dislikes. Soft elements include the trader profile, market selection, tactics,and psychology and attitude. Taken together, the soft elements define a trader’sstyle.These elements are given in-depth consideration when I develop thecodex process approach to trading in Part Three of Getting Started in FOREXTrading Strategies (GSIFTS). But a brief introduction here is useful. Even traditional traders must have answers to the soft elements, although they are oftengiven much less consideration than trading techniques. Decide and define yourstyle before trading. By positioning yourself appropriately in the market, manytrading decisions will be easier to make. Diagnosing problem areas is also asimpler task if you “know thyself.”Even though these elements are relatively nonobjective, they cannot beirrational, hodgepodge, or contradictory. For the best chance of trading success,they should complement each other as well as your trading techniques andmoney management decisions.You may well need to go back and fill in some soft element answers afterdigesting the decisions required in Chapter 3, “Money Management.”
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StyleStyle is the sum of nonquantifiable decisions you make regarding your trading plan. They include, but are not limited to, the markets you trade (yourfocus: short term, intermediate term, long term); the kinds of markets youprefer (trading markets, trending markets); and your attitude and outlookon trading.Style is the cumulative sum of the soft elements defining you as a trader.How much do you trade? Do you like fast markets or slow markets? Tradingmarkets or trending markets? Do you seek big moves or small moves? Are youhappy with a 10 pip winner, or do you need 100 pips? In which markets haveyou been most successful? These are personal decisions with no right or wronganswers, but again, they must complement each other and be realistic.With dozens of pairs and crosses and around-the-clock trading, there isplenty of action in FOREX, so there’s never a reason for trading markets lessthan suitable to the trader’s style.
Market EnvironmentsA market environment (ME) is a rating, either quantified or judgmental, abouta market’s directional movement and volatility. It is a key element of the codexapproach; it impacts trading across a wide range of decisions regarding tradingtechniques, money management, and style.Studying markets and trades in the framework of market environments isa critical codex functionality. Two factors defining market analysis will tell youthe current personality of any market. All markets can be deconstructed intodirectional movement and volatility.Directional MovementWhich way is the market going, up or down? And how quickly over time is itrising or falling? There are different ways to measure directional movement(DM) but it is basically the slope of the line or the price differential from thebeginning point of a trend to the end point of that trend. I prefer the price differential for eyeballing, Charlie-style.In the example shown in Figure 2.1, I would take raw DM = 5 units,based on the close of the first bar and the close of the final bar.For eyeballing I use a range of 1 to 4 and a label of up or down. I visualizea price movement of 100 percent (a vertical line) as 4 and a price movement of0 percent (a horizontal line) as 1, then picture the data as potentially comprising four 25 percent quartiles.
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FIGURE 2.1 Directional Movement.
Any number of ideas and notations will work just fine; use what is comfortable for you. In my system, “1D” means a market is falling very slowly,while “4U” means it is rising very quickly. Other notations are fine, as long asusage is consistent. The idea is to build a catalogue of examples for study,analysis, and hypothesis testing. For example, simply using a range of 1 to 8would work well, also.If you believe you can be objective and consistent, you might not evenwant to use numbers and instead go with simply high, medium, and low.In Figure 2.1 with its raw DM = 5, I rate the overall DM as 2, closerto 1 and to 0 percent change in price than to 4 and 100 percent change inprice.VolatilityVolatility (V) is defined as the “price action over a trend (directional movement)over and above the absolute value of the trend.”While DM is the net price change, volatility is the total of all pricechanges over a trend, given some minimum fluctuation, and divided by DM.For example, if DM = 10 and V = 30, then raw volatility = 3.Volatility is a little more difficult to scale and notate. Through experienceI’ve found it measures typically 200 percent to 1,000 percent of DM, althoughit can go much higher. The longer your chart sample and the smaller the pricefluctuations it records, the larger percentage for volatility. With that you canuse the same notation as for DM, with 1 representing low volatility and 4 representing high volatility.In the example in Figure 2.2, raw DM = 5 units and raw V = 40. Volatility is 8 times the DM, or 800 percent. Given a potential range, as I said, of 200to 1,000 percent, I would rate V as 3.
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FIGURE 2.2 Volatility.
How you measure and notate any of the elements is not as important asensuring that the measurements are consistent. There are statistical methods formeasuring V and all of the elements but they are beyond the scope of this article. It is not difficult to accurately eyeball volatility once you get some practiceon a few dozen charts.
