperformed analysts and an embarrassing number of professional traders.
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When the irrational market hit the wall and fell like ton of manure, so did the mass of irrational daytraders. They only knew one style of trading, couldn't make the adjustment, and watched in amazement as they gave back most, or all, of what they made.
An occasional visitor to the office is a former daytrader named Little Richard. A great guy, about 5'6", he was affectionately known as their "contrarian indicator."
There are some people in this world who have the Midas touch. Whatever they touch turns to gold. Then there are those who, whatever they touch turns to something you wouldn't want to step in. Well, Little Richard was the latter.
Whenever Little Richard would enthusiastically announce that he just bought 500 shares of XYZ stock, the other traders in the office would immediately short XYZ stock. It worked about 80% of the time. Notice I said Little Richard is a "former" daytrader.
Identifying A Trend
Lotsa luck!! It ain't easy. Technical analysis may give you some guidance. But, the question is, once you've identified the trend, how much trend is left? That's the $64,000 question.
Look at the trend line. The steeper the trend line, the more powerful the trend may be. Some traders look for crossing moving average lines or other momentum indicators.
Throw a few support and/or resistance lines on the chart. Then, add some moving averages. Toss in another an oscillator and, before you know it, the chart looks like last night's spaghetti. A good knowledge of technical analysis can make some sense of it. Some say it gives traders an edge.
Both the momentum and/or contrarian approaches can work. It all depends on the trading skill, the chart reading skills and self-discipline of the individual trader. Developing these skills is not like Minute Rice. It takes time, effort, practice and a commitment. The market is a non-forgiving animal that eats up traders for lunch and spits out what little is left. You don't want to take a knife to a gunfight. Be prepared.
The Online Trading Academy offers probably the best and most comprehensive technical analysis and trading courses in the industry. When you complete the Online Trading Academy courses, you will have the information you'll need to give you an edge in identifying trends as well as evaluating and selecting directional, non-directional, short and long term strategies.
Missed Any Columns?
Hey, this is good stuff – especially if you're serious about learning options. The Pulitzer people won't likely be knocking at my door soon, but I've taught a lot of people how to conservatively and consistently make money – and they're still making money to this day. I hope you'll become one of them.
So, if you missed any of my previous columns, click on the following link and, hopefully, they will magically appear. http://forexworlduk.blogspot.com
Who Is This Guy? --
Mike Parnos has "been there and done that" – plenty! Known as "Online Trading Academy's Options Therapist," Mike has been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders. Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."
Volatility Good Or Bad
A little violence is one's life can be very exciting, and profitable. No, I'm not suggesting you go rob your neighborhood liquor store. I'm talking about your trading life. The violence I'm referring to is the up and down fluctuations in the stock market. How severe these fluctuations are is measured by what is called "volatility."
Obviously, when there are dramatic spikes, the volatility can be very high. Conversely, when the stock is moving sideways, and not moving up and down, the volatility is reduced. Remember, earlier we discussed the components of an option price based on the Black Scholes pricing formula. Volatility is one of the ingredients. Basically, increased volatility means there will be a higher premium. Reduced volatility translates into lower premium.
Volatility – Good or Bad?
How do we determine if the price of an option is good or bad? Well, it depends on what we're trying to do. If we're buying a put or call option, and we're hoping for a directional move, we don't want to overpay for the option. So, we look for options that are undervalued instead of options that are overvalued. We're essentially looking for a bargain.
When we buy an option, a portion of the price is "time value." We discussed that quite thoroughly in previous columns. This time value will deteriorate during the life of the option. When picking a direction, we're hoping the underlying stock will move in the appropriate direction before all the time value disappears from the value of the option.
Note: Over 80% of options expire worthless. That should tell you a little about your probability of success from straight option buying. We'll go into that later, in depth, and learn how to improve your chances of becoming profitable.
On the opposite side, if we are selling options, we want there to be as much premium available as possible. Why? Because it goes right into our pocket. In this case, we would WANT the option to expire worthless – because the other person owns it. When we sold them the option, we made a contract to perform. If we don't have to perform, we keep all the premium collected from the sale of the option.
