Lesson 19: Correct Mindset: Probabilities = Edge

Probabilities lie at the heart of all successful trading. To ensure that we a thinking in probabilities throughout our trading day we concentrate on 3 things.

1. Patience: We understand that the best time to trade is when price is Overbought or Oversold, as these areas represent when a move is near exhaustion and is most likely to reverse. This requires patience, as we must wait for price to become OB or OS to have an edge.

2. Execution: From backtesting our strategy we understand that it’s impossible to predict which trades will be winners. We accept we can't predict the future and focus solely on correct execution to give us our edge. Good entries and exits not only increase our profits, but also limit our losses should our trades go against us (stop loss / trailing stop).

3. Honesty: We understand that in business losing is not always losing and winning is not always winning. This honesty give us an edge by allowing us to avoid trying to fix trades in which there were no errors (ie: losing trade with correct money management, entry and stop placement) or emulating trades in which there were mistakes (ie: winning trade with poor entry, exit and/or money management).   

If we can conduct ourselves with a bias on Patience, Execution and Honesty then we are thinking in probabilities and even losing days are good days because we are trading with an edge.

Lesson 18: Overcoming Cognitive Biases = Backtest

As we trade we will come up against some emotional barriers (biases), they are...
1. Loss Aversion: to have a strong preference for avoiding loss over acquiring gains. When self employed we must be both risk takers and bank managers (risk avoiders), this internal battle represents loss aversion. To overcome it we backtest our strategy to prove to "our" bank manager the business is viable.

2. Outcome Bias: to judge a decision by its outcome, rather than the quality of the decision at the time it was made. This is easy to slip into as we are brought up with a bias on test results (school/work). The problem is tests are based on absolutes and established facts, but business works in probabilities because the factors effecting it continually change. To overcome it we must examine our backtesting to learn its "win/loss ratio" and "max losses in a row". Once we have the facts we know when to ride out a rough patch and when to worry.
3. Recency Bias: to favour recent results/data over older ones.  It occurs after a string of positive or negative results, when instead of accepting the fact that in terms of probability we have just been incredibly fortunate or unfortunate, we start to believe that we are truly gifted or cursed. This bias is a sibling of outcome bias, so is dealt with in the same way.

4. Disposition Bias: to let losses run and take profits early. This is a by-product of greed, fear and inexperience. Greed makes you hope a loser will turn around. While fear makes you quit a winner early, in case your gains reverse. Solution, you've guessed it backtest. Everyone overreacts when they don't have the facts.
Once one's overcome Disposition Bias, problems usually start with Recency Bias (string of losses), leading to Outcome Bias (focusing on results) and finally to Loss Aversion (doubting the strategy). When this happens stop trading and do a day or two of backtesting, this helps tune you back into reality and your strategy.

Lesson 17 Build Self-trust: Back-test and Forward-test, become an expert before you begin.

When backtesting we simply select a timeframe and setup we wish to test (ie on the EURUSD), then review its past chart action to see how it performed. This isn’t a completely fail safe method (as it shows past behaviour, not future) but it gives us a good idea of what we can expect from our strategy. As a general rule I find around 150-200 trades good (approx 8 hours work). We want this large number for 2 reasons. Firstly to filter out any odd results, and secondly to become an expert... We have to place, calculate and record the risk of 200 entries, stop losses and trailing stops (if applic). Trading is not an art, it’s a science. Repetition makes us better. We start on the chart by marking each trade entry and putting 2 numbers by it, 1. The "Risk" in pips (Entry - SL). 2. The "Profit/Loss" in pips (Exit - Entry).

Once we have done this for 200 trades we open a spreadsheet. On the horizontal axis we input, "Date/Trade#", "Risk(pips)", "P/L (pips)"," P/L %" and "Total %". We then input the date and trade number in "Date/Trade#" column, the first number from each trade (on your chart) into the “Risk” column, the second number into the “P/L” column, and then divide “P/L” by “Risk” to get the "P/L%". Finally we add up all the "P/L%s" from the given day (week if swing, month if position) and place that number in our “Total %” column.

