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Commodities That Move The Markets

2008-10-17T02:05:00.000-07:00

The daily movements in the world's equity markets are influenced by a multitude of factors ranging from large institutional block trades and program trading to earnings and economic reports. However, one factor that is frequently overlooked is the influence of commodity prices. In fact, fluctuating commodity prices can have a tremendous impact on the earnings of public companies and, by extension, the markets. Read on to learn more about this relationship and why it matters to investors.

Lumber Prices
The average person would probably never ponder the cost of lumber unless he or she was in the process of building a house. However, the pricing of this commodity is closely watched and can affect many companies, such as homebuilders.

However, it's also important to note that many other types of companies pay close attention to lumber prices as well. For example, companies that are looking to expand and build out new locations, such as restaurants, retail chains and even pharmaceutical companies looking to build new manufacturing facilities would naturally be interested in the cost of lumber. After all, even a small tick up in prices can materially affect the cost of a structure.

Random length lumber futures and options trade daily on the Chicago Mercantile Exchange (CME) . Quotes and information may also be published in the Wall Street Journal or Investor's Business Daily and is often noted on major business channels, such as CNBC.

Oil Prices
Many consumers only think about oil prices in the context of how it directly impacts their wallets. In other words, how much they will end up paying at the pump as the result of price fluctuations. However, oil is one of the cornerstones of the North American economy and its price is highly important to companies of all stripes.

The price of oil can affect a variety of companies ranging from retailers to manufacturers of plastics (oil byproducts are a big component in plastic). Just think about how all of the products that are on the shelves at your local Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) are shipped.

By extension, this means that these companies either have to eat the rising cost of fuel or try to pass some of it along to consumers in the form of higher prices. Unfortunately however, if they aren't able to pass along the cost increase, it can have an adverse impact on margins and net income, which can put downward pressure on stock prices and hurt investor returns.

The price of crude can be tracked on the New York Mercantile Exchange (NYMEX).

Cotton Prices
Cotton is used in a wide variety of pruducts. For example, many types of clothes contain large amounts of cotton; therefore, rising prices can have an adverse impact on an apparel retailer's cost of goods sold and declining prices can have a positive impact.

Of course those in the apparel industry aren't the only parties that can be impacted by changing cotton prices. In fact, it's also a key component in things like furniture, coffee filters and a variety of other materials that we all have come to depend on.

As such, companies that sell these items have only a couple of choices when dealing with rising cotton prices. They can raise the price of the product, and/or eat the rising cost. Again either or both of these choices can have an effect on income and by extension stock prices.

Wheat
Wheat is the primary ingredient in many popular cereals and foods. While cereal and other food producers may be able to pass along some of these costs, they may have to absorb some as well. This can impact their margins and, by extension, their profits.

Of course makers of such products aren't the only ones affected. Grocery and convenience stores must purchase the items to keep shelves stocked. Also don't forget about the impact on distributors and any middlemen. Fluctuating wheat prices can have a far-reaching impact on a variety of companies and on consumers.

Corn
Corn in one form or another is used in a variety of products ranging from cereals, building materials, alcohols and even tires.

It's also worth noting that the price of corn is impacted by the demand and production of ethanol, which is an increasingly popular corn based fuel. As the demand for alternative fuels ramps up, corn prices could go even higher. Food manufacturers, retailers, consumers and, by extension, stock prices can be affected by fluctuating corn prices.

Coffee
Rising or declining coffee prices can certainly have an impact on consumers that enjoy drinking it in the morning. It can also have an affect on companies that do a brisk breakfast business, such as diners and fast food chains like McDonalds (NYSE:MCD) or Burger King (NYSE:BKC). Also, companies like Starbucks (NYSE:SBUX), which derives the lion's share of its revenue from coffee or coffee related products, can be dramatically impacted as well.

Gold
The price of gold can have an impact on jewelers as well as on retailers that sell or receive a portion of their sales from jewelry related items. For example, Macy's (NYSE:M) and many of the other well-known mall-based department stores generate a significant amount of revenue from their jewelry departments.

Gold can also be used in medical products, glass making, aerospace and a variety of other businesses. By extension, this means that fluctuations in gold prices can make the markets move.

In addition, because gold is found and valued all over the world, it is considered a universal currency. So, if the outlook for the U.S. equity markets and/or the economy is dim, it's likely that the demand for gold will increase as investors "flock to safety."

If it appears as though the economy is about to perk up, or that corporate earnings are going to be on the rise, investors tend to abandon gold in favor of equities.

Bottom Line
Although there are a variety of factors that can move markets, commodities can have a major influence on businesses, stocks and portfolios. When you're looking to invest in a particular sector or company, take a look at relevant commodity prices and what this might mean for your investments going forward.

by Glenn Curtis,
Glenn Curtis started his career as an equity analyst at Cantone Research, a New Jersey-based regional brokerage firm. He has since worked as an equity analyst and a financial writer at a number of print/web publications and brokerage firms including Registered Representative Magazine, Advanced Trading Magazine, Worldlyinvestor.com, RealMoney.com, TheStreet.com and Prudential Securities. Curtis has also held Series 6,7,24 and 63 securities licenses.

The Importance Of A Profit/Loss Plan

2008-10-16T01:56:00.000-07:00

Who needs a profit/loss plan? Isn't investing only about buying low and selling high? It would be nice to always buy at the bottom and sell at the top, but it is nearly impossible to do so consistently. Furthermore, investors are only human: emotions sway our judgment and it is in our nature to hate losing. Taking a loss on a stock, therefore, is not only detrimental to our pocketbooks, but it also hurts our egos. Time and time again investors take profits by selling an investment that has appreciated, but hold onto declining stocks in the hope of a rebound; oftentimes these investments shrivels to a fraction of their previous worth. So how can an investor avoid this type of outcome? One solution is to learn to be a disciplined investor and to adopt a profit/loss plan. In this article, we'll go over this strategy and show you how to use it to stay in the black.

What Is a Profit/Loss Plan?
This plan is a step that many retail investors (and professionals) often overlook. The profit/loss plan is a set of limits that determines the maximum loss or gain an investor will take on a stock. Containing losses is a very important part of a investing, so the profit/loss plan is crucial to a sound strategy.

We all make stock-picking mistakes and most of us have lost money in the stock market - what sets the great investors apart is their ability to recognize their bad choices and use what they've learned to make up for them later. A profit/loss plan helps you recognize your mistakes by allowing you to separate your emotions from investing. If you aren't too zealous about your gains and you see them purely as a means of increasing your cash flows (rather than your ego), you will have a much easier time letting go of your losses and, therefore, controlling them.

Devising Your Plan
Devising a plan may be more difficult than you'd expect. First, you'll need to set the maximum gain you will accept and the maximum loss you will tolerate for your investments, but these maximums and minimums shouldn't necessarily be the same for every stock. For example, a blue chip stock is more unlikely to rise or fall by 10% within any given year as compared to a small-cap growth stock, which will exhibit more volatility. In other words, you must analyze each stock individually to estimate how much it is likely to move in either direction.

Some investors use technical or fundamental analysis or a combination of both to determine appropriate limits for gains and losses. Another way to devise your limits is by modeling your plan on the performance of a designated benchmark such as an index or even on the past performance of your own portfolio.

Another factor you must consider when devising your profit/loss plan is your risk tolerance, which depends on many factors such as your personality, your time frame and your available capital. Typically, people who are risk averse will have tighter boundaries than those of people who don't mind risk. Risk lovers will try to profit as much as possible from a rising stock, but a more conservative investor may sell the stock early on in its rise to eliminate the risk of losses, which would occur if the stock took a quick downward dive. If you prefer to shy away from risks, a profit/loss plan of 10% each way may not be suitable or even realistic for you. On the other hand, if you are willing to take on the added risks associated with potential profits, then a 10% profit/loss might be more appropriate.

Carrying Out Your Plan
Once you've decided on your numbers, whether conservative or aggressive, you have to put the plan into action with as few hitches as possible. Remember, this plan has a double requirement: you have to sell your stocks (1) if they fall to a certain level and (2) if they rise to a certain level.

Now, brokers will not let you enter two different sell orders for the same security so you need to figure out which one you'd rather enter first. It may be wisest to enter orders that first protect your downside: many wise investors use the stop-loss order, which instructs your broker to buy or sell a stock once it has reached a certain price. The stop loss ensures that you won't get burned on a down market, especially if you aren't able to watch it every second. When you enter in your order with your broker, set the stop price at your maximum loss percentage and then sit and wait. If the price ends up appreciating to your upper boundary, just change the price of your stop loss order, which will then activate the immediate sale of your stock.

Staying Disciplined
Once you have your profit/loss strategy in place, you will have to remember that the whole idea of the plan is to establish strict guidelines for when to sell. Sure, it hurts to see a stock continue to rise once you have sold it, but it is often better to sell on the way up than to wait until you have to dump the stock while the price is collapsing after its peak. Joseph P. Kennedy, Sr. once said, "Only a fool holds out for the top dollar."

Conclusion
Keep in mind that our example figures are generalizations. Devising your plan requires detailed research, analysis, self-assessment and a realistic outlook. Setting a profit limit at 100% (double your money) doesn't make sense if you invest in low-risk companies that grow steadily at 15% per year.

Here are some things to remember:

A stock that declines 50% means you will need to double your money to get back to even. Controlling losses is the key to sound investing.
Making mistakes is human nature. Once you realize this, you will find it easier to move on.
Buying a stock and holding onto it for a very long time doesn't mean you will make money. A buy and hold strategy will work only if you pick the right companies.

The most important part of devising a profit/loss plan is sticking to it!

by Investopedia.com

Getting To Know The Money Market

2008-10-15T01:54:00.000-07:00

Chances are you've heard the term before, but what exactly is the money market? It is the organized exchange on which participants can lend and borrow large sums of money for a period of one year or less. While it is an extremely efficient arena for businesses, governments, banks, and other large institutions to transact funds, the money market also provides an important service to individuals who want to invest smaller amounts while enjoying perhaps the best liquidity and safety found anywhere. Here we look at some of the most popular types of money market instruments and the benefits they offer to the individual investor.

Purposes of the Money Market
Individuals will invest in the money market for much the same reason that a business or government will lend or borrow funds in the money market: sometimes the need for funds does not coincide with having them. For example, if you find you have a certain sum of money that you do not immediately need (to pay down debt, for example), then you may choose to invest those funds temporarily, until you need them to make some other, longer-term investment, or a purchase. If you decide to hold these funds in cash, the opportunity cost that you incur is the interest that you could have received by investing your funds. If you do invest your funds in the money market, you can quickly and easily secure this interest.

The major attributes that will draw an investor to short-term money market instruments are superior safety and liquidity. Money market instruments have maturities that range from one day to one year, but they are most often three months or less. Because these investments are associated with massive and actively-traded secondary markets, you can almost always sell them prior to maturity, albeit at the price of forgoing the interest you would have gained by holding them until maturity.

The secondary money market has no centralized location. The closest thing the money market has to a physical presence is an arbitrary association with the city of New York; although, the money market is accessible from anywhere by telephone. Most individual investors participate in the money market with the assistance (and experience) of their financial advisor, accountant or banking institution.

Types of Money Market Instruments
A large number of financial instruments have been created for the purposes of short-term lending and borrowing. Many of these money market instruments are quite specialized, and they are typically traded only by those with intimate knowledge of the money market, such as banks and large financial institutions. Some examples of these specialized instruments are federal funds, discount window, negotiable certificates of deposit (NCDs), eurodollar time deposits, repurchase agreements, government-sponsored enterprise securities, shares in money market instruments, futures contracts, futures options, and swaps.

Aside from these specialized instruments on the money market are the investment vehicles with which individual investors will be more familiar, such as short-term investment pools (STIPs) and money market mutual funds, Treasury bills, short-term municipal securities, commercial paper, and bankers' acceptances. Here we take a closer look at STIPs, money market mutual funds, and Treasury bills.

Short-Term Investment Pools (STIPs) and Money Market Mutual Funds
Short-term investment pools (STIPs) include money market mutual funds, local government investment pools, and short-term investment funds of bank trust departments. All STIPs are sold as shares in very large pools of money market instruments, which may include any or all of the money market instruments mentioned above. In other words, STIPs are a convenient means of cumulating various money market products into one product, just as an equity or fixed income mutual fund brings together a variety of stocks, bonds, and so forth. STIPs make specialized money market instruments accessible to individual investors without requiring an intimate knowledge of the various instruments contained within the pool. STIPs also alleviate the large minimum investment amounts required to purchase most money market instruments, which generally equal or exceed $100,000.

Of the three main types of STIPs, money market mutual funds are the most accessible to individuals. These funds are offered by brokerage companies and mutual fund firms, which sell shares in these funds to their individual, corporate and institutional investors. Short-term investment funds are operated by bank trust departments for their various trust accounts. Local government investment pools are established by state governments on behalf of their local governments, allowing investors to purchase shares of local government investment funds.

Money market mutual funds are further divided into two categories: taxable funds and tax-exempt funds. Taxable funds place investments in securities such as Treasury bills and commercial papers that pay interest income that is subject to federal taxation once it is paid to the fund purchaser. Tax-exempt funds invest in securities issued by state and local governments that are exempt from federal taxation. These two categories of money market mutual funds provide different patterns of growth, each of which attracts different types of investors.

Treasury Bills (T-Bills)
Treasury bills, commonly known as "T-bills," are short-term securities issued by the U.S. Treasury on a regular basis to refinance earlier T-bill issues reaching maturity, and to help finance federal government deficits. Of all money market instruments, T-bills have the largest total dollar value outstanding--a sum that as of 2004 exceeded $650 billion. In addition to scheduling regular sales of T-Bills, the Treasury also sells instruments called cash management bills on an irregular basis, by re-opening the sales of bills that mature on the same date as an outstanding issue of bills.

When T-bills were initially conceived, they were given three-month maturities exclusively; but bills with six-month and one-year maturities were subsequently added. Three-month and six-month bills sell in the regular weekly auctions, and another bill auction takes place every four weeks for the sale of one-year bills.

T-bills are sold through the commercial book-entry system to large investors and institutions, which then distribute those bills to their own clients, which may include individual investors. An alternative is Treasury Direct, which is run as a non-competitive holding system designed for small investors who plan to hold their securities until maturity. Individual bidders on Treasury Direct have their ownership recorded directly in book-entry accounts at the Department of the Treasury. If an investor purchases T-bills through the Treasury Direct system and wishes to sell them prior to maturity, he or she must transfer them to the commercial book-entry system. The transfer can be arranged only through a depository institution that holds an account at a Federal Reserve Bank; the person making the transfer is required to pay applicable transfer fees.

Conclusion
When an individual investor builds a portfolio of financial instruments and securities, he or she typically allocates a certain percentage of funds towards the safest and most liquid vehicle available: cash. This cash component may sit in his or her investment account in purely liquid funds, just as it would if deposited into a bank savings or checking account. However, investors are much better off placing the cash component of their portfolios into the money market, which offers interest income while still retaining the safety and liquidity of cash. Many money market instruments are available to investors, most simply through well-diversified money market mutual funds. Should investors be willing to go it alone, there are other money market investment opportunities, most notably in purchasing T-bills through Treasury Direct.

by Jason Van Bergen, investopedia.com

4 Steps to Eliminate the Frustration of Using Stop-Losses

2008-10-14T01:50:00.000-07:00

Every trader has had the frustrating experience of placing a stop-loss order too close to the market. It really doesn't matter if the stop was to exit a losing trade or a winning trade, the frustration comes from having the stop get executed and then shortly thereafter the market continues to advance in the direction intended when the trade was initiated.

You either have taken a loss that could have been a gain; or cut a profit short. Of all the issues required to develop my trade approach, I probably have spent more actual time on the issue of improving stop placement than anything else. After giving the issue a lot of thought I decided the issue wasn't whether stops should be; after all trading without stops is an accident waiting to happen. It really is an issue of using stops effectively in order to maximize the probabilities inherent in your trading approach/system.

I took a look into the psychology of the stop-losses and I believe that any trader can improve their use of stops simply be being less aggressive with them. Here are the rules I recommend.

1. First of all, you must accept once and for all that stops are not optional. The surest way to suffer a debilitating drawdown in your equity is to trade without stop protection. This includes mental stops in my opinion.

The purpose of a standing stop-loss order does not have to be solely to exit an existing trade; it needs to be considered as part of a well thought out trading approach that includes the understanding that no trader knows it all. If we are willing to admit to ourselves that we cannot know for certain if any one trade will be a winning trade, then your use of stops is simply an admission of that fact. You, as a serious trader must always have a protective stop working in the market you trade; regardless if you intend that to be an exit order for an open trade you currently have on for today. At the very least, a resting "get me out" stop working against your open trade ensures that if, for whatever reason, you miss something before you exit the trade or enter an overnight stop; you are protected. As most traders know, it is the one time we act with enough over-confidence to assume we don't need a stop this one time (or will place that stop at the end of the day) that our market runs away against us dramatically. Always place a stopï¿½you can always adjust it later as the trade progresses.

2. Next, you must think of stops as profit management tools rather than risk control tools. For the most part, if you have developed a sound enough approach to identifying the marketï¿½s order flow, your trade will work when you are on the right side of the order flow. You could almost say that the initial risk control secured by the first protective stop was immaterial. That stop might as well have never been there. But since you are using solid discipline to protect yourself, once the stop is not needed as a risk control tool as the market goes your way; your stop now becomes a profit management tool. Regardless of your personal trading style or timeframe, you will have the market ï¿½inhaleï¿½ and ï¿½exhaleï¿½ while the price advances toward your initial profit objective. That ebb and flow in price action is normal and expected. The last thing you want to do is place your stop too close to the market to get ï¿½taggedï¿½ during this normal ebb and flow. Rather than roll a protective stop under the market to lock a profit; consider rolling your stop to a breakeven point and wait for the objective to be reached. If you have truly seen the order flow, and you are positioned fairly well to begin with, the probabilities of the market trading your entry price after an advance in your favor drops over time.

After you have a reasonable lead on the market and you are holding a risk-free trade your only need is to watch for something to change. If nothing is changing continue to let the profit run until your objective is reached. If something changes you simply exit the trade with what you have in it at that point. If something changes, and you donï¿½t see that change fast enough to exit with what you have, your breakeven stop will take you out with no damage to your equity. If you had aggressively rolled the stop up behind the market, and been taken out on a normal ebb and flow of price action, you might be tempted to re-enter the trade at a less than optimal time/price relationship; which increases your risk.

3. Use the next highest time frame from your preferred trading time frame to decide where to place a stop. As my trading style evolved over time and through education, I found that my unique style would be considered a ï¿½swingï¿½ trader or a "position" trader (or a little of both). Since I was willing to enter a position and hold it for more than a week or so, the ï¿½random noiseï¿½, or ebb and flow of price action, could easily span several days, even though a day trader might see that as several individual opportunities.

In my case, my initial stop needed to be outside the range of this ebb and flow; which was often the weekly high or low. If the trade was working, and I was in it 3-4 weeks, I might roll my stop to protect the trade but I usually would always make it outside the range for the week. After critically examining the results I found that in most cases you should:
Use the next highest time frame or two from his trading time frame to decide where to place a stop, in most cases the stop will be outside of the normal ebb and flow.

In other words, if you are a day trader using the 60 minute chart for your entry signals, a stop outside the range for the last day or so would work fine. Of course, that needs to be in context with your actual tolerance for risk. If you are looking for 30-50 points on something but a risk-control stop outside the range is 100 points; that wonï¿½t work so well. But in any case, if you are using the next higher time frame to assist you in stop placement you will find you are getting stopped out less often before your trade reaches your profit objective.

4. Benefit from the clear thinking that stop usage brings. I think the a great benefit to always having a stop order working and moving them less aggressively is the peace of mind you have from knowing you are trading in a disciplined manner. Your trade thinking improves when your initial risk is known and protected. Your profit potential improves when you allow the market to behave as it needs to on the way to your objective.

In conclusion, By simply adjusting your use of stops to a less aggressive and more disciplined manner your profit potential is the real main benefit because your losing trades are always going to be there. Using stops less aggressively on your winning trades allows you to hold winners a bit longer. Using stops consistently to begin with limits your equity loss to a more reasonable number until you are holding the winner.

Jason Alan Jankovsky
"The Lion of LaSalle Street"
Jason Alan Jankovsky is a 20 year veteran of leveraged transaction trading. Trading extensively in Futures, Options, and FOREX since 1987, he is self-taught and self-educated. He has authored several trading systems, trained other successful traders, and is often published in industry newsletters. He is the author of "Trading Rules that Work: The 28 essential lessons every trader must master" (Wiley Books, 2006). He hosts a twice daily LIVE internet broadcast on the Global cash FOREX markets providing fundamental and technical insight for traders. Born and raised in Chicago, he is an avid Sailor and Private Pilot.

What Is Market Efficiency?

2008-10-13T01:40:00.000-07:00

When money is put into the stock market, it is done with the aim of generating a return on the capital invested. Many investors try not only to make a profitable return, but also to outperform, or beat, the market.

However, market efficiency - championed in the efficient market hypothesis (EMH) formulated by Eugene Fama in 1970, suggests that at any given time, prices fully reflect all available information on a particular stock and/or market. Thus, according to the EMH, no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else.

The Effect of Efficiency: Non-Predictability
The nature of information does not have to be limited to financial news and research alone; indeed, information about political, economic and social events, combined with how investors perceive such information, whether true or rumored, will be reflected in the stock price. According to EMH, as prices respond only to information available in the market, and, because all market participants are privy to the same information, no one will have the ability to out-profit anyone else.

In efficient markets, prices become not predictable but random, so no investment pattern can be discerned. A planned approach to investment, therefore, cannot be successful.

This "random walk" of prices, commonly spoken about in the EMH school of thought, results in the failure of any investment strategy that aims to beat the market consistently. In fact, the EMH suggests that given the transaction costs involved in portfolio management, it would be more profitable for an investor to put his or her money into an index fund.

Anomalies: The Challenge to Efficiency
In the real world of investment, however, there are obvious arguments against the EMH. There are investors who have beaten the market - Warren Buffett, whose investment strategy focuses on undervalued stocks, made millions and set an example for numerous followers. There are portfolio managers who have better track records than others, and there are investment houses with more renowned research analysis than others. So how can performance be random when people are clearly profiting from and beating the market?

Counter arguments to the EMH state that consistent patterns are present. Here are some examples of some of the predictable anomalies thrown in the face of the EMH: the January effect is a pattern that shows higher returns tend to be earned in the first month of the year; "blue Monday on Wall Street" is a saying that discourages buying on Friday afternoon and Monday morning because of the weekend effect, the tendency for prices to be higher on the day before and after the weekend than during the rest of the week.

Studies in behavioral finance, which look into the effects of investor psychology on stock prices, also reveal that there are some predictable patterns in the stock market. Investors tend to buy undervalued stocks and sell overvalued stocks and, in a market of many participants, the result can be anything but efficient.

Paul Krugman, MIT economics professor, suggests that because of the mass mentality of the trendy, short-term shareholder, investors pull in and out of the latest and hottest stocks. This results in stock prices being distorted and the market being inefficient. So prices no longer reflect all available information in the market. Prices are instead being manipulated by profit seekers.

The EMH Response
The EMH does not dismiss the possibility of anomalies in the market that result in the generation of superior profits. In fact, market efficiency does not require prices to be equal to fair value all of the time. Prices may be over- or undervalued only in random occurrences, so they eventually revert back to their mean values. As such, because the deviations from a stock's fair price are in themselves random, investment strategies that result in beating the market cannot be consistent phenomena.

Furthermore, the hypothesis argues that an investor who outperforms the market does so not out of skill but out of luck. EMH followers say this is due to the laws of probability: at any given time in a market with a large number of investors, some will outperform while other will remain average.

How Does a Market Become Efficient?
In order for a market to become efficient, investors must perceive that a market is inefficient and possible to beat. Ironically, investment strategies intended to take advantage of inefficiencies are actually the fuel that keeps a market efficient.

A market has to be large and liquid. Information has to be widely available in terms of accessibility and cost and released to investors at more or less the same time. Transaction costs have to be cheaper than the expected profits of an investment strategy. Investors must also have enough funds to take advantage of inefficiency until, according to the EMH, it disappears again. Most importantly, an investor has to believe that she or he can outperform the market.

Degrees of Efficiency
Accepting the EMH in its purest form may be difficult; however, there are three identified classifications of the EMH, which are aimed at reflecting the degree to which it can be applied to markets.

1. Strong efficiency - This is the strongest version, which states that all information in a market, whether public or private, is accounted for in a stock price. Not even insider information could give an investor an advantage.

2. Semi-strong efficiency - This form of EMH implies that all public information is calculated into a stock's current share price. Neither fundamental nor technical analysis can be used to achieve superior gains.

3. Weak efficiency - This type of EMH claims that all past prices of a stock are reflected in today's stock price. Therefore, technical analysis cannot be used to predict and beat a market.

Conclusion
EMH propagandists will state that profit seekers will, in practice, exploit whatever abnormally exists until it disappears. In instances such as the January effect (a predictable pattern of price movements), large transactions costs will most likely outweigh the benefits of trying to take advantage of such a trend.

In the real world, markets cannot be absolutely efficient or wholly inefficient. It might be reasonable to see markets as essentially a mixture of both, wherein daily decisions and events cannot always be reflected immediately into a market. If all participants were to believe that the market is efficient, no one would seek extraordinary profits, which is the force that keeps the wheels of the market turning.

In the age of information technology (IT), however, markets all over the world are gaining greater efficiency. IT allows for a more effective, faster means to disseminate information, and electronic trading allows for prices to adjust more quickly to news entering the market. However, while the pace at which we receive information and make transactions quickens, IT also restricts the time it takes to verify the information used to make a trade. Thus, IT may inadvertently result in less efficiency if the quality of the information we use no longer allows us to make profit-generating decisions.

by Reem Heakal, investopedia.com

Stop Loss?? I Don't Want To Use It.

2008-10-12T01:37:00.000-07:00

Last week I was reviewing a website which has a trading signal program for those investors who prefer to not being involved in confusing market analysis and I respect them because such services normally will bring them more time to do other important things in their daily life. But the interesting thing was the most of signalers did not actually place a stop loss point on their recommendations. Is that so because they know they are right all the time? Or that's because they did not lose half of their trading account in an unexpected slump of 200 hundred points and a single trade.

However, the answer is most of them have something between -1000 to -5000 pips of open trades on their signal board and they actually trapped in desperately while they could cut the losing trades and ran another one instead. Also I should mention that there are some other types of system trading that called "Hedge Fund" and I don't actually want to argue if they are right or wrong. I am definitely talking to day traders who get into challenge with big bear every day.

Sometimes, I don't understand why a trader could be convinced of not having a Stop Loss while we see almost every month an unexpected uncounted impulse (I would call it Best of the Test for whom with less of the rest) in the market.

There is no specific rule as to where you should place the stop loss, so consider the below mentioned tips as the general rules and ask your mentor to fit reliable Stop loss rules just for you and your trading system(If you have one?).

Many loser traders do place the same stop loss for all the trades they execute without even trying to measure market environment.
Don't be scared of placing a stop loss while it is for your gain and you must know what your profit objective is.
Stop Loss should not be too close to the current price while most of the stop loss enemies have ruined their trading accounts already just by using very close ones.
Stop Loss should not be too far from the point you get into trade while it's better to not placing any Stop Loss rather taking an unreachable, fictional protector.
Try to not to risk more than the points of your profit goal. Pro traders recommend to only take those trades which have at least 2 points of potential profit per 1 pip of potential lose, but I would say it is completely depends on the money management system that you use, as different money management systems has different recommendations for Risk & Reward.
Sometimes a trading system does not work if you risk less than recommended %7 to %10 of your total account balance. It means you trade oversize or you just entered the market when everyone else getting out of the market. In this case this is not your fault as it has a clear message for you "don't trade this way anymore and ask an expert to solve the problem".
If you are convinced enough that you can make up 1 million dollar out of your 10000 dollars account by not using stop losses as you may think you are the one who knows the price will be back on its way to you instead of hitting new highs, well, simply you are wrong.
Remember, there are no sky limits for the price of any of currencies in FOREX market.
If you don't like to place a pre defined Stop Loss on your trades, please ask someone to show you how to follow a wining trade by using "Trailing Stop".
Be sure it is better to have one or two losing trades with 100 points of lose, instead of being desperate with sinking into -1000 pips of dizziness.

How to Define the Best Stop Loss point?

Try these tools to define the most accurate stop loss points easily:

Use 10 pips over/below the first Parabolic SAR spot(dot) appeared over/below the price candles for Short/Long Trades.
Note#1: Remember you just can use 10 pips above the parabolic SAR dots as an Stop Loss point when you have a Short trade and Vice Versa.
Note#2: You realized that the Stop Loss obtained from SAR is too far from the point which you want to enter the market. OK, this means you are about to enter the market very late so better to not do it.
Use 10 pips over/below the day before yesterday's HIGH and LOW and in the case of the market has moved a lot far, use 10 pips over/below the yesterday HIGH and LOW as a Stop Loss point for your Short/Long trades.
Use two Moving Averages of 55 EMA and 144 MA. You may place your stop loss just 10 pips below/above one of those two MAs depending on how do you set up the profit/loss game for your Long/Short trades.
Note#: If you trade on the range market break out be aware of this kind of Stop Loss setting, and it is quite safer to use another way.
Place the Stop Loss 10 pips over/below Bollinger Bands Upper/Lower band for Short/Long trades.
If you use Elliot Waves theory to analyze the market:
# Place the Stop Loss just 10 pips below the lowest point of the Second (2) wave in bullish trend when you LONG on Wave 3.
# places the Stop Loss 10 pips below the lowest point of the 4th Wave when you go for LONG on 5th Wave.
# Place the Stop Loss right above/below the top/low of the previous wave when you go for SHORT/LONG based on A-B-C correctional waves.

Notes:

Aforementioned suggestions are based on 4Hours chart.
Those ways of defining Stop Loss points has worked for me, but It does not necessarily works for you, so ask your mentor or an expert friend to do evaluate the probability of fitting those suggestions to your trading strategy.
10 pips are because sometimes price hit the important support or resistance levels by more than a touch.
Please don't forget, the Stop Loss issue is not actually a game. It is not even an option for you; it is a "MUST" and will save you when you can do nothing, so refresh your mind in this case.
Forward your questions right to my email address s.a.ghafari@iftc.ir , I'll try my best to give you the best answer. Good Lock

by S.A Ghafari

When Fear And Greed Take Over

2008-10-11T01:33:00.000-07:00

There is an old saying on Wall Street that the market is driven by just two emotions: fear and greed.Although this is an oversimplication, it can often be true. Succumbing to these emotions can have a profound and detrimental effect on investors' portfolios and the stock market.

In the investing world, one often hears about the juxtaposition between value investing and growth investing, and although understanding these two strategies is fundamental to building a personal investment strategy, it is as important to understand the influence of fear and greed on the financial markets. There are countless books and various courses devoted to this topic. Here our goal is to demonstrate what happens when an investor gets overwhelmed by one or both of these emotions.

Greed's Influence
So often investors get caught up in greed ("excessive desire"). After all, most of us have a desire to acquire as much wealth as possible in the shortest amount of time.
The Internet boom of the late 1990s is a perfect example. At the time it seemed all an advisor had to do was simply pitch any investment with a ".com" at the end of it, and investors leaped at the opportunity. Buying activity in Internet-related stocks, many just start-ups, reached a fever pitch. Investors got greedy, fueling further greed and leading to securities being grossly overpriced, which created a bubble. It burst in mid-2000 and kept leading indexes depressed through 2001. For more on the dotcom bubble and other market crashes, see Greatest Market Crashes.

This get-rich-quick mentality makes it hard to maintain gains and keep to a strict investment plan over the long term, especially amid such a frenzy, or as the former Federal Reserve chairman, Alan Greenspan, put it, the "irrational exuberance" of the overall market. It's times like these when it is crucial to maintain an even keel and stick to the basic fundamentals of investing, such as maintaining a long-term horizon, dollar-cost averaging and avoiding getting swept up in the latest craze.

A Lesson From "The Oracle Of Omaha"
We would be remiss if we discussed the topic of not getting caught up in the latest craze without mentioning a very successful investor who stuck to his strategy and profited greatly. Warren Buffett showed us just how important and beneficial it is to stick to a plan in times like the dotcom boom. Buffett was once heavily criticized for refusing to invest in high-flying tech stocks. But once the tech bubble burst, his critics were silenced. Buffett stuck with what he was comfortable with: his long-term plan. By avoiding the dominant market emotion of the time - greed - he was able to avoid the losses felt by those hit by the bust.

Fear's Influence
Just as the market can become overwhelmed with greed, the same can happen with fear ("an unpleasant, often strong emotion, of anticipation or awareness of danger"). When stocks suffer large losses for a sustained period, the overall market can become more fearful of sustaining further losses. But being too fearful can be just as costly as being too greedy.

Just as greed dominated the market during the dotcom boom, the same can be said of the prevalence of fear following its bust. In a bid to stem their losses, investors quickly moved out of the equity (stock) markets in search of less risky buys. Money poured into money market securities, stable value funds and principal-protected funds - all low-risk and low-return securities. In fact 2002 saw the largest amount of outflows, about US$40 billion, from the equity markets since 1988, a year after one of the worst stock market crashes in history, and a record $140 billion flowed into the bond market.

This mass exodus out of the stock market shows a complete disregard for a long-term investing plan based on fundamentals. Investors threw their plans out the window because they were scared, overrun by a fear of sustaining further losses. Granted, losing a large portion of your equity portfolio's worth is a tough pill to swallow, but even harder to digest is the thought that the new instruments that initially received the inflows have very little chance of ever rebuilding that wealth.

Just as scrapping your investment plan to hop on the latest get-rich-quick investment can tear a large hole in your portfolio, so too can getting swept up in the prevailing fear of the overall market by switching to low-risk, low-return investments.

The Importance of Comfort Level
All of this talk of fear and greed relates to the volatility inherent in the stock market. When investors lose their comfort level due to losses or market instability, they become vulnerable to these emotions, often resulting in very costly mistakes.

Avoid getting swept up in the dominant market sentiment of the day, which can be driven by a mentality of fear and/or greed, and stick to the basic fundamentals of investing. It is also important to choose a suitable asset allocation mix. For example, if you are an extremely risk averse person, you are likely to be more susceptible to being overrun by the fear dominating the market, and therefore your exposure to equity securities should not be as great as those who can tolerate more risk.
Buffett was once quoted as saying, "Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market."

Easier Said Than Done
Keep in mind this isn't as easy as it sounds. There's a fine line between controlling your emotions and being just plain stubborn. Remember also to re-evaluate your investment strategy and allow yourself to be flexible to a point, and remain rational when making decisions to change your plan of action.