How do we know if an option is a bargain? Or are we paying top dollar? There has to be a way to measure the price of an option – to determine if it is fairly priced, under priced, or over priced. In the Black-Scholes column, we looked at the "theoretical value" of an option. Those figures are available on the software of any quality broker.
Note: There are dozens of brokers out there – all claiming to be excellent option brokers. There is a huge difference between brokers – in price, efficiency, quotes, charts, etc. Be patient. Don't rush out and open a brokerage account for trading options just yet. We'll be covering the topic of brokers in a few weeks. If you open your account too soon, you may not be able to resist the temptation to trade and guess what? You're not ready to trade yet.
Two Kinds Of Volatility
Let's confuse the issue a little more. There are actually two kinds of volatility – historical and implied. In its simplest terms, "historical" volatility is a measurement that averages out the volatility figures over an extended period of time – perhaps years.
Then, "implied" volatility is a calculation based on what has been happening to the underlying asset recently, and what is projected for the near term. This is another calculation that is normally provided on the site of a good broker. See figure below (courtesy of BrokersXpress.com)
Let's look at the "official" definitions of these terms.
Historical Volatility -- A statistical measure of the amount of fluctuation in a stock's price within a period of time. A stock with high volatility would have rapid up and down movements in its stock price. A stock with very little movement in its price would constitute low volatility.
Implied Volatility -- The volatility of a futures contract, security, or other instrument as implied by the prices of an option on that instrument, calculated using an options pricing model.
A few years back, especially during the internet bubble, volatility was ridiculously high. But, times have changed. For a long time, we have been in a low volatility environment. Options purchasers pay only a fraction for options now, a bargain compared to what they paid for a similar option back in the days of "irrational exuberance."
There is a volatility index called the VIX. It is a calculation of the implied volatility of the 100 stocks in the S&P 100 index. The symbol for that measurement is $VIX. It's a good way to, at a glance, see what the market, in general, is doing.
Volatility Skew Charts
These are charts in which the chart of "historical" volatility is overlaid on the chart of "implied" volatility, enabling you to visually compare them. This is another standard feature available on good broker sites. See figure below (courtesy of BrokersXpress.com)
The chart above compares the historical volatility (red line) with the implied volatility (blue line). The historical volatility looks to be about 90 and the implied volatility is 71.92. So, currently, RMBS is tamer than it has been historically, but not by a lot. However, look at the distance between the blue and red lines after about the first week of April. They're at opposite extremes. The implied volatility was very high and the option premiums were correspondingly high – the perfect environment to sell premium. And, as is usually the case, the uncharacteristically high implied volatility returns to more normal historical levels.
If the implied volatility is currently higher than the historical volatility, the option is overpriced. If the implied volatility is currently below the historical volatility, the option may be a bargain.
This bit of violence (or non-violence) can have a significant effect on an option's price. This is an important concept, but doesn't come into play in all strategies. It's good to know, but it's only one part of many in the decision making process.
Missed Any Columns?
Hey, this is good stuff – especially if you're serious about learning options. The Pulitzer people won't likely be knocking at my door soon, but I've taught a lot of people how to conservatively and consistently make money – and they're still making money to this day. I hope you'll become one of them.
So, if you missed any of my previous columns, click on the following link and, hopefully, they will magically appear. http://forexworlduk.blogspot.com
Who Is This Guy? --
Mike Parnos has "been there and done that" – plenty! Known as "Online Trading Academy's Options Therapist," Mike has been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders. Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."
Obviously, when there are dramatic spikes, the volatility can be very high. Conversely, when the stock is moving sideways, and not moving up and down, the volatility is reduced. Remember, earlier we discussed the components of an option price based on the Black Scholes pricing formula. Volatility is one of the ingredients. Basically, increased volatility means there will be a higher premium. Reduced volatility translates into lower premium.
Volatility – Good or Bad?
How do we determine if the price of an option is good or bad? Well, it depends on what we're trying to do. If we're buying a put or call option, and we're hoping for a directional move, we don't want to overpay for the option. So, we look for options that are undervalued instead of options that are overvalued. We're essentially looking for a bargain.
When we buy an option, a portion of the price is "time value." We discussed that quite thoroughly in previous columns. This time value will deteriorate during the life of the option. When picking a direction, we're hoping the underlying stock will move in the appropriate direction before all the time value disappears from the value of the option.
