THE SIX FORCES OF FOREX

Trading forex is like watching a school of fish move. One minute is total harmony, the next, complete chaos. As the observer of this school of fish, do you believe you can accurately predict the direction the school of fish will move each time? Would you bet on it?

What causes the fish to move the way they do? Why do they work together in one moment, moving with force and precision, and move in what seems to be an infinite number of directions the next? There’s no way to know unless you can sense what the fish sense each time they move. The fish have an instinct about the nature of their environment. They understand the context of all things around them – natively – and can react accordingly. Surely if you shared this understanding you’d be a much more accurate predictor of fish movement!

Trading forex is not much different - we need to develop that keen sense of what is happening around us. Will we ever be able to predict every move in the forex markets? Absolutely not. But we can use our understanding of the context of the market – the six forces of forex – to make better, more profitable trading choices. Once we understand these forces, we can create and operate within a comprehensive trading plan:

1. Who trades forex? Understand who participates in the markets, why they are successful, and how you can emulate them.
2. 􀂃 Why trade forex? There are superior returns in forex, but not for all investors. Are you one of them?
3. Where should you trade? Choose to work with service providers who can efficiently enable your style of trading.
4. 􀂃 What should you trade? Select the currency pair, entry, exit and money management methods that will maximize your returns.
5. 􀂃 When should you trade? Trade when the environment is most likely to produce the best conditions for executing your system.
6. 􀂃 How should you trade? Trade using methods that maximize your ability to emulate the proven winners.

Knowledge of these forces and how they work is a major determinant of your success as a trader. Figure 1 shows these 6 forces, their relative rarity, and their effect on profitability.

Figure 1: The Forex Vortex

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

WHO

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

Figure 2: The Who’s Who of Forex

Each perspective carries a different attitude, goal, investment horizon, and market impact.

They key difference among these market participants is their level of sophistication, where the elements of sophistication include:

1. 􀂃 Money management techniques
2. 􀂃 Profit objectives
3. 􀂃 Level of computerization
4. 􀂃 Quantitative abilities
5. 􀂃 Research abilities
6. 􀂃 Level of discipline

Of course there are sophisticated and non-sophisticated banks, governments, corporations, investment funds, and traders. But among these segments it is the individual trader who has the least amount of external governance. Whereas governments, banks, corporations, and investment funds adhere to regulations and restrictions (to a certain extent), traders are only restricted by their level of capital.

In the absence of these external restrictions, traders fall into two groups: those who can impose internal restrictions – discipline - on their trading strategies and those who cannot: the fence-swingers, et al.

Those who can impose this discipline we will call the sophisticated investor. In the zero-sum game of forex trading, the sophisticated investor uses tools and strategies that emulate those of the highly sophisticated institutional participants to extract profits from the novice participant. It is only the sophisticated investor who has the ability to extract positive returns from the forex markets.

WHY

Forex trading has surged in recent years, as more individuals earn their living trading and the popularity of riskier investment vehicles like hedge funds has increased. The bottom line for these investors is superior returns, and in foreign exchange four major factors create a unique investment environment:

• 􀂃 Liquidity
• 􀂃 Leverage
• 􀂃 Convenience
• 􀂃 Cost

In no other market can you find a playing field that is so biased to the investor, at least on the surface. But to take advantage of these factors you have to be constantly aware of their downside.

Liquidity

In a liquid market there is a high degree of transparency, even when large transactions change hands. The sophisticated investor understands what this means: forex attracts huge players. As a trader grows in sophistication, they understand that these huge players have significant price impact, and watch for their market entry.

Leverage

The low margin requirements in the forex markets make everyone’s what-if analysis yield forecasts with 1000% growth annually. What those forecasts fail to account for is the multiplying effect of leverage during periods of consecutive losses.

Figure 3: The Leverage-Loss Matrix

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

Convenience

The fact that you need to go to bed or spend time with your family does not stop the forex markets from operating. In other markets you can trade a specific window that usually lasts 6-10 hours, which is physically manageable. Forex, on the other hand, demands 24 hour monitoring. That can be accomplished through automated trading systems or, less optimally, through pre-set stop and limit orders or physical monitoring of a trade.

