Your Trading System Needs Internal Controls

I've said this before, but it's worth repeating - especially after reading about the rise and fall of Soul Trader's Grail forex system, which I always regarded as one of the most advanced automated systems around. Reading his explanation of why this system finally had to be shut down really brought home to me the need for rigorous internal controls on your trading system.

By internal controls I mean the type of tracking algorithms that watch over your trading performance and intervene to shut it down when performance begins to dip. Or to paraphrase Soul Trader, "How to identify when the market conditions cause the system to fail, and what to do when it's failed."

String of losses over X% of trading capital? Click: the system goes off until performance improves. Recent trading odds dip below Y%? Sorry, you're out of the market until things perk up - and if they don't perk up, you'll just have to be patient and appreciate the fact that at least your funds are safe. Preserving your capital in adverse conditions is pretty boring, but it's one of the most important single factors in trading success.

The only reason I'm still trading, and have even bothered to return to trading after a recent hiatus, is because of these built-in trading restrictions. I think of them as a firewall between me and the worst the market can dish out. They're not perfect, and they certainly don't prevent all drawdowns all the time, but they're a lot better than nothing at all. In fact, given the choice I'd much rather trade with no stop-losses and strong internal controls than vice versa.

Disclaimer: check back in a few weeks and see if I've abandoned my trading controls because they failed completely in unexpected market conditions.

Back in the Market After Some Forward Testing, a Bad Carry Trade, and a Bit of Boredom

Hello again, and apologies for this blog's recent suspended animation. For various reasons hinted at above I decided to give forex a rest for a while - but I'm now back and have just made my first foray into live trading the EUR/USD again.

The principal reasons I took a break were:

I was frankly a little bored and disappointed with the progress of my EUR/USD trading system. Out of impatience with its performance, I'd convinced myself it didn't actually work with real trades, it just looked good in backtesting. In fact, I ended up questioning the entire idea of backtesting since it offers absolutely no guarantee your trading rules will work into the future. So I decided to give it a break, and maybe come back in a few months, plug in the new data, and see if my system would've actually made decent trades in that time.

Around the same time, largely because I was disillusioned with my own trading system, I convinced myself carry trading was by far the best way to trade. So I devised what I thought was a very clever hedging system using the USD/CAD to balance the volatility of the carry trader's beloved GBP/JPY pair. But unfortunately I decided this just before the GBP/JPY carry trade experienced a giant melt-down that demonstrated how little I know about carry trading or hedging. So I got burned. Thanks to my stop-losses I didn't get wiped out, but I did get scorched pretty badly. (Did I mention I also broke my own trading rules by taking on way too much risk? Well, I did. And it was dumb.) In case you're wondering what a carry trade meltdown looks like, here's a picture. Congratulations to all the GPB/JPY shorts out there, it must've been a fun couple of months:


But there is some good news after this tale of burnout and reckless trading. As I mentioned, I've been letting my trading system sit idle for the past few months while new EUR/USD price data piled up. This new data was the raw material I needed to effectively forward test my system and see if it actually produced real, profitable trades, not just pretty pictures of historical backtests. When I plugged in the new data earlier this week, I was very pleasantly surprised: my system had racked up a very steady, consistent, profitable trading record while I was ignoring it. Which is why I'm back trading (and posting) again.

One of the trading risks I've described before is the desire to fiddle compulsively with your system, even when it's doing just fine as it is - the "If it ain't broke, don't fix it" problem. Since I'm a bit of a compulsive fiddler, my challenge now is to find something else I can fiddle with to keep me from breaking what isn't broke. One thing I've been wanting to learn for a long time is how to program Metatrader to trade my system automatically using their MQL programming language. I suspect it'll be quite a challenge transitioning all my trading rules from Excel to Metatrader - but if I can get them automated it'll save a huge amount of time over the long term. So if there are any experienced Metatrader programmers out there, any advice on getting started with MQL would be much appreciated!

Beware of Sloppiness

Yesterday I made a trade I shouldn't have, and I made it because I was rushing through my trading routine and not paying enough attention to important little details. In short, I was sloppy. And the result was I lost 21 pips I should never have even risked in the first place. That's the great thing about forex - you can usually put an exact cost on your mistakes.