Note: Over 80% of options expire worthless. That should tell you a little about your probability of success from straight option buying. We'll go into that later, in depth, and learn how to improve your chances of becoming profitable.
On the opposite side, if we are selling options, we want there to be as much premium available as possible. Why? Because it goes right into our pocket. In this case, we would WANT the option to expire worthless – because the other person owns it. When we sold them the option, we made a contract to perform. If we don't have to perform, we keep all the premium collected from the sale of the option.
How do we know if an option is a bargain? Or are we paying top dollar? There has to be a way to measure the price of an option – to determine if it is fairly priced, under priced, or over priced. In the Black-Scholes column, we looked at the "theoretical value" of an option. Those figures are available on the software of any quality broker.
Note: There are dozens of brokers out there – all claiming to be excellent option brokers. There is a huge difference between brokers – in price, efficiency, quotes, charts, etc. Be patient. Don't rush out and open a brokerage account for trading options just yet. We'll be covering the topic of brokers in a few weeks. If you open your account too soon, you may not be able to resist the temptation to trade and guess what? You're not ready to trade yet.
Two Kinds Of Volatility
Let's confuse the issue a little more. There are actually two kinds of volatility – historical and implied. In its simplest terms, "historical" volatility is a measurement that averages out the volatility figures over an extended period of time – perhaps years.
Then, "implied" volatility is a calculation based on what has been happening to the underlying asset recently, and what is projected for the near term. This is another calculation that is normally provided on the site of a good broker. See figure below (courtesy of BrokersXpress.com)
Let's look at the "official" definitions of these terms.
Historical Volatility -- A statistical measure of the amount of fluctuation in a stock's price within a period of time. A stock with high volatility would have rapid up and down movements in its stock price. A stock with very little movement in its price would constitute low volatility.
Implied Volatility -- The volatility of a futures contract, security, or other instrument as implied by the prices of an option on that instrument, calculated using an options pricing model.
A few years back, especially during the internet bubble, volatility was ridiculously high. But, times have changed. For a long time, we have been in a low volatility environment. Options purchasers pay only a fraction for options now, a bargain compared to what they paid for a similar option back in the days of "irrational exuberance."
There is a volatility index called the VIX. It is a calculation of the implied volatility of the 100 stocks in the S&P 100 index. The symbol for that measurement is $VIX. It's a good way to, at a glance, see what the market, in general, is doing.
Volatility Skew Charts
These are charts in which the chart of "historical" volatility is overlaid on the chart of "implied" volatility, enabling you to visually compare them. This is another standard feature available on good broker sites. See figure below (courtesy of BrokersXpress.com)
The chart above compares the historical volatility (red line) with the implied volatility (blue line). The historical volatility looks to be about 90 and the implied volatility is 71.92. So, currently, RMBS is tamer than it has been historically, but not by a lot. However, look at the distance between the blue and red lines after about the first week of April. They're at opposite extremes. The implied volatility was very high and the option premiums were correspondingly high – the perfect environment to sell premium. And, as is usually the case, the uncharacteristically high implied volatility returns to more normal historical levels.
If the implied volatility is currently higher than the historical volatility, the option is overpriced. If the implied volatility is currently below the historical volatility, the option may be a bargain.
This bit of violence (or non-violence) can have a significant effect on an option's price. This is an important concept, but doesn't come into play in all strategies. It's good to know, but it's only one part of many in the decision making process.
Missed Any Columns?
Hey, this is good stuff – especially if you're serious about learning options. The Pulitzer people won't likely be knocking at my door soon, but I've taught a lot of people how to conservatively and consistently make money – and they're still making money to this day. I hope you'll become one of them.
So, if you missed any of my previous columns, click on the following link and, hopefully, they will magically appear. http://forexworlduk.blogspot.com
Who Is This Guy? --
Mike Parnos has "been there and done that" – plenty! Known as "Online Trading Academy's Options Therapist," Mike has been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders. Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."
