Developing the "Holy Grail" Trading System

Before I get myself into trouble, let me point out that there is no "Holy Grail" trading system in the world - not yet anyway. If there is, please let me know. I don't mind paying a thousand bucks for it. However, a trading system close to the "Holy Grail" is indeed possible and I'll show you how to develop it.

What moves Forex? Conventional thinking would imply economic fundamentals or factors such as the strength of a country's economy, which contributes to currency flows. Therefore, one would assume that everyone else would buy the US dollar against the British pound. Why not? The US economy is the largest in the world while that of Great Britain has fallen to fifth, behind the US, Japan, Germany and China.

The theory of "the bigger the economy is, the more attractive its currency will be" may be true but in reality, the sterling has advanced more against the dollar. Why is this so?

Let's dissect the market by taking a look at the players in the currency market. They are the financial institutions, commercial banks, insurance firms, pension funds, hedge funds, small funds, international businesses, private investors, retail traders and not forgetting, individuals. Each plays a part in determining the movement of a currency. We can divide them into two categories - "commercial" and "non-commercial".

The "commercials" engage in business activities requiring the use of currencies, whereas the "non-commercials" are into the Forex market for speculative purpose. Therefore the philosophies of the "commercials" and "non-commercials" are very much different - when the "commercials" buy, the "non-commercials" sell; and when the "commercials" sell, the "non-commercials" buy. It is this different point-of-view from two different types of traders, market makers or investors that moves the Forex market.

We have gone through the easy part of identifying the movers of the market. The question now is how to use this piece of information to trade Forex successfully and how to use the above information to develop a "Holy Grail" (almost) trading system.

Earlier, we have determined who the movers of the currency market are. The "commercials" are involved in a nature of business that requires Forex transactions. Examples would be commercial banks, insurance firms and international companies. On the other hand, the "non-commercials" are in the market solely for speculative purpose. Examples would be hedge funds, small funds, private investors, retail traders and individuals.
Best times to trade

Even though the Forex market opens 24 hours a day, 5 days a week, there are specific times in a day where the volume of transactions are high. These are the London session (3AM EST to noon EST), New York session (8AM EST to 5PM EST) and Tokyo session (7PM EST to 4AM EST), in the order of market volume size. Therefore the most profitable trades, in terms of price movement, are usually found in these times. It is advisable for traders to trade during these times.

Best currencies to trade
Every nation in the world has its own currency - the US dollar, Canadian dollar, Russian ruble, South African rand, Mexican peso, Thai baht, Indian rupee, and so on. However the most traded currencies, with the highest volume and liquidity, are the euro, Japanese yen, British pound and the Swiss franc, with euro (EUR/USD) being the most traded currency pair.

Tools of the trade
When it comes to trading Forex, there's only two methods that are utilized. The first is fundamental analysis and the other is technical analysis. Many traders argue that either one is better than the other. I prefer to use both. I will determine my entry and exit points based on technical analysis with the support of economic data or fundamental analysis. This will minimize the risk involved in my trades because the market doesn't lie. Technical analysis will show you why price is behaving in a certain manner and fundamental analysis will prove that you are right.

Best market to trade
Because the strength of a country's economy, which contributes to currency flows, doesn't just change on any external events, currencies tend to trend well. It takes some time for a material change in an economy's strength and therefore the direction of its currency. Due to this reason alone, Forex is a very trader-friendly market, compared to equities, futures, options, etc.

How to best trade the Forex market?
This is the million-dollar question. Remember our "commercial" and "non-commercial" friends? These guys will battle to see who will win ultimately. Here's how it works:
"Commercials" consisting of commercial banks, insurance firms and large companies are loaded with deep pockets and nearly unlimited funds when put together. When the price of a currency declines, the "commercials" will load their positions - they will buy because price is "cheap". When demand exceeds supply, price advances and the "commercials" will unload their positions - they will sell at a higher price for a profit.

Who will they sell to? It's the "non-commercials"! But before we come to a conclusion who the obvious losers in this game are, let me tell you that not all "commercials" will profit from the above example and not all "non-commercials" will lose. It all depends on when the entry or exit is made. Confused?

Let me explain. When price declines and the "commercials" buy, they are practically buying into a falling price (this is possible because of the large funds at their disposal) in the hope that price will eventually advance and they will profit by selling at a higher price. However, there's no guarantee that 100,000 lots bought will each be sold at a higher price. It all depends on market forces - nobody can dictate or control the movement of a currency.

As for the "non-commercials", when price advances, they are practically buying into a rising price in the hope that price will advance even more for them to profit from it. As is the case above, market forces will determine whether this will hold true for the "non-commercials".

What does it all mean?
If you analyze the above, you will notice one common theme. In order to profit from the market, timing is essential - "buy low and sell high". Easier said than done! Every trader knows this. So how can one time his or her entry or exit?
Tricks of the trade

Here's how you should trade the currency market. You should develop your "Holy Grail" (almost) trading system based on the following. It worked for me, which is why it should work for you too.