Cost

“No commission trading” is a marketing slogan many dealers offer as a perceived benefit of forex. But the fact that there is no commission does not change the high level of transaction costs paid to dealers through the bid-ask spread.

There is no doubt that the liquidity, leverage, convenience, and transaction costs found in the forex markets are great tools for investors – but not always. Just as easily as these tools can be used for wealth creation, they can be misused for wealth destruction. The novice investor destroys wealth, and the sophisticated investor creates it.

WHERE

It is one thing to choose a dealer, and quite another to choose the correct dealer. Dealers’ service offerings can take many forms, and each dealer usually has one or two major features that they highlight above all others. When analyzing dealers, first understand and rank all of their service offerings, then apply those findings to your trading style to arrive at your optimal dealer.

Figure 4: The Dealer Comparison Matrix

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

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

They learn about the dealer, visit the site, register for a demo, then scale the learning curve to grow comfortable trading with that dealer, using their charts, etc.

Frequently, the dealer with the best marketing is not the best dealer for the trader, or perhaps, for any trader. Traders use systems that work in the short term, mid term, or long term, with varying holding times and strategies. The type of dealer needed for each approach is quite different.

For every trader there is an optimal dealer. For many, the path of least resistance leads to the dealer who makes first contact, not the dealer who will provide the best trading outcome. The sophisticated investor optimizes returns by matching his trading style to his dealer.

WHAT

A comprehensive trading plan is framed by three main elements: the trading vehicle, or currency pair, the events that trigger market entry and exit, and the overall approach to trade management.

Figure 5: What to Trade

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

All of these factors work together. Trading a high spread currency using short interval entry signals and highly leveraged positions will probably be a failing strategy. Conversely, trading a tight spread currency using mid- to long-interval entry signals and little leverage has a better chance of success.

In the final analysis, the currency, signals, and money management approach must all gel together and exist without contradictions. Novice investors make critical errors by trying to patch together strategies from various sources, rather than systematically building, testing, and deploying a comprehensive trading plan. The sophisticated investor, who does this difficult work, operates with a complementary trading plan that creates consistent profit opportunities.

WHEN

Forex is a 24/7 market – but is the market action the same at all times? Of course not, but not many traders stop to consider the impact of this fact on their trades. Studying historical price data reaching back to January 2000, the impact is clear, as shown in Figures 6 & 7.

Figure 6: When to Trade - AM

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

Figure 7: When to Trade - PM

The markets sleep when London and New York are off.

One of the best ways to validate a technical indicator is volume. When volume is strong, indicators tend to be more accurate. Unfortunately, there is no volume data available for the forex markets. Using trading ranges is the next best thing.

Having this data in hand, the trader can more carefully evaluate when to trade. Not only will technical indicators generally have more accuracy at different points of the day, but there is both more profit potential and less loss potential at other times of the day.

Consider a trade in EURUSD at 10 AM EST vs. one at 10 PM EST. The first has an average trading range of 30 pips, the second, 10 pips. Entering the market during the morning trade creates some interesting possibilities – the market may go against you or with you, but you should be prepared for a ride in either case. On the other hand, if the market goes against you 10 pips at 10 PM, how concerned should you be? Probably not as much as if it was 4 AM.

For a more in-depth discussion of when to trade, including trend, days of the week, and other metrics, register for your free trial at FX Engines. All FX Engines users receive our periodic Case Studies which highlight automated trading strategies.

Anybody can trade based on technical indicators. The novice, in particular, ignores the importance of “when” as he makes trading choices. The sophisticated investor is the one who uses timing to his advantage – creating profit opportunities and limiting losses by observing the market with more perspective.

HOW

Once an understanding of the external elements of trading is completed, the hard work begins: the trader must understand his own mind. The external elements are easy – they are usually rational, factual, consistent, and ordered. The trader’s mind, however, is far from all of that.