Conclusion
You are the final decision-maker for your portfolio and thus responsible for any gains or losses in your investments. Sticking to sound investment decisions while controlling your emotions, whether it be greed or fear, and not blindly following market sentiment is crucial to successful investing and maintaining your long-term strategy. But beware: never wavering from an investment strategy during times of high emotions in the market can also spell disaster. It's a balancing act that requires you to keep your wits about you.

by Investopedia Staff,
Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including more than 1,200 original and objective articles and tutorials on a wide variety of financial topics.

The Only Indicator You Need

2008-10-10T01:23:00.000-07:00

You should try to buy weakness and sell strength. That’s the crowd panicking. The problem is, how do you know they are getting in or getting out?
—Mark Twain, Discussions with Nikola Tesla

Many people are unaware that Samuel Clemens (Mark Twain) was a trader. During his time, traders were referred to as “Speculators” and they had a somewhat unsavory reputation. Speculators were seen as exploiters, making money from other people’s suffering or need.

The worst form of speculator was the carpetbagger who helped rebuild the South with Northern money after the U.S. Civil War. Clemens himself traded in cotton and grains but with little success, according to some biographies of his life.

At the time, the development of futures contracts was in its infancy. The Chicago Board of Trade was only founded in 1848 and probably wouldn’t have survived if futures contracts hadn’t caught the eye of the visionary industrialists and large farmers. Most of the attention that was focused on market opportunities revolved around the Industrial Revolution somehow.

Speculators were often involved in buying land that they hoped to sell to the railroads or lease for the right of way, buying steel to sell to ship builders, and so on. Only occasionally did speculators trade in futures for consumable commodities; it was still a new concept. But even then, during the late 19th century, people saw ahead to the explosive potential in financial markets, and a new class of finance evolved. In today’s world, financial brokers are the gateway between market opportunities and capital—even now when electronic trading typically bypasses the traditional brokerage relationship.

One thing that remains constant in the process of financial evolution is the concept of inside information. To this day, part of what people view as a trading edge is knowing something ahead of time that is potentially market moving. This is not quite the same thing as a tip. Getting a tip means being advised what to do by someone who allegedly knows something.

Market information or trading edge is more about finding a better way to do something that is already known to work. In the opening quote for this rule, it is apparent that Clemens understood the basic nature of the market and knew it could be exploited; his problem was getting the information required to know whether he was in the right place at the right time. This is where the whole business of analysis and indicators came from—an attempt to quantify market information to exploit what already works. The basics of trading have never really changed.

Remember, some of the biggest fortunes ever made from trading came at a time when the only tools available to traders were their guts, intuition, and knowledge of the crowd. I say this because, as you will have guessed by now, I put only a small part of my trade study into technical analysis. I know many will stop there and form some sort of value judgment.

They might assume that because I don’t use what they have used, and they are making money with it, I must not know what they know; perhaps I don’t know the experts they know, or maybe I just have an axe to grind. They might say I am not qualified to discuss technical analysis because I don’t use technical analysis the way they do. The proof is in the pudding, they would argue.

I say this about big-money traders and historical finance because success without analysis is factual history—not because I feel that analysis has no place in trading. Quite the opposite. Successful technical analysis can be a very important part of lasting trading success but, as discussed in Rule #15, like it or not, it can only go so far. The fact is that using technical analysis is like an unskilled carpenter using power tools. Without the basic knowledge of carpentry, an unskilled carpenter will make a wreck of house building when he is turned loose with better tools than he knows how to use. That brings us to this maxim of “the only indicator you need.”

But first we should clarify the thinking behind most of the indicators currently used. Most indicators and oscillators attempt to quantify the concept of overbought or oversold. The psychology behind this thinking is actually very sound, in my opinion. The idea that the market can get overextended in one direction or the other is not a new idea. It is one of the cornerstones of successful trading. That is one of the concepts that will work for successful traders.

The problem is not that the market can and will get overextended; the difficulty is in calculating when that point is reached. Oscillators and indicators are notorious for being lagging indicators for the simple fact that they are historical and not predictive. In most cases, due to the historical nature of these calculated mathematical concepts, they have often identified a reasonable overbought or oversold area but by the time the signal is verified, the 72-hour/bar rule (from Rule #25) has come into play.

The market you suspected was overextended has already begun correcting the other way, and usually that distance has been a substantial move already. Also, most oscillators and indicators are trend following; they help you get positioned in a trend but will never get you positioned at the turn. In addition, by the time the signal to enter the trend is verified and you execute, the very next correction will likely be right back to your entry price or a bit lower. No real progress in any case.

The newest class of oscillators and indicators attempt to be predictive in nature. Many of them are based on extremely complex computations that can only be done in real time by computers. We call traders who use them the “black box” traders. Again, there is nothing wrong with this kind of approach except that it simply cannot account for the most critical part of trading: What is the crowd thinking?

It is crucial to remember when you are using oscillators or indicators of any kind that they are only mathematical computations. They are all moving averages in various degrees of complexity and performance. They are based on assumptions about the nature of markets and they work under the theory of probabilities. Behind all of these attempts to find a better way to do what is already known to work is the issue of historical versus predictive. If you are willing to accept that indicators, oscillators, and technical analysis are historical and not predictive, you are left with the only indicator you really need: Who is getting in and who is getting out?

That brings us to the study of volume and open interest. In my view, this is the only indicator you really need because this is the only indicator that discloses fairly accurately what the crowd is thinking. Either people are getting into the market or they are leaving the market. Since we already know that most active traders are losing every day, then we know that a change in open interest means people don’t want to play, are convinced they will win, or can’t take the pain any more. If open interest rises we can fairly safely assume that traders are confident to get into the market from both sides. If open interest is dropping we can safely assume the losers can’t take the heat anymore. If all of this is accompanied by higher or lower volume, then we can fairly safely judge the level of fear, panic, or hope that traders are expressing.

Now, to be fair with everyone, correctly reading volume and open interest is not as simple as I make it sound. But the underlying psychology will always be the same. By understanding the relationship between price action, volume, and open interest, you can get a fairly accurate read on what the crowd is thinking. Of course, this is an art form and not science.

Markets can change in character in a heartbeat and your understanding of V/OI may have been completely accurate 20 minutes ago but at this precise moment something has changed. That is the dynamic part of trading and part of what makes V/OI so useful. V/OI is the first indicator developed, and everything after is an attempt to improve upon what V/OI can do with one important difference: V/OI has no time/price relationship.

V/OI is historical from the point of view that it discloses how big the market is or whether that has changed somewhat. V/OI also discloses how thick the market is and whether that, too, is changing. When you combine this information with a price advance or decline, you can discern whether more shorts or longs are opening positions or covering, whether they are executing more often or not, whether they are losing confidence in their positions, and a host of other types of information that make it possible to anticipate (not predict!) what is most likely to happen next.

Once the market closes for the day and this data is compiled and released by the exchanges, you have a fairly accurate picture of the mind of the market when you compare what you see to the price action and other indicators. But because V/OI has no time/price component, you may see clearly that the market is setting up for a price advance or decline but there is no way to know how soon or how fast that change in price will occur.

Although V/OI is the single most important indicator because it discloses the most likely thought process behind how prices got to be where they are, it still cannot predict or expose whether that thought process is ripe for change or whether the change is imminent. That is the whole purpose of all the so-called improved indicators and oscillators: to find the time/price relationship for that imminent change. The V/OI indicator shows you it is there; the others try to say the time is now.

If you personally had to choose between the two indications, “Something in the market has changed” and “Whatever is coming, it will come at 11:00 A.M. tomorrow,” which would you rather have? In the case of the markets, knowing that something has changed is the better choice because only one option is available: a reversal in price. Does it really matter if that reversal happens in the coming 20 minutes or if it will take 20 days, as long as you know that the change will most likely be in only the other direction?

As I have said many times before, I am not trying to oversimplify the issue of timing your trades. My intention is to help you understand that the first and best indicator will always be volume and open interest because it provides a more critical component: the issue of a change to the structure of the market. In most cases, a change to the structure of the market means a price reversal of some kind because the traders who put the price where it is are no longer in the market. The thinking of the crowd has changed. Just knowing that piece of information can give your trading a distinct advantage. You just don’t know precisely when the change will result in a price reversal.

Before we close out this rule I want to sum up a few things. First, the study of V/OI is not a small one. You need to make a consistent effort to understand how V/OI can and does change. It would be impossible in this book to have a discussion about all the different ways you can begin to interpret V/OI in the space we have. I have included titles in the Recommended Reading section that will help you better understand this important market study. Second, you must remember that all the other indicators and oscillators developed in the past 150 years are attempts to better quantify the price/time relationship with V/OI as the foundation to start from. V/OI quantifies the depth and nature of the game as it has been played to date; V/OI tells you a change has happened or is happening. What you do with that data is a reflection of your skill at anticipating what is likely to happen next based on your understanding of the crowd’s needs.

Last, V/OI is never predictive. No indicator or oscillator can be predictive. No form of analysis can predict future price action with any degree of consistency. The important issue is to have the tools you need, and to know how to use them to improve upon what already works.

Samuel Clemens and the traders of his era didn’t have V/OI or any other indicator. If he did, he would have known exactly how to use it and what it means because he understood the basics to begin with. Focus your energy on learning the basics, then understanding V/OI. At that point the rest of your trading stands a good chance of falling into place as a winning approach.

A Brief History Of The Hedge Fund

2008-10-09T01:20:00.000-07:00

Famed hedge fund manager Mario Gabelli wrote in 2002: "Today, if asked to define a hedge fund, I suspect most folks would characterize it as a highly speculative vehicle for unwitting fat cats and careless financial institutions to lose their shirts." This characterization stems from the hedge fund's recent history, which began with the headline-making collapse of Long Term Capital Management in 1998 and continued with the sensational meltdown of the Tiger Funds in March of 2000, followed by the reorganization of the once high-flying Quantum Fund in April of 2000. These high-profile incidents overshadow more than half a century of hedge fund history that began when Alfred Winslow Jones launched the first hedge fund in 1949.

The Father of the Hedge Fund
Alfred Jones was born in Melbourne, Australia in 1901 to American parents. He moved to the United States as a young child, graduated from Harvard in 1923 and became a U.S. diplomat in the early 1930s, working in Berlin, Germany. He earned a PhD in sociology from Columbia University and joined the editorial staff at Fortune magazine in the early 1940s.

It was while writing an article about current investment trends for Fortune in 1948 that Jones was inspired to try his hand at managing money. He raised $100,000 (including $40,000 out of his own pocket) and set forth to try to minimize the risk in holding long-term stock positions by short selling other stocks. This investing innovation is now referred to as the classic long/short equities model. Jones also employed leverage in an effort to enhance returns.

In 1952, Jones altered the structure of his investment vehicle, converting it from a general partnership to a limited partnership and adding a 20% incentive fee as compensation for the managing partner. As the first money manager to combine short selling, the use of leverage, shared risk through a partnership with other investors and a compensation system based on investment performance, Jones earned his place in investing history as the father of the hedge fund.

The Rise of the Industry
When a 1966 article in Fortune magazine highlighted an obscure investment that outperformed every mutual fund on the market by double-digit figures over the past year and by high double-digits over the last five years, the hedge fund industry was born. By 1968, there were some 140 hedge funds in operation.

In an effort to maximize returns, many funds turned away from Jones' strategy, which focused on stock picking coupled with hedging, and chose instead to engage in riskier strategies based on long-term leverage. These tactics led to heavy losses in 1969-70, followed by a number of hedge fund closures during the bear market of 1973-74.

The industry was relatively quiet for more than two decades, until a 1986 article in Institutional Investor touted the double-digit performance of Julian Robertson's Tiger Fund. With a high-flying hedge fund once again capturing the public's attention with its stellar performance, investors flocked to an industry that now offered thousands of funds and an ever-increasing array of exotic strategies, including currency trading and derivatives such as futures and options.

High-profile money managers deserted the traditional mutual fund industry in droves in the early 1990s, seeking fame and fortune as hedge fund managers. Unfortunately, history repeated itself in the late 1990s and into the early 2000s as a number of high-profile hedge funds, including Robertson's, failed in spectacular fashion.

The Hedge Fund Today
With media attention still focused on the recent failure of some hedge funds, there has been an increasing move towards their regulation. In 2004, the Securities and Exchange Commission adopted changes that require hedge fund managers and sponsors to register as investment advisors under the Investment Advisor's Act of 1940. This greatly increases the number of requirements placed on hedge funds, including keeping up-to-date performance records, hiring a compliance officer and creating a code of ethics. All hedge funds that fall under the new SEC rules must be registered by Feb 1, 2006. This is seen as an important move in protecting investors.

Despite troubles in the last few years, the hedge fund industry continues to thrive. The development of the "fund of funds", which is simplistically defined as a mutual fund that invests in multiple hedge funds, provided greater diversification for investors' portfolios and reduced the minimum investment requirement to as low as $25,000. The introduction of the fund of funds not only took some of the risk out of hedge fund investing, but also made the product more accessible to the average investor.

Conclusion
Hedge funds have evolved significantly since 1949. Modern hedge funds offer a variety of strategies, including many that do not involve traditional hedging techniques. The industry has also rapidly grown, with recent estimations pegging its size at $1 trillion - quite the leap from the $100,000 used to start the first fund half a century ago.

With a fascinating past that has twice seen media-fostered publicity push the industry to stratospheric highs and vilify it when it fell from grace, it seems highly probable that the cycle will repeat itself at some point in the future. While it is easy to get sucked in by the hype or repelled by the negative press, it's always advisable to take a step back and conduct some due diligence, just as you would prior to making any investment.
Before you put your hard-earned money at risk, you have to make sure you are choosing the right investment for the right reason. Don't blindly chase performance, and remember that past performance is not an indicator of future performance.

by Jim McWhinney, investopedia.com

Trading Psychology And Discipline

2008-10-08T01:17:00.000-07:00

There are many characteristics and skills required by traders in order for them to be successful in the financial markets. The ability to understand the inner workings of a company, its fundamentals and the ability to determine the direction of the trend are a few of the key traits needed, but none of these is as important as the ability to contain emotions and maintain discipline.

Trading Psychology
The psychological aspect of trading is extremely important, and the reason for that is fairly simple. A trader is often darting in and out of stocks on short notice, and is forced to make quick decisions. To accomplish this, they need a certain presence of mind. They also, by extension, need discipline, so that they stick with previously established trading plans and know when to book profits and losses. Emotions simply can't get in the way.

Understanding Fear
When a trader's screen is pulsating red (a sign that stocks are down) and bad news comes about a certain stock or the general market, it's not uncommon for the trader to get scared. When this happens, they may overreact and feel compelled to liquidate their holdings and go to cash or to refrain from taking any risks. Now, if they do that they may avoid certain losses - but they also will miss out on the gains.

Traders need to understand what fear is - simply a natural reaction to what they perceive as a threat (in this case perhaps to their profit or money-making potential). Quantifying the fear might help. Or that they may be able to better deal with fear by pondering what they are afraid of, and why they are afraid of it.

Also, by pondering this issue ahead of time and knowing how they may instinctively react to or perceive certain things, a trader can hope to isolate and identify those feelings during a trading session, and then try to focus on moving past the emotion. Of course this may not be easy, and may take practice, but it's necessary to the health of an investor's portfolio.

Greed Is Your Worst Enemy
There's an old saying on Wall Street that "pigs get slaughtered". These little pigs want more and more. This greed in investors causes them to hang on to winning positions too long, trying to get every last tick. This trait can be devastating to returns because the trader is always running the risk of getting whipsawed or blown out of a position.

Greed is not easy to overcome. That's because within many of us there seems to be an instinct to always try to do better, to try to get just a little more. A trader should recognize this instinct if it is present, and develop trade plans based upon rational business decisions, not on what amounts to an emotional whim or potentially harmful instinct.

The Importance Of Trading Rules
To get their heads in the right place before they feel the emotional or psychological crunch, investors can look at creating trading rules ahead of time. Traders can establish limits where they lay out guidelines based on their risk-reward relationship for when they will exit a trade - regardless of emotions. For example, if a stock is trading at $10/share, the trader might choose to get out at $10.25, or at $9.75 to put a stop loss or stop limit in and bail.

Of course, establishing price targets might not be the only rule. For example, the trader might say if certain news, such as specific positive or negative earnings or macroeconomic news, comes out, then he or she will buy (or sell) a security. Also, if it becomes apparent that a large buyer or seller enters the market, the trader might want to get out.

Traders might also consider setting limits on the amount they win or lose in a day. In other words, if they reap an $X profit, they're done for the day, or if they lose $Y they fold up their tent and go home. This works for investors because sometimes it is better to just "go on take the money and run," like the old Steve Miller song suggests even when those two birds in the tree look better than the one in your hand.

Creating A Trading Plan
Traders should try to learn about their area of interest as much as possible. For example, if the trader deals heavily and is interested in telecommunications stocks, it makes sense for him or her to become knowledgeable about that business. Similarly, if he or she trades heavily in energy stocks, it's fairly logical to want to become well versed in that arena.

To do this, start by formulating a plan to educate yourself. If possible, go to trading seminars and attend sell-side conferences. Also, it makes sense to plan out and devote as much time as possible to the research process. That means studying charts, speaking with management (if applicable), reading trade journals or doing other background work (such as macroeconomic analysis or industry analysis) so that when the trading session starts the trader is up to speed. A wealth of knowledge could help the trader overcome fear issues in itself, so it's a handy tool.

In addition, it's important that the trader consider experimenting with new things from time to time. For example, consider using options to mitigate risk, or set stop losses at a different place. One of the best ways a trader can learn is by experimenting - within reason. This experience may also help reduce emotional influences.

Finally, traders should periodically review and assess their performance. This means not only should they review their returns and their individual positions, but also how they prepared for a trading session, how up-to-date they are on the markets and how they're progressing in terms of ongoing education, among other things. This periodic assessment can help the trader correct mistakes, which may help enhance their overall returns. It may also help them to maintain the right mindset and help them to be psychologically prepared to do business.

Bottom Line
It's often important for a trader to be able to read a chart and have the right technology so that their trades get executed, but there is often a psychological component to trading that shouldn't be overlooked. Setting trading rules, building a trading plan, doing research and getting experience are all simple steps that can help a trader overcome these little mind matters.

Courage, Confidence And Discipline

2008-10-07T01:12:00.000-07:00

If many people have made fortunes from the stock market (true also for the commodities and currency markets), and if they have accomplished their fortunes in different times and in different ways, then clearly it is not the methodology that they employed, nor is it the circumstance when they executed their trades that was the common denominator for their achievements. Obviously, circumstance and methodology were critical components of their success, but neither of them was the common denominator.

Execution is the ability to plan a trade and then to trade the plan in such a skillful way that there is a positive outcome. All markets exhibit three powers or forces that need to be harnessed and understood in order for a trader to execute his or her plan properly. Firstly, there is motive which is governed by price. Price is the motivator, is it cheap or expensive? Should I be buying or selling? Then there is pressure, governed by volume. Who else is buying or selling and how strong is the consensus? Finally there is resistance or circumstance governed by time. Time is the circumstance of the trade. “When,” is answered by the question, "Is this the appropriate circumstance?"

Money always chases the twin forces of “safety and yield.” That is, money will very quickly flow towards the safest haven offering the highest yield. This flow will be governed by the “prevailing perception” of the circumstances surrounding the flows of money.

As long as the same perception prevails, we will have a trend and therefore there is a natural tendency to stay with or conform to the prevailing perception. Our tendencies are governed by the phenomenon of a “crowd mind," which is a mind that is made up of the sum total of all the individuals making up the crowd yet which displays its own unique characteristics. By conjoining with the crowd thought we believe we will find safety and yield. Thus it is said that “the trend is our friend.”

To move out of the trend is to recognize changing circumstances that will cause the trend or “prevailing circumstance” to alter its direction. Recognizing this seed of change early enough and positioning ourselves for the change takes courage, confidence and discipline and are indeed the common characteristics of all the traders or investors who have made fortunes in the market.
Thus, “the trend is our friend – until it ends.”

So if success is the ability to recognize the seeds of change early enough and to have the courage, confidence and discipline to act accordingly, it behooves us to assemble these qualities within our own psyche. Our total psyche is a combination of head (rational thought), heart (conviction of feeling) and gut (intuitive confidence born out of experience). Melding these three qualities together takes technique and discipline. Discipline is what is needed to practice these techniques. The good thing is that there are techniques to practice which will accomplish this goal and each one of us can do so at our own pace and according to our own temperament and intensity of desire, i.e., how much do we really want it?

Here is a truism that sticks well in my mind.

“Sow a thought – reap an action,
Sow an action – reap a habit,
Sow a habit – reap a character,
Sow a character – reap a destiny.”

It seems to me that that we need to explore our habits and, if necessary. change them if we wish to achieve the success that is available to us in the markets or, for that matter, in any aspect of our lives. Habits endure since they have been formed since we were born and some say before that, as a result of many lifetimes of accumulation. Whatever the reason, they definitely endure. Hence, we need techniques to help us change our habits and we need the desire to do so. The question is, where do we get this desire?

Desire is built from motivation. Motive is of course the synergy of:
a) having a target
b) a passion to reach that target because of
c) an ideal greater than the target itself and
d) an urgency to arrive at the target.

Picture a table with four legs. Each leg is a symbol of one of the above four qualities. Leg 1 is “passion”. Being all fired up.

Leg 2 is “target,” a clearly defined objective. (Being fired up with no clearly defined objective, one runs the risk of wasting or dissipating one’s energy.) A target focuses energy.

Leg 3 is an ideal greater than the target itself. If the target is money or profit, then the ideal is the reason for acquiring the money or profit. There must be some higher good that makes having the money all the worth while. Finally leg 4 is “Urgency”. There is only NOW. Now is the only time to propel yourself to the target.

The past is history and the future does not exist. Plant the seed now.
So the first technique is to build motivation by defining your target, being truthful enough with yourself to know if you have passion for that target, align yourself with a higher purpose than just money and recognize that now may be the only chance you will ever have to do it.

Once we are motivated we have to adopt a realistic approach to our thinking. We have to find clarity or otherwise be faced with confusion. In our second technique we have 3 objectives:

a) to establish our position or belief system based on research and experience or in other words to determine what we stand for. (If we don’t stand for something, we will fall for anything)
b) align ourselves with the flow of the market
c) manage our emotions.

In this regard I would like to refer you to one of the best sources of techniques for accomplishing theses objectives. Please do yourselves the favor of studying Dr. Richard McCall’s book called The Way of the Warrior Trader. Although Dr. McCall is a trained psychologist, he is also a highly trained Samurai fighter who also teaches Samurai philosophy to traders. What he does so well in his book is to introduce his students to other forces than the intellect for making trading decisions and reaching clarity. Clarity means getting into the zone. Proper posture and breathing techniques and the control of the Ki energy are aspects of all martial arts. In trading, as with martial arts, one needs to bring these factors into account when training oneself to change one’s habits.

The conflict is not with some other person on the other side of the trade who is out to get you but it is with your own habits deeply ingrained within yourself that inevitably will “get” you.

So practicing yoga or martial art techniques to balance one’s energy and shape one’s thought patterns becomes the basis to restructure our habit molds and thereby recondition ourselves for a different outcome. This will occur quickly or slowly depending on the individual. Unfortunately, this column cannot be the forum for all those details. Suffice is it to say that building a strong and balanced posture both physically and mentally, calming the mind through proper exercise and breathing techniques and employing a tool to help the mind keep focused can be very very helpful.

A helpful tool that Dr. McCall uses is the acronym A.C.T.I.O.N.

A - stands for ACCEPT – accept your loss upfront so that you can be free of it. If you know you can only lose 2% of your equity and you have truly accepted that fact before you enter the trade, you will not have to focus on losing during the trade. You will be able to focus on executing your plan or strategy instead. You will not fall victim to the problem of dollar counting.

C - stands for CENTER – center yourself so that your strategy, your energy and your belief system are all in balance. Do this with correct posture and breathing, a single strategy and repetition.

T - stands for TRUST. Trust your strategy. Trust yourself to execute your strategy, which you will be able to do if you have tested it enough to calculate an expectancy ratio. Without completing this step you will never have the confidence that is required to catch big tigers.

I - stands for IMAGINATION or better yet IMAGE-IN-ACTION. Visualization informs the subconscious with new feelings and thoughts which will replace old feelings and thoughts. The subconscious does not differentiate between something done or something visualized, as long as what is visualized is done so with the same intensity as if it was an actual experience. Therefore practice positive visualization, not positive thinking.

O - stands for ONLY. Only focus on managing the trade you are in. Watch the Tiger carefully. If you lose your focus (bad habit) he will get you.

N - stands for NEVER look back. Let old Tigers go away. That is, NEVER dwell on a past loss, it will erode your confidence and rob you of any courage. Have discipline. Just as in fishing when you bait a hook you will sometimes lose some of your bait. Trading is no different and to catch a tiger you will have to use live bait.

So in the end it seems to me that to be successful at trading, especially at finding and catching the big “Tiger-trades,” one has to assemble a total strategy based on defining one’s objectives, researching and understanding a strategy or methodology, putting it to work in a suitable time frame or at the appropriate time and then finally committing resources in a controlled and thoughtfully managed way.

For me it has come down to the development of courage, confidence and discipline on a personal level and the modification of bad habits which ultimately must be replaced with the correct habits for success. This is an ongoing process and one which can take many years. Markets change their dynamics and even if there are patterns that repeat themselves, the circumstances are usually different.

Individuals change too and in the final analysis, success will come from the aligning of one’s individual dynamics with that of the market. This aligning process is never ending. How well we do it will determine our success and define our own special “holy grail."

All I can say is that I have found Tiger Trading a very enriching experience, sometimes even at the expense of making money. Hopefully, though I will endure and become an expert at Catching the Tiger Trade and my wishes are that you will too. Trading Markets has provided a forum for me to express my overall approach for which I am grateful, the objective of which has been a learning experience for me as well. I wish all of you therefore “Happy Trails.” ( In the words of Arlo Guthrie, I don’t wanna die, just wanna ride on my Uni-cy-cle).

Selwyn Gishen

HEDGE FUND INVESTMENT STRATEGIES

2008-10-06T01:09:00.000-07:00

Hedge funds invest in CDOs with three different strategies:
1. Carry trade;
2. Long/short structured credit;
3. Correlation trade.

These strategies enable hedge fund managers to express certain views on credit markets efficiently.

Carry Trade
This is the easiest and riskiest CDO strategy and consists of buying the equity tranche of CDOs. The return generated by the equity tranche depends on the leverage, the maturity and the composition of the basket of credit forming the CDO. Purchasing CDO equity tranches is equal to selling credit protection.

In June 2003, a hedge fund bought Fixed Income Senior Notes for a par value of $5.5 million (hereafter called simply “Notes”) totaling $148 million. These Notes were part of the CDO tranche with the higher claim collateralized by a private placement of high-yield bonds carried out in 1998. The issuance also included another tranche of Senior Notes, characterized by a floating rate for a par value of $34 million.

The Notes subscribed by the hedge fund were due on August 2010 and paid a fixed 6.71% yearly coupon. Technically the issue had defaulted, and the rating of the tranche subscribed by the hedge fund had deteriorated, going from AA3 in 1998 to Baa3 in 2002, turning into a “container” receiving all the capital and interest payments, which were used to pay Senior Notes first, both at a fixed and floating rate, and Subordinated Notes next.

At the time of purchase in June 2003, the par value of the Notes was $4.26 million and the hedge fund bought them for $3.63 million. The Notes were then bought for a price of 85.27 cents, at a substantial discount on the liquidation value of 94.73 cents.

At the time of purchase, the hedge fund had made a conservative assumption according to which 30% of the high-yield bonds would default and the recovery rate would be of 28 %. As a result, the internal rate of return had been fixed at 13.64 %. The investment was expected to be paid back in 3.5–4 years.

At the time of purchase, the underlying portfolio comprised 117 high-yield bonds characterized by an average price of 74.97 cents, including defaulted securities. The initial analysis conducted by the hedge fund also included the expectation that over the short term the default rate of the collateral high-yield bonds would rise, only to decrease again during the residual life of the securities.

Two months after the Notes had been purchased by the hedge fund, $949 786 had been paid out in terms of capital redemptions for the underlying high-yield notes (accounting for more than 25% of the initial original cost incurred by the hedge fund), against an initial estimate of $500 000. Over the same period, $142 808 worth of interest were also paid out. Moreover, the price of the Notes grew significantly with respect to the initial cost incurred by the hedge fund.

The improved performance of the collateral and the higher than expected capital redemptions generated a return on investment of 15.88 %, well above the estimated 13.64 %.

Long/short Structured Credit
This strategy’s objective is to generate absolute returns, regardless of economic and market conditions such as credit spread moves and the general direction of interest rates. The strategy is naturally long credit and benefits from spread tightening. The effect of market spread widening on long positions can be offset by the manager’s ability to short credits that widen more than the general market in a deteriorating environment. The fund employs fundamental credit analysis to determine long and short relative-value positions in different corporate credits. The fund expresses long views through the purchase of CDO equity tranches, and short views through the purchase of single-name Credit Default Swaps.

The long position in CDO equity tranches locks in positive carry. Furthermore, the ability of the hedge fund manager in performing the credit analysis on the companies underlying the CDO generates the trading ideas: a CDO is a basket of credits and the manager can choose inside this basket the credits he wants to be long or short. So the manager can take advantage of opportunities ranging from sector allocation, allocation to single companies and relative-value trading. Finally, the manager can limit the downside from spread widening through the long positions in credit default swaps.

The ideal portfolio built with long positions in CDO equity tranches and with long positions in CDS can have a convexity return profile: an instantaneous equal proportional shift in all spreads, assuming correlation remains constant, should have positive returns irrespective of spread moves. The most difficult challenge for a hedge fund manager implementing this strategy is the
ability to manage the correlation risk among the CDO tranches.

Correlation Trade
CDOs are a recent innovation that enable investors to buy (or sell) limited protection on credit portfolios. The protection attaches (and detaches) once the portfolio realizes certain default losses. The proper compensation for bearing this specialized risk depends not only on the individual portfolio credits, but also on their prospective dynamics, including their prospective interplay. People use the term “correlation” to discuss this interplay, and the term “correlation trading” to capture involvement in these tranched portfolio protection products.

In a correlation trade, credit protection is sold via the purchasing of CDO equity tranches delta-hedged with credit default swaps (CDS). The correlation trade consists of assuming a long position in the equity tranche of a certain CDO and a simultaneous short position in the mezzanine tranche (or a more senior tranche) of the same CDO, in the attempt to take advantage of the spreads among the different tranches of the CDO. This way the hedge fund is long the implied correlation among the CDO tranches.

Note that the implied correlation is primarily a market-based factor, driven by the demand and supply of protection for each individual CDO tranche. This trade has a positive carry, and returns can be generated if the credit spreads in the underlying portfolio move in a parallel way, that is, widen or shrink simultaneously. The correlation trade is exposed to the risk of an unexpected default in the underlying CDO portfolio but, given that in 2005 the prevailing default rate is at historically low levels, many hedge fund managers are comfortable with assuming that risk.
Some investors are reluctant to embrace correlation trading as a model-driven arbitrage strategy.

On 4th May 2005, Tracinda Corp., a company that already owned about 4% of General Motors, offered $870 million to acquire 4.95% of General Motors, and GM shares at the end of the day jumped by 18.1 %. On 5th May 2005, Standard & Poor’s had downgraded the GM bonds (from BBB– to BB) to the status of “junk bond”, maintaining a negative outlook.

This was a surprising capital structure movement, where the riskiest part of the capital, equities, jumped at a time when the less risky part of the capital, bonds, dropped. Many hedge funds were positioned in a correlation trade: they had short positions (buy protection) in CDO senior tranches and long positions (sell protection) in CDO equity tranches, delta-hedging with single-name CDS or iBoxx index. This correlation trade expected implied correlation to increase and had positive carry.

Because of the downgrade of GM, the equity tranche of many CDOs declined sharply while the mezzanine tranche soared because of a “fly to quality” movement. This means that the spreads moved in a non-parallel way. Merrill Lynch estimated that the CDO correlation trades in April lost 12 %, and for some hedge funds this loss was worsened by the use of leverage.

CONCLUSIONS
The important point to note is that these new strategies are relatively untried and untested in periods of market stress, and hence investors could underestimate certain risks, i.e. correlation.

This article is a part of “Investment Strategies of Hedge Funds” ebooks by Filippo Stefanini for closed private educations only. You should nuy his books for the best completely informations.

The Greatest Investors: James D. Slater

2008-10-05T01:07:00.000-07:00

Born:	U.K., in 1929
Affiliations:	Leyland Motor Corporation Slater Walker Securities BioProjects International PLC Galahad Gold PLC
Most Famous For:	The author of an investment column in London's The Sunday Telegraph under the pen name of "The Capitalist," which became a forum for publicizing his personal stock investment methodology. His strategies were one of the first to be made widely available to the investing public in the U.K. Jim Slater is credited with inventing the price-earnings to earnings-growth ratio (PEG) and popularizing its use in America through his book, "The Zulu Principle" (1992).

Personal Profile
Slater began his career as a chartered accountant and then moved into corporate managerial positions from 1953 to 1963 with three different U.K. manufacturing firms, the last of which was the prominent Leyland Motor Corporation. In 1964, he and Peter Walker founded an investment company called Slater Walker Securities. Through this firm, Slater became famous as a major player in the U.K. in aggressive corporate takeovers, building Slater Walker into a significant industrial and financial conglomerate, which, in 1969, evolved into an investment bank.

Unfortunately for Slater, his successful career in investment banking came to an abrupt end with the collapse of Slater Walker Securities during the U.K.'s 1973-74 recession, leaving Slater personally bankrupt.

He fought his way back to solvency through private investing and launched a career as a financial writer. His widely read investment column, "The Capitalist," and an extremely popular investment advisory service called "Company REFS," which provided "really essential financial statistics" on all publicly traded U.K. companies, positioned Slater as an investment guru.

He became known as one of his country's most successful professional investors. A parallel career as an educator of individual investors and as an author of children's books flourished. In 2007, he remained active today as a major investor in a variety of small, growth-oriented companies.

Investment Style
The stock picking strategy that Slater employed developed from the columns he wrote under the pseudonym "Capitalist" in London's Sunday Telegraph, and which subsequently formed the basis for his "Zulu Principle" of investing. Slater's favored type of investment was the small growth company that was undervalued by the market - a so-called hidden gem. At the core of his methodology is his focus on finding small growth stocks before they hit the big time.