1. The market players usually based their trades on certain predefined price levels. They don't just enter or exit whenever they like. These price levels are the Support and Resistance that many of us come to know of. Currencies tend to move well between these Support and Resistance levels. The most common methods to determine the Support and Resistance levels are Fibonacci, Pivot Points, Trendlines and the Exponential Moving Averages.

2. When the support and resistance levels are determined, the next step is to look at price action at these levels - whether price will break through or reverse. The most common method to analyze price action is through the use of Candlestick and Chart Patterns.

3. Once you have determined the entry point from the above two steps, boost your confidence to trigger the trade with the use of indicators such as Stochastics, RSI and MACD. Even though these indicators are lagging in nature, the appearance of divergence in Stochastics, RSI and/or MACD is not!
4. Always keep a wary eye on the latest economic data which affects the currency - beware of newsbreak which includes release of important economic data. Newsbreak of this kind will influence price movement significantly and render the technical analysis above meaningless.

5. Remember to implement an appropriate "stop-loss" in case price goes against you - never risk more than 3% of your account per trade.

Here you have it. I have provided the five (5) essential steps for you to develop an almost "Holy Grail" trading system for yourself. All you need to do now is to try each specific method outlined above and see which works best for you. Paper trade using historical data - practice until you get it right, keeping in mind the five (5) steps above.

About the Author
K Ronald is a Forex trader and mentor at MBC Solutions Ltd. He is the co-developer of the Millennium Trading System which is widely used around the world. This article is courtesy of http://www.mbc-solutions.com

Source : www.actionforex.com

Avoid Typical Pitfalls and Start To Make Money In Forex

Why do hundreds of thousands online traders and investors trade the forex market every day, and how do they make money doing it?

Trade pairs, not currencies - Like any relationship, you have to know both sides. Success or failure in forex trading depends upon being right about both currencies and how they impact one another, not just one.

Knowledge is Power - When starting out trading forex online, it is essential that you understand the basics of this market if you want to make the most of your investments.

1. The main forex influencer is global news and events. For example, say an ECB statement is released on European interest rates which typically will cause a flurry of activity. Most newcomers react violently to news like this and close their positions and subsequently miss out on some of the best trading opportunities by waiting until the market calms down. The potential in the forex market is in the volatility, not in its tranquility.
   

2. Unambitious trading - Many new traders will place very tight orders in order to take very small profits. This is not a sustainable approach because although you may be profitable in the short run (if you are lucky), you risk losing in the longer term as you have to recover the difference between the bid and the ask price before you can make any profit and this is much more difficult when you make small trades than when you make larger ones.
   
3. Over-cautious trading - Like the trader who tries to take small incremental profits all the time, the trader who places tight stop losses with a retail forex broker is doomed. As we stated above, you have to give your position a fair chance to demonstrate its ability to produce. If you don't place reasonable stop losses that allow your trade to do so, you will always end up undercutting yourself and losing a small piece of your deposit with every trade.
   
4. Independence - If you are new to forex, you will either decide to trade your own money or to have a broker trade it for you. So far, so good. But your risk of losing increases exponentially if you either of these two things:
   

   Interfere with what your broker is doing on your behalf (as his strategy might require a long gestation period);
   

   Seek advice from too many sources - multiple input will only result in multiple losses. Take a position, ride with it and then analyse the outcome - by yourself, for yourself.
   

5. Tiny margins - Margin trading is one of the biggest advantages in trading forex as it allows you to trade amounts far larger than the total of your deposits. However, it can also be dangerous to novice traders as it can appeal to the greed factor that destroys many forex traders. The best guideline is to increase your leverage in line with your experience and success.
   
6. No strategy - The aim of making money is not a trading strategy. A strategy is your map for how you plan to make money. Your strategy details the approach you are going to take, which currencies you are going to trade and how you will manage your risk. Without a strategy, you may become one of the 90% of new traders that lose their money.
   
7. Trading Off-Peak Hours - Professional FX traders, option traders, and hedge funds posses a huge advantage over small retail traders during off-peak hours (between 2200 CET and 1000 CET) as they can hedge their positions and move them around when there is far small trade volume is going through (meaning their risk is smaller). The best advice for trading during off peak hours is simple - don't.
   
8. The only way is up/down - When the market is on its way up, the market is on its way up. When the market is going down, the market is going down. That's it. There are many systems which analyse past trends, but none that can accurately predict the future. But if you acknowledge to yourself that all that is happening at any time is that the market is simply moving, you'll be amazed at how hard it is to blame anyone else.
   
9. Trade on the news - Most of the really big market moves occur around news time. Trading volume is high and the moves are significant; this means there is no better time to trade than when news is released. This is when the big players adjust their positions and prices change resulting in a serious currency flow.
   
10. Exiting Trades - If you place a trade and it's not working out for you, get out. Don't compound your mistake by staying in and hoping for a reversal. If you're in a winning trade, don't talk yourself out of the position because you're bored or want to relieve stress; stress is a natural part of trading; get used to it.
    