This gives us ample data to help create an income (ie Net P/L, win/loss %, biggest win, average win, average loss etc). We don’t cut corners, it’s the repetition that makes us experts, gives us reliable data and creates self trust!

Finally forward testing requires us to trade the strategy in real time using either a demo or micro account (we're not fully invested!). This allows us to practice and learn how to implement it in reality while fixing errors that a moving market with slippage will create, believe me there will be errors! Once we have tripled our demo account we can fully invest.

Lesson 16: Match Yourself to the Market

We must remember that we are traders, not investors. We covered Fundamental Analysis first (how to value currencies) because doing so makes the currency market transparent and unthreatening. But we (traders) understand that most of the time the market is ruled by emotion, (why else would prices fluctuate when there has been no change in valuation) So we trade emotions most of the time and changes in valuation as and when they occur. To increase our chances of success we trade the most liquid pairs, EURUSD, USDJPY, GBPUSD, USDCHF, AUDUSD, EURJPY. All traders are looking for the same thing, overbought and oversold areas. So the more traded a pair is, the more likely these areas (OB/OS) are to work. EURUSD is the most liquid of all pairs and is where we should start.  A lot of people assume that one can only trade if they give up their day job, this is a complete misnomer. Only day traders need to monitor the market constantly throughout the day. The key thing is to find the smallest timeframe you can trade comfortably because the shorter the timeframe, the more setups you get and thus more profit you will make. But you need to remember that every time a session closes you will need to take a look at the chart, a 1 hour chart means we need to look at the end of each every hour (because we use the close as our signal). We have a few options. 1. trading off the weekly or daily charts means we never have to look at the market during the day, but reduces our returns. 2. venture into the hourly charts, H1 requires looking 8 times at work, H4 only twice. OR 3. Daytrade the AM (6am-8am) or PM (5pm-7pm) sessions before/after work. We should play around for a little while but ultimately we want to decide on one pair, one timeframe and one setup because we need to become experts. If we keep changing the parameters we will quite literally become Jacks of all trades, masters of none.

Lesson 12: Basic Technical Analysis, Reading a Chart

We read a price chart from left to right.  There are 2 axis, Price (vertical) and Time (horizontal). The most basic form is a line chart, it is made by joining the closing price of each day/session to form a constant line. Below is an example of the daily EURUSD.

Price can only go in three directions, up (uptrend), down (downtrend), and sideways (range/chop). An uptrend is defined by a series of higher lows and higher highs, a downtrend by a series of lower highs and lower lows and a range by a series of highs and lows that stay within a range.

The next example is of a bar chart. As you can see it has a similar shape to the line chart, but one can now see the additional data the line graph had to miss out to draw a straight line.

On a bar chart each day/session has it's own individual bar. The horizontal line on the left is the open (O), the high of the vertical line is the high (H), the low of the vertical line is the low (L),  and the horizontal line on the right is the close (C).  So we call bar charts OHLC.

The following is a diagram of the same sessions as Japanese candlesticks. As you can see they are much easier to read because they are colour coded, white = up (bullish/optimistic), black = down (bearish/pessimistic). The rectangle is called the real body and the vertical lines are called shadows (upper and lower).

When viewing bars and candles the open gives you a reference, the highs represent the markets hopes, the lows its fears and the close what it truly believes.

Look at the candles above. We can see that although the first candle is technically “bullish” (because it closed higher), it is actually quite pessimistic as it tried hard to make new highs but lost it’s confidence, closing near its low. This is also true with the “bearish” candle which is actually quite optimistic, as it closed nearer it’s high.

Below is our chart of the EURUSD in candle format (green = up, black  = down).