An Introduction to foreign currencies
Why pay attention to the foreign currency markets (FOREX)? Most people value their net worth by performing various calculations and arriving at a number that has a "$" sign in front of it. Everyone wants to see if that number is large or small. Do you receive your monthly statement from your investment broker and smile each time you see the rise in the equity value due to the Dow making new highs month after month? This gain in wealth is an illusion second to none because there is one important number that is missing from your monthly statement. It is the REAL value of the Dow (and all your other assets) after factoring in the collapse of the U.S. Dollars Global Purchasing Power. Instead of going into a big story on the collapse of the U.S. Dollar, let's take a step back and understand what currencies are and how they work.
I have been trading currencies for around 15 years. For the average person, an easy way to understand how and why they are valued against each other as they are is to think of them as different publicly traded companies. For example, there is typically plenty of demand for the stock of a growing solid company. This demand creates higher valuations for the stock which leads to wealth and strong buying power for the company. There are other companies, however, like Enron a few years back that were operating under mass illusion. When the public became aware of this fraud, everybody sold the stock which eventually went to zero and the company filed for bankruptcy. What happened to the main people responsible for the Enron illusion and fraud? One is serving a long prison sentence and the other died of a heart attack during court proceedings. The Enron illusion was nothing more than risk disguised as opportunity.
Currencies are valued the same way. The perception of growth and higher interest rates for a country is going to invite global investors to buy that country's currency which will drive up the value of that currency. The higher the value of the currency, the greater that country's real global purchasing power. If the U.S. Dollar was a publicly traded company today, we would be considered much more an Enron than a Microsoft. The currencies of the world producers and savers are much more the Microsoft's of the world. Global currencies seek safe and strong returns on investment. The U.S. Dollar is not it and the currency markets have been telling us this for years.
As you can see above, there are two primary ways currencies trade. One is the futures and the other is the more common cash market, better known as "FOREX". While they represent the same markets and stay in line with each other, there are some differences. We cover these differences in detail in class.
The main question for currency speculators is how and why prices move in these markets. What is important to understand is that price moves in these markets are a function of pure supply and demand and nothing else. Prices move when this simple and straight forward equation is out of balance.
Let's quantify demand (support) in the chart above. As price is trading sideways, one might think that supply and demand are in balance at 20.50. The truth is that there was never supply and demand balance. It just took a certain period of time for this unbalanced equation to play out. When price rallies initially from that demand level, we know that this can only happen because there are more willing buyers than sellers at 20.50. Therefore, if and when price revisits that level, we want to be a buyer. When we buy, we are buying from someone who is selling after a decline in price and at a price level where demand exceeds supply.
It's not easy! Trading based on the laws and principles of supply and demand will test every emotional bone in your body. As you can see below, price never drops to a low risk/high reward price level on nice green candles and good news. It's always nasty red candles and bad news. This is what drives the masses to sell. The astute market speculator knows, however, that when the last seller sells at a price level where demand exceeds supply, price must rise.
Perhaps you wish to trade currencies but are not sure how to get started. Perhaps you never wish to trade currencies but really want to "value" your assets properly. In either case, there are plenty of reasons why people need to understand how to quantify supply and demand in the foreign currency markets. Email me if you have any questions. I hope to see you at an Online Trading Academy course soon.
I have been trading currencies for around 15 years. For the average person, an easy way to understand how and why they are valued against each other as they are is to think of them as different publicly traded companies. For example, there is typically plenty of demand for the stock of a growing solid company. This demand creates higher valuations for the stock which leads to wealth and strong buying power for the company. There are other companies, however, like Enron a few years back that were operating under mass illusion. When the public became aware of this fraud, everybody sold the stock which eventually went to zero and the company filed for bankruptcy. What happened to the main people responsible for the Enron illusion and fraud? One is serving a long prison sentence and the other died of a heart attack during court proceedings. The Enron illusion was nothing more than risk disguised as opportunity.
Currencies are valued the same way. The perception of growth and higher interest rates for a country is going to invite global investors to buy that country's currency which will drive up the value of that currency. The higher the value of the currency, the greater that country's real global purchasing power. If the U.S. Dollar was a publicly traded company today, we would be considered much more an Enron than a Microsoft. The currencies of the world producers and savers are much more the Microsoft's of the world. Global currencies seek safe and strong returns on investment. The U.S. Dollar is not it and the currency markets have been telling us this for years.
