ForexSpirit

As a counterbalance to yesterday’s ‘the sky is falling’ tirade I’d like to highlight some of the important lessons that I think I’ve learned from the past few months.

I feel that the most prominent lesson that I have learnt is that I have to trust my gut instinct. When you start trading trusting your gut can often be the absolutely wrong thing to do. This is generally due to our lack of trading knowledge and experience at the time. Instead, our gut is using our regular real world experience where we are always right and can do no wrong. Basing our choices off this sort of past experience can lead to a very short trading career.

Getting to the point where your gut is actually more right than it is wrong making trading decisions can be a key turning point. It means that you have successfully obtained a trader’s mindset and your subconscious is making decisions using your trading knowledge.

I came across a post on Forex Factory last Thursday that resonated with me. This post and my reply certainly brought this topic to the fore of my mind.

The post by Sleep1IOpen was:

The only indicator I use is my gut. My gut is right about 90% of the time. Just look at the screen and watch economic news till your eyes bleed. Become what this market is, “a heartbeat”, and respect it because it can make you mad. I had what I like to call the “Neo” effect. Thats when a trader sees “The Matrix” for what it is. Sorry for all the quotes and the cheesy reference to the matrix. HA HA. Just have fun with it and you’ll get it.

My follow-up comment was:

This is a great description of what it means to be a successful trader.

How do you get that gut feeling? By gaining experience which takes hard work. To gain that experience you need to be able to stay in the game. This means that preserving your trading capital is critical.

Don’t blow your wad when you don’t know what you’re doing or even when you think you know what you’re doing. Only put the pedal to the metal when you truly know what you’re doing (which ironically enough means that you are perfectly at peace knowing that you don’t know everything and that you don’t need to know everything to be able to make money at trading).

I mention that preserving trading capital is critical. I know this, yet I was not practising what I was preaching. Friday’s price action has showed me the folly of my ways.

There have been plenty of recent examples that I can think of where my gut has shown it knew more about what was going on even before I could rationally come to the same conclusion.

The dollar weakness in the run up to last week’s Fed interest rate announcement is one case. My gut pointed to further dollar strength after the US CPI data came out on Friday. Not that I ever currently short the euro, but this could have been one opportunity to do so if I was not already so long on this pair. I think it was back in September, in the week leading up to the G7 summit, my gut pointed to a strengthening yen and I shorted it from 117 all the way down.

I have not read the book Blink by Malcolm Gladwell but I came across a synopsis of the book on Friday that seemed to further crystallise the importance of gut instinct in my trading. The premise of the book is that people can make split second decisions based on experience and knowledge that often times beat out any decision that is subsequently arrived at by more logical, analytical means. The argument is therefore that if you have the right number of limited inputs you should go with your first split second decision instead.

Of course the unanswerable but tantalising question I’m now faced with is: have I reached that sort of level of cognitive power in my trading ability or am I just deluding myself?

As I’ve also been mentioning in recent posts, I seem to be over trading. I think this is pretty evident in the increased numbers of trades that I have been placing in recent weeks, in part trying to grab some small and medium sized trades at these cheaper prices.

This is not something that I want to be doing in the long term. I need to return to only putting on a smaller number of trades that I feel have a much higher probability of success. It is much easier and less stressful when only a handful of trades are being managed at any one time. To make it worthwhile I’m musing if I can keep slightly higher gearing per trade or allow for putting on more trades in diverse pairs. I need to balance this carefully as doing both simultaneously can lead to disaster as I have experienced.

Another important and very valuable lesson I’m learning is that I suck at handling corrections. The first problem is that I’m often not able to see or predict them in a timely enough fashion. I can’t really beat myself up too much about this lack of foresight, as I think attaining true accuracy in predicting the next correction is beyond most traders.

The real problems are more to do with that even when I do have an inkling that a correction is about to appear rarely do I do anything to properly prepare for it. Perfect examples of this are January 2007 and right now. Even if I sense that a correction might be on the cards I don’t see to scale back quickly enough or reduce my trading. Instead I just steam ahead at full speed and inevitably get caught out.

Another classic response I seem to have is that I seemingly always pull out of higher up trades at the exact wrong time. I manage to close out my losing trades right at end of the correction. The correction in EUR-USD that ended in June 2006, just under 1.33, stands out in my mind here as a prime example. If I was feeling enough pain to close out my trades at the levels I did then I’m probably not the only one who was feeling the same way. My uncanny predictive ability to close out trades at the worst possible moment is probably nothing more than a skewed recollection that my memory is constructing. It’s akin to the numerous stories of traders seeing their stop loss hit only for the market to zoom back in their original direction. The market wasn’t out to get them personally, although the trader can often feel like it was. When these sorts of thoughts rear their ugly head in my own mind I do my best to dissolve them or at the very least not linger on them. Their staying power can be deceptive, as evidenced by my thoughts on something that happened way back in June. Certain trades, both good and bad, can linger in your mind for a long time.

A second classic response I seem to have when trying to deal with a correction is take the cost averaging part of my trading plan a step further. Often times the correction will result in a half grid move against my long term trend direction. When this grid shift occurs I might still be holding open trades originating from Q1 or Q2 of the old grid position. With a new grid in place I’m more likely to keep them in place and see how price reacts in the lower half of the grid. When I open subsequent positions in the new Q1 and Q2 I’ll resort to using higher gearing that I should be using for a regular Q1 or Q2 entry. I’m continuing to cost average by opening new trades with higher gearing when price is below the entry points of trades I’m already holding.