Market SelectionMarket selection is a vital codex element and is covered in more detail in Parts 2and 3 of GSIFTS. The most popular markets are those involving the U.S.dollar (USD); these are called pairs. The euro (EUR) against the U.S. dollar(EUR/USD) dwarfs all others in trading volume.A pair is a set of traded currencies with the USD as one of the components.A cross is a set of currencies without the USD as a component. See Table 2.1.What pairs or crosses do you trade? Some markets are more volatilethan others; each market has its own, slowly evolving personality occasionallyTABLE 2.1 Most Frequently Traded Currency PairsThe new trader is advised to focus on USD majors and move on to cross rates onlyafter mastering the majors.USD Majors
Cross Rates
EUR/USD
EUR/CHF
GBP/USD
EUR/JPY
USD/CHF
EUR/GBP
USD/JPY
GBP/JPY
AUD/USD
CHF/JPY
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impacted by news events. As you’ll see in the sections that follow, day tradersand the position traders will be attracted to low-volatility trending markets thatcan be managed over longer periods of time. Guerillas and scalpers will seekout high-volatility trading markets offering fast but small profits.
Market CharacteristicsEach market, irrespective of its placement as a specific pair or cross, is a function of the two basic market environment factors—directional movement andvolatility. A third factor can be added. I call it thickness (T). Thickness refers tothe amount of overlap between the high and low price of one trading unit andthe next trading unit. The more overlap, the thicker the market is said to be. Ivery much like and seek thick markets and have had great success trading themboth in futures and in FOREX.Thickness can be measured as the average overlap from one price bar tothe next on a chart, averaged over a given period of time. Thick markets arerecommended to beginning traders.I simply use high, medium, and low as my labels for eyeballing thickness.In Figure 2.3, the market on the left demonstrates high thickness, the one inthe middle is medium thickness, and on the right, low thickness or thin.You can also do something similar for T as for DM and V. Take raw T tobe 0 when there is no overlap and 100 when there is 100 percent overlap, andbreak the data into four 25 percent quartiles. An outside day, where both highsare higher and lows are lower, would still be rated simply as 100 percent raw T.Where price bars have little overlap, they are said to run thin. Fasttrending markets tend to be thin.Remember you are using the average thickness over the trend or chartyou are analyzing. Thickness, fortunately, tends to change slowly, so this is nota major issue.1211 10 9876543210
10
20
30 40
50 60
70
80
90 100 110 120 130 140 150 160 170 180 190 200 210 220 230 241 250 260 270 280 290 300 310 320 330 340
FIGURE 2.3 Thickness.
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The Trader ProﬁlePerhaps the most important soft question is also the easiest to answer: At whatlevel of trading do you feel most at home? Although levels are a continuum andnot easily separated, four basic levels can be considered: guerilla, scalper, daytrader, and position trader. Recognizing your trading level is the first step indefining a trader profile.A trader’s profile is the decision to trade short-term, intermediate-term,or long-term markets. Very short-term traders are guerillas, short-term tradersare scalpers, intermediate term traders are day traders, and long-term traders areposition traders.The orientation in FOREX is even shorter than it is in futures. Very fewtraders are position traders in FOREX; the risk of staying over from one sessionto the next is very high. Guerillas are also called high-frequency traders—and,of course, the brokers love them!My recommendation: Focus on being either a scalper or day trader. SeeFigure 2.4.GuerillasThe guerilla traders are the shortest-term traders. They look for the quickest inand-out possible. A profit of 5 to 20 pips is their trading goal. Caution: Unless
FIGURE 2.4 Basic Trader Proﬁles.There is risk inherent in simply being in the market. The longer you stay, thegreater the risk. Therefore, longer-term traders must seek greater rewardsto compensate for the risk. A guerilla trader should rarely be in a trade formore than 15 to 30 minutes.
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you trade large numbers and receive extremely small bid-ask spreads from yourbroker/dealer, the guerilla approach is not recommended.ScalpersThe scalpers are close cousins of the guerillas. They seek profits in the 10 to 40pip range. If you have a small account and want to be a scalper, stay with themost liquid pairs where pip spreads are small. A 3-pip spread does not soundlike much but, as you will see in Chapter 3, it can eat you alive quickly. Themore you trade, the greater a factor trading costs will become to you.Day TradersThe day traders want trades with a potential of 20 to100 pips. They obviouslytrade less than either the guerilla or the scalper. If you want to be a day trader,you need to use stops, know that they are in effect, or stay online while yourtrade is live. I prefer the day trader profile but, again, it is a personal decisionwith no right or wrong answer.Day traders will often stay with an active trade across multiple tradingsessions, but rarely more than 24 hours. See Figure 2.5.Position TradersThe position traders are rare creatures in the FOREX arena. They are willing tokeep a trade open across two or more trading days. Like the day traders, position traders need to use stops consistently or stay awake as long as a trade is
FIGURE 2.5 Trading Sessions.FOREX sessions are also divided into the U.S. session, the European session,and the Asian session.