Figure 8: The Trader’s Mind

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

Emotion, or lack of discipline, is the greatest enemy of every trader. This is so true that one could argue that discipline is a more precious trading commodity than capital itself, since capital can only be sustained with discipline.

This is not to say that the trader does not have value to bring – he does. In moments of clear, objective contemplation, many traders – even novices – can be builders of excellent trading systems. These systems can take advantage of their understanding of the forces of forex and test out incredibly. Once live, however, the system falls apart. Why?

The simple reason is that emotion has no place in trading. Emotion causes the trader to act differently following large wins or losses. Emotion causes the trader to act irrationally when large moves occur. Emotion causes the trader to apply his trading system inconsistently.

If you took a survey of successful traders you would find many similarities. The traders would understand and apply all of the forces of forex. They would usually trade incredibly simple trading systems. They would trade using conservative, well thought out money management philosophies, and they would trade with absolute consistency.

For the institutional investor, absolute consistency is not a problem, since they have an array of personnel and resources at their disposal. For individual investors, there are three groups. Those who trade without consistency, those who trade with manual consistency, and those who trade with automated consistency. The novice, of course, is the trader who thrashes from trade to trade. The individual investor who uses consistent discipline or automation as the foundation of his trading activity maximizes his level of sophistication.

Why Forex Traders Plan To Fail Before They Even Place Their First Trade & How You Can Know It & ...

Have you heard the wise saying that a trader who fails to plan, plans to fail? I have, and I was once that trader! However, did you know that even though traders who have constructed a plan, which incorporates their trading stategy (their "edge"), they have a plan that is likely to fail?

If we look at all traders who participate in the market: we have one group that fails to plan and therefore plans to fail; another group whose plan is failed; and a third group who properly plans and therefore does not fail.

Is it any wonder that the success rate for forex traders is so slim?

Well it doesn't have to be.

Here's a list of reasons why those whose plan is destined for failure fail:

1. They become emotionally attached to their ideas about how the market should be with minimal or inadequate testing;

2. They fall in love with their back-tested net profit results without fully understanding other key statistical data;

3. They don't admit they're plan is wrong.

Let's explore each point in a little more detail.

1. Becoming emotionally attached to your ideas without adequate results

Most new traders when they realize the importance of obtaining a trading plan and sticking to that plan immediately begin to use the knowledge they have been taught and haphazardly throw it all together into what they deem their "trading plan".

When they are questioned on whether they have a trading plan most of these traders answer with an unequivocal "Yes!".

Most of these traders are destined for failure because their strategy is untested. They rely on blind faith to guide them through the trading jungle to make their untold millions. Would you walk from one length of the Amazon jungle to the other blind-folded? Of course not! You'll have to watch out for all the snakes, tarantulas, and other creepy things that go bump in the night, so why would you approach trading in the same fashion? I mean all you're really doing is placing the blind-fold on your capital!

Why do traders do this?

Because it's easy. That's right... it's easy. They don't need to learn a computer language to type their system into some piece of software that will take them the better part of 6 months to a year to learn, and they don't have to spend any money on buying historical data. Therefore it's easy and it's cheap and it also conserves time!

So does success meet lazy people like this?

Not many! However I will admit that it does meet a fortunate few - only those lucky enough to start their trading during roaring markets where even a monkey can make money! To repeat again: don't wear the blind-fold. Your success may be great at the start, but given time and trades, you'll be the one out of the game - having depleted all your capital.

So what do you do if you KNOW that your method is untested?

If you have the time, the money and the learning capacity I would strongly encourage you to purchase some back-testing software (such as Wealth-Lab Developer), acquire some forex data, ask heaps of questions on the Wealth-Lab forum on how to code your ideas and within 3-6 months you'll be safely coding your own forex system and testing adequately.

If you do not have the time, the money nor the learning capacity I would strongly suggest that you manually write down your system into clearly defined steps that you MUST follow. Then, after opening a DEMO forex account you would trade your system according to the rules you have set out. Trading your rules until about 20 trades have been completed.