For example, in January 2007 when there was a half grid shift down I ended up opening new Q1 entries with 5:1 gearing, as compared to prior Q1 trades that were only 3:1. Similarly, in November when AUD-USD broke through the bottom of my grid at 0.90 I entered new Q1 trades with a gearing of 6:1 compared to what my regular Q1 entry should be at 4:1.

Cost averaging indefinitely in this fashion is a sure road to ruin. It is something that I need to stop doing. One way to prevent me from continuing to fall into this trap is to have a better way of handling my open trades that are currently underwater.

I think the solution to my problem is to step up and make a constant something that I have only been doing in select cases. I need to put a fixed 100 pip stop loss on all my trade entries. I could have avoided lots of recent strife if I had been doing this consistently recently.

I feel that 100 pips is enough to allow any given trade room to breath. If a trade breaches 100 pips into the red then there is probably a pretty good chance that it is going to continue going south.

My current 200 pip laissez-faire, mental stop loss had its advantages but I think the 300 pip move by the US dollar on Friday shows that it isn’t fool proof by any means.

I used the fixed 100 pip stop loss in September and October very regularly on my USD-JPY trades. It worked very well I felt.

I didn’t use it on any of my AUD-USD trades. On my fateful entry at 0.93 on AUD-USD I was down 150 pips before I knew what had happened (the peril of forex being a 24 hour market and my being human and having to sleep). I had no stop loss in place when I entered the trade. Even when I did see that it was 150 pips down I shrugged off closing it out as things were still pretty bullish for the Aussie dollar at the time. Instead I left it to linger which only made things worse as continuing credit crunch woes hit the Aussie dollar hard (being one of the prime high yielding currencies in the carry trade arena).

If I had placed a 100 pip stop loss on the 0.93 trade, and any other new longs that I placed as the Aussie dollar tumbled, thereby ensuring that they would have all been stopped out, I still think that I’d be in a slightly better position than I am now. I might have a bigger dent in my realised losses but I think I’d be far stronger mentally. I wouldn’t have the mental baggage of having to handle and deal with numerous trades that are underwater simultaneously. I can manage dealing the drawdown scenario. It’s something I have been actively dealing with for several weeks now. It’s just that I don’t particularly enjoy it, and I don’t think it plays to any of my strengths. It is sometimes a necessary evil and part of the trading game but I think if I can tweak my trading plan to limit the chances of an extended drawdown occurring then it is in my best interest to make that a reality.

A slight corollary to the stop loss issue is that when using forex.com as my broker I am hindered by not being able to put a stop loss against each individual entry. I can obviously relieve this problem by going back to a broker such as FX Solutions which does allow a stop loss to be placed against each individual trade. I’m going to make the switch back once I am all square. Also, linking back to what I mentioned earlier, if I have less entries open due to actively cutting back from over trading this would also make it easier to manage open trades and their associated stop loss levels.

I can always use the Anti-Hedge re-enter method to get back into a trade when the trend resumes and it feels appropriate to do so. I used this technique quite successfully on many of the USD-JPY trades that were stopped out at their 100 pip stop loss price level during September and October.

In order to make forward progress as a trader I need to identify my strengths and weaknesses on an ongoing basis as my trading skill evolves.

I think I’ve done a pretty honest assessment of some of my strengths and weaknesses here. Now I just need to put together a plan of action that minimises or neutralises my weaknesses (such as always using a 100 pip stop loss to avoid having to deal with prolonged corrections that I do not handle well if I’m trying to manage a large unrealised loss). I need to focus on my strengths. Here I’m going to look for fewer higher probability trades and pay closer attention to my gut feel on both future events (ones that are a few days out) and current news, where I sometimes have a good sense of where price is going during the next session.

I want to try and tie my trade entries more closely to an identifiable catalyst. A catalyst will often be nothing more than a event that has just occurred (for example an economic news release) or a future planned event (such as an upcoming Fed meeting or a trip by the US Treasury Secretary to China). A weaker catalyst could be current price action in the marketplace; a rangebound area might be unfolding and I might look to enter with that as my criteria.

By trying to tie trades more closely with a catalyst I’m hoping to be able to move back towards the smaller in quantity, but higher probability of success, trade pattern.

In the past I’ve often entered a trade on a pure whim. When aiming for bread and butter trades this is a reasonable thing to do as you’re just looking to grab a quick 30 pips from the market availing of the random nature of price movement in that sort of range. I think I want to cut back on this sort of trade entry. If for no other reason, I want to be able to tie any given entry to a catalyst so that I can determine if the price action that unfolds corresponds to my prediction as to what sort of effect the catalyst should be having on the market. If there is a huge discrepancy then I have ammunition to yank the trade even before any stop loss is hit.

When I’m wrong and know that I’m wrong I don’t want to still be in the market and have to work myself out of it with too large an amount of effort.

Working in a framework where unrealised drawdown is hanging over my head is seemingly not something my psyche is able to handle very well. I can deal with it for short periods of time but not weeks on end as I’ve had to endure recently. It is important that I acknowledge this and work to eliminate this sort of situation from my trading future.

It strikes me that some of my proposals here are veering back towards more classical trading mantras. Having a fixed stop loss in place. A catalyst being a sort of ’signal’ to know when to enter a trade.

I guess in a way I am moving in that direction. At the same time I’m not giving up everything to do with the way I have been trading using the 4×1 methodology.

I think more than anything I want to see if I can really draw on this trading gut instinct that I might have finally developed. If I focus on what my sixth sense is still me then I hope the other changes will slot into place.

I now have to mull on these ideas further and determine how they can be successfully incorporated into my trading plan. I am going to flex the 4×1 methodology into something that is truly personal.