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live. These traders trade the least and grab the biggest profits. But the downsideis risk: The longer you are in a trade, the riskier it becomes because of tradeshattering news events or announcements that can quickly destroy a carefullynurtured position.
Psychology and AttitudeSome people have a naturally winning attitude. Others are self-destructive.Nothing brings out that trait faster than leveraged markets such as FOREX. Ifyou don’t have a naturally winning attitude you can develop one, but it is noteasy. If you are self-destructive, your chances of success in the markets are notgood.Psychology in trading is primarily about keeping your emotions in check.The primary emotions of any market trader are fear and greed. The more leveraged and volatile a market, the quicker these emotions can harm your efforts. Ifyou trade stocks with zero leverage, these emotions may not affect your tradingperformance very often or even critically. In FOREX they will come at youevery single trading session.Your psychology and attitude should be reflected in many of your codexdecisions. The exceptionally nervous trader is not a candidate to be a good position trader; it would be better for the nervous trader to scalp the markets andalleviate the worry coming from holding a position a long time.Universally, successful traders are able to keep their emotions out of theirtrading decisions—and it is not easy to do. Keep but move.In Part Two, I detail more specific aspects of psychology and attitude andhow they relate to building a personal trading codex.Fear and GreedIt is said that fear and greed move the markets. When a market istrending up, the buyers are greedy and the sellers are fearful. Whenthe market is trending down, the sellers are greedy and the buyersare fearful. A chart of prices is also a chart of these emotions inaction.
I have found the old 1960s technique of biofeedback to be very useful.Keep a chart of your emotions at different points of each trading session andobserve how they tend to move with the market—or, more specifically, withyour position in the market. Just knowing that this is happening is the best
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FIGURE 2.6 Charting Fear and Greed.Greed: In 1973 the Hunt brothers (Nelson Bunker and William Herbert)began taking delivery on silver futures contracts. Fear: In early 1980, silverpeaked at $54 per ounce, then plummeted on March 17 from $21.62 to$10.80 in a single day.
defense against intruding emotions. If you can’t check your emotions, it is perfectly fine to walk away for a while. The markets and the opportunities will always be there when you return, whether you come back after a few minutes ora few months. See Figure 2.6.
TacticsThis book is about strategy, but tactics are also vital to trading success. If strategy is the plan, tactics are the execution. Strategy will lead to the pot of gold;tactics will deliver it to your house.Market filters and a close monitoring of the effects of news on the markets, as discussed in Chapter 1, can be considered tactics. You may have a greattrade all laid out, but if the Fed makes an unexpected announcement, it may allbe for naught.The tactics of a trade often determine whether you should get right backin a trade if you are stopped out, or whether you should wait for the factorsthat made the trade promising to you to realign themselves.Record keeping is also a tactic. Both a daily and a weekly trading planare important. The currency markets move so rapidly that you simply musthave a complete set of contingency plans at your fingertips at all times.
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Contingency PlanningNever begin a trading session without knowing what you will do in anumber of different scenarios. The markets move quickly, leverage ishigh, and taking time to make a decision adds to trade risk. Thisholds true for trades in which you have an active position and tradesyou are contemplating entering. Ask yourself the following questions:• What if the market opens higher and moves lower?• What if the market opens lower and moves higher?• What if the market collapses?• What if the market soars?• What if volatility changes dramatically?• What if I am stopped out?• What if my proﬁt objective is met?• Under what conditions would I alter my stop or proﬁt objective?
SummaryTraditional traders generally do not give enough consideration to the soft elements and never develop a coherent trading style. Their style is generally ahodgepodge of experience and ad hoc ideas, if it exists in any form. The codexapproach considers style an equal partner with trading techniques and moneymanagement. A coherent trading style that derives from specific pretradechoices gives the trader a framework for making the intelligent and quick decisions necessary in the FOREX arena.