The main tool, which Slater invented and popularized to find this type of stock, was his pioneering price-earnings to growth ratio, or PEG. This equation combines growth and value investing. The formula compares a company's price-earnings ratio with its expected, or estimated, earnings per share growth rate.

Slater realized that a P/E ratio didn't mean that a stock was expensive as long as its earnings growth was high. For example, if company's stock was at a relatively high P/E of 30, but its earnings were expected to grow at a rate of 30%, it would have a PEG of 1, which is generally considered a very favorable value relationship. Slater pioneered the use of the PEG ratio, which today is widely used in investment analysis.

Publications

"Investment Made Easy" by Jim Slater(1995)
"The Zulu Principle: Making Extraordinary Profits from Ordinary Shares" by Jim Slater (1992).
"Beyond The Zulu Principle: Extraordinary Profits From Growth Shares" by Jim Slater(2000)
"How To Become A Millionaire" by Jim Slater(2000).
"Make Money While You Sleep" by Jim Slater (2002).

Quotes

"Most leading brokers cannot spare the time and money to research smaller stocks. You are therefore more likely to find a bargain in this relatively under-exploited area of the stock market."

Highlighting what Slater thought was the inherent greater potential for the growth of smaller companies, he said, "I once compared a very large company with an elephant by making the comment that elephants don't gallop."

"You get out of an investment what you put into it, so the first decision you have to make is how much time you are prepared to devote to the initial task of acquiring a basic knowledge of investment.

Investopedia.com

Ten Things to consider before you trade

2008-10-04T01:04:00.000-07:00

If you’re just starting to trade, the sooner you develop
a realistic attitude about the markets, the better off you’ll be.
TRADING Basics - BY ACTIVE TRADER STAFF

Because trading is an entrepreneurial profession that requires you risk money to make money, it pays to adopt a prudent, conservative attitude toward the markets. Here’s some advice for traders who are getting ready to dip their toes in the trading pool — with a focus on capital (and sanity) preservation rather than fast riches.

1. Don’t be in a rush to trade.
The markets will be there tomorrow, next week, next year, and next decade. Don’t worry about missing the move of a lifetime when you’re testing and paper trading on the sidelines. There are always opportunities somewhere — you lose nothing by investing time educating and preparing yourself.

2. Don’t trade without a reason.
When you finally start trading, don’t trade just because you feel you have to, or out of boredom, or impetuousness. Only risk your money when you have evidence a favorable trade opportunity is present and you have a plan for taking advantage of it.

Also, don’t “revenge trade.” If you suffer a sizable loss or string of losses, it can be tempting to try to trade bigger and more frequently to get the money back as soon as possible. Needless to say, this course of action almost inevitably amounts to throwing good money after bad.

3. Don’t use leverage just because it’s there.
There’s no law that says you have to trade on margin, in any market. The more leverage you use, the more you’re increasing your risk. Leverage is a tool that will benefit you only if you know how to wield it, and that takes time.

4. Beware of early success.
A rash of successful trades early in your career would hardly be a rarity. It’s one of the little tricks the markets play on us — we knock off a few good trades early on and we’re convinced we’re brilliant market players.
There is such a thing as beginner’s luck, and it manifests itself in trading, too, so don’t get overconfident. Many traders who lost money early in their careers were thankful — in retrospect — because it gave them a realistic perspective of the challenges and risks of trading.

Even with experience, it’s difficult to fight off the highs and lows that come with winning streaks and losing streaks. Atrader on a hot streak is more likely to unnecessarily increase trade size — just in time for a big losing trade. It’s difficult, but strive to accept both losses and gains with an even temperament.

5. Do your own work, think for yourself.
“The essence of knowledge is experience, and the essence of experience is self reliance.” This quote from T.H. White’s book, The Once and Future King, succinctly describes a large part of what trading proficiency is all about.

We are somewhat programmed in our culture to think that for any problem or need, there’s a product, pill, or service we can purchase that will allow us to achieve our goals. While it may be tempting to rely on someone else’s trade idea, research, recommendation, or system, we have found that the most progress comes when you do your own analysis, form your own hypotheses, and rely on your own decision making.

It’s also true that studying the work of others is part of a trader’s education, and that there are many ideas in the public domain that can contribute to a successful trading plan. (If nothing else, learning for yourself will make you an informed consumer of others’ ideas.) But there are no shortcuts. Many experienced traders have said that even a successful trading system will fail if it is not executed properly, and the reality is it’s very difficult to put complete trust in something that is not yours — especially if you don’t fully appreciate its nuances and understand why it works and when its likely to fail. That kind of confidence in a trading idea comes primarily from doing your own work and understanding a concept from the ground up. Trade ideas you understand and make sense to you.

6. If it sounds too good to be true, it probably is.
Whether it’s a trading system, hot tip or indicator, anything that promises big bucks and/or virtually no risk is something to avoid. There are no shortcuts in trading — it’s a challenging business that has made mincemeat of swaths of Ph.D.s and successful professionals from other fields. There’s no such thing as a trading strategy that is correct 95 percent of the time, generates six figures per month, and has no downside risk. Be a skeptic. Get corroboration for any trading idea you’re interested in, including the ones you think of yourself.

7. Focus on trade ideas you can define objectively, research extensively, and test intensively.
Vague trading ideas — e.g., “Buy when the market is oversold and sell when you have a nice profit in hand” — produce uncertain results. The trick is to turn market observations and hypothesis into concrete rules you can test on past price data. For example, what constitutes “oversold”? It could mean anything. An objective rule might be, when a market has made lower lows and lower closing prices on five consecutive days. Whether or not this definition turns out to be a good buy signal is something you have to determine objectively through research and testing.

8. Keep a trade journal and review your performance on a regular basis.
Regardless of their background or approach — investing, short-term trading, technical, quantitative, fundamental — virtually all good traders we’ve talked to agree about the immense benefits of maintaining a log of all your trades and
learning from past experiences.

9. Be patient.
In any case, trading is not as easy as it may first appear. It takes time to master any discipline or profession. Would you expect to become a good musician, doctor, or engineer in a single year?
On top of a natural learning curve, trading also happens to be a profession — unlike music, medicine, or law — in which you can lose money on any given day rather than make it. “Wages” are not guaranteed.
Persevere: Success comes with hard work. Some traders go years without a profit before they finally get on track. Remember, the markets will always be there.

10. Have adequate capitalization/trade within your limits.
Undercapitalization dooms most new businesses, and trading is no exception. Not having enough money to trade renders every other point on this list moot.
Also, when you first trade, do it at an equity level that’s even more conservative than your projected minimum. Start out slow. For example, if you’ve determined you have enough money in your trading account to execute a certain trading
strategy using 500-share trade lots of stocks priced below $30, consider starting out trading 100 or even 50 shares at a time until you’re comfortable with your strategy, execution process, brokerage, and the psychological challenge of risking real money. Then, increase your trade size gradually.

Aiming for the Right Target in Trading by Walter T. Downs

2008-10-03T01:02:00.000-07:00

When trading goes right, it can be a great feeling. When trading goes wrong it can be a nightmare. Fortunes are made in a matter of weeks and lost in a matter of minutes. This pattern repeats itself as each new generation of traders hit the market. They hurl themselves out of the night like insane insects against some sort of karmic bug-light; all thought and all existence extinguished in one final cosmic "zzzzzzt". Obviously, for a trader to be successful he must acknowledge this pattern and then break it. This can be accomplished by asking the right questions and finding the correct answers by rational observation and logical conclusion.
This article will attempt to address one question: "What is the difference between a winning trader and a losing trader?"

What follows are eleven observations and conclusions that I use in my own trading to help keep me on the right track. You can put these ideas into table form, and use them as a template to determine the probability of a trader being successful.

OBSERVATION # 1

The greatest number of losing traders is found in the short-term and intraday ranks. This has less to do with the time frame and more to do with the fact that many of these traders lack proper preparation and a well thought-out game plan. By trading in the time frame most unforgiving of even minute error and most vulnerable to floor manipulation and general costs of trading, losses due to lack of knowledge and lack of preparedness are exponential. These traders are often undercapitalized as well. Winning traders often trade in mid-term to long-term time frames. Often they carry greater initial levels of equity as well.

CONCLUSION:

Trading in mid-term and long-term time frames offers greater probability of success from a statistical point of view. The same can be said for level of capitalization. The greater the initial equity, the greater the probability of survival.

OBSERVATION # 2

Losing traders often use complex systems or methodologies or rely entirely on outside recommendations from gurus or black boxes. Winning traders often use very simple techniques. Invariably they use either a highly modified version of an existing technique or else they have invented their own.

CONCLUSION:

This seems to fit in with the mistaken belief that "complex" is synonymous with "better". Such is not necessarily the case. Logically one could argue that simplistic market approaches tend to be more practical and less prone to false interpretation. In truth, even the terms "simple" or "complex" have no relevance. All that really matters is what makes money and what doesn't. From the observations, we might also conclude that maintaining a major stake in the trading process via our own thoughts and analyses is important to being successful as a trader. This may also explain why a trader who possesses no other qualities than patience and persistence often outperforms those with advanced education, superior intellect or even true genius.

OBSERVATION # 3

Losing traders often rely heavily on computer-generated systems and indicators. They do not take the time to study the mathematical construction of such tools nor do they consider variable usage other than the most popular interpretation. Winning traders often take advantage of the use of computers because of their speed in analyzing large amounts of data and many markets. However, they also tend to be accomplished chartists who are quite happy to sit down with a paper chart, a pencil, protractor and calculator. Very often you will find that they have taken the time to learn the actual mathematical construction of averages and oscillators and can construct them manually if need be. They have taken the time to understand the mechanics of market machinery right down to the last nut and bolt.

CONCLUSION:

If you want to be successful at anything, you need to have a strong understanding of the tools involved. Using a hammer to drive a nut in to a threaded hole might work, but it isn't pretty or practical.

OBSERVATION # 4

Losing traders spend a great deal of time forecasting where the market will be tomorrow. Winning traders spend most of their time thinking about how traders will react to what the market is doing now, and they plan their strategy accordingly.

CONCLUSION:

Success of a trade is much more likely to occur if a trader can predict what type of crowd reaction a particular market event will incur. Being able to respond to irrational buying or selling with a rational and well thought out plan of attack will always increase your probability of success. It can also be concluded that being a successful trader is easier than being a successful analyst since analysts must in effect forecast ultimate outcome and project ultimate profit. If one were to ask a successful trader where he thought a particular market was going to be tomorrow, the most likely response would be a shrug of the shoulders and a simple comment that he would follow the market wherever it wanted to go. By the time we have reached the end of our observations and conclusions, what may have seemed like a rather inane response may be reconsidered as a very prescient view of the market.

OBSERVATION # 5

Losing traders focus on winning trades and high percentages of winners. Winning traders focus on losing trades, solid returns and good risk to reward ratios.

CONCLUSION:

The observation implies that it is much more important to focus on overall risk versus overall profit, rather than "wins" or "losses". The successful trader focuses on possible money gained versus possible money lost, and cares little about the mental highs and lows associated with being "right" or "wrong".

OBSERVATION # 6

Losing traders often fail to acknowledge and control their emotive processes during a trade. Winning traders acknowledge their emotions and then examine the market. If the state of the market has not changed, the emotion is ignored. If the state of the market has changed, the emotion has relevance and the trade is exited.

CONCLUSION:

If a trader enters or exits a trade based purely on emotion then his market approach is neither practical nor rational. Strangely, much damage can also be done if the trader ignores his emotions. In extreme cases this can cause physical illness due to psychological stress. In addition, valuable subconscious trading skills that the trader possesses but has no conscious awareness of may be lost. It is best to acknowledge each emotion as it is experienced and to view the market at these points to see if the original reasons we took the trade are still present. Further proof that this conclusion may have validity can be seen in even highly systematic traders exiting a trade for no apparent reason, and pegging a profitable move almost to the tick. Commonly, this is referred to as being "lucky" or being "in the zone".

OBSERVATION # 7

Losing traders care a great deal about being right. They love the adrenaline and endorphin rushes that trading can produce. They must be in touch with the markets almost twenty-four hours a day. A friend of mine once joked that a new trader won't enter a room unless there is a quote machine in it. Winning traders recognize the emotions but do not let it become a governing factor in the trading process. They may go days without looking at a quote screen. To them, trading is a business. They don't care about being right. They focus on what makes money and what doesn't. They enjoy the intellectual challenge of finding the best odds in the game. If those odds aren't present they don't play.

CONCLUSION:

It is important to stay in synch with the markets, but it is also important to have a life outside of trading. It is a rare individual who can do anything to excess without suffering some form of psychological or physical degradation. Successful traders keep active enough to stay sharp but also realize that it is a business not an addiction.

OBSERVATION # 8

When a losing trader has a bad trade he goes out and buys a new book or system, and then he starts over again from scratch. When winning traders have a bad trade they spend time figuring out what happened and then they adjust their current methodology to account for this possibility next time. They do not switch to new systems or methodologies lightly, and only do so when the market has made it very clear that the old approach is no longer valid. In fact, the best traders often use methodologies that are endemic to basic market structure and will therefore always be a part of the markets they trade. Thus the possibility of the market changing form to the extent that the approach becomes useless, is very small.

CONCLUSION:

The most successful traders have a methodology or system that they use in a very consistent manner. Often, this revolves around one or two techniques and market approaches that have proven profitable for them in the past. Even a bad plan that is used consistently will fair better than jumping from system to system. This observation implies that stylistic foundations of a trader's market approach must be in place before consistent profitability can occur.

OBSERVATION # 9

Losing traders focus on "big-name" traders who made a killing, and they try to emulate the trader's technique. Winning traders monitor new techniques that come on the trading scene, but remain unaffected unless some part of that technique is valuable to them within the framework of their current market approach. They often spend much more time looking at how the market seeks and destroys other traders or how traders destroy themselves. They then trade with the market or against other traders as these situations arise.

CONCLUSION:

Once again, we can note that the individuality of a trader and his comfort level and knowledge regarding his system are far more important than the latest doodad or Market guru.

OBSERVATION #10

Losing traders often fail to include many factors in the overall trading process that affects the probabilities of overall profit. Winning traders understand that winning in the markets means "cash flow". More cash must come in than goes out, and anything that effects this should be considered. Thus a winning trader is just as thrilled with a new way to reduce his data-feed costs or commissions as he is with a new trading system.

CONCLUSION:

ANYTHING that affects bottom line profitability should be considered as a viable area of study to improve performance.

OBSERVATION #11

Losing traders often take themselves quite seriously and seldom find humor in market analysis or the trading environment. Successful traders are often the funniest and most imaginative people you will ever meet. They take joy in trading and are the first to laugh or relate a funny story. They take trading seriously, but they are always the first to laugh at themselves.

CONCLUSION:

Its no wonder that one of the first things psychiatrists test for when treating a patient is whether or not the patient has any sense of humor about his affliction. The more serious the tone of the individual, the more likely that insanity has set in.

SUMMARY OF CONCLUSIONS AND OBSERVATIONS

Both winning and losing traders consider trading a game. However, winning traders take the game not as a diversion but as a vocation which they practice with an intensity and dedication that rivals the work ethic of a professional athlete. Since the athletic metaphor seems appropriate, I will sum up on that note.

If trading were a game like basketball perhaps novice traders would realize more readily that what appears as effortless ease of the professional trader in sinking three-point shots is in fact the product of endless hours spent shooting hoops in deserted back yards and empty playgrounds. As in sports, the governing factors are internal and external. We deal with the market and ourselves. Both are like weapons and they can be used proactively or destructively. Each and every trade should be taken with professional care and planning In order to bring these observations home in an even more compelling form, lets add an element of ultimate risk to life and limb and say that our "sport" is more like target practice with a handgun. While it is certainly important to hit the target, it is more important to make sure the gun isn't pointed directly at ourselves when we pull the trigger.
Minute differences in how we take aim in the markets can have amazing impact on the final outcome. The difference is clear: One method is accurate target practice. The other is Russian Roulette.

Walter Downs is a professional trader and market consultant. He is president of CIS Trading Cos., a firm dedicated to the research and development of innovative market techniques
Copyright@ 1999 Walter T. Downs All Rights Reserved. Distribution is allowed with due credit to the author: http://cistrader.com [Note: this site appears defunct as of 4/29/03]

When Trading Journals Don’t Work

2008-10-02T00:08:00.000-07:00

One of the most common pieces of advice trading mentors give to their students is the keeping of a trading journal. By documenting your trading, the common wisdom holds, you can learn what you’re doing right and wrong and speed your learning curve. I happen to be quite a fan of trading journals; indeed, I made journals a mandatory part of the training program at a Chicago-based proprietary trading firm. All too many times, however, I found that the journals did not accomplish their purpose. They became rote exercises that did not get to the heart of either trading problems or solutions. So I thought in this article I’d outline the five most frequent shortcomings with journals and how these can be addressed.

The journal lacks specifics. Many times the journal becomes an outlet for the trader, a way of venting. While there is nothing wrong with venting per se, it is hard to see how *simply* venting in a journal can improve performance. A common entry might state, “I overtraded a slow market and broke all my rules. I know I have to take what the market gives me. Tomorrow I need to trade with more discipline”. All these things may be true, but the entry lacks specifics regarding *why* the trader overtraded; *how* the overtrading will be avoided in tomorrow’s trade; and *what steps* will be taken to return to the discipline. A journal entry that lacks specifics is a statement of good intentions; not a plan. If your journal entry does not include concrete steps that you can follow to address a problem situation, it is unlikely that it will serve as an action guide.
The journal emphasizes problems, not solutions. Traders love to keep journals when they’re losing and then fall off the journaling bandwagon when they’re making money. I would argue that, when you’re making money, that’s the *best* time to keep a journal. Your goal should be to replicate successful trading patterns, not simply analyze problematic ones. The ideal journals isolate what traders do when they’re trading their best, so that these solution patterns can be isolated and mentally rehearsed as part of a learning process. At their worst, journals are like bad parents who chastise their children when they’re doing something wrong, but never offer attention and praise for good behavior. Kids learn to resent such parents, and traders learn to resent problem-focused journaling.
The journal talks too much about the trader and not enough about the markets. Journals are a learning tool, and your ultimate goal is to learn how to trade. By focusing exclusively on your state of mind, what you did or didn’t do in the trade, etc., you lose the opportunity to identify and learn patterns that appear in the market. It’s extremely helpful to review a market day and examine what you could have noticed to alert you to a market move. Perhaps oil made a breakout move preceding a break in the equity indices; perhaps a move in the currency markets could have given you an early read on how the market would respond to Fed news. By retrospectively identifying such trading patterns, you train your mind to look for them the next time they appear.
The journal is reactive, not proactive. This is part of the venting phenomenon: traders will make journal entries after the market day, but rarely use the journal to actively prepare for the coming day’s trade. An ideal journal captures what you’ll be looking for in the coming day in the markets (anticipated setups) and what you’ll be working on in your own trading. Think of your trading as a business and your journal as your business plan for the day. A business plan should reflect your strengths and weaknesses and identify areas of opportunity. A business plan should also detail how you will exploit that opportunity. Learning from past performance is important, but if the learning is not reflected in future plans, it will not be reflected in actual trading outcomes.
The journal lacks metrics. This is perhaps the topic I am most passionate about. I have found that traders can best assess their strengths and weaknesses by keeping detailed records of their trades and by evaluating themselves across a series of performance measures. I cannot tell you how many traders I’ve encountered who don’t have the faintest notion of their average profit per trade; their average win size and loss size; their average holding period per trade; etc. It’s not that the traders don’t care about performance; it’s that they have not drilled down to the trade-by-trade level to see what they’re actually doing in the markets. Many times, traders *think* they’re trading one way, only to find out when they look at the data that they’re not trading that way at all. It’s hard to see how a trader can identify if they’re having problems trading in the morning vs. afternoon; if they’re more often right on the long side than short; or if they are trading large size differently than smaller size if the statistics are not there to be analyzed.

So what’s a trader to do? The first step is to decide whether or not you really *want* to know what you’re doing and how well you’re doing it; whether you want to put in the time and effort to identify the patterns in each trading day—the market’s and your own. To paraphrase U.S. college basketball coach Bobby Knight, many traders want to trade and many want to win, but not many are willing to put in the work it takes to be a winner. While Coach Knight has earned his share of criticism, look at the pure effort he puts into preparation for a coming game. The same intensity of effort can be found in Tour de France leaders Lance Armstrong, Ivan Basso, and Jan Ullrich, as they actively train, plan, and rehearse for each stage of the race. This is the effort required of a winner, and each trader needs to know if he or she has the fire in their belly to sustain such work.

Ultimately, the effort to win is sustained by a desire to know. Excellent traders are always keeping score: they want to know what they’ve done right or wrong, and what’s making and losing them money. They are always working on themselves and their trading. I’ve met far too many “breakeven” traders who, upon inspection, have been losing money consistently. It’s not that they’re lying; they simply don’t want to know the truth. Thus, they avoid it. It is simply too painful to look at the money and opportunities lost. Keeping a journal *should* be painful at times, but it should also bring out the best in you. Without it, you’re likely to be a business without a plan.

by Brett Steenbarger

A Beginner's Guide To Hedging

2008-10-01T00:06:00.000-07:00

Although it sounds like it might be the hobby of your neighbor obsessed with his topiary garden full of tall bushes shaped like giraffes and dinosaurs, hedging is a practice every investor should know about - there is no arguing that portfolio protection is often just as important as portfolio appreciation. Like your neighbor's obsession, however, hedging is talked about more than it is explained, making it seem as though it belongs only to the most esoteric financial realms. Well, even if you are a beginner, you can learn what hedging is, how it works and what hedging techniques investors and companies use to protect themselves.

What Is Hedging?
The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesn't prevent a negative event from happening, but if it does happen and you're properly hedged, the impact of the event is reduced. So, hedging occurs almost everywhere, and we see it everyday. For example, if you buy house insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters.

Portfolio managers, individual investors and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging becomes more complicated than simply paying an insurance company a fee every year. Hedging against investment risk means strategically using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another.

Technically, to hedge you would invest in two securities with negative correlations. Of course, nothing in this world is free, so you still have to pay for this type of insurance in one form or another.

Although some of us may fantasize about a world where profit potentials are limitless but also risk free, hedging can't help us escape the hard reality of the risk-return tradeoff. A reduction in risk will always mean a reduction in potential profits. So, hedging, for the most part, is a technique not by which you will make money but by which you can reduce potential loss. If the investment you are hedging against makes money, you will have typically reduced the profit that you could have made, and if the investment loses money, your hedge, if successful, will reduce that loss.

How Do Investors Hedge?
Hedging techniques generally involve the use of complicated financial instruments known as derivatives, the two most common of which are options and futures. We're not going to get into the nitty-gritty of describing how these instruments work, but for now just keep in mind that with these instruments you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.

Let's see how this works with an example. Say you own shares of Cory's Tequila Corporation (Ticker: CTC). Although you believe in this company for the long run, you are a little worried about some short-term losses in the Tequila industry. To protect yourself from a fall in CTC you can buy a put option (a derivative) on the company, which gives you the right to sell CTC at a specific price (strike price). This strategy is known as a married put. If your stock price tumbles below the strike price, these losses will be offset by gains in the put option.

The other classic hedging example involves a company that depends on a certain commodity. Let's say Cory's Tequila Corporation is worried about the volatility in the price of agave, the plant used to make tequila. The company would be in deep trouble if the price of agave were to skyrocket, which would eat into profit margins severely. To protect (hedge) against the uncertainty of agave prices, CTC can enter into a futures contract (or its less regulated cousin, the foreward contract), which allows the company to buy the agave at a specific price at a set date in the future. Now CTC can budget without worrying about the fluctuating commodity.

If the agave skyrockets above that price specified by the futures contract, the hedge will have paid off because CTC will save money by paying the lower price. However, if the price goes down, CTC is still obligated to pay the price in the contract and actually would have been better off not hedging.

Keep in mind that because there are so many different types of options and futures contracts an investor can hedge against nearly anything, whether a stock, commodity price, interest rate and currency - investors can even hedge against the weather.

The Downside
Every hedge has a cost, so before you decide to use hedging, you must ask yourself if the benefits received from it justify the expense. Remember, the goal of hedging isn't to make money but to protect from losses. The cost of the hedge - whether it is the cost of an option or lost profits from being on the wrong side of a futures contract - cannot be avoided. This is the price you have to pay to avoid uncertainty.

We've been comparing hedging versus insurance, but we should emphasize that insurance is far more precise than hedging. With insurance, you are completely compensated for your loss (usually minus a deductible). Hedging a portfolio isn't a perfect science and things can go wrong. Although risk managers are always aiming for the perfect hedge, it is difficult to achieve in practice.

What Hedging Means to You
The majority of investors will never trade a derivative contract in their life. In fact most buy-and-hold investors ignore short-term fluctuation altogether. For these investors there is little point in engaging in hedging because they let their investments grow with the overall market.

So why learn about hedging?

Even if you never hedge for your own portfolio you should understand how it works because many big companies and investment funds will hedge in some form. Oil companies, for example, might hedge against the price of oil while an international mutual fund might hedge against fluctuations in foreign exchange rates. An understanding of hedging will help you to comprehend and analyze these investments.

Conclusion
Risk is an essential yet precarious element of investing. Regardless of what kind of investor one aims to be, having a basic knowledge of hedging strategies will lead to better awareness of how investors and companies work to protect themselves. Whether or not you decide to start practicing the intricate uses of derivatives, learning about how hedging works will help advance your understanding the market, which will always help you be a better investor.

by Investopedia Staff,

Gauging The Market's Psychological State

2008-09-30T00:03:00.000-07:00

When volume is high, those traders unlucky enough to be losing money in their positions feel the sharp sting of their losses. In order to alleviate the pain, these traders quickly close their positions (at a loss). As losers exit the market, a trend based on high volume is likely to be short lived. But a trend based on moderate volume can last an extremely long time since small losses can accumulate over time into what may become very large losses. The longest trends are probably driven by markets either going nowhere, changing moderately or even moving both up and down day after day, forming only a gradual trend, which is apparent when viewed in retrospect.

But there's still more to the volume story that pertains to market psychology. I've still got a couple of columns to write in order to cover the theme of market psychology in its entirety - there are many more trading indicators that gauge the market's psychological state. Once again, I must express my appreciation to Dr. Alexander Elder for his work, which renders many of the following concepts and indicators in a clear, concise and understandable way for traders everywhere. For much greater detail on all of the topics mentioned below, you can refer to Dr. Elder's trading book companions: "Trading for a Living: Psychology, Trading Tactics, Money Management" and "Come into My Trading Room: A Complete Guide to Trading".

On-Balance Volume (OBV)
Devised by Joseph Granville, on-balance volume is a running total, which rises or falls every trading day, based on whether prices close higher or lower than on the previous day. OBV is a leading indicator, so it typically rises or falls before that of the actual prices. A new OBV high indicates the power of bulls, the weakness of bears and the likely resultant rise of prices. A new OBV low indicates an opposite pattern: the power of bears, weakness of bulls and a possible decrease in value. When OBV shows a signal differing from that of actual prices, it indicates that volume (emotion of the market) is not consistent with consensus of value (actual prices) - a shift in price, which would alleviate this imbalance, is imminent.

Accumulation/Distribution (A/D)
Accumulation/distribution is also a leading indicator pertaining to volume, but it takes opening and closing prices into account. A positive A/D indicates that prices were higher when they closed than when they opened; a negative A/D indicates the opposite. But the bull or bear winners are only credited with a fraction of each day's volume, depending on the day's range and the distance from opening to closing price. Obviously, a wide range between open and close produces a stronger signal A/D, but the pattern of A/D highs and lows is most important. If a market opens higher and closes lower, thereby causing A/D to turn down, an upward-trending market may be weaker than it initially appears.

The significance of accumulation/distribution lies in its insight into the activities of the distinct groups of professional and amateur traders. Amateurs as a group are more likely to influence the opening price of the market since these amateurs base their first trades on the financial news they have read overnight as well as on the corporate news that was issued by their favorite companies after market close. But as the trading day wears on, the professionals determine the day's ultimate results. If the professionals disagree with the amateurs' bullishness at the open, the professionals will drive prices lower for the close. When the pros are more bullish than amateurs, the pros will drive prices higher all day and into the close. As indicators for future trends, the activities of professionals are generally more important than that of the amateurs.

Open Interest
Shifting from our discussion of volume, we find open interest as the next major indicator of crowd psychology. Open interest applies to the futures market and refers to a reading of future contracts or options expiring at a certain time in the future. Open interest adds the total long and short contracts in the market on a given day, and the absolute value of open interest corresponds to a cumulative long or short position. Open interest only rises or falls when a new contract is created or destroyed - one long and one short seller must enter the market to increase the open interest, and one long and one short seller must close their positions for open interest to fall.

Open interest is only of interest (pun intended) when it deviates from its norm. An absolute value is of no interest (bad pun again intended). Open interest reflects the psychology of the market by way of the market's inherent conflict between bulls and bears. To move the open interest indicator up or down, both bulls and bears must be equally confident that their long or short position is correct (or incorrect). A rising open interest demonstrates that bulls are confident enough to enter into contracts with bears, who are equally confident in their bearishness to enter into the position. One group will inevitably lose, but as long as potential losers (either bulls or bears) enter contracts, the rise or fall in open interest will continue. But there is more to the open interest picture than immediately meets the eye.

A rising open interest points to an increase in the supply of potential losers, propelling the trend forward. Open interest that increases during an uptrend reveals that a certain number of bears believe the market is too high; but, if the uptrend increases, their short positions will be squeezed, and their subsequent buying will propel the market even higher; however, open interest that remains relatively constant during a market uptrend indicates that the supply of losers has stopped growing as the only potential candidates to enter into a contract are previous buyers who are looking to make a profit from their position. In this case, the uptrend is likely nearing its end.

During a downtrend, shorts are selling aggressively while the only participants that are buying are bottom pickers. But even value investors exit their positions when prices fall too far, so prices will go even lower. If open interest rises in a declining market, the downtrend is likely to continue. If open interest remains flat in a downtrend, there are few remaining bottom pickers, and the only remaining candidates for the contract are additional bears that shorted earlier and now want to cover and leave the market. Bears that exit with a profit cause a flat open interest in a downtrend, meaning that the best gains from the downtrend have probably already been had.

Finally, a falling open interest shows that losers are exiting positions while winners are taking profits. It also shows there are no additional losers to take the place of those who have given up. The falling open interest is a clear signal that winners are taking their profits and running for the border while losers are giving up hope. A loss of a contract (and a declining open interest) points to the likely end of a trend.

by Jason Van Bergen, investopedia.com

Youh should knoe before and after trade

2008-09-29T00:00:00.000-07:00

Is stress an ultimately meaningless but inevitable part of trading or is your psyche trying to tell you something about your trading approach? Find out what your emotions can reveal about how you trade.

Ask yourself the following question: Have your ever, before placing a trade, thought of all the reasons the trade was a good idea, but once you pulled the trigger obsessed about all the things that could go wrong? Has this nervousness caused you to abandon your trading plan and, perhaps, exit a trade too early — resulting either in an unnecessary loss or unnecessarily small gain?

Before seeking the advice of a Freudian analyst to discover the traumatic events in your childhood that are causing you to abandon discipline, it may be worthwhile to consider more immediate explanations. Most likely, one of three things is going on here or, possibly, a blend of the three.

The first possibility is you simply have trouble putting money at risk. In the past,you’ve never really liked anything more unpredictable than a treasury-bond fund, and you immediately get knots in your stomach when a trade moves one tick against you. The “paranoid” feelings you experience in a trade are completely detached from the reality of the market situation and your trading strategy.

Some people are inherently riskaverse. Regardless of the causes of such feelings, some people can work through them. Others, though, are better off not trading. Because the first rule of trading is capital preservation, refraining from trading can be the best money-management decision some people can make.

The second possibility is you are not really working with a fully developed trading plan. If you can immediately think of 10 things that are wrong with your trade right after you click “buy” or “sell,” you must ask yourself why you didn’t think of them before. The rush of enthusiasm that can accompany an attractive trade setup can quickly disappear once you’ve executed the trade and realize you don’t really know how you’re going to get out or how much you’re risking.

Finally, it might simply be you’re not trading with enough money. No trader or trading strategy can survive undercapitalization. If even a small loss represents a significant percentage of your trading capital — say, 10, 15 or 20 percent — the stress will likely be so great that you will not be able to stick with the trade long enough to profit from it. Lack of capital is the No. 1 killer of most new businesses and almost all new traders.

Paper trades that do not risk real money tend to have less psychological baggage than those that do.

Are you paranoid or are you really being followed?

The problem comes in determining whether your negative feelings are really “risk paranoia” or whether they are tipping you off to flaws in either the design or execution of your trade. In the latter case, there are some simple techniques to consider to reduce or eliminate this problem.

The first solution is to only trade systematically. Removing emotions from trading is the very reason many traders adopt a systematic approach, even if they think they might have better performance trading with discretion.

Truly systematic or mechanical trading approaches leave no room for interpretation. Trades must be executed without hesitation or reflection on the current market circumstances or the possible outcome. Of course, to have the confidence to automatically follow a system requires a great deal of research, historical testing and trial trading — not to mention discipline when it comes time to execute. The upside of mechanical trading is that it can greatly reduce the emotional element of trading.

The second solution is to track your trades and jot down your fears at the time of execution. By comparing these notes to the actual results of the trade, you can see if your fears are unfounded or if your trading plan indeed is flawed. It would be nice to paper trade and make such notes, but trades that do not risk real money tend to have less psychological baggage than those that do.

One idea is to put on very small trades, even if winning trades merely squeak out a small profit (or small loss) after commissions. It’s amazing how even putting a little money at risk can up the psychological ante. It’s similar to being in a quarter/50-cent/dollar poker game: After you go around the table a few of times, that $40 pot seems like all the money in the world. Using this technique gives you the opportunity to analyze your strategy, execution process and mindset with some degree of realism while limiting risk exposure.

A dose of reality

Truth be told, even some veteran traders have difficulty completely removing the fear factor from their trades. This only makes sense, because experienced traders understand the inherent unpredictability of the markets.

Following any strategy — whether it includes discretion or is completely mechanical — requires a fully developed plan, with entry, exit (where you get out with a profit or loss) and moneymanagement (how much you risk) rules.

You also need to know why your system works and when it is likely to fail. Only then will you have enough confidence to survive the bad trades as well as enjoy the good ones.

The Importance Of Diversification

2008-09-28T23:56:00.000-07:00

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries and other categories. It aims to maximize return by investing in different areas that would each react differently to the same event. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here we look at why this is true, and how to accomplish diversification in your portfolio.