In retrospect it's pretty clear to me why I was being so sloppy. I really wanted to make a trade, partly to make up for all my lost trades last week. I started updating all my price data with too little time to spare before my 5:00 pm trading window, so I was in a rush as well. Rushed data analysis + irrational need to trade = trouble. So when my system generated what looked like a valid signal, I placed a trade instantly without double-checking the key variables that went into the signal. It's always a good idea to double-check your data - especially if you're in a hurry.

The error I overlooked in my rush to trade was that I'd entered the date wrong. This isn't the first time I've gotten into trouble with dates, but in the past I took the time to double-check them. Not this time around. It's just about the simplest mistake I could make...and surprise, surprise, it's the simple mistakes that always seem to cost me the most. The good thing is they're also the easiest mistakes to catch.

So I guess the lesson here is, look before you leap.

The good news: a seven trade winning streak. The bad news: the last two don't count.

As if to prove that nothing can ever go completely right in forex, I woke up today to find that my trading system made its seventh winning trade in a row - definitely a new record for real trade predictions, not just theoretical ones in my historical backtests. The problem was, I couldn't make this trade, just as I couldn't make the sixth winning trade last Friday (as I mentioned in my previous rant). The reason being my trading platform FX Engines was still down, and still is last I checked. While I've had a lot of good things to say about FX Engines in the past, this is approaching an unacceptable level of downtime during live trading hours. I can certainly sympathize when a server goes down, which they inevitably do - in fact, I've worked at a dotcom start-up where screwy servers gave me a couple extra weeks paid vacation. But can you imagine what would happen if a big player like Charles Schwab or E-Trade (or Oanda, or GFT, or you name it) went down for two trading days, three if you count the Asian trading session on Sunday? Even if you're a small player, you're going to need the uptime and reliability of a big player if you want to compete.

Anyway, I just had to vent a little because it's kind of a bummer to see a nice run of trades killed off because of technical difficulties, which of course never seem to crop up during a losing streak. That's the last I'll say about it, I promise. Well, unless it happens again.

Happy glitch-free trading!

Missed a winning trade. But I'm not upset. Really. OK, maybe a little.

If you've been following the blog much lately you'll know that I currently get a lot fewer trading signals because of some strict filters I've set up. So when a trading signal does come along, it's a big deal. And yesterday I got one to go short the EUR/USD for 22 pips, and in the ranging price action that followed it turns out it would have been a winning trade. Which would make it the 6th winning trade in a row, possibly setting a new record if I kept track of these things. But I couldn't make it, for a couple of reasons.

First, I was out hiking with some friends and then out having a beer at a favorite venue in San Francisco. So I missed the ideal entry point for my trade, which was at 5:00 pm, just as I was wandering around the forests south of here. When I got back, 10 pips profit had already been shaved off the trade, so it would've been only a 12 pip trade.

All of which is entirely my fault and if the trade had been enough of a priority I clearly would've been sitting right here glued to my laptop. And I wasn't, and while I'm a little annoyed with myself I still had a fun afternoon. And fun has a cost, which in this case can be measured in pips.

The second reason is that FX Engines, my trading platform, had a server go down and wasn't working at all. This is the first time they've gone down during trading hours and it came as a bit of a nasty surprise. Who knows, maybe if I'd showed up on time the site still would've been up and I could've made the trade, but there's not much point in wondering about it now.

Anyway, the upshot of all this was: no 22 pips, and a break in a nice winning streak. The larger lesson, and one I think I'll revisit in a more comprehensive post on the subject, is that there are a lot of unforeseen logistical risks to your trading lurking out there and you'd better be ready to fix the ones you can (like being on time for a trade, if that's important to you) and accept the ones you can't (like your broker's server going down). And if the same problems keep cropping up, it might be time to make some changes to your trading setup. But more about all that in a future post...

The Unlikely is Not Impossible

And sometimes it's even likely. This is a paradox I often find myself wrestling with as a trader, particularly since I like to think I approach the forex market with a statistical mindset. Why do you think I go on about Bollinger Bands so much? They're one of the more statistical indicators out there, based on a measurement of 2 standard deviations from a specified moving average. But if you trade long enough, you discover that your statistical ideas about market behavior often run headlong into the painful realities of how the market actually behaves.