As you can see above, there are two primary ways currencies trade. One is the futures and the other is the more common cash market, better known as "FOREX". While they represent the same markets and stay in line with each other, there are some differences. We cover these differences in detail in class.
The main question for currency speculators is how and why prices move in these markets. What is important to understand is that price moves in these markets are a function of pure supply and demand and nothing else. Prices move when this simple and straight forward equation is out of balance.
Let's quantify demand (support) in the chart above. As price is trading sideways, one might think that supply and demand are in balance at 20.50. The truth is that there was never supply and demand balance. It just took a certain period of time for this unbalanced equation to play out. When price rallies initially from that demand level, we know that this can only happen because there are more willing buyers than sellers at 20.50. Therefore, if and when price revisits that level, we want to be a buyer. When we buy, we are buying from someone who is selling after a decline in price and at a price level where demand exceeds supply.
It's not easy! Trading based on the laws and principles of supply and demand will test every emotional bone in your body. As you can see below, price never drops to a low risk/high reward price level on nice green candles and good news. It's always nasty red candles and bad news. This is what drives the masses to sell. The astute market speculator knows, however, that when the last seller sells at a price level where demand exceeds supply, price must rise.
Perhaps you wish to trade currencies but are not sure how to get started. Perhaps you never wish to trade currencies but really want to "value" your assets properly. In either case, there are plenty of reasons why people need to understand how to quantify supply and demand in the foreign currency markets. Email me if you have any questions. I hope to see you at an Online Trading Academy course soon.
Back To Basics Limit Order
Question from a student: I'm completely confused by limit orders. What good do they do, especially in relation to risk management? Can I hold an overnight position on a stock bought at $20.00 (ordered, say, thirty seconds before the market closes) and set a stop loss of $19.90 on it, so that if the stock gets a surprise downgrade the following morning, I won't take such a horrendous loss on it? Is this possible, using some type of Good Til Cancelled scenario. I guess what I'm trying to say is: is there any way to competently guess the market in order to limit devastating losses? If not, then why not use market orders exclusively? The risk is the same, and more often than not, market orders are much cheaper. Any help here would be greatly appreciated.
Mike 's Answer: Let's start with a simple definition. Limit orders specify a specific price (or better) and share size. Market orders are executed at the price the market is at - At Time of Execution. Limit orders do not suffer slippage, but run the risk of not being filled. Market orders are almost always filled, but you can get filled "away" from the price you had in mind.
Now, the question you pose ultimately has to do with Stop Loss Limit versus Stop Loss Market orders. In your scenario, you are long and taking it overnight. You had good reasons to do so, but an extraordinary event causes it to gap down several points.
Scenario #1: You bought at $20 and place a Stop Loss Limit of $19.90. The market gaps down to $17. The first trade was well below your SLL of $19.90. You do not get filled, thus, you are now holding a $3 dollar loser. You still have the position and we can work with this, but clearly, this is not the best scenario.
Scenario #2: You bought at $20 and place a Stop Loss Market. The market gaps down to $17. The first trade was at $17. This activates your Market Sell order. You will probably be filled on the next trade at the Inside Bid price ( $16.99, $17 or $17.01). You have been filled, thus, you have taken a $3 dollar loser. You are out of the trade, which is good, but you have suffered a significant draw down. I could be glib and say "Welcome to trading," but let's see what we could do. Again, this is not a good scenario.
Scenario #1 protects you against normal wear and tear of price movement, although $0.10 is fairly tight for an overnight stop. Most traders are trying to maintain at least a 1:3 Risk to Reward ratio. That is to say, if you risk a dime, you expect 30 cents minimum. Overnights are high risk trades, as you cannot control events (assassinations, fraud, terrorism or just a good old earthquake – I live in California) and, therefore, should you take one home, you need to have very high probability that a excellent reward awaits you (high risk better equal high reward). Extraordinary events do catch us. So a Stop Loss Limit actually protects you by giving you the opportunity to "work" the position rather than "eat" the big loser.