Different Types of Risk
Investors confront two main types of risk when investing:

Undiversifiable - Also known as "systematic" or "market risk", undiversifiable risk is associated with every company. Causes are things like inflation rates, exchange rates, political instability, war and interest rates. This type of risk is not specific to a particular company and/or industry, and it cannot be eliminated or reduced through diversification; it is just a risk that investors must accept.
Diversifiable - This risk is also known as "unsystematic risk", and it is specific to a company, industry, market, economy or country; it can be reduced through diversification. The most common sources of unsystematic risk are business risk and financial risk. Thus, the aim is to invest in various assets so that they will not all be affected the same way by market events.

Why You Should Diversify
Let's say you have a portfolio of only airline stocks. If it is publicly announced that airline pilots are going on an indefinite strike and that all flights are canceled, share prices of airline stocks will drop. Your portfolio will experience a noticeable drop in value. If, however, you counterbalanced the airline industry stocks with a couple of railway stocks, only part of your portfolio would be affected. In fact, there is a good chance that the railway stocks' prices would climb as passengers turn to trains as an alternative form of transportation.

But you could diversify even further because there are many risks that affect both rail and air because each is involved in transportation. An event that reduces any form of travel hurts both types of companies - statisticians would say that rail and air stocks have a strong correlation. Therefore, to achieve superior diversification, you would want to diversify across not only different types of companies but also different types of industries. The more uncorrelated your stocks are, the better.

It's also important that you diversify among different asset classes. Because different assets - such as bonds and stocks - will not react in the same way to adverse events, a combination of asset classes will reduce your portfolio's sensitivity to market swings. Generally, the bond and equity markets move in opposite directions, so, if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive results in another.

There are additional types of diversification and many synthetic investment products have been created to accommodate investors' risk tolerance levels; however, these products can be very complicated and are not meant to be created by beginner or small investors. For those who have less investment experience and do not have the financial backing to enter into hedging activities, bonds are the most popular way to diversify against the stock market.

Unfortunately, even the best analysis of a company and its financial statements cannot guarantee that it won't be a losing investment. Diversification won't prevent a loss, but it can reduce the impact of fraud and bad information on your portfolio.

How Many Stocks You Should Have
Obviously owning five stocks is better than owning one, but there comes a point when adding more stocks to your portfolio ceases to make a difference. There is a debate over how many stocks are needed to reduce risk while maintaining a high return. The most conventional view argues that an investor can achieve optimal diversification with only 15 to 20 stocks spread across various industries.

Summary
Diversification can help an investor manage risk and reduce the volatility of an asset's price movements. Remember though, that no matter how diversified your portfolio is, risk can never be eliminated completely. You can reduce risk associated with individual stocks, but general market risks affect nearly every stock, so it is important to diversify also among different asset classes. The key is to find a medium between risk and return; this ensures that you achieve your financial goals while still getting a good night's rest.

by Investopedia .com

Investment Scams: Conclusion

2008-09-27T23:51:00.000-07:00

Now that you're familiar with the various kinds of online investment scams, we hope you'll be prepared for anything the fraudsters throw at you. We'll be happy if this tutorial saves one person from being scammed out of their hard-earned money.

To recap:

Many scams on the 'Net aren't new at all. They're just variations on classic Ponzi schemes, pump and dump scams, and offshore investing scams.
Bulletin boards are especially dangerous because you don't know the identity of who is posting. Take all posts with a grain of salt.
Newsletters are often written by paid promoters. Always be skeptical: if things sound too good to be true, they probably are.
Spam isn't even worth the second it takes to hit delete.
If you encounter a scam, contact the SEC.

Dealing With Investment Fraud

2008-09-26T23:50:00.000-07:00

If you come across or are the victim of an investment scam, the best thing to do is report it to the Security and Exchange Commission (SEC). They have online forms to contact them at their complaint site: http://www.sec.gov/complaint.shtml.

You can also write them at:

Securities and Exchange Commission
Office of Investor Education & Assistance
450 Fifth Street, N.W.
Washington, D.C. 20549-0213
Fax: 202-942-9634

You can forward spam or copies of fraudulent message board postings to:
enforcement@sec.gov.

When contacting the SEC, you only need to give as much personal information as you wish. However, the more information you give them, the better they will be able to help you. Include specific details of how, why and when you were defrauded with any contact info you have on the fraudulent person or company you are reporting.

Investment Scams: Newsletters

2008-09-25T23:47:00.000-07:00

Almost every stock pick site offers a newsletter that is supposedly full of useful insights and great stocks. There are many good newsletters out there, but some are just promoting stocks under the guise of presenting investors with "free unbiased information."

In fact, many companies hire employees or pay people to write online newsletters to promote their stock. In theory, this practice is not illegal. But federal securities laws require newsletters to disclose who paid them, the amount paid, and the type of payment. Most fraudulent newsletters fail to provide this information. Instead, they lie about the income they receive, their independence, their research, and their historical results. They stand to profit handsomely if they convince investors to buy or sell particular stocks. Newsletters also use the pump and dump technique discussed earlier. With enough people on the list, it is possible to create movement in the price of small stocks.

Even worse is junk e-mail or "spam." As spam costs next to nothing to create, it has become the tool of choice for many fraudsters. Often these messages consist of “get-rich-quick” schemes and offer "guaranteed results." If the sender is unfamiliar to you or the message is addressed generally (great investment tip) it is likely a scam. Brokers and traders don't give away good tips to random people for free. Besides, no reputable company would spam to get their name out. The smartest thing you can do is hit your delete button.

Identifying these shady e-mails isn't tough. Besides promising huge results with no risk, look for CAPITALIZED LETTERS WITH MANY EXCLAMATION MARKS!!! FOR SOME REASON SCAM ARTISTS THINK YOU'LL LISTEN IF THEY WRITE LIKE THEY ARE SCREAMING AT YOU!!! Another clue is when the e-mail comes from free e-mail providers such as yahoo.com or hotmail.com. Spammers use these addresses to hide where the original message comes from.
Below are some examples of e-mails to watch out for. These are real, uncut, uncensored, spam scams sent to our Inbox at Investopedia:

Example 1 ;

-----Original Message-----

From: madlyn1538j78@mailcity.lycos.co.jp

Sent: Thursday, May 23, 2002 4:30 PM

To: Maire

Subject: Introducing the "Energy" Market

Get The Wealth You Deserve

Unlock the Doors to STAGGERING PROFITS!

Take Advantage of Market Trends As They Happen!

NOW is the Time to Embrace The ENERGY Markets!

Commodity Trading Makes Millions Every Day!

Powerful Profits Await YOU In The ENERGY Markets!!!

Fortunes will literally be made in the next few months!

Summer Driving Vacations alone will drive gas prices up very soon!

*We all NEED ENERGY...every day!

*We all U.S.E Energy...every day!

*Your Life Resolves around ENERGY!

*Every Major Country in the world consumes ENERGY daily!

Prices reach extremes for reasons...

Do you want to know the reasons WHY?

Get Your FREE Energy Investment Information Packet at:

http://www.ynotuweb.com/energymarkets

The Five Major Energy Markets are:

*Unleaded Gasoline

*Electricity

*Natural Gas

*Heating Oil

*Crude Oil

OPEC announced 11/1/01 they would be cutting oil production

because prices were just too low.  OPEC AGAIN announced

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such terms as "expect", "believe", "may", "will", and "intend" or

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Investment Scams: Bulletin Boards

2008-09-24T23:46:00.000-07:00

There are literally hundreds of investment boards where anyone can rant, rave, or post BS. Online bulletin boards (BBs) come in various forms, including newsgroups, usenet, or web-based boards. Some of the larger BBs, like those found on sites such as Raging Bull, Boards on Yahoo! Finance, and Silicon Investor, see thousands of messages posted on an hourly basis.

While there are many valid and useful posts on these boards, a large number of tips turn out to be bogus. Fraudsters most often use a pump and dump scheme on BBs by pretending to reveal inside information about big upcoming announcements, great new products, or lucrative contracts. The opposite can be done too. If fraudsters hold a short position in a company, they will try to spread negative rumors in the hope that investors will panic and push prices down.

Here's the tricky part about BBs: anonymity. You don't know for sure who you're dealing with and how credible they are. People claiming to be unbiased observers who've carefully researched a company may actually be company insiders, large shareholders, or paid promoters. A single person can easily create the illusion of widespread interest in a small, thinly-traded stock by posting a series of messages under various aliases.

In the aftermath of the dotcom bubble, bulletin boards experienced a dramatic drop in traffic. Thankfully, many investors realized they couldn't believe everything they read online. But that's not to say there is no valuable information on BBs. Before Enron went bankrupt, posts were made online that revealed many of the fraudulent practices taking place at the energy giant. Regrettably, at the same time, there were countless posts that were bullish on Enron. It's nearly impossible to sort out the valuable posts from the fake ones.

Investment Scams: Different Types Of Scams

2008-09-23T23:44:00.000-07:00

Very few of the scams on the Internet are new. Most of the swindling techniques we see today originated long ago as telemarketing, direct mail, or even door-to-door selling schemes. But the Internet adds another troubling dimension to these old tricks. For example, a fancy Web site can create the illusion of a large and reputable company, especially if it provides links to legitimate sites.

Here are some of the largest and most successful investment scams:

Ponzi Scheme - A type of pyramid scheme, this is where money from new investors is used to provide a return to previous investors. The scheme collapses when money owed to previous investors is greater than the money that can be raised from new ones. Ponzi schemes always collapse eventually.
Pump and Dump - A highly illegal practice where a small group of informed people buy a stock before they recommend it to thousands of investors. The result is a quick spike in stock price followed by an equally fast downfall. The perpetrators who bought the stock early sell off when the price peaks at a huge profit. Most pump and dump schemes recommend companies that are over-the-counter bulletin board (OTCBB) and have a small float. Small companies are more volatile and it's easier to manipulate a stock when there's little or no information available about the company. There is also a variation of this scam called the "short and distort." Instead of spreading positive news, fraudsters use a smear campaign and attempt to drive the stock price down. Profit is then made by short selling.
Off Shore Investing - These are becoming one of the more popular scams to trap U.S. and Canadian investors. Conflicting time zones, differing currencies, and the high costs of international telephone calls made it difficult for fraudsters to prey on North American residents. The Internet has eroded these barriers. Be all the more cautious when considering an investment opportunity originating in another country. It's extremely difficult for your local law enforcement agencies to investigate and prosecute foreign criminals.
Prime Bank - This term usually describes the top 50 banks (or thereabouts) in the world. Prime banks trade high quality and low risk instruments such as world paper, International Monetary Fund bonds, and Federal Reserve notes. You should be very wary when you hear this term--it is often used by fraudsters looking to lend legitimacy to their cause. Prime bank programs often claim investors' funds will be used to purchase and trade "prime bank" financial instruments for huge gains. Unfortunately these "prime bank" instruments often never exist and people lose all of their money.

Investment Scams: Introduction

2008-09-22T23:41:00.000-07:00

Ever find a scam like this in your e-mail? We sure get enough of them in the Investopedia Inbox.

To: investor@worldwideweb.com
Subject: This is your lucky day!!!

I don't usually send out stuff like this, but what I have to tell you is just too good. For the last six months I've been developing the ULTIMATE TRADING PROGRAM. I've figured out exactly how to pick the next Microsoft. In fact, over the last year I've had a 3,000% return on my investment!!!

In my investing program there is absolutely NO RISK. In fact, it's such a SURE THING that we'll guarantee you cannot lose your investment. Thing is, if you want a part of the action, you'll have to send me $499.95 today. There are just too many other investors who want to get in on this...

The Internet is a great tool for investors, allowing us to research investments and trade securities with unprecedented ease. Unfortunately, the lack of rules on the 'Net also makes it a perfect place for fraud to flourish.

In this tutorial, we look at the ins and outs of Internet investment fraud. We examine different scams, see how they are carried out, and discuss how to avoid them.

How is Trading Forex Different from Trading Stocks?

2008-09-21T23:34:00.000-07:00

The foreign exchange market, often referred to as forex, is the market for the various currencies of the world. It is a market which, at its core, is rooted in global trade. Goods and services are exchanged 24 hours a day all over the world. Those transactions done across national borders require payments in non-domestic currencies.

For example, a US company purchases widgets from a Mexican company. To do the transaction, one of two things is going to happen. The US firm may, depending on the contract terms, make payment in Mexican Pesos. That would require a conversion of Dollars in to Pesos to make payment. Alternately, the payment could be made in Dollars, in which case the Mexican company would then exchange the Dollars for Pesos on their end. Either way, there is going to be some transaction which takes Dollars and swaps them for Pesos.

That is where the forex market comes in. Transactions like that take place all the time. The market maintains a rate of exchange between the US Dollar and the Mexican Peso (and between and amongst all other world currencies) to facilitate that activity. Consider the amount of global trade which takes place and you can see why the forex market is the biggest in the world, dwarfing all others. Literally trillions of dollars worth of forex transactions take place each and every day.

How is the Forex Market Different?
There are some significant differences between the forex market and others like the stock market. While it may be the feeling that a good trader should be able to handle any market, the fact of the matter is that some structural differences in forex can require a different trading approach.

Time
For most stock traders, the first difference they will notice between the forex market and equities is timeframe. Although the hours of stock trading have been expanding in recent years, the forex market is still the only one which can truly be viewed as 24-hour. There is ready forex trading activity in all time zones during the week, and sometimes even on the weekends as well. Other markets may in fact transact 24-hours, but the volume outside their primary trading day is thin and inconsistent.

No Exchanges
The lack of an exchange is probably the next big thing that sticks out as being different in forex. While it is true that there is exchange-based forex trading in the form of futures, the primary trading takes place over-the-counter via the spot market. There is no NYSE of forex.
On the largest scale, forex transactions are done in what is referred to as the inter-bank market. That literally means banks trading with each other on behalf of their customers. Larger speculators also operate in the inter-bank market where they can execute multi-million dollar trades with ease. Individual traders, who generally trade in much smaller sizes, primarily do so through brokers and dealers.
This is something which can trouble stock traders. There is no central location for price data, and no real volume information is attainable. Since volume is an often reported figure in the stock market, the lack of it in spot forex trading is something which takes a bit of getting used to for those making the switch.

Transaction Processing
Also, the lack of an exchange means a difference in how trading is actually done. In the stock market an order is submitted to a broker who facilitates the trade with another broker/dealer (over-the-counter) or through an exchange. In spot forex much of the trading done by individuals is actually executed directly with their broker/dealer. That means the broker takes the other side of the trade. This is not always the case, but is the most common approach.

Transaction Costs
The lack of an exchange and the direct trade with the broker creates another difference between stock and forex trading. In the stock market brokers will generally charge a commission for each buy and sell transaction you do. In forex, though, most brokers do not charge any commissions. Since they are taking the other side of all the customer trades, they profit by making the spread between the bid and offer prices.

Some traders do not like the structure of the spot forex market. They are not comfortable with their broker being on the other side of their trades as they feel it presents a type of conflict of interest. They also question the safety of their funds and the lack of overall regulation. There are some worthwhile concerns, certainly, but the fact of the matter is that the majority of forex brokers are very reliable and ethical. Those that are not don't stay in business very long.

Margin Trading
The forex market is a 100% margin-based market. This is a familiar thing for those used to trading futures.
In fact, spot forex trading is essentially trading a 2-day forward (futures) contract. You do not take actual possession of any currency, but rather have a theoretical agreement to do so in the future. That puts you in a position of benefiting from prices changes. For that your broker requires a deposit on your trades to provide surety against any losses you may incur. How much of a deposit can vary. Some brokers will asked for as little as 1/2%. That is fairly aggressive, though. Expect 1%-2% on the value of the position in most cases.

Now, unlike the stock market, margin trading does not mean margin loans. Your broker will not be lending you money to buy securities (at least not the way a stock broker does). As such, there is no margin interest charged. In fact, since you are the one putting money on deposit with your broker, you may earn interest in your margin funds.

Interest Rate Carry (Rollover)
When trading forex, one is essentially borrowing one currency, converting it in to another, and depositing it. This is all done on an overnight basis, so the trader is paying the overnight interest rate on the borrowed currency and at the same time earning the overnight rate on the currency being held. This means the trader is either paying out or receiving interest on their position, depending on whether the interest rate differential is for or against them.

This is commonly handled is what is referred to as a rollover. Spot forex trades are done on a trading day basis, and as such are technically closed out at the end of each day. If you are holding your position longer than that, your broker rolls you forward in to a new position for the next trading day. This is generally done transparently, but it does mean that at the end of each day you will either pay or receive the interest differential on your position.

The type of trader you are and the way your broker handles rollover will be the deciding factors in determining whether the interest rate differentials are an important concern for you. Some brokers will not apply the day's interest differential value on positions closed out during the trading day. By that I mean if you were to enter a position at 10am and exit at 2pm, no interest would come in to play. If you were to open a position on Monday and close it on Tuesday, though, you would have the interest for Monday applied (the full day regardless of when you entered the position), but nothing for Tuesday. (Note: There is at least one broker who calculates interest on a continuous basis, so you will always make or pay the interest differential on all positions, no matter when you put them on or took them off).

It should also be noted that although some folks will claim there is no rollover in forex futures, the interest rate spread is definitely factored in. You can see this when comparing the futures prices with the spot market rates. As the futures contracts approach their delivery date their prices will converge with the spot rate so that the holders will pay or receive the differential just as if they had been in a spot position.

Intervention
Fixed income traders know that central bankers, like the Federal Reserve, are active in the markets, buying and selling securities to influence prices, and thereby interest rates. This is not something which happens in stocks, but it does in the forex markets. This is known as intervention. It happens when a central bank or other national monetary authority buys or sells currency in the market with the objective of influencing exchange rates.

Intervention is most often seen at times when exchange rates get a bit out of hand, either falling or rising too rapidly. At those times, central banks may step in to try to nullify the trend. Sometimes it works. Sometimes not.

The US has traditionally taken a hands-off approach when it comes to the value of the Dollar, preferring to allow the markets to do their thing. Others are not quite so willing to let speculators determine their currency's value. The Bank of Japan has the most active track record in that regard.

John Forman is the author of The Essentials of Trading, and a professional market analyst and strategist with 20 years of experience trading stocks, futures, forex, and pretty much anything else traded by individuals. If you would like to learn more about how you can identify price targets in this fashion, you'll want to take a look at the video John has prepared on the subject. Click here for more information.

The Myth Of Profit/Loss Ratios

2008-09-20T23:24:00.000-07:00

When trading the forex market or other markets, we are often told of a common money management strategy that requires that the average profit be more than the average loss per trade. It's easy to assume that something that has been so widely advised must be a good thing. However, if we take a deeper look at the relationship between profit and loss, it is clear that the "old", commonly held ideas may need to be adjusted. In this article, we'll look at this common trading advice in terms of the profit/loss ratio.

Profit/Loss Ratio
A profit/loss ratio refers to the size of the average profit compared to the size of the average loss per trade. For example, if your expected profit is $900 and your expected loss is $300 for a particular trade, then your profit/loss ratio is 3:1 - which is $900 divided by $300.

Many trading books and "gurus" advocate a profit/loss ratio of at least 2:1 or 3:1, which means that for every $200 or $300 you make per trade, your potential loss should be capped at $100.

At first glance, most people would agree with this recommendation. After all, shouldn't any potential loss be kept as small as possible and any potential profit be as much as possible? The answer is: not always. In fact, this common piece of advice can be misleading, and can cause harm to your trading account.

The blanket advice of having a profit/loss ratio of at least 2:1 or 3:1 per trade is over-simplistic because it does not take into account the practical realities of the forex market (or any other markets), the individual's trading style and the individual's average profitability per trade (APPT) factor, which is also referred to as statistical expectancy.

APPT is Key to Profitability
Average profitability per trade basically refers to the average amount you can expect to win or lose per trade. Most people are so focused on either balancing their profit/loss ratios or on the accuracy of their trading approach that they are unaware that a bigger picture exists: Your trading performance depends largely on your APPT.

This is the formula for average profitability per trade:

Average Profitability Per Trade = (Probability of Win x Average Win) - (Probability of Loss x Average Loss)

Let's explore the APPT of the following hypothetical scenarios:

Scenario A:
Let's say that out of 10 trades you place, you profit on three of them and you realize a loss on seven. Your probability of a win is thus 30% or 0.3, while your probability of loss is 70% or 0.7. Your average winning trade makes $600 and your average loss is $300.

In this scenario, the APPT is:

(0.3 x $600) – (0.7 x $300) = - $30

As you can see, the APPT is a negative number, meaning that for every trade you place, you are likely to lose $30. That's a losing proposition!

Even though the profit/loss ratio is 2:1, this trading approach produces winning trades only 30% of the time, which negates the supposed benefit of having a 2:1 profit/loss ratio.

Scenario B:
Now let's explore the APPT of a trading approach that has a profit/loss ratio of 1:3, but has more winning trades than losing ones. Let's say out of the 10 trades you place, you make profit on eight of them, and you realize a loss on two trades.

Here is the APPT:

(0.8 x $100) – (0.2 x $300) = $20

In this case, even though this trading approach has a profit/loss ratio of 1:3, the APPT is positive, which means you can be profitable over time.

Many Ways of Becoming Profitable
When trading the forex market, there is no one-size-fits-all money management or trading approach. Traditional advice, such as making sure your profit is more than your loss per absolute trade, does not have much substantial value in the real trading world unless you have a high probability of realizing a winning trade. What matters is that your APPT comes up positive and that your overall profits are more than your overall losses.

by Grace Cheng
Grace Cheng is a forex trader, creator of the PowerFX Course and author of "7 Winning Strategies for Trading Forex" (2007, Harriman House). This revealing book explains how traders can use various market conditions to their advantage by tailoring a strategy to suit each one. The book is a perfect complement to the PowerFX Course. The PowerFX Course, designed for both new and current traders, teaches tools and trading approaches that combine technicals, fundamentals and the psychology of trading forex. It also includes Grace's proprietary tips and tricks. Grace's works have been published in The Trader's Journal, Technical Analysis of Stocks & Commodities, Smart Investor and other leading trading/investment publications.

Visit her popular forex blog at www.GraceCheng.com.

Trading's 6 Biggest Losers

2008-09-19T23:21:00.000-07:00

Rogue trading makes headlines. The idea of a single person losing millions and occasionally billions of dollars is always interesting, but it is even more so when that person is losing other people's money.

In this article we will look at six of the rogue traders (in no particular order) who became famous for their very public losses.

Nick and the Nikkei - $1.3 Billion
Nick Leeson is probably the most famous rogue trader in the world. He even wrote a book on the subject, which was aptly titled "Rogue Trader" (1996). In 1992, he was the stereotypical rising star and his magic touch allowed him to become the head of Barings operations on the Singapore International Monetary Exchange - all at the tender age of 28.

But, he soon lost his trading touch and started to rack up a number of large losses. He used his position as both the head trader and the one responsible for settling trades in the office to hide his losses in a secret account, which was numbered 88888.

At the beginning of 1995, his trading losses were already significant when he had the enormous misfortune of placing a short straddle on the Nikkei, which was a bet that the market wouldn't make a large move overnight. However, the next day there was an earthquake in Kobe, which sent the Nikkei lower and led to a massive loss In an attempt to recoup these losses, Leeson made large risky bets that the Nikkei would recover quickly form the quake, which it didn't, leading to further losses.

In the end, Leeson lost an estimated $1.3billion for the bank, which resulted in the bankruptcy of Barings, a bank that had survived for more than two centuries in the industry. Leeson received a six-and-a-half year sentence but was released early for good behavior after being diagnosed with cancer.

John Rusnak and the Yen - $691 Million
John Rusnak of Allfirst Financial found failure in the Japanese yen. Initially, from when he was hired in 1993 and up until 1995, when the Asian markets were doing well, so did Rusnak. But, Rusnak started gambling and losing progressively larger amounts as the previously friendly markets turned against him in 1996. By 1997, Rusnak had lost $29.1 million. By 2001, he had lost $300 million. And, in a stroke of incredibly bad luck, he sold over $300,000 in options which brought his total losses to $691 million.

Like Leeson, it was Rusnak's ability to work the regulatory system to conceal his losses that allowed him to do much more damage than should have been possible. In the end, Rusnak received a jail sentence of seven-and-a-half years and is on the hook for paying back the $691 million.

Mr. Copper - $2.5 Billion
Yasuo Hamanaka, better known as Mr. Copper, was a trader for Sumitomo Corporation. Hamanaka specialized in, of course, copper. He is said to have controlled 5% of the world copper market, but failed in an attempt to corner the market. In 1996, Sumitomo Corp. disclosed $2.6 billion loss on copper trades.

The range of his activities and the time period in which they occurred (a full decade ending with a 1996 conviction and eight-year prison sentence) have raised questions about whether he was a rogue trader or simply a member of a price-fixing conspiracy. His conviction centered on his having forged his supervisor's signature in a letter, but the extent to which he went rogue is still in question.

Liu Qibing - $200 Million - $1 Billion (unconfirmed)
An even more mysterious 2005 copper caper occurred when Liu Qibing, a man who may or may not have been a metals trader for the Chinese government, took a huge bet (around 200,000 tons) that copper prices were going to fall. However, copper prices rose substantially over the life of the trade as global demand for copper increased, which led to massive losses on the trade.

As the paper trail led back to the Chinese State Reserve Bureau, other traders realized China would have to fill the amount shorted. This drove copper prices up. The Chinese government tried to depress prices by claiming copper reserves five-times larger than previously estimated and, in a bizarre twist, denied that a Liu Qibing had even existed to place a short. The extent of the losses are up for debate, as are the current whereabouts of the ephemeral Liu Qibing.

Brian Hunter and Amaranth - $6.5 Billion
Hedge fund traders get an easy ride when it comes to rogue trading because they are expected to take big risks, but Brian Hunter of Amaranth should be considered a textbook case.

His gambles in natural gas futures were initially successful, particularly so when Hurricane Katrina wreaked havoc on the infrastructure and pushed prices up while Hunter happened to hold a long position. The huge profits attracted more and more investors to Amaranth, providing Hunter with more capital to gamble with.

Sadly, Hunter's ability to predict the weather turned out to be no more consistent than the TV forecasters' and the natural gas futures turned on him. In one day, on September 14, 2006, Hunter lost $560 million alone. In total, he ended up losing around $6.5 billion, which led to closure of Amaranth.

Jerome Kerviel - $7.1 Billion
Surpassing even Hunter's losses, Jerome Kerviel has set the bar improbably high for future rogue traders. His losses from speculation in European futures cost his employer, Société Générale, more than $7 billion.

As with Leeson and Rusnak, Kerviel was able to manipulate the system using knowledge he gained while working in the office that monitored traders prior to being promoted to a trading position. He made no personal profit from his rogue trading. The 2007 mortgage meltdown probably hastened his fall from grace, but the highly leveraged and unapproved trades were bound to have disastrous consequences.

Conclusion
This is a far from complete list. It's missing Robert Criton, the scourge of Orange County, Peter Young and his propensity to wear women's clothes at trials, and many other equally compelling tales. At the heart of all of these, however, is the old tale of hubris. When a trader begins to feel that he or she has a special gift for sniffing out money-making positions, it can be a dangerous situation. Unfortunately, luck is a fickle friend. When these formerly magical traders start losing, they often look for ways to magnifying their bets and win back their losses.

Aside from the financial damages that rogue traders inflict upon the market, they do serve one very important function; they remind us that seeking exceptional returns means taking on equally exceptional risk. There is no magic trick that can change this fact, so an investor has to know how much risk he or she can safely handle as well as when to quit.

by Andrew Beattie,
Andrew Beattie is a freelance writer and self-educated investor. He worked for Investopedia as an editor and staff writer before moving to Japan in 2003. Andrew still lives in Japan with his wife, Rie. Since leaving Investopedia, he has continued to study and write about the financial world's tics and charms. Although his interests have been necessarily broad while learning and writing at the same time, perennial favorites include economic history, index funds, Warren Buffett and personal finance. He may also be the only financial writer who can claim to have read "The Encyclopedia of Business and Finance" cover to cover.

The Stop-Loss Order - Make Sure You Use It

2008-09-18T23:18:00.000-07:00

What with so many facets to look at and brood over when weighing a stock buy, it's easy to forget about the little things. The stop-loss order is one of those little things, but it can also make the world of difference. Just about everybody can benefit from this tool in some way. Read on to find out why.

What Is a Stop-loss Order?
It is an order placed with a broker to buy or sell once the stock reaches a certain price. A stop-loss is designed to limit an investor's loss on a security position. Setting a stop-loss order for 10% below the price at which you bought the stock will limit your loss to 10%. For example, let's say you just purchased Microsoft (MSFT) at $50 per share. Right after buying the stock you enter a stop-loss order for $45. This means that if the stock falls below $45, your shares will then be sold at the prevailing market price.

Positives and Negatives
The advantage of a stop order is you don't have to monitor on a daily basis how a stock is performing. This is especially handy when you are on vacation or in a situation that prevents you from watching your stocks for an extended period of time.

The disadvantage is that the stop price could be activated by a short-term fluctuation in a stock's price. The key is picking a stop-loss percentage that allows a stock to fluctuate day to day while preventing as much downside risk as possible. Setting a 5% stop loss on a stock that has a history of fluctuating 10% or more in a week is not the best strategy: you'll most likely just lose money on the commissions generated from the execution of your stop-loss orders.

There are no hard and fast rules for the level at which stops should be placed. This totally depends on your individual investing style: an active trader might use 5% while a long-term investor might choose 15% or more.

Another thing to keep in mind is that once your stop price is reached, your stop order becomes a market order and the price at which you sell may be much different from the stop price. This is especially true in a fast-moving market where stock prices can change rapidly.

A last restriction with the stop-loss order is that many brokers do not allow you to place a stop order on certain securities like OTC Bulletin Board stocks or penny stocks.

Not Just for Preventing Losses
Stop-loss orders are traditionally thought of as a way to prevent losses thus it's namesake. Another use of this tool, though, is to lock in profits, in which case it is sometimes referred to as a "trailing stop". Here, the stop-loss order is set at a percentage level below not the price at which you bought it but the current market price. The price of the stop loss adjusts as the stock price fluctuates. Remember, if a stock goes up, what you have is an unrealized gain, which means you don't have the cash in hand until you sell. Using a trailing stop allows you to let profits run while at the same time guaranteeing at least some realized capital gain.

Continuing with our Microsoft example from above, say you set a trailing stop order for 10% below the current price, and the stock skyrockets to $80 within a month. Your trailing-stop order would then lock in at $72 per share ($80 - (10% x $80) = $72). This is the worst price you would receive, so even if the stock takes an unexpected dip, you won't be in the red. Of course, keep in mind the stop-loss order is still a market order -- it's simply stays dormant and is activated only when the trigger price is reached -- so the price your sale actually trades at may be slightly different than the specified trigger price.

Advantages of the Stop-Loss Order
First of all, the beauty of the stop-loss order is that it costs nothing to implement. Your regular commission is charged only once the stop-loss price has been reached and the stock must be sold. It's like a free insurance policy!

Secondly, but most importantly, a stop loss allows decision making to be free from any emotional influences. People tend to fall in love with stocks, believing that if they give a stock another chance, it will come around. This causes procrastination and delay, giving the stock yet another chance and then yet another. In the meantime, the losses mount....

No matter what type of investor you are, you should know why you own a stock. A value investor's criteria will be different from that of a growth investor , which will be different still from an active trader. Any one strategy may work, but only if you stick to the strategy. This also means that if you are a hardcore buy-and-hold investor, your stop-loss orders are next to useless.

The point here is to be confident in your strategy and carry through with your plan. Stop-loss orders can help you stay on track without clouding your judgment with emotion.

Finally, it's important to realize that stop-loss orders do not guarantee you'll make money in the stock market; you still have to make intelligent investment decisions. If you don't, you'll lose just as much money as you would without a stop loss, only at a much slower rate.

Conclusion
A stop-loss order is such a simple little tool, yet so many investors fail to use it. Whether to prevent excessive losses or to lock in profits, nearly all investing styles can benefit from this trade. Think of a stop loss as an insurance policy: you hope you never have to use it, but it's good to know you have the protection should you need it.

by Investopedia.com,

Placing stops: The personal “risk-tolerance” myth

2008-09-17T23:16:00.000-07:00

The bad news: The market doesn’t care what you’re comfortable risking.
The good news: You don’t need to rely on your feelings to place stops.
BY ACTIVE TRADER STAFF

One of the most dangerous clichés in trading is that how much you risk is a matter of personal preference — akin to whether you like your meat medium
rare or medium, or your martinis straight up or on the rocks.

Have you ever listened to an industry speaker or author conclude a discussion
of a trade setup with the advice that you “always need to place a stop to protect
yourself”? When asked where that stop should be placed, the answer is often
something like, “Risk is a matter of personal preference. Every trader must determine what he or she is comfortable risking.”

In case you didn’t hear the “thump,” that was somebody punting. Most likely,
the person a) doesn’t have a clue where the stop should be placed, or worse, b)
knows that virtually any stop will hurt the strategy’s performance and doesn’t want to tell you that.

Besides the basic issue of whether stop-loss orders are always necessary or
advantageous, the hard truth is that effective stop placement is a challenge.
However, it does not have to be based on hunches or how comfortable you feel.

Imagine the following scenario:
You’re trading an instrument with an average daily range of one (1.00) point,
and each 1-point move represents $1,000. The average move (up or down)
from the close of one day to another is .75. The average weekly range (high to
low) is 2.5 and the average move from the close of one week to the next is 1.5.

Say you get a buy signal on Monday and go long on the close at 80; you expect
to make at least a 5-point profit on your trade. You want to protect your position
with a stop-loss order if the market goes against you. Where do you place it?
Should this decision simply be based on a dollar amount you feel “comfortable”
losing, as so many people often advise?

The basic information about this market’s average daily and weekly moves
provides a resounding “no” to this question. Say you have $20,000 in your trading account and you’ve decided you’re comfortable risking $1,000 on a trade. (We will ignore for the moment this represents a 5- percent risk of account equity — a high percentage by most standards.) Because a one-point move represents $1,000, you would have to place your stop at 79 to keep the trade in your comfort zone.

This trade plan might be psychologically comforting, but it’s also a virtually
guaranteed loss. Assuming this instrument keeps trading in line with its average
performance, you could expect price to be 1.5 points higher or lower when it
closes one week from now. If you bought at the absolute low for the week, you
might be lucky enough to see a 2.5-point gain sometime during the week. At any
rate, a 5-point move in one week is probably not in the cards.

On the other hand, the daily close-toclose move is .75, which means your 1-
point stop could be hit in less than two days. The average daily range is 1 point,
so if the next day’s high is lower than your entry price and the market is
falling, you could easily be stopped out in less than 24 hours.