11. Don't trade too short-term - If you are aiming to make less than 20 points profit, don't undertake the trade. The spread you are trading on will make the odds against you far too high.
    
12. Don't be smart - The most successful traders I know keep their trading simple. They don't analyse all day or research historical trends and track web logs and their results are excellent.
    
13. Tops and Bottoms - There are no real "bargains" in trading foreign exchange. Trade in the direction the price is going in and you're results will be almost guaranteed to improve.
    
14. Ignoring the technicals- Understanding whether the market is over-extended long or short is a key indicator of price action. Spikes occur in the market when it is moving all one way.
    
15. Emotional Trading - Without that all-important strategy, you're trades essentially are thoughts only and thoughts are emotions and a very poor foundation for trading. When most of us are upset and emotional, we don't tend to make the wisest decisions. Don't let your emotions sway you.
    
16. Confidence - Confidence comes from successful trading. If you lose money early in your trading career it's very difficult to regain it; the trick is not to go off half-cocked; learn the business before you trade. Remember, knowledge is power.

The second and final part of this report clearly and simply details more essential tips on how to avoid the pitfalls and start making more money in your forex trading.

1. Take it like a man - If you decide to ride a loss, you are simply displaying stupidity and cowardice. It takes guts to accept your loss and wait for tomorrow to try again. Sticking to a bad position ruins lots of traders - permanently. Try to remember that the market often behaves illogically, so don't get commit to any one trade; it's just a trade. One good trade will not make you a trading success; it's ongoing regular performance over months and years that makes a good trader.
   
2. Focus - Fantasising about possible profits and then "spending" them before you have realised them is no good. Focus on your current position(s) and place reasonable stop losses at the time you do the trade. Then sit back and enjoy the ride - you have no real control from now on, the market will do what it wants to do.
   
3. Don't trust demos - Demo trading often causes new traders to learn bad habits. These bad habits, which can be very dangerous in the long run, come about because you are playing with virtual money. Once you know how your broker's system works, start trading small amounts and only take the risk you can afford to win or lose.
   
4. Stick to the strategy - When you make money on a well thought-out strategic trade, don't go and lose half of it next time on a fancy; stick to your strategy and invest profits on the next trade that matches your long-term goals.
   
5. Trade today - Most successful day traders are highly focused on what's happening in the short-term, not what may happen over the next month. If you're trading with 40 to 60-point stops focus on what's happening today as the market will probably move too quickly to consider the long-term future. However, the long-term trends are not unimportant; they will not always help you though if you're trading intraday.
   

6. The clues are in the details - The bottom line on your account balance doesn't tell the whole story. Consider individual trade details; analyse your losses and the telling losing streaks. Generally, traders that make money without suffering significant daily losses have the best chance of sustaining positive performance in the long term.
   

7. Simulated Results - Be very careful and wary about infamous "black box" systems. These so-called trading signal systems do not often explain exactly how the trade signals they generate are produced. Typically, these systems only show their track record of extraordinary results - historical results. Successfully predicting future trade scenarios is altogether more complex. The high-speed algorithmic capabilities of these systems provide significant retrospective trading systems, not ones which will help you trade effectively in the future.
   

8. Get to know one cross at a time - Each currency pair is unique, and has a unique way of moving in the marketplace. The forces which cause the pair to move up and down are individual to each cross, so study them and learn from your experience and apply your learning to one cross at a time.
9. Risk Reward - If you put a 20 point stop and a 50 point profit your chances of winning are probably about 1-3 against you. In fact, given the spread you're trading on, it's more likely to be 1-4. Play the odds the market gives you.
   

10. Trading for Wrong Reasons - Don't trade if you are bored, unsure or reacting on a whim. The reason that you are bored in the first place is probably because there is no trade to make in the first place. If you are unsure, it's probably because you can't see the trade to make, so don't make one.
    

11. Zen Trading- Even when you have taken a position in the markets, you should try and think as you would if you hadn't taken one. This level of detachment is essential if you want to retain your clarity of mind and avoid succumbing to emotional impulses and therefore increasing the likelihood of incurring losses. To achieve this, you need to cultivate a calm and relaxed outlook. Trade in brief periods of no more than a few hours at a time and accept that once the trade has been made, it's out of your hands.
    

12. Determination - Once you have decided to place a trade, stick to it and let it run its course. This means that if your stop loss is close to being triggered, let it trigger. If you move your stop midway through a trade's life, you are more than likely to suffer worse moves against you. Your determination must be show itself when you acknowledge that you got it wrong, so get out.
    

13. Short-term Moving Average Crossovers - This is one of the most dangerous trade scenarios for non professional traders. When the short-term moving average crosses the longer-term moving average it only means that the average price in the short run is equal to the average price in the longer run. This is neither a bullish nor bearish indication, so don't fall into the trap of believing it is one.
    

