ForexSpirit

This is the last post in a series recounting some trading questions put to me and my subsequent replies that hopefully provide a modicum of clarification. The section dealing with breakouts is a good refresher, especially for me, given my inability to ride all the breakouts that occured this week. The first three parts of this series can be found here: Part 1, Part 2 and Part 3.

I’ve read and re-read BWILC and employed the techniques for over two months now, and producing nice returns on the cable with little leverage in my demo acct. I’ve abandoned all but the most basic technical analysis and feel a sense of freedom.

All that above I say with caution, for I could just have been lucky while riding a bull run.

You’re right to wonder whether trading success in the short term is down to skill or just pure dumb luck. Unfortunately, it’s impossible to tell. As I mentioned in my Seven Deadly Sins post it is only over the long run that we have any hope of determining if our trading results are due to a measure of skill or if randomness has prevailed. To that end all you can do is to stick at it and try your best to make sure that it’s your skill and knowledge that comes through.

So I have a question for when times get rough:

1) Dirk talks about 1 currency pair, 1 direction. When that trend ends or starts to end, will we know? Say we do, then do we change our direction, or do we sit on the sidelines, or do we move to another pair where the trend is strong?

We should have a fair idea that the main trend is coming to an end. The main fundamental reasons why we’ve chosen to trade in that one direction will most likely start to crumble or be usurped by other fundamentals.

Will we be able to time the end of the trend? Most likely not even close. The trend might end earlier then we thought possible, or continue way longer than we can reasonably explain.

Whenever we do decide to stop trading in that one direction one of two things will have come to pass. Either we’ll have stopped too early and will then miss out on continued movement in the one direction, or we’ll have experienced the start of the new trend and will be nursing some losses as we realize that we’ve left it too late. Which is more preferable will probably depend on a myriad of things: your risk level, the overall market environment, underlying fundamentals, etc.

If there’s another more compelling one direction in a different currency pair then it might be better to bail out early and switch your currency pair focus. Instead, if your one currency is still the best game in town but the trend is looking dicey, then it might be worth hanging in there, even given the prospect of getting caught in the fall. Reducing leverage even further here might be the best way to capture that last bit of profit from the over extended move and limit your losses when the reversal does come.

The carry trade is a good example here. Everyone knows that it will end one day, but no-one knows exactly when. [Note: this answer was written earlier this year, well before the credit crunch that has been afflicting the markets for the past several weeks.] Do you try and continue to short the yen knowing that when the reversal does come it will be quick and brutal? Or do you just wait it out and look to trade the yen long when the correction is underway?

1b) Although I agree with Dirk’s logic of specializing in one pair, it would make sense to me to only stick to pairs with strong trends, so for example, once my main pair’s direction becomes unclear, shouldn’t I temporarily trade my secondary pair (which has a clearer trend) until my primary becomes clear again?

The one currency one direction mantra is to get you to simplify your trading approach above all else. You do not have to purely stick to only one currency.

By starting to focus on just a single currency you learn its every quirk. Once you have been familiar with it, probably to the extent that it bores you, then it’s probably time to add another currency pair to your roster.

The more you follow the fundamentals the more it becomes apparent that all the currencies are linked, almost like a web. Untangling the web becomes an interesting, never-ending endeavor.

The carry trade currently has a huge implicit impact on the other major currencies along with the minor currencies with high interest rates. The global nature of our world and economies means that things are never as cut and dried as they seem.

When it comes to learning any complex task it helps to start off by keeping things as simple as possible. Thus the rationale for just sticking with the one currency pair. With limited time and energy it also helps limiting the number of currencies you specialize in so that you’re not overwhelmed.

Take on what you can comfortably manage. It can take time to become familiar and intimate enough with a currency pair to be able to trade it. Understanding how it moves and what moves it is one thing. Being able to profit from that movement is something quite different.

If you’re at the stage when you are trading multiple pairs then it does make sense to only put trades on which ever pairs that you are most confident in their trend. If the trend and movement in a pair is unclear then stay out. Patience is something you can never have too much of in trading (as I learnt once again this summer).

2)How should we trade breakouts? Obviously many can be fakeouts or failures to perpetuate a long trend, so how do we make trades safely? I imagine there are both fundamental and technical considerations.

There’s no magic way to trade breakouts. Any large trend can be easily identified by its previous breakouts.

Any trend following system has to profit from breakouts or else you’ll never make any money.

Since the 4×1 methodology is most definitely a trend following system then breakouts have to part of the game plan. You only have to look at systematic breakout trading systems, such as the turtle system, to realize that trading breakouts often has a very low percent win rate on the actual trades themselves.

Profit has to be extracted from making the most of those breakouts so that rewards on the successful breakouts pay the expenses of the many losing trades. It needs a high R-multiple on the winning trades.

Trading breakouts using the 4×1 methodology you end up borrowing a lot of factors from the systematic approach. You never know which breakout is going to be a winner or not so you have to play them all. If the breakout is real then you’re going to see some profit from it. If the breakout fails then the low leverage used by the 4×1 methodology is going to be the safety net.

Most breakouts are going to occur higher up in the grid and thus the leverage used on any trade placed to try and capture is going to be using rather low leverage (1:1 up to 3:1 max). There can only really be three outcomes on placing such a breakout trade (basically any trade high up in the grid).

One is the breakout occurs and you get some nice profits. Second is that the breakout fails but doesn’t retrace by much. You hold on for another breakout attempt or see if a retrace/correction does happen. Lastly the breakout fails and the market corrects drastically, whereupon your exit criteria are hit and you bail from the trade. If the main trend is still in place then even if the breakout fails, holding on should see another attempt succeed.

If the failure is such that you need to exit the trades then most likely price has reached much lower in your grid. You just need to exit according to your plan and look to get back in at a better price so that you can recover the loss and go on to make additional money as the trend reasserts itself. Major support and resistance levels in play and the important fundamentals of the day are going to have direct impact on how best to manage the situation.

If a breakout is on the cards and your analysis of the fundamentals has the trend continuing then you have to play. On the other hand, if a breakout situation arises but the fundamentals are weak then you might want to consider passing. Range trading could unfold. When in doubt I would probably err on the side of playing a possible breakout but with reduced leverage. You have to be in it to win it.

Hope the success continues. Thanks for your advice and all the best.

You’ve asked a lot of good questions, hopefully my answers have been of some help.