Basically, you’ve put yourself in a position with a high probability of losing
because your stop placement is arbitrary — based on a “gut feeling” of how much money is appropriate to lose, rather than analysis.
In this case, the market itself — by virtue of its most basic price movement,
or volatility, statistics — was telling you a 1-point stop was not a good idea; to
stay in this position long enough to profit, you needed to use a wider stop.

This example obviously simplifies many facets of a trade. In practice, analysis
of a trade setup’s characteristics will help determine an appropriate stop. For
example, by analyzing 50 previous examples of the setup you were using for this
trade, you might have found that 55 percent of the time price fell 1.25 to 1.5 points below the entry price before rallying. To avoid the chance of getting stopped out on such moves, you could place your stop more than 1.5 points below the entry point. This might not feel “comfortable” to you, but it’s what the market is telling you is necessary.

Now let’s revisit the topic of trade risk as a percentage of account equity. In this
example, 5 percent of account equity was initially risked on the trade. One of
the more useful trading clichés is that professional money managers typically
risk only 1 to 2 percent of account equity per trade. Again, this is painting in
broad strokes, but it is true that the less capital you risk per trade, the less likely you are to be destroyed by a handful of large losing trades.

Risk becomes an increasingly more complex topic as you trade more instruments
and strategies. But keep in mind you always need to balance risk in two
fundamental ways: 1) as a dollar amount based on a percentage of total account
equity, and 2) as a percentage of the market price (the difference between
your entry price and your stop). Among other things, doing so will determine
how big your position should be.

For example, say you’re risking 2 percent of your account per trade representing
$2,000 (which means you have $100,000 in your account). You go long a stock at $50 using a tested strategy that indicates your stop should be three points away (at $47). To determine how many shares to buy, divide the amount of money you can risk on the trade by the stop size, in this case 2000/3, or 666 shares (rounded down).

So the next time someone describes a trading strategy and suggests you
should place a stop where you feel “comfortable,” remember one thing:
When it comes to stops, skip the comfort and go directly to the facts.

Trailing Stops

2008-09-16T23:15:00.000-07:00

Now that we have taken the necessary precautions to avoid catastrophic losses by using disciplined money management stops, it is appropriate to concentrate on strategies that are designed to accumulate and retain profits in the market. When properly implemented these strategies are intended to accomplish two important goals in trade management: they should allow profits to run, while at the same time they should protect open trade profits.

While their application is extremely wide, we do not believe that trailing stops are appropriate in all trading circumstances. Most of the trailing exits we will describe are specifically designed to allow profits to run indefinitely. Therefore they are best used with trend following type systems. In counter-trend trading, more aggressive exits are more suitable. The "when you've got a profit, take it" philosophy works best when you are trading counter-trend, since the anticipated amount of profits is limited. However, to take quick in a trend is usually an exercise in frustration: we exit the market with a small profit only to watch the huge trend continue to move in our direction for days or months after our untimely exit. We therefore recommend using different exit strategies based on the underlying market condition. We will discuss the more aggressive exits later; for now we will concentrate on exits designed to accumulate large profits over time.

A thorough understanding of trailing stops is critical for trend-following traders. This is because trend following is typically associated with a lower percentage of profitable trades; which makes it particularly important to capture as much profit as possible when those large but infrequent trends occur. Typical trend followers make most of their profits by capturing only a few infrequent but very large trends, while managing to cut losses effectively during the more frequent sideways markets.

The rationale behind the use of the trailing stop is based on the anticipation of occasional extremely large trends and the possibilities of capturing substantial profits during these major trends. If the entry is timely and the market continues to trend in the direction of the trade, trailing stops are an excellent exit strategy that can enable us to capture a significant portion of that trend.

The trailing stops we will describe in this and following articles have similar characteristics that are important to understand as we use them to design our trading systems. Effective trailing stops can significantly increase the net profits gained in a trend-following system by allowing us to maximize and capture large profitable trades. The ratio of the average winning trade to the average losing trade is usually improved substantially by the use of trailing stops. However there are some negative characteristics of these stops. The number of profitable trades is sometimes reduced since these stops may allow modestly profitable trades to turn into losers. Also, occasional large retracements in open trade profits can make the use of these stops quite difficult psychologically. No trader enjoys seeing large profits reduced to small profits or watching profitable trades become unprofitable.
The Channel Exit

The simplest process for following a trend is to establish a stop that continuously moves in the direction of the trend using recent highest high or lowest low prices. For example, to follow prices in an uptrend, a stop may be placed at the lowest low of the last few bars; for a downtrend, the stop is placed at the highest high of the last few bars. The number of bars used to calculate the highest high or lowest low price depends on the room we wish to give the trade. The more bars back we use to set the stop, the more room we give the trade and consequently the larger the retracement of profits before the stop is triggered. Using a very recent high or low point enables us to take a quick exit on the trade.

This type of trailing stop is commonly referred to as a "Channel Exit". The "channel" name comes from the appearance of a channel formed from using the highest high of X bars and the lowest low of X bars for short and long exits respectively. The name also derives from the popular entry strategy that uses these same points to enter trades on breakouts. Since we are focusing on exits and will be using only one boundary of the channel, the term "channel" may be a slight misnomer, but we will continue to refer to these trailing exits by their commonly used name.

For most of our examples we will assume that we are working with daily bars but we could be working with bars of any magnitude depending on the type of system we are designing. A channel exit is extremely versatile and can work equally well with weekly bars or five-minute bars. Also keep in mind that any examples referring to long trades can be equally applicable to short trades.

The implementation of a channel exit is very simple. Suppose we have decided to use a 20-day channel exit for a long trade. For each day in the trade, we would determine the lowest low price of the last 20 days and place our exit stop at that point. Many traders may place their stops a few points nearer or further than the actual low price depending on their preferences. As the prices move in the direction of the trade, the lowest price of the last twenty days continually moves up, thus "trailing" under the trade and serving to protect some of the profits accumulated. It is important to note that the channel stop moves only in the direction of the trade but never reverses direction. When prices fall back through the lowest low price of the last twenty days, the trade is exited using a sell stop order.

The first and obvious question to answer about channel exits is how many bars to use to pick the exit point. For example, should we set our stop at the lowest low of 5 days or the lowest low of 20 days, or some other number of days? The answer depends on the objectives of our system. A clearly stated set of objectives for the system is always very helpful at these important decision points. Do we want a long-term system with slow exits or do we want a short-term system with quicker exits? A longer channel length will usually allow more profits to accumulate over a long run if there are big trends. A shorter channel will usually capture more profits if there are smaller trends. In our research, we have found that long-term systems generally work well with a trailing exit at the lowest low or the highest high of the last 20 days or more. For intermediate term systems, use the lowest or highest price of between 5 to 20 days. For short-term systems, the lowest or highest price of between 1 to 5 days is usually optimal.

Trailing stops with a long-term channel accumulate the largest open profits if there is a sustained trend. However this method will also give back the largest amount of open profits when the stop is eventually triggered. Using a shorter channel can create a closer stop in order to preserve more open trade profits. As can be expected, the closer stop often does not allow profits to accumulate as nicely as the longer channel, and often causes us to be prematurely stopped out of a large trend. However, we have noticed that a very short channel length of between 1 to 3 bars is still highly effective in trailing a profitable trade in a runaway trend. The best type of channel exit to use in a runaway trend is a very short channel, for example 3 bars in length. We have observed that this exit in a strong trend often keeps us in a trade until we are close to the end of the trend.

It appears that there is a conflict of exit objectives here. A longer channel length will capture more profit but give back a large proportion of that profit; a shorter channel length will capture less profit, but protect more of what it has captured. How can we resolve this issue and create an exit that can both accumulate large profits, as well as protect these profits closely? A very effective exit technique calls for a long-term channel to be implemented at the beginning of the trade with the length of the channel gradually shortened as larger profits are accumulated. Once the trade is significantly profitable, or in a strongly trending move, the goal is to have a very short channel that gives back very little of the large open profit.

Here is an example of how this method might be implemented. At the beginning of a long trade, after setting our previously described money management stop to avoid any catastrophic losses, we will trail a stop at the lowest low of the last 20 days. This 20-day channel stop is usually far enough from the trade to avoid needless whipsaws and keep us in the trade long enough to begin accumulating some worthwhile profits. At some pre-determined level of profitability, which can be based on a multiple of the average true-range or some specific dollar amount of open profit, the channel length can be shortened to take us out of the trade at the lowest low of 10 days. If we are fortunate enough to reach another higher level of profitability, like 5 average true ranges of profit or some other large dollar amount, we can shorten the channel further so that we will exit at the lowest low of 5 days. At the highest level of profitability, perhaps a very rare occurrence, we might even be able to place our exit stop at the previous day's low to protect the great profit we have accumulated. As you can see, this strategy allows plenty of room for profits to accumulate at the beginning of a trade and then tightens up the stops as profits are accumulated. The larger the profits, the tighter our exit stop. The more we have, the less we want to give back.

There is another way of improving the channel exit that is worthwhile to discuss: this is to contract (or expand) the traditional channels using the height of the channel, or some multiple of the average true range. How this might work is as follows: Supposing you are working with a 20-day channel exit. First you calculate the height of the channel, as measured by the distance between the highest 20-day high and the lowest 20-day low. Then you contract the channel by increasing the lowest low value and decreasing the highest high value previously obtained to determine the exit points. For instance, in a long trade, you could increase the lowest low price by 5% of the channel height or 5% of the average true range, and use that adjusted price as your exit stop. This creates a slightly tighter stop than the conventional channel. More importantly, it allows you to execute your trade before the multitude of stops that are already placed in the market at the 20-day low.

The last point can be considered an important disadvantage of the channel exit. The channel breakout methods are popular enough to cause a large number of entry and exit stops to be placed at previous lowest low and highest high prices. This can cause a significant amount of slippage when attempting to implement these techniques in your own trading. The method of adjusting the actual lowest low or highest high price by a percentage of the overall channel height or the average true range is one possible way to move your stops away from the stops placed by the general public and thereby achieve better executions on your exits.
by Chuck LeBeau
Chuck Le Beau's System Traders Club

Jones V. Harris Associates: the Market (not the Courts) Should Set Fund Advisory Fees Background

2008-09-15T23:07:00.000-07:00

Defendant Harris Associates, L.P. serves as manager of the Oakmark Funds, open-end funds (typically mutual funds) without restrictions as to the amount of shares issued; the fund will buy back shares at current asset value whenever investors wish to sell. Open-end funds have grown in popularity because net returns have exceeded market average, and fund managers' compensation has grown commensurately.

Plaintiffs Jerry N. Jones, Mary P. Jones, and Arline Winderman - all individual investors in several of the Oakmark funds - argued that Harris Associates breached its fiduciary duty by charging excessive management/ advisory fees in violation of section 36(b) of the Investment Company Act of 1940. That provision states that fund advisors owe a fiduciary duty to the fund with respect to the compensation they receive related to their advisory role, and that an investor in that fund can bring an action for breach of this duty.

The district court granted summary judgment in favor of Harris Associates and the Plaintiff appealed. The Seventh Circuit's decision on appeal is found at Jerry N. Jones et al v. Harris Associates, L.P., 527 F.3d 627 (7th Cir. 2008).

Section 36(b) and the Gartenberg precedent
The district court ruled in favor of Harris Associates by following the precedent of Gartenberg v. Merrill Lynch Asset Management Inc., 694 F.2d 923 (2nd Cir. 1982) and concluding that Harris Associates' fees were "ordinary."

Gartenberg articulated two similar versions of a test to determine a violation of section 36(b): 1) "whether the fee schedule represents a charge within the range of what would have been negotiated at arm's-length in the light of all of the surrounding circumstances;" and/or 2) whether the advisor-manager charges "a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining." 694 F.2d at 928

The court noted that Oakmark Funds charge fees similar to those charged by similar funds, and that those fee structures are legal. 527 F.3d at 631. The court also noted that Oakmark funds have grown "more than the norm for comparable pools," suggesting that Oakmark funds are worth the fee expense. Id.
The Plaintiffs argued that the court should not follow Gartenberg for two reasons.

1) Gartenberg relies too heavily on market prices as the measure of reasonableness. The plaintiffs contended that this was inappropriate because fund fees are set incestuously (meaning that advisors dominate the market of mutual funds, which rarely change advisors) rather than by competition.
2) If any market is used as a benchmark, it should be the market for advisory services rendered to institutional clients, which pay lower fees. The Plaintiff claimed that the advisors should charge individual clients the same fees as those charged to institutional clients.

The court rejects Gartenberg while affirming the district court opinion
After reviewing support and criticism for the Gartenberg approach, the Seventh Circuit expressed its disapproval for Gartenberg. The court rejected the notion that the judiciary should play a role in regulating the rates charges by advisors except in the most extraordinary circumstances. Rather, the court firmly held that the market (fund trustees and investors, in the case of mutual funds) will dictate the appropriateness of a rate. If fund charges excessive rates, investors will move their money to another fund.

The court stated: "Section 36(d) does not say that fees must be 'reasonable' in relation to a judicially created standard. It says instead that the advisor has a fiduciary duty." 527 F.3d at 632. The court noted that the term "fiduciary duty" is familiar from the law of trusts, indicating a duty of "candor in negotiation, and honesty in performance" but leaving open the ability of the fiduciary to negotiate fairly for his own compensation. Id. When the settlor or persons charged with a trust's administration decide on a particular compensation for the fiduciary, that decision is final, not subject to judicial review except perhaps in instances of fraud. Id. The court wrote: "Judicial price-setting does not accompany fiduciary duties. Section 36(b) does not call for a departure from this norm." Id. at 633.

This same concept applies outside of the traditional trust realm - the court applied the concept to business corporations, lawyers, and more. In each such instance, the fiduciaries may bargain hard to demand substantial compensation, but the investors or clients - not the judiciary - make the ultimate decision regarding the fees paid.

The same theory applies in mutual funds, where a committee of independent directors sets the top managers' compensation without any judicial review for "reasonableness." Id. Market competition will ultimately weed out the businesses and funds that set compensation too high, because those funds will charge more, with fewer profits to distribute to investors, who may therefore go elsewhere with their investment dollars. Id.

The court rejected plaintiffs' arguments on appeal, finding that the competitiveness among funds for investors prevents funds from charging excessive fees. "Mutual funds rarely fire their investment advisors, but investors can and do "fire" advisers cheaply and easily by moving their money elsewhere." Id.. at 634. The court also rejected the plaintiffs' argument that institutional funds should provide the benchmark for fees, since institutional funds require a lower time commitment. Id.

Result: Courts will question fees only in exceptional circumstances
Courts that follow the Seventh Circuit's lead in the future will take a laissez-faire approach to fund manager/advisor fees. In order to successfully challenge fees as excessive under section 36(b) of the Investment Company Act of 1940, investors may have to demonstrate extraordinary facts like fraud and deception resulted in the fees charged.

Limiting Losses

2008-09-14T23:05:00.000-07:00

It is simply not possible for any trader - whether amateur, professional or anywhere in between - to avoid every single loss. The disciplined trader is fully cognizant of the inevitability of losing hard-earned profits and, as such, is able to accept losses without emotional upheaval. At the same time, however, there are systematic methods by which you can ensure that losses are kept to a minimum.

The System/span>
Every trader should employ a loss-limit system whereby he or she limits losses to a fixed percentage of assets, or a fixed percentage loss from capital employed in a single trade. Think of such a system as a circuit breaker, or collar, on the trade. After a certain percentage has been lost from his or her trading account or principal traded, the trader may very well stop trading entirely or may immediately exit the losing position. With this system, exiting a losing position is a single, unemotional decision that is not affected by any hopes that “the market is sure to turn around any minute now.”

A 2% Limit of Loss
A common level of acceptable loss for one's trading account is 2% of equity in the trading account. The capital in your trading account is your risk capital, the capital that you employ (that you risk) on a day-to-day basis to try to garner profits for your enterprise.

The loss-limit system can even be implemented before entering a trade. When you are deciding how much of a particular trading instrument to purchase, you would simultaneously calculate how much in losses you could sustain on that trade without breaching your 2% rule. When establishing your position, you would also place a stop order within a maximum of 2% loss of the total equity in your account. Of course, your stop can be anywhere from a 0% to 2% total loss. A lower level of risk is perfectly acceptable if the individual trade or philosophy demands it.

Every trader has a different reaction to the 2% rule of thumb. Many traders think that a 2% risk limit is too small and that it stifles their ability to engage in riskier trading decisions with a larger portion of their trading accounts. On the other hand, most professionals think that 2% is a ridiculously high level of risk and prefer losses to be limited to around 0.5-0.25% of their portfolios. Granted, the pros would naturally be more risk averse than those with smaller accounts - a 2% loss on a large portfolio is a devastating blow. Regardless of the size of your capital, it is wise to be conservative rather than aggressive when first devising your trading strategy.

Monthly Loss Limit of 6%
So, you have now established a system whereby your loss from each individual trade is limited to 2% of your risk capital. But it doesn't take a rocket scientist to realize that even losing a moderate 1% of your account's value in ten days within a month results in a rather devastating 10% of your account's value within that month (not withstanding any profits that you might have made in the other 12 odd trading days within the month). In addition to limiting losses from individual trades, we must establish a circuit breaker that prevents extensive overall losses during a period of time.

A useful rule of thumb for overall monthly losses is a maximum of 6% of your portfolio. As soon as your account equity dips to 6% below that which it registered on the last day of the previous month, stop trading! Yes, you heard me correctly. When you have hit your 6% loss limit, cease trading entirely for the rest of the month. In fact, when your 6% circuit breaker is tripped, go even further and close all of your outstanding positions, and spend the rest of the month on the sidelines. Take the last days of the month to regroup, analyze the problems, observe the markets and prepare for re-entry when you are confident that you can prevent a similar occurrence in the following month.

How do you go about instituting the 6% loss-limiting system? You have to calculate your equity each and every day. This includes all of the cash in your trading account, cash equivalents and the current market value of all open positions in your account. Compare this daily total with your equity total on the last trading day of the previous month and, if you are approaching the 6% threshold, prepare to cease trading.

Employing a 6% monthly loss limit allows the trader to hold three open positions with potential for 2% losses each, or six open positions with a potential for 1% losses each and so forth.

Making Necessary Adjustments
Of course, the fluid nature of both the 2% single trade limit and the 6% monthly loss limit means that you must re-calibrate your trading positions every month. If, for example, you enter a new month having realized significant profits the previous month, you will adjust your stops and the sizes of your orders so that no more than 2% of the newly calculated total equity is exposed to a risk of losses. At the same time, when your account rises in value by the end of the month, the 6% rule of thumb will allow you to trade with larger positions the following month. Unfortunately, the reverse is also true: if you lose money in a month, the smaller capital base the following month will ensure that your trading positions are smaller.

Both the 2% and the 6% rule allow you to pyramid, or add to your winning positions when you are on a roll. If your position runs into positive territory, you can move your stop above breakeven and then buy more of the same stock - as long as the risk on the new aggregate position is no more than 2% of your account equity, and your total account risk is less than 6%. Adding a system of pyramiding into the equation allows you to extend profitable positions with absolutely no commensurate increase in your risk thresholds.

Conclusion
The 2% and the 6% rules of thumb are highly recommended for all traders, especially those who are prone to the emotional pain of experienced losses. If you are more risk averse, by all means, adjust the percentage loss limiters to lower numbers than 2% and 6%. It is not recommended, however, that you increase your thresholds - the pros rarely stray above such potential for losses, so do think twice before you increase your risk thresholds.

by Jason Van Bergen, investopedia.com

Trade What You Know and Know What You Trade

2008-09-13T23:03:00.000-07:00

Those who haven’t worked in the industry may not be aware that nowadays most investment bank traders will only trade one particular sector or cross rate or country. This has not necessarily always been the case. When I first started in the industry as an 18 year old trading Japanese warrants in 1989 all the banks involved in that market divided their trading books into alphabetical order. For example, I traded all warrants whose company names were from S to Z such as Sumitomo Chemical and Toyota. While this arrangement had seemed to work during the bull market years, it was only when the market got tougher during the crash years that banks realised that it would be far better to divide the trading books by sector as there was no discernable correlation between the contracts we were trading and it was possible for example for all traders to be taken short in say steel stocks because they started with different letters and were therefore traded by different traders.

Similarly, in recent years the number of traders who are allowed to trade a variety of products has been reduced too in an effort to smooth out the performance of trading desks. Without a doubt these are among the reasons why on the whole the performance of bank trading desks has become more consistent.

Futures pit locals also stood in one pit all day and every day and now that most futures markets are screen based the majority of consistently profitable futures traders still trade one contract or spread, day in and day out. By doing this traders become better acquainted with how their markets trade and get a better idea of where opportunities are in their market as opposed to risk. There is another equally important facet to this type of trading and that is by knowing his/her market a trader is less likely to incur losses from a lack of knowledge of that product. To illustrate what I mean by this I will describe a few situations that I have personally witnessed.

When the LIFFE floor was in full flow there were a few traders who arbitraged between the prices of Bund futures on LIFFE and the DTB (now Eurex). Both contracts had similar specifications and so this style of trading had little downside. When the markets went screen based, the French Exchange listed a Gilt Futures contract to compete with LIFFE. A group of very successful Bund arbitrageurs decided to arbitrage between these contracts and couldn’t believe their luck when the French contract listed with a large price discrepancy to the LIFFE contract.

They began to short one contract and buy the other but the prices did not change. Eventually a third party I believe realised what was going on and contact was made with this group of arbitrageurs to explain to them that the two contacts had completely different specifications and while their prices were different their yields were the same. I believe that each arbitrageur lost in the region of GBP 75,000 in only a few hours as a result of this lack of due diligence.

Similarly a convertible bond team at a major US bank suffered huge losses from not understanding the intricacies of a new style of preference CB and they traded them as if they were standard CBs. In both these example we are not talking about inexperienced traders but traders with great experience and who were until then highly profitable.

These are just two of many similar instances that I can recall over my career thus far which is why I am such a firm believer in the due diligence process and why I advocate to my clients to know what you trade and trade what you know. Sometimes if you trade a contract or product which you know little about the opportunity which you think you are spotting is actually not an opportunity but a mistake. I saw this particularly with some highly intelligent quantitative CB traders that I worked with who would scan for great trades only to be told by a more experienced trader that there were reasons why they looked like great trades which were usually because of some specific market nuances. They were in fact not great opportunities and the ‘cheap’ bonds they had found wee cheap for a good reason!

I remember a trader at one bank that I worked at, upon moving from the Gilt trading desk to a general proprietary desk where he could trade anything, told me that he found his new position far harder. There were so many contracts and products to choose from there seemed like there were opportunities everywhere, whereas his experience told him that many of these ‘opportunities’ were more likely to be risk. He in fact asked to go back to the Gilt desk because he felt he could make far more money just trading that one contract because he knew it so well.

While banks and bank trades now realise that they will actually make more money by specialising, private traders believe they are knowledgeable about a variety of markets and trade accordingly. Often they are encouraged by technical analysis supporters who believe that the same methods of analysis can be applied to all markets. Indeed this is one of the reasons why technical analysis is so popular among private traders because it supposedly gives them a way of analysing any market they choose. Traders often scan hundreds or thousands of stocks or contracts through their chosen system looking for the ones which seem to offer the best opportunity. However in doing this they increase the chances of trading something they know little about and therefore open up the potential for losses such as those I have described.

Some traders initially think that their opportunities will be less if they specialise in one or two sectors, but what they find is that there are still enough to make money. More importantly, their trading becomes more consistent and they start to eliminate some of the avoidable losses that dogged their trading from time to time. In fact even some technical traders have admitted to me that they seem to do better on the contracts that they know more about and acknowledge that rather than their technical skills being the reason for their profits it may well be their knowledge that is helping them.

As with all of my views and beliefs this is based solely on my experiences. When I began my trading career at the age of 18 I had not read any books or attended any seminars by traders. I have learned my trading from the profits and losses of myself and the traders that I have worked closely with. I guess this is one advantage of working on trading floors in that I have been able to watch others trade and do not have to rely on stories which may or may not be embellished. It is my feeling based on this experience that every trader would benefit from knowing what they trade and trading what they know.

Gary Norden is a former options market maker on LIFFE, has managed derivative trading desks, and is now is Director of Marketwise Trading & Consulting. http://trade2win.com

Assessing Market Behavior with the Herrick Payoff Index and New High-New Low Index

2008-09-12T23:01:00.000-07:00

Assessing the market's psychology is any trader's or investor's ultimate goal as today's actions determine tomorrow's consensus of value (the prices of stocks, futures, options, commodities, etc.). There are some fairly esoteric indicators (and more being constructed all the time) that are used to refine well-known measures for the purpose of creating more valid predictors of market behavior, for the present and the future.

Some of the more interesting (and often complex) measures of crowd psychology include the Herrick Payoff Index (HPI) and the new-high new-low index (NH-NL). (I am indebted to Dr. Alexander Elder for rendering these complex indicators understandable.)

Herrick Payoff Index
John Herrick's technical index tracks volume, price and open interest into an aggregate value that is meant to capture trends and their reversals. HPI uses daily high and low prices, volume and open interest - preferably of all contracts (futures and options) - from a period of at least three weeks. HPI applies these to prices of the most active delivery month. Instead of using closing prices, the HPI measures mean prices, which are the average consensus of value for the day. Quite simply, when volume increases, the absolute value of the HPI also increases.

Further, you may remember that a rising open interest is a bullish signal in an uptrend and a bearish signal in a downtrend. Conversely, a falling open interest is a bearish signal in an uptrend and a bullish signal in a downtrend. A flat open interest is neutral. We can apply these principles to the HPI: when it breaks its longer-term trend line, it gives a leading signal, indicating that a price trend is likely to be broken through. When HPI crosses its center line, the price trend is confirmed.

But we can extend these principles further: when prices reach a new low but the HPI records a higher volume than a previous decline, a buy signal is issued (this is a bullish divergence). When the HPI turns up from this second bottom, the trader has an opportunity to place a protective stop below the latest low price. The corresponding bearish divergence occurs when prices hit a new high, but the HPI reaches a lower top. The short-sell signal occurs when the HPI turns down, so the trader would use a stop above the latest high. The Herrick Payoff Index is an excellent indicator of the market's overall bullishness or bearishness. When the HPI is above its center line, bulls are in control. When the HPI lies below the center, a trader would be wise to sell short.

New-High New-Low Index (NH-NL)
Applicable only to the stock market, the NH-NL measures how many stocks have reached new highs and how many stocks have reached new lows on any given trading day. The numerical value for NH-NL is simply the result of new lows subtracted from new highs, and is often used to predict a new market bottom or top when it diverges from actual prices.

For any given stock, a new high is reached when the bulls are utterly in control; a new low indicates that a plethora of bears have ganged up on the bulls to drive the stock ever downward. The NH-NL acts as a leading indicator to the market's bullishness or bearishness: when NH-NL rises above its center line, the bulls lead the market. When it falls below the center line, the bears are the market's leaders. If both the market and the NH-NL reach new highs, the bullish trend is likely to continue. When both market and NH-NL reach new lows, bearishness will likely persist.

Divergences are also extremely important in interpreting the NH-NL. If the market rallies, but NH-NL declines, the uptrend is likely reaching its high point. Similarly, if NH-NL hits a lower peak than the market's new high, a bearish divergence is realized. This means that the rampaging bulls are weakening somewhat. If stocks fall but NH-NL moves higher, an uptrend may be imminent. If the NH-NL reaches a shallower bottom than a new low, the bullish divergence indicates that bears are beginning to lose their strangle-hold.

In absolute numbers, a major reversal is often considered to be a peak in NH-NL at +100 or less. If higher than +100, the market may not collapse, but it will likely not hit new highs. If the NH-NL low approaches -100, then a major upside reversal is imminent. If, however, NH-NL is lower than -100, the downtrend is losing a bit of strength, but it will probably not immediately reverse course to the upside.

The NH-NL also indicates appropriate trading actions for existing open positions. If NH-NL rises, long positions can be held and even increased. If, however, NH-NL declines when the market rallies, long positions should be liquidated. Falling NH-NL confirms short positions; but shorts need to be covered if the market falls and NH-NL rises. On a flat market day, a rising NH-NL is a bullish message, and a falling NH-NL encourages shorts. Over the long term, if NH-NL is negative for some time then suddenly rises above the center line, a bull market is nigh. If it stays positive for a long time before falling below the center line, your best position is short.

by Jason Van Bergen,

What Is An Emerging Market Economy?

2008-09-11T23:00:00.000-07:00

A term coined in 1981 by Antoine W. Van Agtmael of the International Finance Corporation of the World Bank, an emerging, or developing, market economy (EME) is defined as an economy with low-to-middle per capita income. Such countries constitute approximately 80% of the global population, representing about 20% of the world's economies.

Although a loose definition, countries whose economies fall into this category, varying from very big to very small, are usually considered emerging because of their developments and reforms. Hence, even though China is deemed one of the world's economic powerhouses, it is lumped into the category alongside much smaller economies with a great deal less resources, like Tunisia. Both China and Tunisia belong to this category because both have embarked on economic development and reform programs, and have begun to open up their markets and "emerge" onto the global scene. EMEs are considered to be fast growing economies.

What an EME Looks Like
EMEs are characterized as transitional, meaning they are in the process of moving from a closed to an open market economy while building accountability within the system. Examples include the former Soviet Union and Eastern bloc countries. As an emerging market, a country is embarking on an economic reform program that will lead it to stronger and more responsible economic performance levels, as well as transparency and efficiency in the capital market. An EME will also reform its exchange rate system because a stable local currency builds confidence in an economy, especially when foreigners are considering investing. Exchange rate reforms also reduce the desire for local investors to send their capital abroad (capital flight). Besides implementing reforms, an EME is also most likely receiving aid and guidance from large donor countries and/or world organizations such as the World Bank and International Monetary Fund.

One key characteristic of the EME is an increase in both local and foreign investment (portfolio and direct). A growth in investment in a country often indicates that the country has been able to build confidence in the local economy. Moreover, foreign investment is a signal that the world has begun to take notice of the emerging market, and when international capital flows are directed toward an EME, the injection of foreign currency into the local economy adds volume to the country's stock market and long-term investment to the infrastructure.

For foreign investors or developed-economy businesses, an EME provides an outlet for expansion by serving, for example, as a new place for a new factory or for new sources of revenue. For the recipient country, employment levels rise, labor and managerial skills become more refined, and a sharing and transfer of technology occurs. In the long-run, the EME's overall production levels should rise, increasing its gross domestic product and eventually lessening the gap between the emerged and emerging worlds.

Portfolio Investment and Risks
Because their markets are in transition and hence not stable, emerging markets offer an opportunity to investors who are looking to add some risk to their portfolios. The possibility for some economies to fall back into a not-completely-resolved civil war or a revolution sparking a change in government could result in a return to nationalization, expropriation, and the collapse of the capital market. Delicate exchange rate fluctuations could transform into an all-out devaluation resulting merely from investors speculating in the possibility of political disorder or losing faith in the banking system. Because the risk of an EME investment is higher than one of a developed market, panic, speculation and knee-jerk reactions are also more common - the 1997 Asian crisis, during which international portfolio flows into these countries actually began to reverse themselves, is a good example of how EMEs can be high-risk investment opportunities.

However, the bigger the risk, the bigger the reward, so emerging market investments have become a standard practice among investors aiming to diversify while adding risk.

Local Politics vs. Global Economy
An emerging market economy must have to weigh local political and social factors as it attempts to open up its economy to the world. The people of an emerging market, who before were protected from the outside world, can often be distrustful of foreign investment. Emerging economies may also often have to deal with issues of national pride because citizens may be opposed to having foreigners owning parts of the local economy.

Moreover, opening up an emerging economy means that it will also be exposed to not only new work ethics and standards but also cultures as well: indeed the introduction and impact of, say, fast food and music videos to some local markets has been a by-product of foreign investment. Over the generations, this can change the very fabric of a society and if a population is not fully trusting of change, it may fight back hard to stop it.

Conclusion
Although emerging economies may be able to look forward to brighter opportunities and offer new areas of investment for foreign and developed economies, local officials of EMEs need to consider the effects of an open economy on its citizens. Furthermore, investors need to determine the risks when considering investing into an EME. The process of emergence may be difficult, slow and often stagnant at times. And even though emerging markets have survived global and local challenges in the past, they had to overcome some large obstacles to do so.

by Reem Heakal, investopedia.com

38-STEPS TO BECOMING A SUCCESSFUL TRADER

2008-09-10T22:56:00.000-07:00

Steps to Successful Commodities Futures Trading as published in Commodity Futures Trading Club News
and in Traders Organization's Real Success Daytrading Course

We accumulate trading information - buying books, going to seminars and researching.
We begin to trade with our 'new' knowledge.
We consistently 'donate' and then realize we may need more knowledge or information.
We accumulate more information.
We switch the commodities we are currently following.
We go back into the market and trade with our 'updated' knowledge.
We get 'beat up' again and begin to lose some of our confidence. Fear starts setting in.
We start to listen to 'outside news' & other traders.
We go back into the market and continue to donate.
We switch commodities again.
We search for more trading information.
We go back into the market and continue to donate.
We get 'overconfident' & market humbles us.
We start to understand that trading success fully is going to take more time and more knowledge then we anticipated.