14. Stochastic - Another dangerous scenario. When it first signals an exhausted condition that's when the big spike in the "exhausted" currency cross tends to occur. My advice is to buy on the first sign of an overbought cross and then sell on the first sign of an oversold one. This approach means that you'll be with the trend and have successfully identified a positive move that still has some way to go. So if percentage K and percentage D are both crossing 80, then buy! (This is the same on sell side, where you sell at 20).
    

15. One cross is all that counts - EURUSD seems to be trading higher, so you buy GBPUSD because it appears not to have moved yet. This is dangerous. Focus on one cross at a time - if EURUSD looks good to you, then just buy EURUSD.
    

16. Wrong Broker - A lot of FOREX brokers are in business only to make money from yours. Read forums, blogs and chats around the net to get an unbiased opinion before you choose your broker.
    
17. Too bullish - Trading statistics show that 90% of most traders will fail at some point. Being too bullish about your trading aptitude can be fatal to your long-term success. You can always learn more about trading the markets, even if you are currently successful in your trades. Stay modest, and keep your eyes open for new ideas and bad habits you might be falling in to.
    

18. Interpret forex news yourself - Learn to read the source documents of forex news and events - don't rely on the interpretations of news media or others.
    

by : John Gaines
online trading, currency trading, financial service

Position Sizing Is More Important Than You Think

Position Sizing™ and your personal psychology are the two most important aspects of trading and they are probably the two most neglected topics. Chapter 14 of the second edition of Trade Your Way to Financial Freedom, is all about helping you understand the importance of position sizing.

Before we discuss this topic, let me give you some important background information. I tend to think of trading systems by the distribution of R-multiples that they generate. And the average R (or mean R) of the system's R-multiple distribution is the expectancy of the system. It tells you what to expect from the average trade.

So let me give you a simple trading system, one that is probably much simpler than any you'd trade. Twenty percent of the trades are 10R winners and the rest of the trades are losers - 70% are 1R losers and the remaining 10% are 5R losers. Is this a good system? Well, if you want a lot of winners, then it certainly isn't - it only has 20% winners. But if you look at the average R for the system it's 0.8R. That means on the average, you'd make 0.8R per trade over many trades. Thus, when it's phrased in terms of expectancy, it's a winning system.

Let's say that you made 80 trades with this system in a year. On the average you'd end up making 64R - which is excellent. If you allowed R to represent 1% of your equity (which is one way to do position sizing), then you'd be up about 64% at the end of the year.

I frequently play a marble game with this R-multiple distribution to teach people about trading. The R-multiple distribution is represented by marbles in a bag. The marbles are draw out one at a time and replaced. The audience is given 100,000 to play with and they all get the same trades.

So let's say we do 30 trades, and they come out as shown in the table:

R-Multiples Draw In A Game
-1R	-5R	-1R
-1R	-1R	-1R
-1R	-1R	+10R
-5R	-1R	-1R
-1R	-1R	+10R
+10R	-1R	-1R
-1R	-1R	-1R
-1R	-1R	-5R
-1R	-1R	+10R
+10R	-1R	+10R
+8R	-14R	+30R

If you look at the bottom row, you see the total R-multiple distribution after each ten trades. After the first 10 we were up +8R, we then had 12 losers in a row and were down 14R after the next 10 trades. And finally we had a good run on the last 10 trades, with four winners, getting 30R for the ten trades. Over the 30 trades we were up 24R. And if you divide 24R by 20 trades is gives us a sample expectancy of 0.8R. Thus, our sample expectancy was exactly the same as the expectancy of the marble bag. That doesn't happen often, but it does happen.

Now let's say that you are playing the game and your only job is to decide how much to risk on each trade or how to position size the game. How much money do you think you'd make or lose? Well, in a typical game like this, 1/3 of the audience will go bankrupt (i.e., they won't survive the first five losers or the streak of 12 losses in a row); another 1/3 of the audience will lose money; and the last third will typically have made a huge amount of money - sometimes over a million dollars. And in an audience of say 100 people, except for the 33 or so who are at zero, I'll probably have 67 different equity levels.

That shows you the power of position sizing. Everyone in the audience got the same trades, those shown in the table. Thus, the only variable working was how much they bet or their position sizing. And through that one variable we had final equities than ranged from zero to over a million dollars. That's how important position sizing is. And by the way, I've played this game hundreds of times, getting similar results each time.

Position sizing is that important and I'd suggest that you take a look at chapter 14 of my book because many people have told me that it turned their trading around, making them winners instead of losers. Next week, I'll tell you a lot more about position sizing - how to do it and what its purpose is.

Dr. Van K Tharp
TradingEducation.com

Reducing Risk By Currency Hedging

Ray Dalio explains the various strategies on offer for those who wish to hedge their currency exposure – the prudent thing to do when international exposure reaches 15 per cent of a portfolio.