Lesson 11: Introduction to Technical Analysis (Price Charts)

Technical Analysis is the study of price action (charts). It has been used in the west for approximately 100 years, while in Japan it has been in use for over 300. Price action it is said to depict the battle between the Bulls and Bears. The Bulls pushing the market up with their horns, the Bears pulling the market down with their paws. When looked at over a period of time one can identify if investors have been buying or selling an instrument (trend), price levels where investor confidence has waned (supply/demand) and areas to buy or sell (Entries/Exits). These are our 3 Technical Analysis objectives. 1. Identifying Direction (trend). 2. Identifying Overbought/sold areas (suppy&demand). 3. Identifying Entries/Exits. This in essence, is all trading is! If you get the direction wrong, are not aware of potentially weak areas in price and don't know when to buy or sell, you're going to lose money! NB although It’s important to understand the concepts of bullish and bearish I prefer not to view the marketplace as a battle ground. The market is one entity not some schizophrenic beast, to me the market is human (as it’s made up of humans) and price action represents its/our overriding emotion. Be it optimism (up), indecision (choppy) or pessimism (down).

Lesson 10: Trade and Money Management Strategy

Recap of the prior 4 lessons... Currencies are abbreviated to a 3 letter code and then put into pairs. When viewing a quote ie “EURUSD 1.30025 - 1.30027” the EUR is the 1st currency, the USD is the 2nd currency, the first number is the “bid/sell” price,  the second number is the “ask/buy” price.  The difference between the bid and ask is called the spread. If you bought the EURUSD you would be buying EUR and selling USD. if you sold the EURUSD you would be buying USD and selling EUR. There are 4 FX markets. 1. Spot in which you actually purchase currency, 2&3. Futures and Options in which don’t actually buy the currency but a contract instead.  and 4. Spread Betting where you can trade just like Spot, Futures or Options, but bet instead. Placing a trade... To buy hit the “ask/buy” button on your platform, to sell you hit “bid/sell”. Bet Size means how much do you want to bet per point (a 10 pip move at £2 per point = £20). Stop Loss and Take Profit orders do exactly what they say. Generally you want a RRR of 1:2 or greater, so your TP should be twice the size of your SL. You can move you SL in a trade, this is called a trailing stop (ensure you track loosely to ensure you’re not stopped out early). Managing Money... Divide your capital into 100 even lots, to ensure your maximum loss on any one trade will only be 1% of your account. In each trade our risk is the point difference between our Entry and Stop prices, we call this the “Stop Size”. To ensure that our Stop Size (entry price - stop price) does not exceed our max risk per trade (1% of our capital), we need to divide max risk per trade (1% of our capital) by our Stop Size (Entry - Stop price), this gives us a bet size that will not exceed our max risk per trade.

Lesson 9: Money and Risk Management.

The Forex market is very volatile which means despite doing the right thing, you can still stack up a quite few losses before you make good. Most profitable traders lose approx 60% of the time but still make a good return, but only because they know how to manage money. Firstly divide your capital into 100 even lots, to ensure your maximum loss on any one trade will only be 1% of your account. This also aids you emotionally as it allows you to be wrong quite a few times without having a major effect on your capital. To figure out what 1% of your account is, divide your capital by 100. So if our account was £500 our Max Risk per trade/bet would be £5 (£500 / 100 = 5). In each trade our risk is the point difference between our Entry and Stop price, we call this the “Stop Size”. If our entry price on a EURUSD trade was 1.30000 and our stop was 1.29990  our Stop Size would be 10 points (1.30000 - 1.29990 = 0.0010). We need to ensure that our Stop Size (entry price - stop price) does not exceed our max risk per trade (1% of our capital), or we will have lost more than 1% of our account on 1 bet/trade. To do this we divide Max risk per trade (1% of our capital) by our Stop size (Entry - Stop price), to get our Bet Size. In this case £5 (1% of our capital) / 10 (stop size) = £0.5 (bet size). A lot of traders spend their time counting pips, thinking that they've had a marvellous day if they make 100 points. But of course it all depends on what you were risking! if you only risked 50 pips that would be fine (a RRR of 1:2), doubling your money for a return 2%. But if you risked 200 pips (a RRR of 1: 0.5), it’s crap as you’re only getting half your risk back, a 0.5% return. As you can see measuring risk is far more important than measuring any other unit.