--------------------------------------------------------------------------------
Many Traders Will Give up at this Point as they Realize Work is Involved
We get serious and start concentrating on learning a 'real' methodology.
We trade our methodology with some success, but realize that something is missing.
We begin to understand the need for having rules to apply our methodology.
We take a sabbatical from trading to develop and research our trading rules.
We start trading again, this time with rules and find some success, but overall we still hesitate when it comes time to execute. We start trading again, this time with rules and find some success, but overall we still hesitate when it comes time to execute.
We add, subtract and modify rules as we see a need to be more proficient with our rules.
We go back into the market and continue to donate. We go back into the market and continue to donate.
We start to take responsibility for our trading results as we understand that our success is in us, not the trade methodology.
We continue to trade and become more proficient with our methodology and our rules.
As we trade we still have a tendency to violate our rules and our results are erratic.
We know we are close.
We go back and research our rules.
We build the confidence in our rules and go back into the market and trade.
Our trading results are getting better, but we are still hesitating in executing our rules.
We now see the importance of following our rules as we see the results of our trades when we don't follow them.
We begin to see that our lack of success is within us (a lack of discipline in following the rules because of some kind of fear) and we begin to work on knowing ourselves better.
We continue to trade and the market teaches us more and more about ourselves.
We master our methodology and trading rules.
We begin to consistently make money. We begin to consistently make money.
We get a little overconfident and the market humbles us.
We continue to learn our lessons.
We stop thinking and allow our rules to trade for us (trading becomes boring, but successful) and our trading account continues to grow as we increase our contract size.
We are making more money then we ever dreamed to be possible.
We go on with our lives and accomplish many of the goals we had always dreamed of.

from -- http://www.commodities-futures.com/

9 Fund of Hedge Fund Database Tips

2008-09-09T22:54:00.000-07:00

If you need a list of hedge fund of funds or are thinking of purchasing a fund of hedge fund directory or database here are my top 9 tips:

Take the time to call or at least email the firm who offers a fund of hedge fund database, these will sometimes be referred to as fund of hedge fund or fof directories.
Only work with well known, reputable firms that specialize in providing hedge fund databases or hedge fund of fund databases. Avoid small shop fly-by-nighters at all costs
Take the time to really get familiar with the information provided within the database, ask for a sampleof what the information will look like. It really is an investment that could save you literally thousands of hours IF you pick the right hedge fund database for your business model. See a Hedge Fund of Fund of Hedge Fund Database Sample.
Ensure that the database is updated at least once a quarter, contact details and firm information gets old very quickly.
Expect to pay $750-$8,000 for a high quality hedge fund database, many cost around $2,800 while others can cost up to $30,000/year. Be sure and know the trade-offs of buying a physical database versus subscribing to one online. If you don't have a hard copy of the data in Excel or Access format you may not be able to use it once a time-based subscription expires. For some firms this is fine, for others it would be a costly mistake.
Make sure the hedge fund database you use is compatible with your systems. Do you use SalesForce? Act? Goldmine? Excel? Word?(lord help you)
While you are kicking the tires of your potential new hedge fund database make sure it has complete information on a firm. You don’t want to call a firm asking if you can send over your PowerPoint presentation only to find out they are really a competitor or a division within another firm you called that same day.
Don’t steal a database. This may sound obvious, but it is common for employees to copy parts of a database for later use or use some other un-ethical means of obtaining database details. Don’t, it is not worth it. Always take the high road and you can stand behind every action you have ever taken.
This list only contains 9 tips instead of 10 because this one is worth more than the rest combined. Ask hard questions when you are buying fund of hedge fund database. Ask how often your database details will be updated. Ask exactly how many hedge funds are updating their information. Some databases will say that they have details on 9,000 hedge funds while the reality is that some of them haven't updated their information in 4 years...make sure all of the data is being updated at least once a year.

- Richard - http://richard-wilson.blogspot.com

The Running of the Hedgehogs

2008-09-08T22:49:00.000-07:00

Byron Wien, one of the most popular commentators in the history of Wall Street, left a cushy job at Morgan Stanley in 2005 in order to join Pequot Capital, a hedge fund, as chief investment strategist. He apparently wasn’t forced to take the industry’s vow of omertà. When asked to explain the staggering growth of late, he puts it quite simply: “One of the main reasons is that it became legitimate for institutions to invest. In the early days, you signed up in a dark alley with a flashlight. Today, a typical institutional portfolio now has about 15 to 25 percent in such alternative investments.”

There’s no need for flashlights anymore, but the industry still has its critics, who voice everything from concern about leverage and lemminglike rushes that could threaten the stability of global markets to disgust at the astronomical fee arrangements. No less an authority than Warren Buffett has accused the industry of selling hokum, calling the typical compensation structure a “grotesque arrangement.” But whom did Business Week suggest as “the next Warren Buffett”? That would be Eddie Lampert, a hedge-fund manager.

The big are getting colossal.
A year ago, there were only four $20 billion–plus outfits; now, there are seven—JPMorgan, Goldman, Bridgewater Associates, D.E. Shaw, Farallon Capital, Renaissance Technologies, and Och-Ziff Capital. The first U.S. hedge fund to offer its stock to the public, Fortress, gained 67.6 percent on its first day of trading. There will be more firms taking that path.

They’re suffering from wandering eyes.
Among the big players, it is now almost impossible to find a pure hedge fund—meaning one that sticks to a specific investing style or niche. When you have so much money to invest, you can be forced out of your own specialty, lest you end up trading with yourself. SAC Capital just joined KKR, for example, in a $3.8 billion bid for an education company. Some funds are going so far as to invest in the movies.

They’re searching for a needle in a very large haystack.
Ask any hedge-fund manager, and he will tell you that the easy money has already been made, and there are no “obvious trades” sitting around. A recent report by the European firm Dresdner Kleinwort points out that if 4 percent of assets under management go to fees, and another 4 to 5 percent is spent on trading commissions and interest, hedge funds would need to pull in 20 percent annually to justify their costs. That forces them to take ever greater risks.

The club is no longer taking in as many new members.
Believe it or not, it’s harder to start a hedge fund now than it was a few years ago. According to Hedge Fund Research, in 2006, 1,518 hedge funds launched, compared with 2,073 in 2005. Robert Merton, a Nobel Prize–winning economist, couldn’t raise enough to launch a fund last year and abandoned his effort. Not that it can’t be done if you have the right team and a prior track record. Don Morgan, the former head of high yield at MacKay Shields, left in 2006 to found Brigade Capital. Because of non-hire agreements, he waited a year to launch a long/short credit-focused hedge fund so that most of his former team could join him. The result: At a time when you need at least $100 million in committed investor funds as table stakes, Brigade earned a seat at the table on day one.

Obscene fees are becoming … wait for it … even more obscene.
Hedge funds are one of those unlikely industries where the newcomers charge more than old hands. In one sense, this is crazy: The most lopsided arrangement in finance—you win, I win/you lose, I win—is getting even more perverse in its tilt.

But it can’t go on forever, can it? It’s likely that fees will come down if only because of competition itself, but it won’t be anytime soon. At least not while institutional investors continue to throw money at this bandwagon. Cliff Asness of AQR Capital puts it this way: “We often hear in hedge-fund circles that institutions are coming to the hedge-fund world, so fees must fall, as institutions are fee-sensitive. Can this be the world’s first example of predicting that massive demand for a product will lower fees?”

The government is getting nosy.
In 2004, the SEC required hedge funds to register with the agency, which was kind of like getting 19-year-olds to register for the draft. It didn’t have any immediate consequences, but it could lead to something serious. The courts then threw that rule out, and regulatory talk died down until the Connecticut-based fund Amaranth lost about $6 billion on natural-gas futures last year. It’s died down yet again, but is only one meltdown or scandal from flaring back up. All the big hedge funds have bulked up their lobbying budgets of late.

Investment banks are morphing into hedge funds.
If you can’t beat ’em, join ’em, right? More and more, Goldman Sachs and its ilk are making their money from proprietary trading, which means, simply, the managing of their own assets rather than, say, yours. These operations now dwarf many traditional investment-banking practices, like mergers and acquisitions. Goldman Sachs produces hedge-funders like the Dominican Republic produces shortstops. About one in five of the world’s top hedge-fund managers used to work at Goldman. So, hedge funds really are something of a cabal.

Given hedge funds’ uneven performance of late, why has the flood of money not tapered off?

Well, for one, the appetite for risk among investors seems to be at some kind of historical high. But paradoxially, it’s also a desire for downside protection. The popularity of hedge funds still has a lot to do with how they performed five years ago. Seriously. During the bear market of 2000 to 2002, when the market fell 40 percent following the dot-com collapse, the average hedge fund didn’t lose money.

With severe losses still fresh in their memories, pension-fund managers and other institutional investors are perfectly happy to shave a little off the top for that kind of downside protection. The question is in how many funds it still exists.

The limelight awaits.
Many successful managers are doing what anyone with a newfound fortune does: trying to get close to political power (via donations) or the social elite (via philanthropy and art-world involvement). Marc Lasry of Avenue Capital recently hired Chelsea Clinton as an analyst.

And now for the doomsday scenario.
The only year that assets under management declined in the history of hedge funds was in 1994. Why? Rising interest rates and the digestion of the massive growth of the previous few years. Sounds familiar, doesn’t it? A sharp spike in interest rates could be devastating to an industry that relies so heavily on borrowed money.

Citadel, for example, had balance-sheet leverage of 11.5x last year—meaning it had borrowed more than eleven times more money than it actually had at the time, ballooning its gross-asset exposure to some $150 billion. This level of leverage adds tremendous risk. One prominent hedge-fund manager told me that any single hedge fund, other than three he could think of, could blow up and not really have any effect on the broader markets. But if one of the three did—and he named Citadel in that group—then the dominoes could start to tumble.

So, in the end, when someone blurts out, “Hedge funds are a venal get-rich scheme that we’ll all end up paying for,” should you nod solemnly like you agree? No, don’t do that. Try instead to crib the argument of an actual hedge-fund manager: “The proliferation of hedge funds has both decreased volatility in the market and increased the long-term risk of a systematic collapse.

In the first case, it’s because hedge funds are more nimble than traditional long-only funds and can swoop in and correct market mispricings before they can get extreme. But it also means opportunities become fewer. And because hedge funds need good returns through the cycle, this reduced opportunity forces them to take more and more risk, increasing their exposure to risky investments, which, in the long term, will increase the likelihood of a systematic panic in the market.” In their report, the Dresdner Kleinwort analysts had their own term for just such a panic; they called “the great unwind.” You’ll know when it happens because in addition to dire headlines and more histrionics than usual on CNBC, the value of your Manhattan apartment will suddenly drop by half.

Don’t worry too much, though.
While the Dresdner analysts termed the likelihood of it inevitable, they concede that it’s not exactly predictable. Which means that it will happen, but it could be tomorrow or it could be in 100 years, when all of Manhattan will be underwater and your apartment won’t be worth anything anyway.

Consecutive Losses and the Trading Psychology Spiral

2008-09-07T22:46:00.000-07:00

You go long and the market immediately goes down - you go short and the market immediately goes up. That's 2 consecutive losses, and you are getting a little 'anxious' so you don't take the 'next' trade. Of course, this trade is a winner. Now to make the situation worse, you then 'chase' the move, and as soon as you enter the trade it immediately reverses, thus giving you another loss – this is now 3 in a row. Ok one more ‘try’ - this can't happen on every trade can it?

This time though, you will be real clever. You have noticed that the market is in a range, and it's the bounce from the low/retrace from the high that is causing all the problems. So this time, the next trade you take will be a range extreme fade AND the hell with your trading method. The market is at the range low, and per your new ‘on the fly’ trading plan, you go long. Instead of bouncing again, the range immediately breaks out to the downside. Not only does this give you consecutive loser 4, but the loss occurred from trading against one of your ‘best’ method trade setups, and becomes a trade which is giving enough profit to pay for the previous 3 losers, and make you net ahead.

Now what are you supposed to do – QUIT? AND to be sure that there is no more temptation – your throw your computer out the window, and dive out right behind it. You are in a trading psychology spiral.

WHAT is a Trading Psychology Spiral?
I think of a trading psychology spiral as the transition from trading losses that you have accepted both as a part of your trading method, and as something that is inevitable in trading, into a surge of emotions that continually builds to a point where you can no longer accept anything. As this eventually ‘spirals’ out of control – trading method becomes completely ignored, and is then replaced by emotional responses and decisions for everything that is done. Even if quitting was really the only viable thing to do at the time, the trading psychology spiral can cause an emotional response where this isn’t even considered, until the situation becomes so desperate, that the trader can’t take it any longer AND does have to quit.

This isn’t a discussion about emotions and trading, and the various fears and issues that keeps a trader from trading to begin with; as we know, emotions are an inherent part of trading – you learn to control them OR you can’t trade. This is a discussion about emotions that are typically controlled well enough so that you ‘can’ trade, but then something happens where the trader loses that control, and their emotions spiral. A series of consecutive losing trades, especially those caused by deviating from the trading plan, are a root cause for this happening.

This also isn’t about something that happens only to inexperienced and unprofitable traders. There are going to be those times where nothing a trader does will work, and that result is going to be a series of consecutive losers. So the situation is the same, it’s the reaction that may be different. For instance, traderA may go into a panic causing them to spiral out of control, losing all self-confidence and self-trust, and ultimately more money than was intended. On the other hand, traderB may go into a period of revenge trading, coupled with an increase of their trading size, as they are ‘sure’ that each next trade is going to bring them back to even. Also, a spiral out of control, and the losses continue – AND also a loss of more money than was intended. WHAT does traderC do?

Controlling The Trading Psychology Spiral
Consider: each time a tpsych spiral occurs AND you go out of control - the quicker the next spiral is going to occur, and the faster you will go out of control when it happens. This is going to continue, until trading becomes too painful, and you will not be willing to trade any longer.

Consider: it is better to work through the emotions instead of quitting. Quitting is too easy, and this provides no solution or aid in preventing this from coming back and intensifying each time you have a rough period. As well, you have lost the ability to 'count' on yourself when you need to do so the most. To control a tpsych spiral, before you go out of control, is a tremendous win in and of itself. Do this, and get your trading back on track, and you will have made gains the value of which you can't imagine, as you will know that you may have losing periods BUT you can trust yourself to remain in control, and not magnify the damage.

In light of this, take what you believe to be your key trading issues, write them on an index card, and stick them on to your monitor. The objective is realization and awareness, thus making these issues available to your conscious as a reminder, instead of only available to your subconscious as a problem. As you make your notes BE SURE that you are writing short non-judgmental notes - DON'T let the 'solution' make the 'problem' worse.

For instance, consider the combination of a build of emotions coming from consecutive losses which are also occurring during congestion - write notes similar to these on your card:
a build in emotions may come from a series of quick consecutive losses quick consecutive losses often come from trading inside of congestion are your losses 'base' congestion method trades OR are you overtrading there is nothing wrong with 'base' method trade loses your trading results are fine when you 'base' method trade

Now consider the same situation BUT different notes:
don't be a stupid idiot and overtrade congestion like you always do you are going to lose your ass and end up with another losing day like usual you do this same crap every day and the same thing happens you have no reason to even trade if this is all that you are going to do

Remain Neutral
Remain neutral - another note for your index cards.
Another approach may be to write notes that include the things you can remember yourself doing or feeling as you transition from acceptable emotion to tpsych spiraling, for instance: shortness of breath - sweating - squirming in your chair - unable to sit down. AND as the spiraling becomes more intense: cussing - screaming - throwing things - breaking things. UNTIL the spiraling is out of control: panic - desperation. Clearly, there is a whole list of physical responses to uncomfortable emotional situations; realizing them as they occur may be a step in controlling them before they ‘take-over’ and lead to spiraling.

Be Aware
I want to know the potential for the spiraling situation. It is VERY important to acknowledge that you have emotions, and not try to ignore them or hide from them as a solution to the problem OR because you perceive them to be a sign of weakness.

This actually will just make the situation worse. You are human - humans have emotions - emotions become more intense in more difficult situations. So, I don't need to know how I am going to have responded as I go out of control. I do need to know, and have something to remember, and/or think about, that can keep this from happening - that can keep me as neutral as possible, in what would be the more difficult trading periods – something that will 'push' me back to tmethod AND 'away' from tpsych.

WHAT does traderC do?
traderC is the trader who remains the most neutral in winning and losing; the most neutral in all situations. It's this neutrality that becomes essential in keeping the emotions from becoming a trading psychology spiral, as the trader can 'accurately' evaluate their losses in terms of method. This trader will only trade their most 'base' method setups after any difficult period AND IF these lose, so be it, that possibility has already been accepted. Go on to the next method trade – it probably will be a winner.
by Barry Lutz
Barry Lutz has been trading, as well as teaching others to trade since 1997, through his firm Tactical Trading, LLC. He also writes a daily trading teaching lesson called the Trade Journal. http://trade2win.com

HISTORY OF HEDGE FUNDS

2008-09-06T22:43:00.000-07:00

This section details some of the important events in the history of hedge funds.
Back in 19 49, Alfred Winslow Jones, a former reporter for Fortune, started the first hedge fund with an initial capital of only US$100 000. Jones’ core intuition was that by correctly combining two speculative techniques, i.e. using both short sales and leverage, it would be possible to reduce total portfolio risk and construct a conservative portfolio, featuring a low exposure to the general market performance. Jones also had two other major ideas: to cater to investors, he had invested all his savings in the fund he managed, and his profit came from a 20% stake in the generated performance rather than from the payment of a fixed percentage of assets under management. This approach made it possible to bring the interests
of manager and investor together.

Today, the archetype described above characterizes only a small number of hedge funds:
the term is now used to refer to a vast realm of different management models.
At present, a hedge fund has five main characteristics:
• The manager is free to use a wide range of financial instruments.
• The manager can short sell.
• The manager can use leverage.
• The manager’s profit comes from a management fee, which is fixed and accounts for 1.5–2.5 %, and from a 20–25% fee on profits. Generally, the performance or incentive fee is applied only if the value of the hedge fund unit grows above the historical peak in absolute terms or over a one-year period.
• The manager invests a sizable part of his personal assets in the fund he manages, so as to bring his own interests in line with those of his clients.

In 1952, Jones opened up his partnership to other managers and started to hand over to them the management of portions of the portfolio, and within a short period of time he assigned them the task of picking stocks. Jones would allocate the capital among his managers, monitor and supervise all investment activities and manage the company’s operations. The first hedge fund in history turned into the first multi-manager fund in history.

In 1967, Michael Steinhardt started Steinhardt, Fine, Berkowitz & Company with eight
employees and an initial capitalization of $7.7 million. Steinhardt began his career as a stock picker and then, as his hedge fund grew, shifted to a multi-strategy fund. In the 1980s Steinhardt became head of a hedge fund group with roughly US$5 billion of assets under management and with over 100 employees. Steinhardt ended his hedge fund career in 1995 after suffering big losses in 1994.

By 1969, the US Securities and Exchange Commission (SEC) had started to keep a watchful eye over the blossoming industry of hedge funds as a result of the rapid growth A Few Initial Remarks 3 in the number of new hedge funds and of assets under management. At that time, the commission estimated that approximately 200 hedge funds were in existence, with $1.5 billion of assets under management. 1969 was also the year that George Soros created the “Double Eagle” hedge fund, the predecessor of the more renowned Quantum Fund.

The first fund of hedge funds1 was Leveraged Capital Holdings, created in Geneva in 1969 by Georges Karlweis of Banque Privée Edmond de Rothschild, which had the purpose of investing in the best single-managers of the time. Leveraged Capital Holdings also represents the first European hedge product.

In 1971, the first US fund of funds was started by Grosvenor Partners, and in 1973, the Permal Group launched the European multi-manager and multi-strategy fund of funds, called Haussmann Holdings N.V. The people who were given the task of creating the investment team for Permal were Jean Perret and Steve Mallory (hence the name Permal).

Then, in 1980, Julian Robertson and Thorpe McKenzie created Tiger Management Corporation and launched the hedge fund Tiger with an initial capital of $8.8 million. In 1983, Gilbert de Botton started Global Asset Management (GAM), a company specializing in the management of funds of hedge funds, which in 1999 was acquired by UBS AG and by the end of 2004 had some E38 billion of Assets under Management (AuM).

At the beginning of the 1990s, Soros, Robertson and Steinhardt managed macro funds worth several billion dollars and invested in stocks, bonds, currencies and commodities all over the world, trying to anticipate macro-economic trends.

In 1992, alternative investment instruments started to draw the attention of the press and of the financial community, when George Soros’s Quantum Fund made huge profits anticipating the depreciation of the British pound and of the Italian lira.

The early 1990s were the heyday of macro funds. The exit of the British pound and the
Italian lira from the European Monetary System in September 1992 allowed Soros to cash in an incredible profit of $2 billion.

On 4th February 1994, the Fed unexpectedly introduced the first rate hike of one quarter of a percentage point, which caused US treasuries to topple and led to a temporary drain of liquidity on the markets. The twin effect of panic on the markets and leverage proved disastrous for Steinhardt Partners, which in 1994 suffered a loss of 31 %. Steinhardt decided to retire at the end of 1995, despite the fact that during that year he had been able partly to recover the 1994 losses, ending 1995 up 26 %.

Later on, hedge funds bounced back into the headlines when in the first nine months
of 1998 Long Term Capital Management, managed by John Meriwether and a think tank
including two Nobel laureates in Economics (Myron Scholes and Robert Merton), generated a staggering $4 billion loss, starting a domino effect that left many banks, financial institutions and big brokers in many countries teetering on the brink of default. Only the prompt intervention of a bail-out team led by the Federal Reserve of Alan Greenspan avoided the onset of a systemic crisis.

In October 1998, when the Japanese yen appreciated against the dollar, Robertson suffered a loss of about $2 billion. In 1999, his long/short equity strategy, based on the analysis of fundamentals of listed companies, did not work at all in the market driven by the tail wind of the New Economy. After withdrawals from investors, assets under management had plunged from $25 billion in August 1998 to less than $8 billion at the end of March 2000. At the end of March 2000, when the “dot-com” speculative bubble was at its peak, Robertson announced the liquidation of the Tiger Fund.

In April 2000, George Soros changed his chief investment strategist and soon after the CEO of Soros Fund Management LLC as well. Soros announced to his investors that he would stop making large leveraged macro investments. To reduce the risk he would downsize his return objectives.

This article is a part of “Investment Strategies of Hedge Funds” ebooks by Filippo Stefanini for closed private educations only. You should nuy his books for the best completely informations.

Trailing Stops - The Chandelier Exit

2008-09-05T22:34:00.000-07:00

The Chandelier Exit hangs a trailing stop from either the highest high of the trade or the highest close of the trade. The distance from the high point to the trailing stop is probably best measured in units of Average True Range. However the distance from the high point could also be measured in dollars or in contract based points
Here are three simple examples: (As usual we will use long side examples. Simply reverse the logic for short trades.)

1. Place a stop at the highest high since we entered the trade minus three Average True Ranges.
2. Place a stop at the highest high of the trade minus $1500.00.
3. Place a stop at the highest high of the trade minus 150 points.

The value of this trailing stop is that it moves upward very promptly as higher highs are reached. The Chandelier name seems appropriate and should help us to remember the logic of this very effective exit. Just as a chandelier hangs down from the ceiling of a room, the Chandelier Exit hangs down from the high point or the ceiling of our trade.

The reason we prefer to use units of Average True Range to measure the distance from the high to our stop is that the ATR is applicable across markets and is adaptive to changes in volatility. We can use the same formula to trade corn, yen, coffee, or stocks. If the trading ranges expand or contract our stop will automatically adjust and move to the appropriate level continuously staying in tune with changing market conditions. (Members who are not already familiar with the many valuable applications of Average True Range should be sure to review Bulletins #10, 11, 13, and 14.)

In Dr. Van K. Tharp's excellent book, Trade Your Way to Financial Freedom, he refers to a study he conducted to demonstrate that an effective exit strategy could produce profits even with random entries. We were not surprised to see that the exit methodology he used to produce the profitable test results across a diversified portfolio of futures markets was the Chandelier Exit. (Tharp used three ATRs trailing from the highest or lowest close and used a ten-day exponential moving average to calculate the ATR.)

Protecting Open Profits
When we discussed the Channel Exit in Bulletin #34 we suggested that at the beginning of a trade we should use a wide stop and then, as profits are accumulated, tighten the stop by reducing the number of bars in the Channel. The same profit-protection logic can be applied using the Chandelier Exit. At the beginning of a trade the distance to the stop in most futures markets should probably be in the neighborhood of 2.5 to 4 Average True Ranges. As the trade becomes increasingly profitable we can bring the stop closer by reducing the units of ATR from the high to our stop.

Let's assume that we started with 3 ATRs at the beginning of the trade. After we have reached our first profit level we might tighten the stop to trail the high point at only 1.5 ATRs. After the second profit level is reached we might want to tighten the trailing stop to only one ATR. We have had good results with some highly profitable trades by trailing exits as close as a half an ATR. We have found that some markets have better trending characteristics than others and we prefer to adjust the trailing stops on a market by market basis so there is no universal formula that we would recommend. The important message we want to convey is that to capture the maximum profit potential of trend-following trades the trailing stops need to be tightened as significant profits are accumulated.

Keep in mind that although the highs used to hang the Chandelier move only upward the changes in volatility can shorten or lengthen the distance to the actual stop.

If you want to see less fluctuation in the stop distance use a longer moving average to calculate ATR. If you want the stop placement to be more adaptive to changing market conditions, use a shorter moving average. We normally use about twenty bars to calculate the ATR unless there is a specific reason to adjust it. In our experience the use of very short averages (3 or 4 bars) for the ATR can often create problems when there are brief periods of small ranges that tend to bring the stops too close.

These abnormally close stops may cause us to exit prematurely. If we want to have a short and highly adaptive ATR without risking placing stops that are too close, we can calculate a short average and a longer average (maybe four bars and twenty bars) and use the average that produces the widest stop. This technique allows our stops to move away quickly during periods of high volatility without the risk of being unnecessarily whipsawed during brief periods of low volatility.

Combining the Channel Exit and the Chandelier

We like to start our trades with the trailing Channel Exit and then add the Chandelier Exit after the price has moved away from our entry point so that the open trade is profitable. The Channel Exit is pegged at a low point and does not move up as new profits are reached. The Channel Exit will move up only when enough time has passed that the previous low is dropped from the data period of the channel. The Channel Exit moves up very gradually over time but it does not move up relative to any recent highs that are being made. This is why we need the Chandelier Exit in place to make sure that our exits are never too far away from the high point of the trade.

By combining the two exit techniques we can use the Channel Exit as an appropriate stop that very gradually rises at the beginning of the trade. However if the trade makes a run in our favor the prices will quickly move very far away from our slowly trailing Channel Exit. Once we are profitable we need to have a better exit that protects more of our profit. At this point it would make sense to switch to the Chandelier Exit which will rise instantly whenever new highs are reached. This valuable feature of the Chandelier makes it one of our most logical exits from our profitable trades.

As you can see, the Chandelier Exit is a very useful tool. However coding the Chandelier Exit in TradeStation is not necessarily a straightforward matter. For the convenience of our members we are posting the TradeStation code on our web site at: http://www.traderclub.com/toolkit.htm#chandelier
by Chuck LeBeau

What makes a Good Trading Strategy?

2008-09-04T22:30:00.000-07:00

Ask most NEW traders, and they will tell you about some moving average or combination of indicators or a chart pattern that they use. This is, as the more experienced trader knows, an entry point and not a strategy.

Any trader who is more experienced will say a strategy should also include money management, risk control, perhaps stop losses and of course, an exit point. They might also say that you must let your profits run and cut your losses short. A well-read trader will also tell you that your strategy should fit with your trading personality.

BUT there is one other vital ingredient that many traders forget - and that is to fully understand the "personality" of what you trade. Some traders specialise in say, gold or Brent crude or currencies or they might specialise in a particular index such as the FTSE 100 or the Dow but many traders choose to trade shares. Indeed some traders dabble in a bit of everything. I think this is the area that causes many traders to fail or at least not reach their full potential.

In my view: You absolutely MUST specialise.
I am sure that on the surface most people would say that sounds sensible but here is why it is a MUST!
Superficially, many charts look the same. I bet if you had not seen the charts for some time and someone where to show you a chart of Brent Crude over 6 months and then a chart of Barclays PLC over the same 6 months you would be hard pushed to say which was which purely on the look of the chart.

However, I bet that if you found a trader who trades ONLY Barclays day in and day out and also found someone who trades ONLY Brent Crude day in and day out, both of them would easily identify which was which. WHY?

Because every share, index or commodity has it's own "personality".
Some will be volatile intra-day, some will follow their sector or the main index (market followers), some will do their own thing, some will spike up and down regularly, some will stop at key moving averages and some will just plough through. Some will move by 5% on average before they retrace and some by 2%. Some will gap up or down regularly, some will not. You get the idea!

Therefore, no matter how good you are at analysing indicators, moving averages, trends and patterns, the same strategy WILL NOT work for everything. I would go so far as to say that a strategy that works well for Bovis Homes, for example, is likely NOT to work for BT Group - they have very different "personalities".

So let's return to our question: What makes a good trading strategy? Let me answer with a series of ten questions that you need to find answers to, in order to build a REALLY GOOD strategy.
1. What do you want to trade (share, index, commodity, currency, etc)? If your answer is shares (plural) I would urge you to pick one typical share at this stage to really specialise. You can add more later.
2. What "personality" does that share, index etc have?
3. What entry system is the most reliable for that share?
4. What stop loss system is the most effective for that share?
5. What average risk will a typical trade carry?
6. What exit system works well for that share?
7. What is your trading personality (attitude to risk, losses, discipline, how much do you worry etc) and can you trade that strategy without overriding it?
8. What timescale do you want to trade? (Using intra-day or end of day data)
9. How much data do you keep on past trades to help identify strategy weaknesses?
10. How does all this fit with your trading objectives?

Once you have an answer to each question you need to do one final thing. Make sure all those things fit together and complement each other. For example, if the ideal stop loss position represents a big average risk and conflicts with your own attitude to risk, you need to start again. If you will override your exit point because greed makes you hang in for more, you need to think again. Perhaps you shouldn't trade that stock in the first place - look for one with a different "personality" which will lead to a strategy you can trade comfortably.

It is a long and sometimes painful iterative journey. You might need to go round and round in ever decreasing circles over a long time.
Testing and refining, testing and refining before you can truly have a reliable and repeatable strategy that REALLY WORKS for you.

THEN, you can look for other things to trade that have the same "personality" as your specialist stock, index, commodity or currency.
But if it were easy, everyone would be doing it right?
Good luck and enjoy your trading.
David Graeme-Smith
Short Swing Trading

Trading and Ego

2008-09-03T22:26:00.000-07:00

Does your ego get in the way of your trading? After a couple of wins do you think you can't fail and go on to lose all your days gains? Here we look at ego and how to control it when trading.

Imagine a stage populated by the main characters that comprise your inner "trading decision making committee". It's a short odds bet that the loudest shout for leading man / woman will come from the ego. Brushing aside rationality and requests for inclusion alike, the ego will pronounce his / her pre-eminence and sieze control.

Trading is a magnet for ego. It is full of promise and challenge and all egos relish a good scrap,especially when the odds are stacked against them and they have a sniff of heroism in the sweetened air. Statistics that regularly confirm that only 10-20% of traders are consistent net winners are music to the ego's ears. No self respecting ego could countenance the prospect of being in the realm of the also ran, those poor, impoverished,less able 80-90%.

So, the battle commences and continues until the ego has been shown a yellow card and has to have some sobering time out. Receding into the unfamiliar shadows the ego usually brings with it an account balance fresh from a rendezvous with nemesis.

Learning to become a good, consistently successful trader requires what could be termed an "egodectemy". Clearly, the market, over time, has many opportunities to perform effective surgery. But, at first the patient is not usually receptive to his / her diagnosis. The market, as it does in its offhandedly impersonal way,steadily tosses out a few more slings and arrows and eventually the ego runs for cover, though still, naturally, on the defensive. A fugitive from self scrutiny, the ego, as befits the original usurper, skulks off in search of more accommodating terrain.

Paradoxically, the ego enjoys its separateness yet cleaves towards an unspoken desire for belonging that cannot be expressed. It refutes team games unless it can be Captain and hijacks any endeavour where it can walk its strident talk. The ego's myopic mini dramas condemn it to have ,at best, peripheral vision of what may be happening elsewhere, particularly the market, with predictably dire consequences. With the ego in the head trader's seat the drive for action will be paramount ,for the ego both needs and loves being in the thick of the action, whatever the merits marketwise.

The ego has a voracious appetite and overtrading is its soulfood. Yum,Yum.
Let's be under no illusions. The ego is a destructive force in our trading. It manages to trip us up over and over again and is disposed to cause catastrophe given half a chance. The brothers and cousins of mistakes that Jesse Livermore talked about were mainly relatives in the ego family.

No question that on our trading skills balance sheet the ego is a permanent tenant in the liability column, the asset column being considerably overshadowed until it reaches for the light.

Where there's a will though, there's a way. The way of the consciously undertaken "egodectemy", self sought and administered. We call our asset column forward to shine the moment we call time on the ego's proclaimed predominance. Slowly, through the mist the vision gets clearer ,there's more space and we can advertise our "under new management" sign above our trading station.

The receding noise of the ego facilitates the growing presence of quieter qualities such as intuition. Intuition is perhaps the yin to the ego's yang, the passive to the active. Unlike the ego which announces itself with such immediate urgency, intuition presents itself self effacingly.

It doesn't require the ego's fanfare. It carries no agenda, grinds no axes and seeks no reward or acknowledgement. If we can learn to encourage and empower our intuition it can become our greatest trading tool [assuming it is used in conjunction with self discipline]. As we learn to listen to ourselves our intuition " speaks " to us more. It brings a distilled experience to its open secrets. As we listen so our profitability increases.

So how does the ego accept pretenders to its throne such as intuition ?
It will probably seek to spam intuition's inbox and scatter its speculative spores in order to wrest back its fading grasp . Intuition is not exempt from egos predatory pulse. To the ego,all is fair game. So, aswell as the necessity to be vigilant in monitoring our trades we need to be vigilant for contaminations by the ego. Being of passive nature, intuition requires some degree of protection from attempted "coups".

Perhaps I stand accused of laying too many ills and grievances at the ego's door but I'd rather be "guilty" of this than of watching my account get mullered due to a lack of discriminatory self awarenesss. For trading mastery, read 24/7 ego monitor.

There's no teabreaks ,quiet carefree moments of reverie, or laughter [apart from the gallows variety] as the ego's auditor. It's not a job for the faint of heart. The ego and its conspiratorial cohort, the saboteur, join forces as account assassins to best effect when concentration and discrimination are at a low ebb, like it or not.

The ego's toolkit, though insidious and pervasive, can be neutered and rendered ineffective with patience, practice and persistence. It becomes easier with practiced awareness to spot those trades that are initiated by the ego, its trading ASBO's become increasingly visible. For, the real deal is that the ego is not actually terribly bright. Confronting it and slowly stripping its stranglehold away can be a satisfying, enjoyable and increasingly profitable process.

Prioritising intuition allows for the gradual development of trust which in turn allows for intuitive insights to be made tangible as signals to act upon. Trusting ourselves and our signals and acting upon them with growing confidence supports the process of decision making. Perhaps some of these decisions may reflect a counter intuitive approach buy hey, let's not get too ahead of ourselves here. Running before you can walk is one of the ego's most cherished mantras.

Going against the needy impulses of the ego is usually very beneficial, whatever the financial outcome because it affirms that we are in charge and responsible. Of course, intuition is only one of the skills available to counter the ego's threat and itself is not infallible ,in trading or elsewhere. But it can be our alert, our standby and our alarm, always on call for us if we give it space. Trading intuitively doesn't preclude mistakes. Even in the heart of the zone the collective unconscious is probably not fully visible and if it was we'd probably be so blissed we'd close our trade . But intuition does give us an edge that is personal and can be developed further.