Investing internationally is a package deal. One gets two exposures – the underlying asset and the currency – wrapped into one. These exposures, however, are separable through currency hedging. International investors can and should decide first, how much of each to have and second, how to independently manage these exposures.

Making these decisions, creating a currency hedging plan, is prudent when the international exposure reaches 15 per cent to 20 per cent of a total portfolio. Failing to do so leaves a large, inadvertently acquired, unmanaged risk in the portfolio. The purpose of this article is to provide a basic overview of the key issues that investors should address in developing a hedging strategy.

A general rule to bear in mind when creating your hedging strategy, you should follow the same steps you would follow to decide on any exposure in your portfolio: most importantly, you should decide on the appropriate strategic exposure to foreign currency and whether this exposure should be actively or passively managed.

What should the strategic exposure be?

Phrased differently, assuming no market view, how much foreign currency exposure should I have in my portfolio? The process you should use to answer this question should be the same as the process you use to determine your asset allocation mix. It should be based on the expected returns, risks and correlations of currencies.

Once you have decided on the amount you want to keep in your portfolio, the hedge ratio you set should be the amount that leaves you with your desired net currency exposure. For example, if you determine that you would like to have 10 per cent of your portfolio exposed to foreign currency, and you currently have 20 per cent, you would set a benchmark of 50 per cent hedged. Rather than determining the appropriate percentage to be hedged, you should determine a desired strategic currency exposure and hedge to achieve it. That hedged amount will be your benchmark.

So what is the right strategic exposure to have? As mentioned, that depends on your assessment of the expected returns and risks of currencies, as well as the expected correlations with other exposures in the portfolio. Because currency movements are zero sum – for one currency to go up, another must go down – it is probably best to assume that the expected return is zero, although the actual return might be quite different. This simply means the expected return is zero. The standard deviation of a typical currency portfolio has been about 11 per cent over the past 25 years, which is also a reasonable assumption going forward. The correlations with the other assets in the portfolio depend on the assets, but in general are quite close to zero.

Where will plugging these numbers into a portfolio optimiser take you? While there are a wide range of outcomes depending on unrelated factors (such as the choice of assets in your overall portfolio), there are some common outcomes. Generally speaking, analysis will lead investors to hedge away currency risks, such that the amount left is not greater than 10 per cent to 15 per cent of the portfolio. If your international investments equal 20 per cent to 30 per cent, that might lead to normally being 50 per cent hedged. If your international investments comprise only 10 per cent to 15 per cent of your portfolio, you might opt to remain unhedged.

There are only two characteristics which are unique to currencies that you need to understand to solve for the right strategic exposure:

1. it costs money to hedge and
2. currency exposures are incremental to other exposures, not instead of them.

Concerning the first point, the expected return of being hedged is slightly less than that of being unhedged because of the transaction costs of hedging. These are typically five to 10 basis points (if done passively), so it should be assumed that a hedged portfolio will have a five to 10 basis point lower return than an unhedged portfolio. Given this, you need to assess incremental benefit, what is it worth to reduce or eliminate an exposure that has a standard deviation of 11 per cent and no expected return? One typically sees that risk reduction from hedging occurs in a non-linear way; the benefits of the first 25 per cent or 50 per cent of hedging are much greater than those coming from next 25 per cent or 50 per cent. For this reason, it is rarely the case that being 100 per cent hedged is appropriate.

Regarding the second point, because currency exposures are incremental to other exposures, not a replacement for, lower risk is achieved by having less currency exposure versus more.

Currencies have little or no correlation with other assets in the portfolio. One might think that this is a reason to keep them (i.e. remain unhedged) because they would diversify, hence reduce a portfolio’s risk. In fact, the reverse is the case: having significant currency exposure in a portfolio increases risk, even though currencies are uncorrelated with other assets. This is because currency exposure is additive to other exposures. Normally replacing a higher correlation asset with a lower correlation asset reduces risk because there is a substitution of risk while total exposure is unchanged. When you increase overall exposure (e.g. buy gold futures as an overlay on a portfolio), the effect is to increase portfolio risk, even if the correlation were negative. Similarly, when reducing currency exposure, you will almost certainly reduce portfolio risk, despite currency’s low correlations.

There is only one other point that should be made before concluding the discussion of strategic exposure: the time horizon is relevant. The longer the time horizon, the less risky currency will appear because over a long enough time horizon, its effect on the return approaches zero. If time horizon is a consideration, it is important to understand how long you must wait to be unconcerned about currency risk. Based on past currency movements, in order to be 90 per cent confident that currencies will have an annual return of less than -1 per cent to +1 per cent, you would have to wait 325 years. For most investors, that is too long to patiently accept the unhedged currency risk.

Once desired strategic exposure is determined, you should focus on benchmark exposure and the hedge ratio that gets you there. There are four possible benchmarks – 100 per cent unhedged, 100 per cent hedged, partially hedged (e.g. 50 per cent) and option hedged. All four can be obtained passively. Option hedged benchmarks (e.g. buying puts to hedge the currency exposure) are sometime used instead of a partially hedged benchmark where the investor is more inclined to have currency losses come in smaller, more frequent doses than larger, infrequent amounts. These hedges should not be used as an alternative to fully hedged or fully unhedged benchmarks because they will systematically deliver either more or less currency exposure than is consistent with your strategic objective.