What set me off on this particular tangent was a recent article in The Economist. (Seems I reference them in every other post. Such is intellectual laziness.) It was commenting on the recent volatility in world financial markets, seen in the meltdown of the Chinese stock market, the serious decline in US markets, and similar turbulence in all the other markets I don't really follow. What really got my attention were these remarks about the statistical likeliness (or rather, unlikeliness) of all this marketplace drama:

"According to Goldman Sachs, the latest jump in the Vix (a measure of stockmarket volatility) took it eight standard deviations from its average. If conventional models are correct, such an event should not have happened in the history of the known universe. Then again, the move in energy prices that caused the collapse last year of Amaranth, the hedge fund, was a nine standard-deviation event. [I wrote about the Amaranth collapse a while back, follow that link to learn more about how they screwed up.] Perhaps modellers do not know the universe as well as they would like to think."

Eight standard deviations. Nine standard deviations. These make the 2 deviations of my Bollinger Bands look painfully inadequate to accurately gauge possible market fluctuations. The key of course is that these types of events are extremely unlikely. Just like the global financial implosion triggered by Russia's loan defaults and the devaluation of the Thai baht back in 1997. Extremely unlikely events, and yet they brought Long-Term Capital Management crashing down. [Wrote about them too. Follow the link for more hedge fund meltdown fun. So, got any assets in hedge funds?]

Extremely unlikely, and yet they happened. In fact, if you look at historiy it seems inevitable that extremely unlikely events like these will happen again. So what does that make them - likely? Depending on your timeframe, yes and no (century: likely, month: unlikely). And they're definitely severe enough to include in whatever rosy model you have for trading and investment success. If you live in an earthquake zone (which I do) you don't expect one every day. But you do prepare yourself for the day when the floor starts moving. So how strong is your trading floor?

Related article:
The Economist: Grey Tuesday - An overdue sell-off flusters exchanges and sobers investors

Risk/Reward Ain't Always What It Seems

It's very easy to get caught in the illusion that a tight stop-loss and a generous take-profit/limit order are going to earn you profits in that ratio. You know, setting your stop at 20 pips, your take-profit at 50 pips, and waiting for those consistent profits to start rolling in. This is a newbie error I made plenty of times before learning my lesson. What I've found since then is that a very generous stop-loss and a conservative take-profit strategy is often more consistently profitable.

A case in point: I'm currently running a GBP/USD trading system that features timed exits of around a week, take-profit at 100 pips, and stop-losses set at 300 pips. Yes, 300 pips. Sounds a bit weird, I know, but the key here is that those stop-losses almost never get hit. What's far more likely is that the price will advance 100 pips in that week, or the trade will time out if it doesn't (and sometimes with a profit). In fact, I could probably run the system without a stop-loss at all and the results would be similar, thanks to those timed exits - I'll have to backtest that notion soon, though the idea of trading without any stop-losses makes me nervous.

In general I've found that stop-losses work best for me in extreme emergencies, when the market is acting wilder than usual and hence could lose me more than usual. So for my trading style it makes sense to set them at the outer limits of the likely trading range, rather than squarely in the middle of the range where they're likely to get hit by a whipsaw or retracement.

How undervalued is the yen?

I just read an excellent article in the most recent Economist discussing the undervaluation of the Japanese yen, which their editors assert is putting the global economy at serious risk. This story ties in closely with an earlier article about the carry trade, of which the yen forms an integral part because of low Japanese interest rates.

The Economist's take on the situation is that speculation by carry traders combined with complacency by world governments is holding the yen's value down at an artificially low level. How low? The article claims it could be undervalued by as much as 40% vs the Euro. That's a lot. And when the yen finally does begin to adjust upward (not if, but when), there are as many as $1 trillion in carry trade positions that will start unraveling with every pip it rises.

Say you've bought the GBP/JPY pair with a highly leveraged forex account and are making a nice profit off the dramatic interest differentials between these two pairs. Suddenly the yen appreciates by 1%. Then 2%. Then 5%. It's not a pretty picture. There's a reason this strategy has been called "Picking up nickels in front of a steamroller." So if you've been pursuing a carry trade system with the yen, this article is a compelling argument against complacency in your positions.