In this case, it has gapped down against you. Almost always, there will be "gap filling" pressures. Gap fills take place in the first 45 minutes (sometimes an hour). Thus, instead of canceling your SLL and blowing out the position at Market, watch for the first hour. We are not trying to make a profit here, but rather, to manage and salvage our loss (You are not "hoping" for it to come back, you are calculating a better exit). If the gap fills only 38.2%, sell the whole position. If the Gap fills 50%, sell half of your position, and watch for any weakness. If weakness shows, blow out the balance. If the gap fills 61.8% or higher, then hold on a little longer, because this higher percentage of gap fill shows this stock has some strength. Be prepared to dump the whole thing if there is any indication of weakness.
Again, we are trying to cut your loss, not make a profit on a loser. If you were fortunate to retrace to the 61.8 % fill, you have saved about $2 of the loss. The percentages I mentioned here are Fibonacci Retracement numbers.
So, we are at decision point. First, should you take this stock home overnight? NEVER take home a loser. If you take a 'long ' home, you want it closing on or near the high of the day with increasing volume.
Next, what stop loss to use? First question for every good trader is, "How much am I willing to lose if I am wrong?" Whatever that amount is, multiply it by 3, and then look to see if you can achieve that profit. If not, pass on the trade.
An example of this to consider: You say, "I can afford to lose $0.50/share on this trade". Therefore, you have calculated that you can make $1.50/share in potential profit. Now look at the reality of the situation. You are playing a $20 stock. For it to move $1.50 the next day, it will have to move 7.5% or better. Is this realistic? If it is, then you must realize that you are playing with a fairly volatile stock (probably a Beta of 2 - 2.5). Most stocks move a couple of percent in a day. So, if the stock has been moving only 3 or 4 % in its recent history, you must decide on one or two possibilities. First, a $0.50 stop loss is too large to protect the risk/reward scenario. If the stock only moves 5%, then $1 is the profit target, thus, you should probably reduce your stop loss to only $0.33 (remember 1:3 ratio).
The 2nd thing to consider is the aspect of "extraordinary events" - how do you factor them into your risk profile? Look at the over-all picture. Has the market been clearly trending or is it choppy? Are there good Economic and Market indication to support your decision to hold overnight? If you only expect to make $.25 or $.50 the next day, but could suffer a $2-$3 loser, then why not buy it the next day. Sure, you may lose some profitability to gap ups or release of news, but the game is learning "how not to lose" and Capital Preservation. Remember, better money missed, than money lost!
So, in reality, it does not matter which Stop Loss you use - Limit or Market - but rather the risk/reward scenario, your risk tolerance, the stocks characteristics and the possibility/probability of bad news. A trade plan (which includes a Stop Loss) is absolutely necessary.
However, we all get caught occasionally - That IS trading- but if you follow the "loss management" I proposed above considering Gap fill, you can hold your account together to fight another day.
Last comment. You mention that Market orders are much cheaper than Limit. First, check around with other broker dealers. If you are working with very cheap commissions, then you may be doing yourself a disservice. A $5 market order on a 1000 shares costs about $25 with only a $0.02 slippage. A $15 limit order is $15, as there is no slippage. I have no idea who you are with, what prices you pay, but please consider what we call "load" - which is slippage + commission + fees. You might be surprised what that "cheap" ticket is really costing you. You can check out our partners page to see which broker/dealers also offer tuition rebates – a win/win situation:
Thanks for your question and happy trading
Mike 's Answer: Let's start with a simple definition. Limit orders specify a specific price (or better) and share size. Market orders are executed at the price the market is at - At Time of Execution. Limit orders do not suffer slippage, but run the risk of not being filled. Market orders are almost always filled, but you can get filled "away" from the price you had in mind.
Now, the question you pose ultimately has to do with Stop Loss Limit versus Stop Loss Market orders. In your scenario, you are long and taking it overnight. You had good reasons to do so, but an extraordinary event causes it to gap down several points.
Scenario #1: You bought at $20 and place a Stop Loss Limit of $19.90. The market gaps down to $17. The first trade was well below your SLL of $19.90. You do not get filled, thus, you are now holding a $3 dollar loser. You still have the position and we can work with this, but clearly, this is not the best scenario.
Scenario #2: You bought at $20 and place a Stop Loss Market. The market gaps down to $17. The first trade was at $17. This activates your Market Sell order. You will probably be filled on the next trade at the Inside Bid price ( $16.99, $17 or $17.01). You have been filled, thus, you have taken a $3 dollar loser. You are out of the trade, which is good, but you have suffered a significant draw down. I could be glib and say "Welcome to trading," but let's see what we could do. Again, this is not a good scenario.