If you choose an option benchmark, it is essential that the one you pick is consistent with your strategic objectives. For example, some options are consistent with a 50 per cent hedged objective, while others are not. Their deltas, sensitivity to price changes, will be broadly equivalent to desired hedged ratios. When choosing an option hedge instead of a corresponding partially hedged benchmark (e.g. 50 per cent), it is also essential to measure the actual performance in relation to the passive option hedge, not the partially hedged alternative. That is because options have different systematic risks than their corresponding partial hedges. For example, options will do better when the markets move a long way directionally. If an active manager is operating to an option mandate, but is being measured against a 50 per cent hedged benchmark, the differences in returns of the manager and the benchmark will be the systematic risk and the manager’s alpha combined. As a result, one cannot distinguish how well the manager is performing from how well options are doing relative to the 50 per cent hedged. For example, a manager could outperform the fixed hedge ratio but underperform the option hedge alternative, giving the mistaken impression that the manager added value when in reality he did not. That is why the benchmark should always be the investor’s passive alternative. For most investors, the option hedged strategy is inconsistent with strategic objectives.

Active or passive?

The only purpose of active management is to add value to the strategic exposure’s passive return. The ‘active’ vs. ‘passive’ decision should be made for currency the same way it is made for other markets: based on expectations for value-added. This statement is true for all managers, whether managing to a fixed benchmark (100 per cent hedged, 100 per cent unhedged or partially hedged), or an option hedged benchmark. The investor should specify the benchmark and study the manager’s performance relative to it.

Investors should also understand and assess how a manager attempts to add value. There are only two ways to add value: fundamentally and technically. Tactical deviations from a benchmark might differ (e.g. price direction, interest rate carries, volatility, etc.), but a manager’s approach to making this bet will be fundamental, technical or some mixture of the two. Fundamental analysis is based on the belief that there are cause-and-effect relationships that need to be understood in order for pricing anomalies to be sensibly identified and acted upon. Technical analysis is based on the assumption that past price relationships are indicative of future price relationships. Whether betting on price, volatility or anything else, managers follow one or both approaches. In assessing currency managers, like any other manager, you should decide on which approach is more consistent with your own investment philosophy.

Since you would only hire an active manager because you expect they are likely to add value, it is worth knowing how they have added value in the past. Brian Strange of Currency Performance Analytics conducted a comprehensive study of currency manager performance in 1998. He studied the performance of 158 currency overlay mandates managed over a 10-year time frame and determined that currency overlay managers have added considerable value, about 1.9 per cent per year on average. Since then, several follow-up studies by other consultants have arrived at the same basic conclusions.

When examining individual managers, it is often difficult to compare their value-added (alpha) because virtually no two client mandates are the same. Judging performance against hedged and unhedged mandates is made additionally difficult by the effect that the market’s direction has on the alpha. For example, managers who are operating to an unhedged benchmark will find it easy to add value when foreign currencies are falling, while managers who are operating to a fully hedged benchmark will find it tough. To achieve the best perspective concerning the managers’ ability to add value, you should examine performance across mandates.
In summary, the alternatives an investor must decide between are expressed in figure one.

An investor’s benchmark can be either a fixed hedge ratio (e.g., 50 per cent hedged) or an option hedge. Active managers can be hired to beat the benchmark, or passive managers can be used to match it. When you are able to check the box that best suits your objectives, you will have moved most of the way toward having a currency hedging plan. Selecting specific managers and deciding on other aspects of the mandate (e.g. is cross-hedging appropriate) is also required, but these choices will be vastly easier to make once you have made the core strategic decision.

Ray Dalio is president and chief investment officer of Bridgewater Associates.

Trading Forex With A Strategy

Trading successfully is by no means a simple matter. It requires time, market knowledge and market understanding and a large amount of self restraint.

Anyone who says you can consistently make money in foreign exchange markets is being untruthful. Foreign exchange by nature, is a volatile market. The practice of trading it by way of margin increases that volatility exponentially. We are therefore talking about a very 'fast market' which is naturally inconsistent. Following that precept, it is logical to say that in order to make a successful trade, a trader has to take into account technical and fundamental data and make an informed decision based on his perception of market sentiment and market expectation. Timing a trade correctly is probably the most important variable in trading successfully but invariably there will be times where a traders' timing will be off. Don't loose heart if you loose on some trades. Experienced and seasoned traders do not expect to generate returns on every trade.

Let's enumerate what a trader needs to do in order to put the best chances for profitable trades on his side:

Trade with money you can afford to lose:
Trading forex markets is speculative and can result in loss, it is also exciting, exhilarating and can be addictive. The more you are 'involved with your money' the harder it is to make a clear-headed decision. Money you have earned is precious, but money you need to survive should never be traded.