After traders obtain their results from their testing period they unfortunately look at only one figure and make a rash conclusion about the system based on that one performance figure, namely, the net profit. This then leads us into the next problem of why traders plans are failed prior to placing their first live trade...

2. They fall in love with the net profit result and no longer question it any further!

The net profit is only one statistic among thousands, however, to keep things simple we will look at the top 3 results that you need to make sure you fully understand.

Here are the other statistical pieces of data that you should look at when your system has completed its testing period:

I. How many trades did it have? If you have made a nice profit, but have only had 3 trades during the testing period you do not have a sufficient sample space to arrive at any safe conclusions. Can you imagine what would happen to Neil Armstrong if NASA had only done 3 computations on how they would arrive on the moon??!! If it's not good for NASA then it's probably not good for you either, however, as NASA do zillions of computations you would only need to conduct about 20 trades as the bare minimum before you can arrive at any safe conclusions;

II. What was your money management procedure during the testing phase? This is by far the most important point, however, you need to make sure your system is properly working prior to even embarking on this difficult area (hence the reason why it is a CLOSE second to the above point). Be sure you fully understand what I am about to explain (read it several times to absorb it if need be)... If you test a method whereby you rely on a percentage amount of capital on a trade you can be biasing your results!

How?

Let us look at the following comparison sheet where we plot 21 trades with their pip return (we'll assume that each pip = US$1), and compare the returns against using 10 contracts per trade, 10% capital per trade, or 2% risk per trade...

Example Trade Sheet

Now as you can see from the results they can easily be doctored according to the different type of money management technique you use and what variable you decide to use it on (i.e. who is to say that we not use 20 contracts per trade, or 20% capital, or 5% risk per trade - all of these would inflate the net return figures).

It is best when you trade to stay at a fixed quantity. If you use any results that require a percentage calculation of the equity balance prior to the trade quantity being calculated you will BIAS the last trades more than the trades at the start. Hence, using a fixed quantity throughout the entire sample is one of the true indications of whether your system is profitable or not.

III. What was the drawdown? This is the largest peak to trough distance on your equity curve. In other words, if you were to enter in on the day the equity curve made a peak, how much would you have lost if you bailed out at the lowest point? To test this manually you would obtain an equity curve peak trace how far the equity curve goes down until it moves higher that the peak you started from - the lowest point made between these two points will be your trough figure which you will then subtract from your starting peak figure. The figure with the largest % loss would be your drawdown.

You would then need to look at this drawdown figure and determine whether or not it fits your risk profile. Would you be okay mentally if your account was down the drawdown % figure? If not, then you're going to have to re-create another system. As a rule I don't like systems that generate more than 30% drawdown.

One other statistic that incorporates drawdown that I like to check to determine whether the system is profitable or not is the recovery factor. The recovery factor divides the net profit by the drawdown (without the negative sign). As an example, if the net profit were $5,659 and the drawdown were -$3,542 dividing the net profit by the drawdown would result in a recovery factor of 1.597 (get rid of the minus sign). I generally prefer systems to have this statistic above 3.

So even though we have created our system that fits our personality and risk tolerance level well trades can still fail by not heeding the third and final statement...

3. Don't fall in love with the system

Most traders once they have designed a system cannot believe that their system is making a loss, or worse yet, a loss greater than the system's historical drawdown.

So, to combat this they dig their head in the sand hoping that the problem will go away. Just as trades fall in love with their position, at their own peril, falling in love with their system is also to their detriment.

Treat this as a business with your system as one of your salesmen. If the salesman is costing more than he is bringing in then you need to fire him and find another one.

How do you know if your system is no good?

As a rule I look at the historical drawdown of my system and add 10%. As an example, if my system had historical drawdown of 20% once the system reached 20% x 1.1 = 22% I would stop trading this system and move onto another. And sometimes you can still trade the same system, just with different variables, or a minor tweak.

Be sure that you fully understand the implications presented to you in this article. Trading is a business, therefore conduct it like one, as it is one of the most difficult endeavors you could ever undertake.