Scenario #1 protects you against normal wear and tear of price movement, although $0.10 is fairly tight for an overnight stop. Most traders are trying to maintain at least a 1:3 Risk to Reward ratio. That is to say, if you risk a dime, you expect 30 cents minimum. Overnights are high risk trades, as you cannot control events (assassinations, fraud, terrorism or just a good old earthquake – I live in California) and, therefore, should you take one home, you need to have very high probability that a excellent reward awaits you (high risk better equal high reward). Extraordinary events do catch us. So a Stop Loss Limit actually protects you by giving you the opportunity to "work" the position rather than "eat" the big loser.
In this case, it has gapped down against you. Almost always, there will be "gap filling" pressures. Gap fills take place in the first 45 minutes (sometimes an hour). Thus, instead of canceling your SLL and blowing out the position at Market, watch for the first hour. We are not trying to make a profit here, but rather, to manage and salvage our loss (You are not "hoping" for it to come back, you are calculating a better exit). If the gap fills only 38.2%, sell the whole position. If the Gap fills 50%, sell half of your position, and watch for any weakness. If weakness shows, blow out the balance. If the gap fills 61.8% or higher, then hold on a little longer, because this higher percentage of gap fill shows this stock has some strength. Be prepared to dump the whole thing if there is any indication of weakness.
Again, we are trying to cut your loss, not make a profit on a loser. If you were fortunate to retrace to the 61.8 % fill, you have saved about $2 of the loss. The percentages I mentioned here are Fibonacci Retracement numbers.
So, we are at decision point. First, should you take this stock home overnight? NEVER take home a loser. If you take a 'long ' home, you want it closing on or near the high of the day with increasing volume.
Next, what stop loss to use? First question for every good trader is, "How much am I willing to lose if I am wrong?" Whatever that amount is, multiply it by 3, and then look to see if you can achieve that profit. If not, pass on the trade.
An example of this to consider: You say, "I can afford to lose $0.50/share on this trade". Therefore, you have calculated that you can make $1.50/share in potential profit. Now look at the reality of the situation. You are playing a $20 stock. For it to move $1.50 the next day, it will have to move 7.5% or better. Is this realistic? If it is, then you must realize that you are playing with a fairly volatile stock (probably a Beta of 2 - 2.5). Most stocks move a couple of percent in a day. So, if the stock has been moving only 3 or 4 % in its recent history, you must decide on one or two possibilities. First, a $0.50 stop loss is too large to protect the risk/reward scenario. If the stock only moves 5%, then $1 is the profit target, thus, you should probably reduce your stop loss to only $0.33 (remember 1:3 ratio).
The 2nd thing to consider is the aspect of "extraordinary events" - how do you factor them into your risk profile? Look at the over-all picture. Has the market been clearly trending or is it choppy? Are there good Economic and Market indication to support your decision to hold overnight? If you only expect to make $.25 or $.50 the next day, but could suffer a $2-$3 loser, then why not buy it the next day. Sure, you may lose some profitability to gap ups or release of news, but the game is learning "how not to lose" and Capital Preservation. Remember, better money missed, than money lost!
So, in reality, it does not matter which Stop Loss you use - Limit or Market - but rather the risk/reward scenario, your risk tolerance, the stocks characteristics and the possibility/probability of bad news. A trade plan (which includes a Stop Loss) is absolutely necessary.
However, we all get caught occasionally - That IS trading- but if you follow the "loss management" I proposed above considering Gap fill, you can hold your account together to fight another day.
Last comment. You mention that Market orders are much cheaper than Limit. First, check around with other broker dealers. If you are working with very cheap commissions, then you may be doing yourself a disservice. A $5 market order on a 1000 shares costs about $25 with only a $0.02 slippage. A $15 limit order is $15, as there is no slippage. I have no idea who you are with, what prices you pay, but please consider what we call "load" - which is slippage + commission + fees. You might be surprised what that "cheap" ticket is really costing you. You can check out our partners page to see which broker/dealers also offer tuition rebates – a win/win situation:
Thanks for your question and happy trading
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