If in doubt, stay out:
If you're unsure about a trade and find you're hesitating, stay on the sidelines.

Trade logical transaction sizes:
Margin trading allows the forex trader a very large amount of leverage, trading at full margin capacity can make for some very large profits or losses on an account. Scaling your trades so that you may re-enter the market or make transactions on other currencies is generally wiser. In short, don't trade amounts that can potentially wipe you out and don't put all your eggs in one basket.

Identify the state of the market:
What is the market doing? Is it trending upwards, downwards, is it in a trading range. Is the trend strong or weak, did it begin long ago or does it look like a new trend that's forming. Getting a clear picture of the market situation is laying the groundwork for a successful trade.

Determine what time frame you're trading on:
Many traders get in the market without thinking when they would like to get out, after all the goal is to make money. This is true but when trading, one must extrapolate in his mind's eye the movement that one expects to happen. Within this extrapolation, resides a price evolution during a certain period of time. Attached to this is the idea of exit price. The importance of this is to mentally put your trade in perspective and although it is clearly impossible to know exactly when you will exit the market, it is important to define from the outset if you'll be 'scalping' (trying to get a few points off the market) trading intra-day, or going longer term. This will also determine what chart period you're looking at. If you trade many times a day, there's no point basing your technical analysis on a daily graph, you'll probably want to analyse 30 minute or hour graphs. Additionally it is important to know the different time periods when various financial centers enter and exit the market as this creates more or less volatility and liquidity and can influence market movements.

Time your trade:
You can be right about a potential market movement but be too early or too late when you enter the trade. Timing considerations are twofold, an expected market figure like CPI, retail sales or a federal reserve decision can consolidate a movement that's already underway. Timing your move means knowing what's expected and taking into account all considerations before trading. Technical analysis can help you identify when and at what price a move may occur.

Gauge market sentiment:
Market sentiment is what most of the market is perceived to be feeling about the market and therefore what it is doing or will do. This is basically about trend. You may have heard the term 'the trend is your friend', this basically means that if you're in the right direction with a strong trend you will make successful trades. This of course is very simplistic, a trend is capable of reversal at any time. Technical and fundamental data can indicate however if the trend has begun long ago and if it is strong or weak.

Market expectation:
Market expection relates to what most people are expecting as far as upcoming news is concerned. If people are expecting an interest rate to rise and it does, then there usually will not be much of a movement because the information will already have been 'discounted' by the market, alternatively if the adverse happens, markets will usually react violently.

Use what other traders use:
In a perfect world, every trader would be looking at a 14 day RSI and making trading decisions based on that. If that was the case, when RSI would go under the 30 level, everyone would buy and by consequence the price would rise. Needless to say, the world is not perfect and not all market participants follow the same technical indicators, draw the same trendlines and identify the same support & resistance levels. The great diversity of opinions and techniques used translates directly into price diversity. Traders however have a tendency to use a limited variety of technical tools. The most common are 9 and 14 day RSI, obvious trendlines and support levels, fibonnacci retracement, MACD and 9, 20 & 40 day exponential moving averages. The closer you get to what most traders are looking at, the more precise your estimations will be. The reason for this is simple arithmetic, larger numbers of buyers than sellers at a certain price will move the market up from that price and vice-versa.

Source:
www.eagletraders.com

Price Action Into A Forex Trading System

Trading the Forex market has became very popular in the last few years. But how difficult is it to achieve success in the Forex trading arena? Or let me rephrase this question, how many traders achieve consistent profitable results trading the Forex market? Unfortunately very few, only 5% of traders achieve this goal. One of the main reasons of this is because Forex traders focus in the wrong information to make their trading decisions and totally forget about the most important factor: Price behavior.

Most Forex trading systems are made off technical indicators (a moving average (MA) crossover, overbought/oversold conditions in an oscillator, etc.) But what are technical indicators? They are just a series of data points plotted in a chart; these points are derived from a mathematical formula applied to the price of any given currency pair. In other words, it is a chart of price plotted in a different way that helps us see other aspects of price.

There is an important implication on this definition of technical indicators. The fact that the readings obtained from them are based on price action. Take for instance a long MA crossover signal, the price has gone up enough to make the short period MA crossover the long period MA generating a long signal. Most traders see it as “the MA crossover made the price go up,” but it happened the other way around, the MA crossover signal occurred because the price went up. Where I'm trying to get here is that at the end, price behavior dictates how an indicator will act, and this should be taken into consideration on any trading decision made.

Trading decisions based on technical indicators without taking price action into consideration will give us less accurate results. For example, again a long signal generated by a MA crossover as the market approaches an important resistance level. If the price suddenly starts to bounce back off that important level there is no point on taking this signal, price action is telling us the market doesn't want to go up. Most of the time, under this circumstances, the market will continue to fall down, disregarding the MA crossover.