Lesson 8: Spread Betting Entry, Exit and RRR

Once you have identified an opportunity, you will want to place your bet. Let's say you want to go long (buy) the EURUSD. To go long hit the “buy/ask” button (to short = sell, hit the "sell/bid" button) on your platform, you will then be asked to specify the bet size. Bet size = how much do you want to bet per pip (the last digit on the right of the quote). Some firms allow you to bet as little as 10p a point, this means that every point is worth 10p, so a 10 point move would equal £1 (10x10=100p). If desired (you should) you can also place a stop loss order, an area where you would wish to close your bet should it go against (an insurance policy if you will) and a take profit order, representing a level of profit you would be happy with. In these orders you are asked to type in the exact price at which you would want to sell. Here's an example, we buy the EURUSD at 1.30000, we place our stop at 1.29990 (-10pips) and a take profit order at 1.30020 (+20pips). You can see we are are basically trying to double our money. We call this a risk reward ratio of 1:2, because we are risking 1 (10pips) to get 2 (20pips) back. A RRR of 1:2 is genuinely accepted as the absolute minimum a trader should accept. Throughout your trade you are able to update your stop and take profit levels (however you rarely change your take profit area). This is fab as it means we can lock in gains reducing our RRR. For example when our trade moves in our favour by 10 pips it has not yet hit our profit target but we could move our stop loss to our entry price, essentially making our risk 0,  (If we bought and sold at 1.30000 we would register no loss or gain) so our RRR would be 0:2. When you move your stop, it is called a trailing stop. When trailing a stop we have to give price a little wiggle room because the collective market agreement of what something is worth fluctuates a fair bit! ;) So to avoid being stopped out too early we have to keep our stop loss wide.

Lesson 7: What Forex Market to Trade? Forex Spot, Futures, Options and Spread Betting

Forex Spot is the most traded market in the world with a daily turnover of around 1.5 trillion dollars! Spot basically translates to "now". So if you were to trade it, you would be buying or selling a pair at the price it is right now and would own the currency you were buying (although not physically, this would be completely impractical, it's all electronic). Futures are very different. When trading any future you are not actually buying the base product (currency in our case), you are buying a contract. This contractual agreement is a little like asking someone to reserve a sofa you like for 3 months at a set price, you put a deposit down but contractually you must (are obligated) pay for it at the end of the 3 months. The idea is that if you think the price of the sofa (currency) will go up, you buy the contract (guaranteeing a set price for 3 months). If you’re right the price of the sofa will have gone up in value and you profit from the difference by selling on the contract or the sofa. Options are very similar to futures with the exception that you are not obligated to buy the “sofa” at the end of the 3 months (in this circumstance you just lose your “deposit”) also the contracts can vary in length. When spread betting one can trade just like the spot, future or options market but you never actually own the currency or contract, instead you place a bet with a financial bookmakers (a “Corals” for finance). The bets you place with them unlike a regular bookie, are open, meaning you can alter them just like a trade (you can add to, reduce or close your bet whenever you want). The major benefit to spread betting is that all winnings are tax free (because it is gambling). There’s no right or wrong method, just choose what suits your needs. If you only have limited funds it might be best to spread bet (but always with a stop, otherwise your losses are limitless!), as the minimum deposit and trade sizes are considerably smaller than other types of accounts.