The art of the chart is in the heart aswell as the eye. Once we stop looking so hard we can start to see and then sometimes we can put a trade on and just close our eyes and trust. Working out an approach to the market from an intuitive perspective is not an exact science but if we can receive what the market gives us, process it and extract its kernels of wisdom then maybe we have a chance to thrive, a chance to meld our confections of desire into success.

Martin is an experienced, qualified facilitator/coach with trading experience in the equity markets. Martin offers one to one trading coaching for all levels of experience. You can contact him... http://trade2win.com

Risk Arbitrage

2008-09-02T22:16:00.000-07:00

In economics, arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets: a combination of matching deals are struck that exploit the imbalance, the profit being the difference between the market prices. A person who engages in arbitrage is called an arbitrageur.

For example, if you can buy items at one price at a factory outlet and sell them for a higher price on an internet auction website such as eBay, you can exploit the imbalance between those two markets for those items. The term "arbitrage", however, is usually applied only to trading in money and investment instruments (such as stocks, bonds, and other securities), not to goods, and the difference in prices is usually referred to as "the spread", so arbitrage is often defined as "playing the spread" in the money market.

Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency exchange rates, the price of commodities, and the price of securities in different markets all tend to converge to a fixed price. The speed at which the prices converge is one measure of the efficiency of a market. Arbitrage tends to reduce price discrimination by encouraging people to buy an item where the price is low and resell where the price is high. Sellers of goods and services often attempt to prohibit or discourage arbitrage.

Traditionally, arbitrage transactions in the securities markets involve high speed and low risk. At some moment a price difference exists, and the problem is to execute two or three balancing transactions while the difference persists (that is, before the other arbitrageurs act).

In the 1980s a practice with the oxymoronic name of "risk arbitrage" became common. In this form of speculation, one trades a security that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to be corrected by events. The standard example is the stock of a company, undervalued in the stock market, which is about to be the object of a takeover bid; the price of the takeover will more truly reflect the value of the company, giving a large profit to those who bought at the current price—if the merger goes through as predicted.

The transaction involves a delay of weeks or months and may entail considerable risk if borrowed money is used to magnify the reward through leverage. One way of reducing the risk is through the illegal use of inside information is obvious, and in fact risk arbitrage with regard to leveraged buyouts was associated with some of the famous financial scandals of the 1980s such as those involving Michael Milken and Ivan Boesky.

Examples
Here’s a theoretical example: Suppose that the exchange rates (after taking out the fees for making the exchange) in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo are ¥1000 = £6 = $10. Converting $10 to £6 in Tokyo and converting that £6 into $12 in London, for a profit of $2, would be arbitrage.

One real-life example of arbitrage involves the stock market in New York and the futures market in Chicago. When the price of a stock in New York and its corresponding future in Chicago are out of sync, one can buy the less expensive one and sell the more expensive. Because the differences between the prices are likely to be small (and not to last very long), this can only be done profitably with computers examining a large number of prices and automatically exercising a trade when the prices are far enough out of balance. The activity of other arbitrageurs can make this risky. Those with the fastest computers and the smartest mathematicians take advantage of series of small differentials that would not be profitable if taken individually.

Risks
Arbitrage transactions in modern securities markets involve fairly low risks. Generally it is impossible to close two or three transactions at the same instant; therefore, there is the possibility that when one part of the deal is closed, a quick shift in prices makes it impossible to close the other at a profitable price. There is also counter-party risk, that the other party to one of the deals fails to deliver as agreed; though unlikely, this hazard is serious because of the large quantities one must trade in order to make a profit on small price differences.
These risks become magnified when leverage or borrowed money is used.

Another risk occurs if the items being bought and sold are not identical and the arbitrage is conducted under the assumption that the prices of the items are correlated or predictable. In the extreme case this is risk arbitrage, described earlier. In comparison to the classical quick arbitrage transaction, such an operation can produce disastrous losses.

Long-Term Capital Management (LTCM) lost $100 billion mis-managing this concept in September 1998. LTCM had attempted to make money on the difference between different bond instruments. For example, it would buy U.S treasury bonds and sell Italian bond futures. The concept was that because Italian bond futures had a less liquid market, in the short term Italian bond futures would have a higher return than U.S. bonds, but in the long term, the prices would converge. Because the difference was small, large amount of money had to be borrowed to make the buying and selling profitable.

The downfall in this system began on August 17, 1998, when Russia defaulted on its rouble debt and domestic dollar debt. Since the markets were already nervous due to the Asian crisis, investors began selling non-U.S. treasury debt and buying U.S. treasuries, which were considered a safe investment.

As a result the return on U.S. treasuries began decreasing because there were many buyers, and the return on other bonds began to increase because there were many sellers. This caused the difference between the returns of U.S. treasuries and other bonds to increase, rather than to decrease as LTCM was expecting. Eventually this caused LTCM to fold, and a bailout had to be arranged to prevent a collapse in confidence in the economic system.

An ironic footnote is that they were right long-term (the LT in LTCM), and a few months after they folded their portfolio became very profitable. However the long-term does not matter if you cannot survive the short-term, and that they failed to do.
From Wikipedia, the free encyclopedia
http://en.wikipedia.org/

The 22 Rules of Trading

2008-09-01T22:13:00.000-07:00

We give you Master Trader Dennis Gartman's 22 Rules of Trading, many of which you can apply to all sorts of life situations, as well as the markets.

Every day, Dennis Gartman gets up at bout 2:30 AM and writes an information packed 4 page newsletter on the world markets, oil, currencies, commodities political happenings and much more. He is read by the major trading houses and traders all over the world, as they stumble bleary eyed into work, grabbing the Gartman Report to find out what happened as they slept and to get insight as to what the issues of the day will be, and suggestions on how to trade. Dennis puts his trades on public display and talks you through his logic.

It is a most remarkable work, and I find it a key part of my struggle in trying to keep up with what is going on. I am always amazed when on the occasions I find myself in the office at an early hour to find Dennis' letter hit my inbox about 5:00 AM. His travel schedule makes mine look tame, and from wherever in the world he finds himself, he writes and sends his letter. And he still maintains a single digit handicap on the golf course.

On the Friday after Thanksgiving, he publishes his "Rules of Trading," adding to them as wisdom increases. Here is today's list:
1. Never, under any circumstance add to a losing position.... ever! Nothing more need be said; to do otherwise will eventually and absolutely lead to ruin!
2. Trade like a mercenary guerrilla. We must fight on the winning side and be willing to change sides readily when one side has gained the upper hand.
3. Capital comes in two varieties: Mental and that which is in your pocket or account. Of the two types of capital, the mental is the more important and expensive of the two. Holding to losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital.
4. The objective is not to buy low and sell high, but to buy high and to sell higher. We can never know what price is "low." Nor can we know what price is "high." Always remember that sugar once fell from $1.25/lb to 2 cent/lb and seemed "cheap" many times along the way.
5. In bull markets we can only be long or neutral, and in bear markets we can only be short or neutral. That may seem self-evident; it is not, and it is a lesson learned too late by far too many.
6. "Markets can remain illogical longer than you or I can remain solvent," according to our good friend, Dr. A. Gary Shilling. Illogic often reigns and markets are enormously inefficient despite what the academics believe.
7. Sell markets that show the greatest weakness, and buy those that show the greatest strength. Metaphorically, when bearish, throw your rocks into the wettest paper sack, for they break most readily. In bull markets, we need to ride upon the strongest winds... they shall carry us higher than shall lesser ones.
8. Try to trade the first day of a gap, for gaps usually indicate violent new action. We have come to respect "gaps" in our nearly thirty years of watching markets; when they happen (especially in stocks) they are usually very important.
9. Trading runs in cycles: some good; most bad. Trade large and aggressively when trading well; trade small and modestly when trading poorly. In "good times," even errors are profitable; in "bad times" even the most well researched trades go awry. This is the nature of trading; accept it.
10. To trade successfully, think like a fundamentalist; trade like a technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technicals. When we do, then, and only then, can we or should we, trade.
11. Respect "outside reversals" after extended bull or bear runs. Reversal days on the charts signal the final exhaustion of the bullish or bearish forces that drove the market previously. Respect them, and respect even more "weekly" and "monthly," reversals.
12. Keep your technical systems simple. Complicated systems breed confusion; simplicity breeds elegance.
13. Respect and embrace the very normal 50-62% retracements that take prices back to major trends. If a trade is missed, wait patiently for the market to retrace. Far more often than not, retracements happen... just as we are about to give up hope that they shall not.
14. An understanding of mass psychology is often more important than an understanding of economics. Markets are driven by human beings making human errors and also making super-human insights.
15. Establish initial positions on strength in bull markets and on weakness in bear markets. The first "addition" should also be added on strength as the market shows the trend to be working. Henceforth, subsequent additions are to be added on retracements.
16. Bear markets are more violent than are bull markets and so also are their retracements.
17. Be patient with winning trades; be enormously impatient with losing trades. Remember it is quite possible to make large sums trading/investing if we are "right" only 30% of the time, as long as our losses are small and our profits are large.
18. The market is the sum total of the wisdom ... and the ignorance...of all of those who deal in it; and we dare not argue with the market's wisdom. If we learn nothing more than this we've learned much indeed.
19. Do more of that which is working and less of that which is not: If a market is strong, buy more; if a market is weak, sell more. New highs are to be bought; new lows sold.
20. The hard trade is the right trade: If it is easy to sell, don't; and if it is easy to buy, don't. Do the trade that is hard to do and that which the crowd finds objectionable. Peter Steidelmeyer taught us this twenty five years ago and it holds truer now than then.
21. There is never one cockroach! This is the "winning" new rule submitted by our friend, Tom Powell.
22. All rules are meant to be broken: The trick is knowing when... and how infrequently this rule may be invoked!

Extracted from frontlinethoughts.com (and available from many web sites). Thanks Dave for sharing this

When do we get there?

2008-08-30T22:12:00.000-07:00

Every beginning trader wants to know how long it will take to become
successful, but only a liar would say there’s an appropriate answer.
BY ACTIVE TRADER STAFF

Among all the questions submitted to Active Trader, one of the most difficult to answer is, “How long should it take me to become a profitable trader?” People are inclined to think in terms of the training or education that result in the ability to practice other professions:
You go to school to study a certain subject or enter some kind of apprenticeship, learn what you need to learn, graduate or get certified, and then you’re successful, or at least have the opportunity to be.

For example, if you get an undergraduate degree, spend three years in law school, and then pass the bar, you can practice law. If you put in the comparable time in medical school and pass your boards, you get to be a doctor. Of course, doing so doesn’t necessarily mean you’ll be a good, or particularly successful, lawyer or doctor, but such measures do provide a baseline of competency and the opportunity to earn a living.

Profitability is the only real “certification” in the markets,
and it is conferred on a diverse population, regardless
of educational background or formal trading.

In trading, however, there are no similar measuring sticks, and certainly no guarantees of earning a living. You might never be a successful trader no matter how much time and effort you put into it. The notion that most people who try to
trade end up losing money is probably true (although it is unverifiable), because most people enter the markets without enough knowledge or money and are scared out of trading for good after they experience a big loss.

In short, for all except the lucky, the only thing that can be said is that it will probably take you longer to become a trader than you think. And that’s if you have the financial wherewithal and perseverance to learn through first-hand experience.

Unlike law or medicine, there are no comparable degrees or professional certifications that brand you as someone able to trade profitably. Yes, brokers and money managers must pass certain exams (the Series 7, for example, for stock brokers) and file paperwork with the government, but these requirements
do not mean someone has made money in the past or will make money in the future. Profitability is the only real “certification” in the markets, and it is conferred on a diverse population, regardless of educational background or formal training.

Part of the problem is that “successful” can take so many forms in this context. What does successful mean? That your part-time trading is simply profitable? That your part-time trading outperforms the major stock indices? That you support yourself solely from trading? That you are rich beyond your
wildest imagination?

The other major problem is the absence of any kind of universal timetable. The time commitment for full-time law school and medical school programs is pretty much universal in the U.S., so you have a very specific horizon on which you’re operating. Trading has nothing comparable. Someone dedicated to a full-time job would have much less time to learn about the markets than someone who was able to devote all of his or her time to trading.

Also, there is the matter of aptitude, although it is impossible to quantify. Broadly speaking, those with analytical minds and mathematical proclivities might have a leg up on those who hate numbers and can’t stomach risking money. Still yearning for some hard numbers? When asked what it took to become a profitable trader, John Hill of system-testing firm FuturesTruth is credited with having said, “Five years and $50,000.” It’s as good a guess as any. But with all the variables and the differences from person to person, it’s better to think in
terms of learning slowly, trading conservatively, protecting capital, and accumulating experience over time. And if anyone tells you they can teach you how to trade in a weekend (or a week, or a month), take a pass.

Source : activetradermag.com

Currency Pairs Selling Their Personalities

2008-08-29T22:10:00.000-07:00

Forex (Foreign Exchange) simply refers to the buying of one currency and selling of another at the same time. The forex market is the largest financial market in the world, even bigger than stock markets. Its daily turnover exceeds $3 trillion. The forex market is a global network of buyers and sellers of currencies, and is done over-the-counter (OTC), which means that there is no central exchange and clearinghouse where orders are matched. Forex trading takes place 24 hours a day, five and a half days a week, unlike stock markets which have specified opening and closing times for trading.

Almost all currencies can be traded through a forex broker. Currencies are represented by three letters, where the first two letters stand for the name of the country and the third stands for the name of the currency. Some of the most traded currencies are: the US dollar (USD), the Euro (EUR), the Japanese yen (JPY), the British pound (GBP), the Swiss franc (CHF), the Canadian Dollar (CAD) and the Australian Dollar (AUD). A currency always goes up or down in value in relation to another currency. For example, when you simply say the US dollar is going down, it doesn't make much sense because the US dollar could be going up against the Australian dollar but down against the Euro. Hence currencies are always traded in pairs, and are quoted in a manner like this: EUR/USD. The first currency in the pair is called the base currency and the second is called the counter or quote currency.

The four most traded currency pairs are known as majors and they are:

EUR/USD
USD/CHF
GBP/USD
USD/JPY

As you can see from these pairs, the Euro, Swiss franc, British pound and Japanese yen are traded against the US dollar. As each pair has its own personality, it is essential for you to learn a bit more about each one, and understand the factors influencing their movements,

EUR/USD
The most recent 2007 Bank for International Settlements (BIS) survey shows that the most traded major currency pair is the EUR/USD with 27% of total daily volume. The EUR/USD is a great pair to trade for both new and seasoned currency traders. It is a very active pair with moderate volatility, which attracts traders to it like bees to honey. Its movements are quite smooth and there is enough action for day and short-term traders to capture meaningful profits.

EUR/USD tends to be negatively correlated to the USD/CHF and positively to the GBP/USD. What this means is that if EUR/USD goes up, then most likely USD/CHF will go down. This close relationship can be seen even on an intraday basis. In fact, this negative correlation is the closest relationship in the forex markets. You can take advantage of this relationship by opening both the EUR/USD and USD/CHF charts in your trading software, and compare both together. This way, you can have a better idea of where either pair could be moving next.

When you trade this pair, you need to be concerned with the bigger economic picture of both the Eurozone and the United States, and keep up with what monetary policymakers are saying about their country's economy and their domestic currency. The Federal Reserve (Fed) is the central bank of the United States and its current chairman is Ben Bernanke. The European Central Bank (ECB) is in charge of monetary policy for the the Euro, and its president is Jean-Claude Trichet.

USD/CHF
The 2007 BIS survey shows that trading of the USD/CHF constitutes only 5% of total daily volume, which makes it the least traded among the majors. Its bid/ask spread is usually wider than that of EUR/USD as a result, but don't let that stop you from trading this pair. It is still a popularly traded pair and its movements are negatively correlated to that of EUR/USD. Sometimes USD/CHF leads the movement of EUR/USD, other times it's the other way around. In general, the Swiss franc usually benefits from financial market or geopolitical turmoil as it is seen as a safe-haven currency.

USD/CHF tends to be influenced more by US fundamentals rather than economic and monetary happenings in Switzerland. The central bank of Switzerland is the Swiss National Bank (SNB) and its chairman is Jean-Pierre Roth. Switzerland relies heavily on export, like Japan and the Eurozone.

GBP/USD
GBP/USD, nicknamed Cable, is the third most liquid currency pair, according to the 2007 BIS survey, making up 12% of daily market turnover in the forex market. This pair is notorious for its wild and ultra-volatile movements, and is certainly not for the new trader. Price breakouts tend to be false and it is easy for new traders to get whipsawed by market noise. The British pound tends to move in the same direction as EUR/USD although that is not always the case. As the pound has a relatively high interest attached to it, it is seen as a high-yield currency.
The Bank of England (BOE) is the central bank of the United Kingdom, and Mervyn King is the governor. A series of interest rate hikes by the BOE in late 2006 and 2007 led the British pound to rise to the highest rate against the Euro in 2007.

USD/JPY
USD/JPY is the second most traded currency pair, with 13% of total daily volume according to the 2007 BIS survey. This currency pair is most actively traded during the Asian session, and has a tight bid/ask spread most of the time. Its movements are smooth and the pair reacts quickly to the risk environment in the financial markets. In times of risk aversion, the yen tends to strengthen against other currencies as global investors close out their carry trades.
The Bank of Japan (BOJ) is the central bank. Since Japan is highly dependent on exports, the BOJ has a strong interest in keeping the yen low compared to other currencies. On several occasions in the past, the BOJ has physically intervened in the forex market by selling the yen against US dollars and Euros, thus artificially weakening its currency for the sake of its export industry.

Summary
Each currency pair has its own characteristics and is influenced by different factors. It is important for a trader or investor to understand these characteristics and to trade or invest accordingly. You may find that one of them suits your own trading or investing style better, and in that case, just focus on what you think is best for you. There is always a currency pair out there among the hundreds which will catch your fancy and meet your goals.

Grace Cheng is the founder and editor of www.GraceCheng.com a leading financial website dedicated to the latest market news and opinions relating to forex and stock markets. She is also author of "7 Winning Strategies For Trading Forex" (2007, Harriman House) and the creator of the online PowerFX Course. She is actively involved in the financial markets.

Master Your Trading Mindtraps

2008-08-28T21:55:00.000-07:00

The popularization of speculative trading activity in the financial markets, partly due to the development of retail trading solutions offered on the internet, has created a new population of traders in the market. Most of these traders are non-professionals that are attracted by the potential to generate revenue quickly.

Falsely Created Expectations
Many novice traders may believe that it is very easy to make money, especially when they are trying a broker service using a free practice account.

However, if these traders manage to generate a sudden substantial return, it can lead them to believe that trading is an easy occupation - and one in which revenue can be quickly generated with little work on the part of the trader. For the inexperienced, one good pick can make it seem like market speculation might become the key to success and wealth.

Unfortunately, when these inexperienced speculators overtake this virtual investing environment and decide to start trading live accounts and risking real money on the market, the activity becomes much more complex. In many cases, the days of outstanding day trading performance come to look suddenly and distressingly like old souvenirs - it is an abrupt initiation into the pitiless reality of the financial markets.

Real Life vs. Practice
When new traders take the leap from the their virtual trading accounts to trading with real money, they are entering into the most difficult step of their initiation to trading: trading psychology.

In other words, while it may be very easy to trade when the risk of loss does not exist, when the trader's hard-earned dollars are thrown into the mix, his or her focus and price objective can go out the window. Often, traders using virtual accounts will feel relatively comfortable even when the market moves against the positions they enter. This allows them to keep their focus on their price objective and wait for the market to get moving in the right direction. Because there is little consequence tied to "virtual money", personal emotion does not interfere. Unfortunately, when a trader's actions come to affect the gain or loss of his or her own personal assets, that trader is less likely to behave in such a methodical way.

Emotions Can Rule the Trade
Emotions can be seen as the trader's worse enemies; they often lead to misjudgment and loss.

Feelings generate what psychologist Roland Barach calls "mindtraps" in his book, "Mindtraps: Unlocking the Key to Investment Success" (1988). Roland Barach provides a collection of 88 lessons explaining the pitfalls, such as fear and greed, that hold many traders back.

Greed
Greed can lead a trader to hold on to a position too long in hopes of a higher price, even as it falls. This emotion has been the main reason behind many trades that have gone from large gains to large losses. To thwart this emotion, try to take an objective look at the reasoning behind your positions. When one of your positions experiences a large run up, ask yourself whether the reasons behind your initial investment still remain; if not, it may be time to close or reduce the position.

Fear
Fear can prevent a trader from entering trades along with taking them out of positions far too early. If an investor is too concerned with potential loss and the risks that come with an investment, he or she can often be dissuaded from a good opportunity. Also, if a trader is more susceptible to fear, he or she may sell out of an investment far too early based on the fear of losing the gain they have made. In many cases, this can prevent a trader from cashing on a much bigger gain.

Paralyze by Analyze
Paralyze by analyze is an interesting phenomenon in which traders get so caught up in analyzing everything about a potential investment that they never actually pull the trigger on the trade. In this case, what often happens is that the investor will constantly question all of the little details found in the analysis in an attempt to perfectly analyze a situation. This is a truly unachievable task that can prevent a trader both from making monetary gains and from making experiential gains by getting into the trade.

There are a wide range of other emotions that can rule a trader but the important thing for any market participant is to recognize these emotions.

Acknowledge Your Emotions
All traders will experience at least one mind trap, but it is the very best traders that learn to recognize, understand and neutralize them. This process forms the foundation of any trader's training. Therefore, if you want to become a (successful) trader, you should first spend some time getting to know yourself and the particular mindtraps you tend to fall into. A skillful trader tends to have a strong desire to master his or her emotions and prevent them from affecting his or her performance.

Trading Nirvana
Traders are only human and, as such, perfection may not exist in trading. However, profitable trading can be achieved when a trader learns to manage his or her emotions. This will be easier for some than for others, but it is only through experience in the market that this skill can be developed. Therefore, before you can learn how to win, you have to take some risks (or at least get into the market) and learn to master the emotions that making (and sometimes losing) money stirs up.

by Nathan Halfon
Nathan P. Halfon is the director of institutional business development for ACM Forex in Geneva, a leader in online currency trading.

Risk Management 101

2008-08-27T21:52:00.000-07:00

Risk management is the most important trading principle an investor can employ. A very important aspect to the psychology of trading is the ability to create and maintain a trading plan. As a famous saying in the market goes, "if you fail to plan, plan to fail." Planning is closely linked to the discipline of a trader. Experienced traders know that discipline and a trading methodology are key to long term survival in the financial markets.

Common for very new traders to make money on demo accounts, but many times these same traders lose when entering the live market because they fail to exercise discipline when real money is involved. Trading Forex is a challenging and potentially profitable opportunity for educated and experienced investors. However, before deciding to participate in the market you should consider your investment objectives, level of experience and risk appetite. Most importantly, do not invest money you cannot afford to lose.

Money Management Strategy
Below is a Basic and effective money management strategy that will help you control your trading. Your risk per trade should never exceed 3% per trade. It's better to adjust your risk to 1% or 2%. I prefer a risk of 1% but if you are confident in your trading system then you can lever your risk up to 3%.

1% risk of a 10,000 account = 100.

You should adjust your stop loss so that you never lose more than 100 per a single trade. If you place your stop loss 50 pips below/above your entry point.

50 pip = 100 1 pip = 2

The size of your trade should be adjusted so that you risk $2/pip. If the trade is stopped, you will lose 100 which is 1% of your balance. Another key component to money management is Risk-to-Reward Ratios.

Risk-to-Reward Ratio
The following shows you possible risk-to reward ratios, and the win ratios required to break even in a trading system. Risk-to-Reward Ratio (in pips) and Win Ratio Required to Break Even (%)
40/20 (2 to 1) = 67%, 40/40 (1 to 1) = 50%, 40/60 (1 to 1.5) = 40%, 40/80 (1 to 2) = 33.5%, 60/20 (3 to 1) = 75%, 60/60 (1 to 1) = 50%, 60 /90 (1 to 1.5) = 40%, 60/120 (1 to 2) = 33.5%

Never risk more pips on a trade then you plan to make. It doesn't make sense to risk 100 pips in order to make only 10. Why? See below example.
Profit taking level (pips): 10
Stop used or pips at risk: 100

You win 10 times which makes 100 winning pips. You only lose once and have to give back all profits. Clearly a profit taking level of 10 and a risk level of 100 is not the best trading strategy. A more sensible strategy is 3 to 1. For example if you risk 10 pips you should be looking to make at least 30 pips in profit. Most traders analyze place sensible trades yet they tend to over leverage themselves, get in with a position that is too big for their portfolio, and as a consequence, often end up forced to exit a position at the wrong time. Trading in small increments with protective stops on your positions will allow one the opportunity to be successful in Forex trading.

Trading Discipline
Discipline is probably one of the most overused words in Forex trading education. Despite the cliché, discipline continues to be the most important behavior one can master to become a profitable trader. Discipline is the ability to plan your work and work your plan. It's the ability to give your trade the time to develop, without hastily taking yourself out of the market simply because you are uncomfortable with risk. Discipline is also the ability to continue to trade the methods and patterns even after you've suffered losses.

Many traders come with false expectations of the profit potential, and lack the discipline required for trading. Short term trading is not an amateur's game and is not the way most people will achieve quick riches. Forex trading may seem exotic or less familiar then traditional markets such as equities. However, it does not mean that the rules of finance and simple logic are suspended. One cannot hope to make extraordinary gains without extraordinary risks, and that means suffering inconsistent trading performance that often leads to large losses.

Trading currencies is not easy, and many traders with years of experience still incur losses on a periodic basis. One must realize that trading takes time to master and there are absolutely no short cuts to this process. One of the worst blunders that Forex traders can make is attempting to trade without sufficient capital. The trader with limited capital not only will be a worried trader, always looking to minimize losses beyond the point of realistic trading. He will also frequently be taken out of the trading game before he can realize any sense of success trading methods or patterns.

Protecting Capital and Minimizing Cost
The final aspect of risk management and trading discipline is protecting your capital. Forex traders who understand the importance of risk management and trading discipline usually understand the importance of protecting and preserving their capital. In the Forex market the easiest way for a trader to lose capital is through paying the spread. Some dealing firms charge extremely high spreads that can eat at a trader's capital without them noticing.

The solution to this problem is to find a broker that charges reasonable spreads and also search for trade rebate programs. Rebates are a fairly new concept in the Forex market, usually offered by Introducing brokers, a trade rebate is a way for a trader to be rebated on a small portion of the spread. Although a normal rebate is only a few dollars per standard lot, active traders soon realize how taking advantage of rebate is not only a smart thing, but also can greatly improve their profitability and overall trading success.

Simply put, the less you pay in spread the greater your chances are of seeing profitable trade returns and trading longevity. Competitive spreads, not over-leveraging and a disciplined money management strategy are the keys to being successful in the Forex market.
You can find more how-to and educational articles to improve your investing and trading each day on TradingMarkets.com.

Alexander Nekritin is a professional trader with over 8 years of experience. His specialties include risk management and system development. Alexander is the CEO of NCMFX, Inc., which is a forex introducing broker and an educational company that helps suit client?s needs in forex trading. He offers a Forex Broker Review to his clients that assists in learning the MetaTrader4 platform. Alexander has a degree with a concentration in Investment Banking and derivative instruments from Babson College in Massachusetts.

Forex may be chaotic...but some things are still predictable

2008-08-26T21:48:00.000-07:00

I was just reading this post over at Trader Rich's Forex Project about a study at MIT that concluded that "treasury bonds are random, the stock market is correlated, and forex is chaotic." Firstly, let me say I haven't actually read the study in question, and probably never will. What I have read is Rich's summary of the study author's summary of his findings in Currency Trader Magazine. Also I've never studied chaos theory, higher math or physics. So obviously I'm extremely well-qualified to comment on this research in a thoughtful, informed, and in-depth manner. So here goes...

While I agree that a lot of forex market activity appears chaotic, and as soon as you come up with a predictive rule the market breaks it, there are still a few things you can predict with some accuracy amid all the chaos. And these are the things that keep me trading forex. Off the top of my head, they are:

• Trading range: I can say with reasonable confidence that the trading range of the EUR/USD tomorrow will be somewhere between 30 and 150 pips. Occasionally it may be more, occasionally less. But it will almost certainly not be 500 pips. Or 1000 pips. Nor will it flatline and refuse to move at all. Now a currency whose range varied from 10 to 1000 pips a day on a fairly unpredictable basis...that would be chaotic.

• Reaction to certain news events: some events will move the market. Period. What direction, and how many pips, can be hard to prediect. But I can predict with a high degree of confidence that there will continue to be news events that shake things up periodically.

• Periodic emergence of trends: very real, very tradeable trends will emerge from the chaos every so often, and in all likelihood will continue to do so. Just looking at a price chart without a single fancy indicator on it can tell you this.

• If you place trades long enough you'll eventually get one right. This is the principle behind the Martingale strategy. I'm not saying it's a good strategy to use, but it's based on a statistically valid and predictable observation. Chaos or no chaos, the odds will eventually swing in your favor.

• Buying some currency pairs pays you interest. Holding others costs you interest. This is what carry trading is all about.

• Someone who routinely takes on too much risk when trading in chaotic conditions probably won't last as long as someone who knows exactly how much risk they can afford to take.

• Someone with a clear head can combine observations like these into a trading strategy with decent odds of paying off in the long run. Someone whose outlook is clouded by wishful thinking, impatience, inconsistency, lack of discipline or impulse control, and any other problems of the compulsive gambler doesn't have a chance in the world.
• Forex can be boring for long periods. Whether that's chaotic or not I can't really say. But it's certainly predictable.

I'm sure the chaos theorists wouldn't disagree with any of this, and would point out why chaos theory allows for all of these possibilities. But I'm not writing for them - I'm writing for the traders out there like me who see a statement like "forex is chaotic" and think they must be crazy to keep chasing the market if the MIT scientists say it's a giant chaotic whirlpool ready to suck your accounts dry. So if I've made any of you feel a little better, I've done my job. Enjoy the chaos!
http://www.forexforays.com/labels/Carry%20Trading.html

Hedge Funds Risk Management

2008-08-25T21:47:00.000-07:00

A Short Review of Hedge Fund Risk Management

When trying to maximize absolute returns, the importance of assessing and mitigating risk shouldn't be underestimated. Some memorable examples like LTCM and Tiger Fund not only show how heavy losses can be for some participants of the hedge fund industry, but also reinforce the perception that a good record of high absolute returns can mean absolutely nothing in an environment of improperly managed risk.

The most important lesson in terms of Hedge Fund Risk Management comes from the improper name of this kind of alternative investment: The idea that all systematic risks are diversified away is not applicable here, with the Hedge Fund returns, in reality, representing a combination of superior management of market inefficiencies and conscious exposure to some specific systematic risks. Only the systematic risks that are “undesirable” from a strategic point of view are diversified away. So, hedge funds, in reality, are not fully hedged.

Moreover, the adequate measure in terms of risk management exposure moves from the realm of excess risk in comparison to a benchmark to a total risk approach. Total return here is what matters for managers and investors and not a comparison of the hedge fund performance to some benchmark, like in other types of funds.

Also, the leptokurtosis (“fat tails”) and negative skewness associated to most class of hedge funds present a significant challenge to quantitative methodologies based on the assumption of returns normality (e.g. Riskmetrics classic approach), with the area becoming a very good study case for new approaches, like Extreme Value Theory (EVT).

Finally, with this complex framework in mind, the need for an initial and constant due diligence and managerial tracking surges as the most important issue from an investor's or fund of funds' perspective. Here, the obligation of full portfolio transparency (for legitimate investors, but not for the whole market) becomes mandatory for the successful risk manager, while, of course. other types of risk commonly non addressed through quantitative methodologies, (e.g. the liquidity barriers established through long “lock-up” periods) can't also be underestimated.

Once aware of the formal conditions offered by a hedge fund manager, knowing your manager's style in-depth and keeping frequent meetings and discussions based on updated full portfolio/single positions disclosures is the key to avoiding pitfalls as an investor.
An authoritative source in the subject is Jaeger, L., ed. The New Generation of Risk Management for Hedge Funds and Private Equity Investments, Institutional Investor Books, 2004.

What Every Forex Trader Should Know About ECNs vs. Deal Desks

2008-08-24T21:39:00.000-07:00

Many forex traders are concerned about going to an ECN broker and not trading through a deal desk. In this article I hope to shed some light about how this works and what to look for when selecting a broker to make sure that you don't become a victim of un-just dealing practices.

An ECN dealing model allows the many market participants to execute trades with each other through an electronic network. That's what an ECN stands for; electronic communications network. As you know, forex is a zero sum game so for every winner there is a loser; for everyone going long there is someone going short. So what an ECN does is match up your order with the order of another market participant. You are probably asking yourself the same question as I asked myself when I first found out about an ECN, will there be a seller every time I am buying and vice versa? The answer is that there are market makers and banks in the ECN that are consistently taking on trades and hedging their risk.

They may have their own buy and sell programs that they are trading on. These banks allow clients to get better liquidity and tighter pricing in the ECN. One of the most profound benefits of using an ECN is that you get anonymity, as the other participants do not see who is trading on the other end and cannot flag your account and trade directly against you. Another benefit to consider is that you can make your own market in an ECN; meaning you can place orders in between the bid and the ask price. If you are not willing to trade at a particular price point, you are able to place a bid or offer in between the spread in hopes of the ECN finding a fit counterparty â€“ this is not a possibility with a deal desk.

Some forex dealing firms use a dealing desk approach. With this approach their desk acts as a sole market maker and takes all long and short positions on. The desk has certain risk parameters that have been set up and based on these calculations the aggregate net position of the dealing desk is hedged.

So, if the desk itself is net long or short a certain amount of EUR/USD for example, they will take a trade of that amount in the opposite direction with a liquidity provider. If all the clients are net long 1 billion EUR/USD, the desk will go long 1 billion EUR/USD and thus have a hedged position.

So for every pip they loose in aggregate to their clients they will win on their hedge. Its obviously not as simple as I just explained it but that's the basic nature of the dealing model. Some of the advantages of going through a deal desk are that you always know your transaction costs as the spreads stay fixed, you know who the counterparty will be every time in case you need to get issues resolved.

There are however some disadvantages as well, the dealer will always know who you are, and you can not go in between the bid and the ask.
Although many people are strong proponents of the ECN model which does seem a lot more transparent, the dealing desk approach can work just as well, as long as you are trading at a well capitalized firm with numerous deep liquidity relationships.

The bottom line is you want to make sure that everything about your dealing firm, platform and over all trading set up is a fit to your needs. However there are some things you need to check right away to make sure that you are trading at a solid firm, because what good are tight spreads if you cannot withdraw your money at the end of the year? It's always a good idea to research your forex broker before you decide which route you'd like to go.