Don't get us wrong here, technical indicators are a very important aspect of trading. They help us see certain conditions that are otherwise difficult to see by watching pure price action. But when it comes to pull the trigger, price action incorporation into our Forex trading system will definitely put the odds in our favor, it will generate higher probability trades.

So, how to create a perfect Forex trading system?

First of all, you need to make sure your trading system fits your trading personality; otherwise you will find it hard to follow it. Every trader has different needs and goals, thus there is no system that perfectly fits all traders. You need to make your own research on various trading styles and technical indicators until you find a concept that perfectly works for you. Make sure you know the nature of whatever technical indicator used.

Secondly, incorporate price action into your system. So you only take long signals if the price behavior tells you the market wants to go up, and short signals if the market gives you indication that it will go down.

Third, and most importantly, you need to have the discipline to follow your Forex trading system rigorously. Try it first on a demo account, then move on to a small account and finally when feeling comfortably and being consistent profitable apply your system in a regular account.

Source:
www.straightforex.com

Essential Elements of a Successful Trader

Courage Under Stressful Conditions When the Outcome is Uncertain

All the foreign exchange trading knowledge in the world is not going to help, unless you have the nerve to buy and sell currencies and put your money at risk. As with the lottery “You gotta be in it to win it”. Trust me when I say that the simple task of hitting the buy or sell key is extremely difficult to do when your own real money is put at risk.

You will feel anxiety, even fear. Here lies the moment of truth. Do you have the courage to be afraid and act anyway? When a fireman runs into a burning building I assume he is afraid but he does it anyway and achieves the desired result. Unless you can overcome or accept your fear and do it anyway, you will not be a successful trader.

However, once you learn to control your fear, it gets easier and easier and in time there is no fear. The opposite reaction can become an issue – you’re overconfident and not focused enough on the risk you're taking.

Both the inability to initiate a trade, or close a losing trade can create serious psychological issues for a trader going forward. By calling attention to these potential stumbling blocks beforehand, you can properly prepare prior to your first real trade and develop good trading habits from day one.

Start by analyzing yourself. Are you the type of person that can control their emotions and flawlessly execute trades, oftentimes under extremely stressful conditions? Are you the type of person who’s overconfident and prone to take more risk than they should? Before your first real trade you need to look inside yourself and get the answers. We can correct any deficiencies before they result in paralysis (not pulling the trigger) or a huge loss (overconfidence). A huge loss can prematurely end your trading career, or prolong your success until you can raise additional capital.

The difficulty doesn’t end with “pulling the trigger”. In fact what comes next is equally or perhaps more difficult. Once you are in the trade the next hurdle is staying in the trade. When trading foreign exchange you exit the trade as soon as possible after entry when it is not working. Most people who have been successful in non-trading ventures find this concept difficult to implement.

For example, real estate tycoons make their fortune riding out the bad times and selling during the boom periods. The problem with trying to adapt a 'hold on until it comes back' strategy in foreign exchange is that most of the time the currencies are in long-term persistent, directional trends and your equity will be wiped out before the currency comes back.

The other side of the coin is staying in a trade that is working. The most common pitfall is closing out a winning position without a valid reason. Once again, fear is the culprit. Your subconscious demons will be scaring you non-stop with questions like “what if news comes out and you wind up with a loss”. The reality is if news comes out in a currency that is going up, the news has a higher probability of being positive than negative (more on why that is so in a later article).

So your fear is just a baseless annoyance. Don’t try and fight the fear. Accept it. Have a laugh about it and then move on to the task at hand, which is determining an exit strategy based on actual price movement. As Garth says in Waynesworld “Live in the now man”. Worrying about what could be is irrational. Studying your chart and determining an objective exit point is reality based and rational.

Another common pitfall is closing a winning position because you are bored with it; its not moving. In Football, after a star running back breaks free for a 50-yard gain, he comes out of the game temporarily for a breather. When he reenters the game he is a serious threat to gain more yards – this is indisputable. So when your position takes a breather after a winning move, the next likely event is further gains – so why close it?

If you can be courageous under fire and strategically patient, foreign exchange trading may be for you. If you’re a natural gunslinger and reckless you will need to tone your act down a notch or two and we can help you make the necessary adjustments. If putting your money at risk makes you a nervous wreck its because you lack the knowledge base to be confident in your decision making.

Patience to Gain Knowledge through Study and Focus

Many new traders believe all you need to profitably trade foreign currencies are charts, technical indicators and a small bankroll. Most of them blow up (lose all their money) within a few weeks or months; some are initially successful and it takes as long as a year before they blow up. A tiny minority with good money management skills, patience, and a market niche go on to be successful traders. Armed with charts, technical indicators, and a small bankroll, the chance of succeeding is probably 500 to 1.

To increase your chances of success to near certainty requires knowledge; acquiring knowledge takes hard work, study, dedication and focus. Compile your knowledge base without taking any shortcuts, thereby assuring a solid foundation to build upon.

by Jimmy Young
EURUSDTrader