Lesson 6: Currency Quotes

Currencies are abbreviated to a 3 letter code, EUR = Euro, USD = US Dollar, JPY = Japanese Yen, CHF = Swiss Franc, GBP = GB Pound. In any transaction there are always two commodities, so currencies must be put into pairs. In stocks we sell money to buy stock while companies sell stock to buy money. So in FX we must sell Money to buy Money and vis versa. The most common pairs are the EURUSD, GBPUSD, USDJPY and the USDCHF, aka the "majors". Please note they cannot be reversed ie USDEUR. Generally the currency with the higher IR comes first, with exception of the EUR which always comes first. When reading a quote, ie  "EURUSD 1.30025" we call the EUR the 1st currency, the USD the 2nd currency and the number represents how many 2nd currency (USD) the 1st currency (EUR) can buy. In this case 1 EUR can buy 1.30025 USD. If we buy the EURUSD we would be buying EUR (1st currency) and selling/"borrowing" USDs (2nd Currency). If we sell the the EURUSD we would be selling /"borrowing" EUR's (1st currency) and buying USD (2nd currency), this applies across all pairs. There are 5 decimal places after the 1 in 1.30025 as the FX market is so leveraged (tiny movements = big gains). When we buy or sell our profit/loss is calculated by the last number on the right of the quote, in this case the 5. We call this the pip, (we’re trading in thousandth of a penny increments!) sometimes the 2nd or 3rd number on the right is used as the pip depending on the pair, but don’t worry we’re always told which it is in the order entry screen. Finally when you view a pair there are always 2 prices, the “bid/sell” price (lower) and “ask/buy” price (higher), the difference between them is called the spread and is how brokers make their money. They match a buyer paying 1.30027 with a seller selling at 1.30025 to make a 2 pip profit. On the majors spreads of anything up to 2-3 pips are acceptable.

Lesson 5: Trading the Carry Trade (A Long Term Strategy)

As you've probably guessed we’re going to work our trading ideas from the carry trade and safe haven plays. Let’s do a brief recap here so you don’t need to re-read all the lessons to date. The Carry Trade: Okay so a Central Bank spends it's time either trying to stimulate a flagging economy (lowering IR, lowering Reserve Requirements and buying Debt), or containing a booming economy (raising IR and Reserve Requirements). This makes our life very easy for spotting potential Carry Trades... If we hear that a central bank is flooding it's economy with money and lowering IR, we know it's a great time to borrow money from it cheaply. While if we hear that a central bank is struggling to contain an inflationary economy (raising IR / Reserve Requirements) we know it's a great time to deposit money with them, and that's just what we do! We're almost a reverse Robin Hood, we borrow from the poor, and deposit with the rich. Very rarely one of the 3 “mega economies” (US, EU, Asia) goes into recession (2 consecutive negative quarters of growth/GDP). Our objectives must change from one of capital growth to capital preservation, so we buy the safe haven currencies (US Dollar, Japanese Yen or the Swiss Franc) until the problem “mega economy” has returned to growth (positive GDP). Our strategy can be summed up as “Money always flows to the highest IR except in times of global fear, when it seeks safety”.

Lesson 4: Safe Havens

Okay sometimes, very rarely the Carry Trade doesn't work. Why? Because of “global fear” (recession). In times of global fear, investors objectives change from one purely of capital growth (greed) to that of capital preservation (fear). So instead of buying risky currencies offering high returns, they buy safe havens with no regard to whether they offer any return or not. Its important not to confuse “global fear” with just fear. This is because in all potential carry trades the country with the lower IR will most likely be suffering/recovering from a recession, so feeling some fear. While the country with the higher IR will naturally be experiencing growth, so some positive emotion. IMO The best way to identify “global fear” is to divide the world into 3 mega economies of. 1. US Economy, 2. EU Economy (when added up has a GDP roughly the size of the US) 3. Asian Economy (China+Australia+Japan again equal a GDP roughly that of the US). If any one of these 3 mega economies (US, EU, Asia) falls into recession you want to start trading the safe havens until it has returned to growth(a recession is defined as 2 consecutive negative quarters of growth/GDP), because it affects the entire world as they rely on each other for imports and exports. On a global level this means slower growth everywhere... In the currency market our safe havens are the US Dollar, as it’s the biggest single economy, the reserve currency of the world and is how we price oil. The Swiss Franc, a relic of the cold war when the Swiss Franc offered some safety because of it’s neutrality. And the Japanese Yen, being based in the East it’s economy is thought to be  far enough removed for it not to be too heavily affected by economic problems in the West. Although one can poke some holes in the theory behind the safe havens they work because of 2 reason 1. traders and investors have little other option and 2. The Crowd effect, the desire to follow that which others are doing.