In general first find out the firms capitalization. You can find this at http://www.cftc.gov/marketreports/financialdataforfcms/index.htm. You want to make sure that the firm is well capitalized, I would say over $25 million for adjusted net cap is a good start. This means that they have enough money to have solid liquidity relationships. Next I would actually ask the firm who their liquidity providers are. You want to make sure they are big firms like JP Morgan or Bank of America. Some firms may claim they have no dealing desk on their websites, but in actuality send all their order flow to another dealing desk, you need to be really careful about that. In this case you would be much better of using an IB as you can lower your transaction costs by receiving a volume rebate and trading at the source.

One way to check this quickly is an ECN will always have floating spreads. Spreads can not be fixed at an ECN. So if somebody is offering fixed spreads and saying they have no dealing desk. Guess what? They are going to another dealing desk.
Happy Trading,

Alexander Nekritin
Alexander Nekritin is a professional trader with over 8 years of experience. His specialties include risk management and system development. Alexander is the CEO of NCMFX, Inc., which is a forex introducing broker and an educational company that helps suit client's needs in forex trading. He offers a Forex broker review to his clients that assists in finding an appropriate clearing firm. Alexander has a degree with a concentration in Investment Banking and derivative instruments from Babson College in Massachusetts.

Trading vs Gambling

2008-08-23T21:37:00.001-07:00

What are the differences between trading and gambling?

Many people think that trading is similar to gambling. Is this really the case?
For example, let’s take a look at Black Jack. If you start with $10,000 gambling capital, placing bets of $100 per hand and play 100 hands per day, how long will you last? In the game of Black Jack, with Las Vegas Strip rules, a casino has a built-in advantage of 1.5% over the player in the long run. That means that on average, a player will lose $1.5 per any $100 he bets with. After 100 hands, on average he’ll be down $150. Starting with a capital of $10,000 a player would last about 67 gambling days. That is very similar to the previously described trading scenario. In such case I would choose gambling because at least I would be losing my money in a more pleasant environment.

I chose Black Jack for our example because it is the only casino game in which it is possible for a skilled player to increase his odds to such extent as to be able to beat the House in the long run. A skilled counter can obtain advantage of up to 1.5% per hand over the House in the long run. That means that such a player playing 100 hands per day and average hand being $100 could double his gambling capital of $10,000 in less than 50 days. Similar odds apply to trading stocks, with more potential for profit and less chances for being kicked out of a casino. In order to make it work for you, we’ll need to get the odds on your side. Now lets look at how we can extract as much profits from our trades as possible.

Understanding Trailing Stops
Once you are in the trade and the price has started moving in your direction, you need to extract as much profit as possible. Not being able to do so will make you a losing trader in the long run. How can a trader lose if he only takes small profits at a time? Profit is profit, isn’t it? Not exactly… Profit of $550 is not the same as a profit of $850. If such profits are followed by three losses of $200 each, profit of $550 will become $50 loss, while profit of $850 will become $250 win. Do you get my point?

Profits are always followed by losses and if the profits are small they will not make up for the losses that will eventually and surely follow. However, becoming too greedy can turn a small profit into a loss. This will make you lose money in the long run. The best solution to resolving these conflicts is to use trailing stops.
As the name says, trailing stop follows the stock price that is moving in your direction. For example, let’s say that we have bought two S&P 500 contracts at 875.

We will automatically put our stop loss at 1 point below the support line or if that is over our 4% limit we will put our stop loss at 871. The price starts to move upwards and reaches 876. We will now move our stop loss at $871.75. For every one point move in our direction we will move our stop loss 0.75 points up (or down if we were in a shortsell trade).

However if we were trading two contracts and the price has in our example hit 879 (4 points profit for ES or 10 points for NQ) we would sell one contract to protect our profit and for the remaining contract we would use trailing stop.
April 2004
By Zoran Kolundzic
http://www.wizardoftrading.com/go/emini.html

Technical Indicators In Forex Trading - Understanding Their Limitations

2008-08-22T21:36:00.000-07:00

Forex traders often look at indicators such as Bollinger Bands, Pivot Points, MACD, Moving Averages and the such to help them determine where to enter or exit trades. Using technical indicators is fine, however many traders overemphasize their importance or just plain misunderstand them.

Many forex traders think that they can simply download an indicator and then mechanically apply it into their trading and do so profitably. This is just a plain illusion. Successful traders realize that there is a lot more to using indicators than just asking them to generate buy/sell signals or pin-point exact entry points. Technical indicators for them represent just one part of their trading strategy.

Let's take a look at some of the reasons why you should not put all your faith into those sometimes confusing little indicators.

Take Moving Averages (MA¡¯s) for example. They are "supposed" to show the direction of the trend. The most common and often used are the simple 200day MA, 100day MA, 50day MA, 35day MA and the 21day MA but they are only valid on daily graphs. Some forex day traders say that a good signal is when the 50day MA is crossed by the 13day MA and that when this occurs you should trade in the direction of the cross.

The problem with this (apart from the fact that it only works on daily graphs) is that these types of ¡°crosses¡± do not occur often enough for traders to exploit them. This can often lead to a situation where traders are seeing what they thought was a cross now reverse and uncross. Even worse, it can lead to a situation where day traders are "chasing" and trying to anticipate a cross. If you are doing this, you are distancing yourself from the market which you are trying to trade. Not only are you trying to guess what the price is going to do next but you are guessing what the indicator, based on the prices, is going to do next.

Other problems with technical indicators involve issues with the quotes and prices given to you by your broker. Forex brokers are market makers and as such different brokers will give you different quotes and prices at a specific point in time. Naturally, a different price could lead to a situation where different traders, trading the same market have the same indicators giving them different responses. That¡¯s how arbitrary technical indicators can be.

Finally, a lot of these technical indicators were developed by people trading the stock market. With the growth of computers and software packages that incorporate these indicators, technical analysis has become very popular and spread to other markets such as the forex market. What currency traders should be aware of however, is that as these indicators were developed in a time where real time information did not exist. As such, the limitations of technical analysis becomes even more exaggerated in forex trading ¨C not only is technical analysis an interpretation of historical events but it becomes even more so in the forex market, a market moved by real time events.

Conclusion:

Successful forex traders understand the limitations of technical indicators and realize that technical analysis should incorporate just one part of their trading strategy. In a recent international Forex market event visited by the major banks and institutions - the main players that influence the foreign currency market ¨C a survey was done to better understand what analysis they use. The results might be surprising to some tarders. The survey showed that a mere 26% use technical analysis and indicators compared to 41% who said they use fundamental analysis.
Jovan Vucetic is the Editor of Margin Strategies, an educational forex website, which reviews forex trading systems. Learn about different types of forex trading strategies including a purely mechanical trading system which does not require interpretation of the usual Technical Indicators.

Emissions Trading: The Good, the Bad, and the Ugly

2008-08-21T21:35:00.000-07:00

The green movement has created a plethora of buzzwords. One of the popular phrases is emissions trading. And for good reason. Businesses, traditional and emerging, will soon be affected by this indirect carbon tax depending on where they fall in the supply chain.

One possible regulatory system for limiting future carbon dioxide emissions is a cap-and-trade system. Under this system, permits to produce carbon dioxide emissions are issued by the government and then sold and traded in the marketplace. Total carbon dioxide emissions (represented by the number of permits) are capped, and the market is allowed to set the price of those emissions (as opposed to the carbon tax system where the price is set by law and the market determines the total carbon emissions). The underlying motivation of the system is to achieve desired emissions reductions in the most economically efficient manner possible.

There is a variety of emissions trading proposals that differs in the details and in how draconian the measures are. One of the biggest points of variation is how the allocation of permits is handled. The emissions trading scheme instituted in the European Union allocated permits in most countries by a process called grandfathering. In this scheme, permits were awarded (for free) to existing firms based on the portion of national emissions they had created in the past. Firms could then freely trade the permits they had privately been awarded (through brokers, mind you), or in spot markets, where goods are sold for cash and immediate delivery.

A criticism of this cap-and-trade system has been that it has created huge profits for some firms that have produced the most emissions in the past. These firms have received a large number of permits and have been able to reduce their emissions more cheaply than the cost of permits. This has allowed them to make a large profit off the excess permits they could sell. Other proposals have used an auction scheme of allocation where firms bid on permits to buy them from the government. Under this scheme, the auction price of permits is essentially a tax, with the proceeds going to the government. Some of you may already be raising an important point: How much additional costs (read: overhead) the politicians pile on this tax for their friends and lobbyists affects how well the process works, or does not work.

Of primary concern for business planning is how an emissions trading scheme will affect the price of energy and transportation fuel. Unlike a carbon tax, where determining the cost is relatively straightforward, it is a much more difficult and complicated task to determine the costs imposed by an emissions trading scheme.

The cost of permits, which determines the increase to the cost of energy and transportation, depends on several variables in emissions trading schemes: the number of permits issued, whether the scheme covers one nation or is international, whether the use of carbon sinks (natural systems to soak up and absorb carbon dioxide, such as planting trees) is allowed, or whether a company can pay for carbon offsets in a country not covered by the trading scheme to meet its limitation.

International schemes have the advantage that emission reductions can be made in those countries where they are cheapest, while firms in those countries can sell their permits to firms in other countries where the cost of reducing emissions is higher. Allowing for the purchasing of carbon offsets in countries not covered by the scheme can have the same effect, as will allowing for the use of carbon sinks.

Some proposed schemes, such as one recently proposed in the U.S. Senate, consider a safety valve mechanism. The idea behind this is to make the system a hybrid emissions trading/carbon tax system. Permits are issued to limit total emissions, and these are traded among firms as needed. However, if the price of permits rises above a certain threshold, firms can then buy excess permits from the government at the threshold price. This amounts to an emissions trading system with a price cap. The advantage of this scheme is that it gives policy makers flexibility. They can set the number of permits and the price cap in such a manner as to achieve whatever exact policy they want from a pure carbon tax to a pure emissions trading system, all with a single mechanism.

Depending on the specifics of the trading scheme, and the specific nature of a given firm, emissions trading represents either a potential profit or a potential cost. Under any emissions trading scheme, the costs of energy and transportation will rise, just as it will under a carbon tax scheme. Some firms will be able to cover these costs with profits made from selling excess permits, while others (particularly heavy industry) will be hit with even higher costs. The key is to know where you stand and try to keep your options open as much as possible since it is likely that in the next administration and congress, there will be either a carbon tax or an emissions trading scheme in place.

What all this carbon tax debate is pointing to is the urgency to begin planning NOW for emissions trading inevitability to help protect your business from rising energy and transportation costs.

Simplify Your Trading

2008-08-20T21:33:00.000-07:00

I've found I trade best when I reduce the process to the bare essentials, with as few distractions and decisions as possible. The more moving parts a trade has, the more things there are to go wrong, upset you, make you doubt your trading strategy, and cause you start making changes at the worst possible moment. The more you can reduce the logistical overhead of any given trade, the less likely you are to become emotionally involved in it, and the more time you'll have to focus on the big picture and plan your next trade.

Here are a few strategies that might help cut down on the amount of time and energy you need to devote to a particular trade. (For those who've followed this blog for any length of time, apologies if I'm sounding like a broken record :-)

• Are you using a dozen different indicators and signals to initiate trades? Try combining them into a single signal that gives you a simple Yes/No answer about entering a trade. I do this by using MS Excel to calculate signals such as Bollinger Bands and moving averages and then layering them using the =IF(OR...) function, which tells me if any of my signals have fired. An additional advantage of using Excel is that it reduces the amount of time I need to look at charts, which leads me to my next simplifying strategy...

• Don't look at charts so much, especially ones with a dozen different indicators jumping up and down. Charts are great for many things, but as I've noted before, it can become very difficult to tear yourself away from them, and if you're not careful you can start spotting patterns in them that aren't there. The fact is, you don't need charts to trade. In many ways an Excel price table will serve you as well or better, if you know how to use it. I still use charts but primarily to identify interesting patterns that I then plug into Excel to test historically. I haven't actually entered a trade based on a chart in almost a year. (Yes, I know, I've discussed chart-based trades using Bollinger Bands, but these were actually initiated out of an Excel formula rather than looking directly at the chart. OK, so I guess charts are good for illustrating points on your blog as well!)

• Use a consistent exit strategy that requires as little discretionary input from you as possible. For example, you can combine your exit signals in the same way you combine your entry signals, giving you a simple, unambiguous Yes/No as to when to exit a trade. Or, always set the same fixed limit order to take profit at the same level, and stick with it. Or, consider exiting automatically at certain times of day; this is my exit strategy, and every day at 5:00 PM Pacific Time I either exit my current trade, or roll it over to the next day. Which leads me to...

• Combine your trades whenever possible. If you find you keep jumping in and out of the market with trades in the same direction, you'll save a lot on spread costs, and avoid the risks of slippage, bad timing, and poor execution by just trading once.

• Use the Fire-and-Forget Principle. Focus on pre-determining and automating all the variables in your trades (exits, stop losses, etc.) so that once you've pulled the trigger, you can walk away and the trade will take care of itself with no further attention from you.

• Are you trading multiple currency pairs that are tightly correlated? There's not much point, since they're all likely to move in the same direction at the same time. You might as well just pick one of them and cut down on the distraction of following multiple pairs. This excellent article at Investopedia identifies pairs that are closely correlated, either positively or negatively. For instance, the EUR/USD almost always moves in precisely the opposite direction as the USD/CHF pair. So if you're making long EUR/USD trades and short USD/CHF trades simultaneously, you might as well just choose one or the other, because you're making practically the same trade (and paying more on spread costs, too).

• Trade less often. It's much easier to overtrade than undertrade, so odds are you're overtrading.

Hope these suggestions help simplify your trading and boost your profits...if you have other ideas about how to streamline the trading process, please feel free to post them in the Comments below.

Money Market: Eurodollars

2008-08-19T09:27:00.000-07:00

Contrary to the name, eurodollars have very little to do with the euro or European countries. Eurodollars are U.S.-dollar denominated deposits at banks outside of the United States. This market evolved in Europe (specifically London), hence the name, but eurodollars can be held anywhere outside the United States.

The eurodollar market is relatively free of regulation; therefore, banks can operate on narrower margins than their counterparts in the United States. As a result, the eurodollar market has expanded largely as a way of circumventing regulatory costs.

The average eurodollar deposit is very large (in the millions) and has a maturity of less than six months. A variation on the eurodollar time deposit is the eurodollar certificate of deposit. A eurodollar CD is basically the same as a domestic CD, except that it's the liability of a non-U.S. bank. Because eurodollar CDs are typically less liquid, they tend to offer higher yields.

The eurodollar market is obviously out of reach for all but the largest institutions. The only way for individuals to invest in this market is indirectly through a money market fund.

Which Forex Strategy Is Right For Me?

2008-08-15T11:03:00.000-07:00

Learning to trade Forex is not an easy task, but by no means is it difficult either. Learning to trade Forex does not require a great intellect or a college degree. Doctors have failed as traders and construction workers have become millionaires. Trading is all about discipline, determination and perseverance.

The key is to understand who you are as a trader and trade to your strength. Leveraging your strength can be magnified by deploying the appropriate Forex trading strategy. There are hundreds, if not thousands of Forex trading strategies out there. Logic will tell us that there is a currency strategy out there which leverages our strengths. It is not a one-size-fits-all world. To immediately cut to the chase and take away the magic, it all comes down to two basic Forex strategies; trend-following and range-bound. All Forex trading strategies use a variety of indicators and combinations, MACD, Moving Averages, Stochastic, Chart Patterns, Candlesticks, Pivot Points, Fibonacci ratios, Elliott Wave analysis, Bollinger Bands and the list goes on and on. Let¡¯s take away the magic again. These indicators and studies are merely measuring support and resistance and trend in the Forex market.

But which strategy really works? This is the age old question?

First, we must understand who we are as traders. Does our personality fit the pip sniper mode or does our disposition attract us more towards swing trading. Finding your trading personality will mean studying and experiencing the different time frames and associated Forex trading strategies. Over time you will notice a higher level of success and/or comfort trading one style over others. Pay attention! The market is telling you where your skill is more capable of extract consistent profits for the market. This is why journaling is so important to your Forex trading routine.

Secondly, if you are using someone else¡¯s strategy, a most of us are, deploy this strategy without change until you fully and completely understand all aspect of the strategy through back-testing and actual experience. As I was told; dance the dance you have been taught until you learn a dance of your own!

Don¡¯t fall into the trap of jumping from strategy to strategy or combining different strategies when the one you are using doesn¡¯t yield immediate success. This is only a recipe for disaster. Take the time to really understand the trading strategy. Study the components individually so a deeper understanding of the strategic mechanisms is mastered.

Above all, know when and when not to deploy this strategy. You will not find consistent success implementing a trend following system in a range-bound currency market.

So what¡¯s the right strategy for you? It is simple, the one that works. It doesn¡¯t matter if it is complicated or simple, trend-following or range-bound, uses Fibonacci studies, pivot points or both. If you understand the components, internalize its use, and drive consistent profits into your trading account, then you have your Forex trading strategy.

It doesn¡¯t matter what the experts say, your account balance is the ultimate judge and jury for your Forex trading strategy.
Todd Judkins specializes in teaching real people how to trade the Forex market for long term success by focusing on strategic, mind and money skills. He is a currency trader, educator and success coach to traders. Are you now ready to take action? To begin training with Todd immediate, online Forex trading visit: http://www.forexjourney.com and sign up for his FREE WEBINAR and FREE Forex Webinar.

The opportunities of trading the Forex hedged grid system

2008-08-10T11:14:00.000-07:00

I have seen the hedged grid system been used successfully (and highly unsuccessfully) over the last few years. Unfortunately the failures tend to discourage traders from taking advantage of this great system. I have found that the failures are mainly due to ignorance, impatience and greed (common reasons for trading failure).

In a nutshell the grid system uses the following methodology. You start by buying and selling a currency. When the price moves a predetermined distance (grid leg) you cash in the positive leg, leave the negative leg and buy and sell again. Sooner or later the system goes positive and you would then cash in when it is positive.

This is a brief summary of the content of our free hedged grid trading course available on expert-4x.com. Please refer to this course for more details of how money is made. The attraction is that the system is reasonably mechanical, can be programmed and does not take much supervision as exclusively entry orders are used.

Money is made when the price retraces 100%, 50%, 33% at various levels. This starts looking like a strategy that supports the Fibonacci concept. The grid system is also based on the nature of the market to trade sideways 80% of the time and to trend 20% of the time.

The dangers are that what if the price does not retrace and continues to trend. The Grid system can not make money in a trending market – full stop. One has to realize that. You therefore need Strategies to minimize damage during these periods:-

Firstly I have found that the biggest mistake made by traders is that they select a very small grid leg sizes e.g. 20 to 30 pips. This is a recipe for disaster. The trick is to use big leg sizes between 150 and 300 pips. What this does is that it sometimes turns a trending phase into movement in a sideways market. I would typically use 300 pips for the GBPJPY and 150 pips for the EURUSD for instance.

Secondly there is no rule that says that the legs have to be the same size. So I change my leg sizes in trending markets to be even bigger. If I started with 150 for the 1st leg I would go to 200 for the 2nd leg and 250 for the 3rd leg etc. This makes sure that I am carrying less loss making transactions in a trend.

Thirdly – sometimes it is wise to increase the number of lots with the trend compared to the numbers against the trend in a good trend. However be aware of having the same number of sell and buy transactions. All you will have done was lock in your current status in a 100% hedge.

Fourthly – This is the biggest change and most important one that I personally have made in my grid trading strategy. Always cash in all your transactions when your system is positive and when the price reaches the end of one of your grid legs. By cashing in you are reducing the risk of carrying negative lots in a trending market. This also gives you an opportunity to re-assess the market conditions.

Fifthly:- Cash in a start again is always an option. One of my strategies is to cash in all my open positions when the 3rd leg of my grid is reached and start again. Experience has taught me that this is a short term pain that goes away very quickly and is soon forgotten.

People that have traded the grid system will immediately see how the above approaches will reduce the risks of exponential losses building up in a strongly trending market.
Mary McArthur is a Trader associated with expert-4x.com. She provides the main input into the page rated Forex Trading Blog www.forextradeoftheday.com and assists with the educational and trading alert services provided by www.forextradersupportservices.com. She is considered an expert of the hedged grid system and has co authored a free grid trading course on www.expert4x.com . She can be contacted at marymacarthur@expert4x.com.

Learning about carry trades

2008-08-07T11:27:00.000-07:00

One of the areas I've been pretty ignorant about in the world of forex is carry trading, which relies on interest rate differentials between currencies to profit from interest rather than fluctuations in the actual currency prices (though those can certainly contribute nicely to any interest gains if they trend in the right direction).

As usual, the Oanda forums proved to be a trove of information on the subject: currently I'm in the midst of this thread, and am finding the posts by Interest-Hawk and the excellently named HAPHAZARD_TRADING particularly interesting.

Interest-Hawk describes the steady profits he's been making with a long position in the GPB/JPY pair, which will pay out just over $22 a day per lot in interest. As he describes his strategy, "I trade using FXCM (a topic for another thread) and they require a 2% margin to earn interest. For me, that comes down to every 100k lot costs me $2000. 2k per lot, simple as that. Each of those lots then pays me exactly $22.70 per day, every day of the year in rollover interest. That breaks down to doubling my initial investment (In interest ONLY) every 88 days."

That got my attention pretty quickly, as did HAPHAZARD_TRADER's list of the currency pairs in his interest-positive basket:

"GBP/CHF, LONG
GBP/JPY, LONG
AUD/JPY, LONG
USD/JPY, LONG
USD/CHF, LONG
EUR/HUF, SHORT, for those who like 100 pip spreads

Not all at once and all the time, but I'll keep trading them so long the INTEREST keeps rollin in."

Carry trading is probably not a great strategy for those who are impatient, short-term in outlook, or addicted to the thrill of freqent trading. That said, I do see an opportunity for a hybrid strategy that combines trading and carrying, with the potential to benefit from both. Here's how I would go about designing it:
• Identify a pair like GPB/JPY with a high interest differential
• Create a rule-based trading strategy for it as I would for any other pair, but with the exception that...
• This strategy would focus only on interest-positive trades: in the case of the GBP/JPY, long trades.
• Once I had a working trading strategy that I felt comfortable with, regardless of interest, I'd then start placing long trades with it. If all went well, I'd be gaining interest while hopefully profiting from uptrends in the GBP price as well.

In this type of hybrid system, any losses in trading would be offset by gains in interest, and in the best case, interest and trading gains would coincide to generate significant profits...especially when daily compounding enters the picture.

Another strategy is to open inversely correlated positions that are both interest-positive. This way, any losses in one currency's price would be (roughly) offset by gains in the other, while both earned interest. This is the idea behind a balanced basket of interest-earning currencies.

But I'm still very new the whole carry trade concept, so there's a still a lot to learn. If I've made any amateurish errors here, any carry traders in the audience are welcome to correct them in the comments below.

TRADING: A MIND GAME

2008-08-05T11:39:00.000-07:00

You must change your mental attitude first from a normal person to that of a speculator. Almost all traders I have met, except a few successful ones who really made millions and billions trading in the market, simply waste all their time trying to learn the easiest part in perfection, like about how to read data and charts, and trying to perfect entry and exit skills, etc. Trading is a mind game and without having a right frame of mind, it is a losing game even before it starts. Training a trader�s mind is the first step for any successful trader but almost all new traders neglect that part and that explains why more than 95% of traders are a failure in the long run.
Acquiring the knowledge of the market is not difficult for anyone with average intelligence after a few years of hard study in the market. But it is neither the level of intelligence nor the knowledge that decides the outcome of the market operations of a trader. It is the decision making process that is so hard for most traders to overcome and that is the main reason for a success or a failure for all the traders.

Some find it easy to make decisions and stick to it and most find it so hard to make decisions and stick to it. Unfortunately, any decision making process in trading is a pain-taking process and humans tend to avoid pains and go for pleasures even if for temporary ones. Assuming one has acquired enough market knowledge and acquired one�s proven trading system (this is the second most important element of success in trading, in fact. An edge in any system is based on the quality of info one has, charts being only an info of secondary quality not the best one)

Through studies and research, a trader faces the task of making decisions to put this knowledge and system into practice. Then, how many traders can honestly say they can commit their ranch when the trade is suggested by their own system (given that trading is just a chance game) and let the profit run for weeks and months when their system tells them, and how many can manage to cut the loss as a routine process when the situation arise.

It all sounds so easy when saying it but so difficult when doing it affecting real money in the market. I still do not sleep well when I am running position because even if the profits are running into a few hundred dollars and the system is telling you to carry on, there is no guarantee that the profit will turn into a yard or two in a month time, and it may even turn into a loss in a day or two when something unexpected happens.

A painstaking process in real sense. The pain is not knowing what will happen in the future and in fear of losing. So at the end of the day, assuming one has decent trading system and market knowledge and decent info, it is ultimately how disciplined and how well that trader can take the pain of making right decisions at the right time that decides the outcome of the trades. Hence I call trading a mind game.

When I interview prospective young traders, I always look for disciplined and strong-willed person as my first priority as long as one has decent education, but strangely in many cases, it is some kind of genius or half-genius with lots of brains with no disciplines who turn up for an interview thinking only bright people can make good traders.

In fact, I always try to pyramid while position trading medium-term once I am convinced of a new medium-term trend emerging. Like in USD/JPY position trading 135-132 as an initial position, adding in 132 and 129 areas. Same for AUD/USD and EUR/USD with similar strategies. But sitting on positions and watching the counter-rallies costing truck load of money is not easy job to do and causes lots of pain all the time.

Most traders even among experienced ones cannot bear that pain and give up too early. But there is no other way to make a big money and we have to bite the bullet and "sit and accumulate" as long as the medium-term trend is intact. That is why I always believe psychological aspects of trading is far more important than anything else in successful trading. A mind game like those bluffing game of poker.
Entries and exits can never be "irrelevant" for any trader for any purpose. It is just that psychological aspects of trading are much more important than entries and exits, and decisive for the success or failure of a trader in the long run. Perhaps exits are more important than entries because any perfect or near-perfect entries are possible only in hindsight.

Forex Spot Trades Vs. Currency Futures

2008-07-30T11:45:00.000-07:00

Over the last several years, Forex Dealers have been springing up everywhere. Attending the New York City Trader's Expo this year, I was surprised at the number of FX dealers that were all exhibiting very similar offerings. Some competitors even used the same trading platform just white labeled to appear customized.
My thoughts were there must be tremendous profits in the FX Dealer business to support the preponderance of dealers offering truly non-differentiated offerings.
My next obvious thought was, where does this profit come from? These guys generally do not charge commissions, so how do they get paid?

Dealer profiting - your Loss is their gain
They make their money in several ways, first is from the bid/ask spread which normally is at least 2 pips and sometimes as high as 5 or 7 depending on the dealer.
The second way and some say the sneaky of dealer profiting is to actually take the other side of your trade. Your losses go directly into the dealer's pocket.

How is this possible? A little known fact about trading with FX dealers is that your trade isn't actually placed in the true interbank market, but merely held on the dealer's own books. They are the counterparty, therefore your losses enrich the dealer and your gains come directly from the dealer. Conflict of interest? I'll let you decide.

Dealers are improving; however, some are moving to a non-dealing desk model and having several banks compete for your trades with the best price on the pair. You are trading with the dealer as your counterparty in an unregulated marketplace - seems pretty risky for the serious trader.

Is there an alternative for the active currency trader?
Yes. There is an excellent alternative in the form of currency futures offered by the CME. I am particularly partial to the E-mini version of the currency contracts from the CME.

The E-Mini Euro symbol E7 is the one I am most familiar with. It moves in $6.25 ticks and the advantages of trading this future over the EUR/USD pair offered by dealers are several. First and foremost is the very tight spread and low commissions offered by most brokers.

Secondly is a regulated marketplace with price transparency.
Thirdly, your broker can't play games with your trades as dealers sometimes do, as the trade is made in the actual marketplace and not held on dealers' books.

The bottom line
FX dealers offer more flexibility for the FX trader, particularly small traders. They provide access to the market for those very little capital. In fact, several even allow you to trade micro lots with just one dollar in the account! The spreads and other negatives have less of an impact if you're a longer term or swing trader.
Currency futures definitely have the advantage for short term/day trading/scalping. In the end, it really comes down to personal choice and style.
Good Luck!

Dave Goodboy is Vice President of Marketing for a New York City based multi-strategy fund.

Why Hedge Foreign Currency Risk

2008-07-26T11:49:00.000-07:00

International commerce has rapidly increased as the internet has provided a new and more transparent marketplace for individuals and entities alike to conduct international business and trading activities. Significant changes in the international economic and political landscape have led to uncertainty regarding the direction of foreign exchange rates. This uncertainty leads to volatility and the need for an effective vehicle to hedge foreign exchange rate risk and/or interest rate changes while, at the same time, effectively ensuring a future financial position.

Each entity and/or individual that has exposure to foreign exchange rate risk will have specific foreign exchange hedging needs and this website can not possibly cover every existing foreign exchange hedging situation. Therefore, we will cover the more common reasons that a foreign exchange hedge is placed and show you how to properly hedge foreign exchange rate risk.

Foreign Exchange Rate Risk Exposure - Foreign exchange rate risk exposure is common to virtually all who conduct international business and/or trading. Buying and/or selling of goods or services denominated in foreign currencies can immediately expose you to foreign exchange rate risk. If a firm price is quoted ahead of time for a contract using a foreign exchange rate that is deemed appropriate at the time the quote is given, the foreign exchange rate quote may not necessarily be appropriate at the time of the actual agreement or performance of the contract. Placing a foreign exchange hedge can help to manage this foreign exchange rate risk.

Interest Rate Risk Exposure - Interest rate exposure refers to the interest rate differential between the two countries' currencies in a foreign exchange contract. The interest rate differential is also roughly equal to the "carry" cost paid to hedge a forward or futures contract. As a side note, arbitragers are investors that take advantage when interest rate differentials between the foreign exchange spot rate and either the forward or futures contract are either to high or too low. In simplest terms, an arbitrager may sell when the carry cost he or she can collect is at a premium to the actual carry cost of the contract sold. Conversely, an arbitrager may buy when the carry cost he or she may pay is less than the actual carry cost of the contract bought. Either way, the arbitrager is looking to profit from a small price discrepancy due to interest rate differentials.

Foreign Investment / Stock Exposure - Foreign investing is considered by many investors as a way to either diversify an investment portfolio or seek a larger return on investment(s) in an economy believed to be growing at a faster pace than investment(s) in the respective domestic economy. Investing in foreign stocks automatically exposes the investor to foreign exchange rate risk and speculative risk.

For example, an investor buys a particular amount of foreign currency (in exchange for domestic currency) in order to purchase shares of a foreign stock. The investor is now automatically exposed to two separate risks. First, the stock price may go either up or down and the investor is exposed to the speculative stock price risk.

Second, the investor is exposed to foreign exchange rate risk because the foreign exchange rate may either appreciate or depreciate from the time the investor first purchased the foreign stock and the time the investor decides to exit the position and repatriates the currency (exchanges the foreign currency back to domestic currency). Therefore, even if a speculative profit is achieved because the foreign stock price rose, the investor could actually net lose money if devaluation of the foreign currency occurred while the investor was holding the foreign stock (and the devaluation amount was greater than the speculative profit). Placing a foreign exchange hedge can help to manage this foreign exchange rate risk.

Hedging Speculative Positions - Foreign currency traders utilize foreign exchange hedging to protect open positions against adverse moves in foreign exchange rates, and placing a foreign exchange hedge can help to manage foreign exchange rate risk. Speculative positions can be hedged via a number of foreign exchange hedging vehicles that can be used either alone or in combination to create entirely new foreign exchange hedging strategies.

Arbitrage

2008-07-24T11:58:00.000-07:00

There is no free lunch.
Old Stock Exchange adage

Arbitrage strategies are very popular in the hedge fund world, but before turning to their description, it is necessary to clarify the specific meaning of the term “arbitrage” in this context.

From an academic point of view, an arbitrage stands for a risk-free transaction that
generates an instant profit: a theoretical example of arbitrage is the concurrent purchase and sale of the same security on different markets at different prices. By buying the same security at a lower price and selling it right away at a higher price, an arbitrageur earns an immediate profit at no risk, saving the settlement and delivery risks.

But in the hedge fund business the term arbitrage has developed a different sense, in that it does not refer to risk-free positions, but rather to positions involving risks other than the market risk. Hedge fund arbitrages in practice are directional positions on spreads: if the spread widens or narrows as anticipated, the manager makes a profit; otherwise he suffers a loss. Therefore we must not be misled by the word arbitrage: a hedge fund may well suffer a loss even when it has constructed an arbitrage position – what it takes, is for the spread to widen or narrow contrary to predictions.

An arbitrage opportunity may appear when given technical, geographical, legal or administrative barriers interfere with the correct interaction between two markets trading the same security, thus preventing the security from having the same price on both markets.

In a perfect world, there would be no arbitrage opportunities, and in the real world most arbitrage opportunities tend to disappear quickly, unless there are high transaction costs that hamper frequent arbitrages. Over time, inevitably, other arbitrageurs will get organized to take advantage of arbitrage opportunities, narrowing down the price difference until it disappears. Arbitrage opportunities draw various arbitrageurs to the market, and they will erode each other’s profits by competing against one another. Once again, to make a return it is necessary to take on risks!

It is important to note that arbitrageurs are not asked to forecast the absolute movement of two securities, but rather the relative movement of one over the other, irrespective of market direction.

Any arbitrage opportunity faces so-called steamroller risks. Through a colorful analogy, an arbitrageur is seen as somebody who picks up a few coins from the ground in front of a moving steamroller: the man runs no risk provided he never forgets that the steamroller is forging ahead towards him. In order to earn a few coins the man runs the risk of being steamrolled.

Risks can also come from regulatory or tax changes, which may force the arbitrageur to close a position while losing money. Or, as illustrated below in the ADR arbitrage example, sometimes conditions regulating the short sale of a security may change suddenly, and the security may be called in by the owner; or sometimes the borrowed security may pay out a dividend, which is going to represent an unexpected cost for the arbitrageur.

The greater the number of arbitrageurs operating on a given market, the higher the
competition, which means that the returns realized by the arbitrageurs will be lower. The current trend in the hedge fund business is that the massive money flow towards arbitrage strategies makes it more and more difficult for managers to generate interesting returns.

Most of the low-hanging fruits have already been picked!
This article is a part of “Investment Strategies of Hedge Funds” ebooks by Filippo Stefanini for closed private educations only. You should nuy his books for the best completely informations.