One of the most informative parts of the article for me was its discussion of how hundreds of billions of dollars in yen carry trades aren't closely tracked by official statistics. The reason for this is that unlike spot currency traders who will sell the yen to buy a higher yielding currency, hedge funds will instead use financial instruments called currency forward swaps to place their carry trades. How can you measure how much these off-balance-sheet transactions add up to? According to the article, "A better clue comes from record net 'short' positions in yen futures on the Chicago Mercantile Exchange. Estimates of the total size of the carry trade range as high as $1 trillion."

In short, it's well worth reading, whether you're a carry trader or just trade the yen on a regular basis. And even if you don't go near the yen in your trading, keep in mind that any major movement in this currency will have significant spill-over effects into others.

Here's the article: Carry on living dangerously

Whipsaws and Fake-outs

Some of the most frustrating and costly market phenomena a trader is likely to see are whipsaws and fake-outs. Actually these are pretty much the same thing, with the difference that calling it a fake-out attributes a negative intention to the market, essentially accusing it of messing with your head. And a whipsaw or fake-out can indeed have a serious impact on your confidence in yourself and your trading system. If you spend your days looking for price break-outs and trends and instead you get a string of these nasty up-and-down spikes, you may wonder why you got into trading in the first place. The past couple weeks have been a vivid case-study in whipsaws and fake-outs, which is why they seemed like a good topic for today.

So what is a whipsaw/fake-out, exactly? It's a point in the market where the price moves dramatically up or down, and in the early stages may look identical to the start of a new trend. Then, instead of continuing the trend or leveling off, it'll suddenly dive back down (or up, in the case of a downward spike) to a price close to where it started. If you've watched forex charts for any length of time, they've almost certainly crossed your path. But if you're new to the currency markets, or aren't sure exactly how to spot one, here are a couple from the past week's EUR/USD market.


What causes them? Well, almost by definition they are points when there is insufficient momentum in a particular direction to sustain a trend. Because market sentiment is ambivalent, divided fairly evenly between longs and shorts, the price is able to continue its break-out and falls back to where it started. If you've placed your limit/take-profit orders at an optimistic price point in anticipation of a strong trend, you're likely to find the whipsaw comes nowhere near them and lands you back within a few pips of your entry price, and a few pips poorer thanks to spread costs.

The most dangerous whipsaws include price spikes in both directions, which after convincing you to place a trade in the direction of the first spike, then turn around and take out your stop-losses with the second spike.

If we broaden the definition a little bit, stop-hunting could be considered a type of whipsaw that's staged by a broker within their own trading platform with the specific goal of hitting their clients' stop-loss orders. If you see a whipsaw on your broker's charts but not on anyone else's, chances are you got stop-hunted.

That's not to say you can't make money on a garden-variety whipsaw or fake-out; I have no idea if it's possible during stop-hunting. If you're good at identifying markets in which they're likely to emerge (like the current one), you can adjust your trading strategy accordingly by placing your limit orders at levels closer to the entry price than you would in a trending market. You might also try combining these more modest limit orders with a tight trailing stop to help prevent all your profits evaporating when the price suddenly changes direction.

Or, if you're like me and find whipsaws and fake-outs too nervewracking, unpredictable, and costly to play with, you can work on filtering them out of your trading by avoiding market conditions when they occur. In my experience these tend to be in range-bound markets with low volatility and little notable economic news to fuel a true break-out. I'm sure someone out there is getting rich off these things, but it's definitely not me!

The Single Greatest Money Management and Risk Reduction Tool Ever Invented

It's taken hundreds of hours of careful analysis, hard-won insights and intense, often painful first-hand experience to discover the single most important key to successful risk management and capital preservation in a trader's career. And unlike so many tools available out there, this one doesn't involve complicated algorithms, clever hedging, or stop-losses that don't always stop your losses. In fact, this Holy Grail of risk management can be summed up in just two words:

Don't trade.

By which I don't mean never trade - I just mean don't trade unless you have absolute confidence in your trade and are willing to let it run its course to success or failure.