Lesson 3: How a Central Bank Makes its Decision

So a Central Bank’s objectives are to  maintain 1. High Employment, 2. Steady Growth and 3. Low Inflation. So obviously it needs a way to measure each of these areas. To measure employment it uses the monthly/yearly unemployment figures. In the US they are confusingly called NFP’s (non farm payrolls) which records all those employed, but not at a farm, so the entire service sector of the US (80% of its economy!). Thankfully the rest of us manage to call them unemployment figures. To measure growth they view the monthly/yearly GDP figures (gross domestic product), which is the gross income from a country's goods and services. Finally to measure inflation it uses the monthly/yearly CPI figures (consumer price index), which is an index that records price increases/decreases from a set basket of consumer products. Are there other ways to measure these figures? Absolutely, dozens but none are as respected as the ones mentioned. Do you really need to know this stuff? Well, you don’t need to be a mechanic to drive a car, but it’s not a bad idea to know how to fill up your radiator fluid. Having said that, it’s important to remember that you’re a trader not a central banker. Some will swear you should monitor these figures religiously but I would argue that they’re non of our business. We don’t trade employment, growth, or inflation figures, We trade money. The only thing that can affect the supply of money is it’s central bank, so ultimately I only follow their decisions. CPI can go up warning of inflation and possible IR hikes but until the central bank does something, the supply of money hasn’t changed. The decision is always based on the 3 objectives of the central bank, never one factor. This is why predicting what a central bank may do should be avoided.

Lesson 2. The Central Bank

Each country has it’s own Central bank with the exception of Country’s in the EU whom are governed by the ECB (European Central Bank). The Central Bank has 3 objectives. 1. High Employment, 2. Growth 3. Manage Inflation (2% per year) . It does this by increasing the supply of money in times of recession to encourage spending and decreasing supply in times of growth, to reign in spending. It has 3 tools to do this. 1: Interest Rates: It can raise or lower its interest rate to make its currency cost more or less to borrow. A low IR makes borrowing it cheap, so there's plenty of supply in the economy.  While a high IR makes money expensive (a luxury) so there will be far less supply. 2: It can set the minimum amount of cash retail banks must hold in their bank vaults, this is called the Reserve Requirement. This essentially dictates to "barclays" how much they can loan out. A low reserve requirement means they can make lots of loans, increasing the supply of money in the economy. A high reserve requirement means they can only loan out a limited amount of money, decreasing the supply. Tool 3: Open Market Operations (buying bonds): Sounds terrifying but is the easiest to understand. In this scenario the Central bank enters the market place and loans money to either businesses or the government, injecting cash into the economy. Of course it is a little harder to get the money back because it all depends on when the borrower can pay it back ;). So it's not so good at reducing supply! The basic concept is this... If the central bank is lowering interest rates & reserve requirements and buying lots of debt, it is making money affordable, to try to stimulate the economy. If it is raising interest rates and reserve requirements, it is making money expensive, to try to cool an overheated economy where the price of basic necessities are so inflated the poor are struggling to afford them. If you can get this you're well on your way.

Lesson 1. The Carry Trade

Currencies are valued through interest rates. The Central Bank of a country ( Bank of England / Bank of Japan / Federal Reserve / European Central Bank etc) sets an interest rate at which retail banks (Barclays etc) can borrow and deposit money from it, just like the retail banks (Barclays etc) do for us. However it is far simpler as central banks can only set one interest rate for both deposits and loans. Ie the Bank of Japan let's you borrow and deposit Yen for 0.1%, the ECB's rate for the Euro is 0.75%. All one then does is borrow cheap money (Yen) from a Central Bank with a low interest rate (BoJ) , then deposit it (as Euros) at a Central Bank offering a high interest rate (ECB). You then profit from the difference in interest rates (0.75 - 0.1 = 0.65%) and as the demand for the high interest rate currency (Euros) increases it will of course further increase in value. Thus when you eventually sell your Euros, you will be able to buy back more yen and be richer. This is called the Carry Trade it is the most important currency strategy and all investment banks do it.