Here are some examples of times you might want to use this cutting-edge trading tool:

• You have no idea what the market is doing
• You have no idea what your trading system is doing
• You're faced with conflicting trading signals
• You're faced with zero trading signals
• You disagree with your trading signals
• You're panicking in the midst of a nasty drawdown and liable to do something desperate
• You've just opened a trading account, added a couple moving averages to your charts (using the default settings, of course) and are planning to make as many trades as possible today, sleep or no sleep
• The phrase "I'll trade my way out of this" keeps crossing your mind

I'm not saying it'll be easy. When faced by the most difficult market conditions, sometimes the most difficult thing to do is sit on your hands, watching patiently from the sidelines.

Best of all, for a short time only, I'm offering this remarkable trading tool* to you free of charge. Now the only question is, do you have the courage not to trade?

*May not in fact be the greatest risk management tool ever invented, as if anyone could even know that in the first place. But it's a damn good one.

Related topics:
Simplify Your Trading
Signs You May Be Overtrading
Sometimes No Signals Are Good Signals

Taking on Excessive Risk

This seemed like a good topic for today because I've been taking on too much risk at certain points in my trading without really thinking about it - and I suspect that's how it happens to a lot of traders. My risk management mistake is failing to scale back my position after a loss if I decide to continue the trade in the same direction. This happened today as I decided to continue a long trade I started yesterday. Both trades went the wrong direction thanks to some good US CPI numbers, and according to a strict fixed fractional strategy I should have jettisoned a few mini-lots today to bring my position into the proper ratio with my reduced capital. But I didn't, ending up with a position, and a loss, that is significantly larger than it should be.

There are a few reasons I give myself for failing to scale back losing positions like this: (1) overconfidence that my system's accuracy will turn the loss around quickly and fix the problem (2) the fact that I hate spending money on spread costs, and I'd have to spend more to exit and then re-enter positions with a smaller lot size (3) concerns about sloppy execution and losing a few pips in the time it takes to exit and enter the trades. The last two reasons are somewhat valid, but the amounts I'd be saving are almost certainly smaller than what I'm losing by taking on too much risk.

In my experience, excessive risk tends to creep up on you like this when you're not paying attention, or paying attention to the wrong things, like that loss you really need to recoup in a hurry. Some common justifications for taking on too much risk that you might want to watch out for are:

• Just this once - kind of like that last drink or cigarette before you quit.
  
  
• Total impulse - you prevent yourself from thinking about it, you just leap without looking because forex is only interesting if it's a gamble.
  
  
• Good reasons for a bad idea - sure, saving on spread costs is a good idea, but not if you end up risking 25% more than you should.
  
  
• False sense of security - you set a very tight stop-loss and it keeps getting hit over and over again. In this case the thing that makes you feel safest in your trading is actually the biggest threat to your success.
  
  
• Boredom #1:I haven't analyzed my trading and I don't feel like it because it's boring, and therefore I have no idea what's too risky.
  
  
• Boredom #2: Trading with lower levels of risk is incredibly boring and way too much like my day job to be worthwhile.
  
  
• Starting with an unreasonable goal and reasoning backwards from it - I'm in a hurry to get rich and I can only make $1 million in 6 months if I take on this much risk.
  
  
• Pursuing a statistically valid but aggressive strategy like Martingale without the funds to back it up.
  
  
• Setting up an automated trading system but failing to monitor it closely and after a losing streak it ends up risking way too much.
  
  
• Misidentifying high risk events as low risk. For instance, trading on big news events can seem like a higher reward/lower risk scenario. All you do is see which way the trend is going and jump on it, right? But then there are the whipsaws, and the stop-hunting, and the various fake-outs the market likes to pull at these times, and what seemed low risk turns out to be quite risky after all.
  
  
• "Picking up nickels in front of a steamroller" - certain types of carry trading have been described this way. It's easy to focus on a reliable trickle of profits and be lulled into ignoring the underlying risks of your position. This is another example of misidentifying high risks as low risks.
  

Those are just a few of the ways this can turn into a very risky business very quickly. If you've got more to suggest, please post them in the comments...