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3Chapter
Money ManagementSit on your hands, Dad; sit on your hands!—Charles B. Goodman
oney management is the art of breaking even! At least that is what mymentor, Charles B. Goodman, always told me. Even a blind squirrelgathers a few nuts. If you are in the game long enough, the nuts willfind you. If you lose money and are shown the door, someone else will gatherthem. The first step to being around for nut time is breaking even.Most traders lose; if they broke even they would still be in the game. Ifyou’re not in the game, you can’t win.Although profit maximization should be an important element in yourmoney management plans, it is clear that risk avoidance is more critical. A realloss carries more weight than a potential profit.Of the three trading elements, money management is perhaps the mostimportant. Sadly, it is not given such status by most traders, nor does the literature accurately indicate its place in successful trading. If you have a mediocretrading technique, good money management can make it successful, or at leastkeep you from getting hurt. But if your money management is poor, the besttechniques available won’t save you from ruin in the long run.I’ve already written about the concepts of transparency and opaqueness, and I say more about them in Parts 2 and 3. These concepts alsoapply to money management. The more transparent and connected to theactual markets your money management techniques are, the better. Opaqueness spells failure for money management. I once knew a trader who simplyentered and exited the market on indicator signals, without reference toactual market prices or actions. He did not last long. The indicator approach
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to entry and exit caused him to accept small profits and stand for largelosses.To some degree, money management has to be subjective. The marketsdo strange things, and when you have an open position, reality sometimes demands action—rules or no rules. Nonetheless, an objective, rule-based moneymanagement codex is a required starting point. In most cases, even ad hoc subjective decisions can be made within the context of your codex.Because most traditional traders focus on trading techniques, moneymanagement is too often an ad hoc effort. Money management is typically a setof rules for entry and exit, most often comprised merely of stops to get out of abad trade before too much capital erosion has occurred. Profits are taken whenit feels right or when the trader gets nervous. Intuition is fine, but it should beonly supplemental to your defined trading codex.
Risk and RewardTraders should consider three primary ratios within the context of what type oftrader they are—or hope to become. The biggest single error is mismatchingthese ratios with the selected trading profile and/or the characteristics of themarket being traded.You can’t be a scalper making 20 pips on a good trade and factor in losing60 percent of your trades. The cost of trading is too high. It is nearly impossibleto limit losses in FOREX to less than 10 pips, costs included. A position tradermay be elated to make a 100 pip trade. But if this occurs in only 1 trade out of20, that trader is finished anyway. See Table 3.1.The bigger your average trade objective, the less you can afford on aggregate account drawdown; if you make two or three losing trades you will dig ahole from which it will be difficult or impossible to recover. The lower the ratiobetween your specific trade win-loss percent, the higher must be your aggregatewin-loss percent. I have seen many traders fail simply because they denied thereality of these basic money management concepts.TABLE 3.1 Do the MathAverage TradeObjective
AggregateAccountDrawdown
Win-to-LossPercentage ofSpeciﬁc Trades
AggregateWin-to-LossPercentage
25 pips
50%
1:1
5:1
50 pips
33%
2:1
4:1
100 pips
25%
3:1
3:1
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The three ratios that need to be considered are:1. Aggregate account drawdown or risk.2. Win-to-loss percentage for specific trades.3. Aggregate percentage of wins to losses.The parameters and ratios you set for money management must worktogether in harmony. They must also be in sync with your trading profile. Forexample, you can’t expect to have a 10:1 winning ratio of trades with amaximum 5-pip loss per trade. Part Two details these ratios for the codexapproach.In the accompanying box are two more examples to give you a sense ofhow these ratios interact. The position trader can live with perhaps a 30 percent win-to-loss ratio if the trader is nailing 100-pip trades and limitinglosses to 25 pips. The guerilla needs to achieve success on a very high number of trades because of the low ratio between winning trades and losingtrades.A Successful Position TraderA basic concept for all traders is that the lower the ratio betweenyour individual wins and losses (or proﬁt objectives and stops, asrealized), the higher the ratio of aggregate wins and losses must be.A successful position trader:• Has an average individual win/loss ratio of 5:1. This means forevery $1 he loses in a trade, he makes $5.• Has an average aggregate win/loss ratio of 1:3. This means forevery one winning trade he has three losing trades.Do the math: Out of 20 trades, 5 are winners and 15 are losers.On the losing trades he is out $1 x 15 trades = $15. On the winningtrades he is proﬁtable $5 x 5 trades = $25.Consider a guerilla whose individual win/loss ratio is 1:1. Hewins $1 for every $1 he loses. A 1:3 aggregate ratio puts him out ofbusiness very quickly.
Ceteris paribus (that is, all other things being equal), the position tradermust be capitalized better than the scalper. Capital clout is required in order tostay with a position over multiple trading sessions. It takes time for 100- to200-pip profits to accrue.
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After you’ve ascertained your trading profile, grab a calculator and play“what if ” with each of the three ratios. In Part Three you’ll need to put thesein stone, but for now just get a feel for how they work or don’t worktogether.Analyzing your trades vis-à-vis these ratios can tell you a lot about your trading performance—your strengths as well as your weaknesses. By keeping statisticson each trade and also a running total, the codex trader can make adjustments asnecessary before disaster strikes. As a diagnostic tool, money management is thefinancial analysis of FOREX trading.
EntryHow do you enter a market? Does the signal come from your trading technique? Probably. It does for most traders, traditional or codex. That’s the easypart. Every trader is fully focused when it is time to enter a market.Trade or Pass• Does the trade fall into my trader proﬁle?• Does it meet my money management criteria such as the ratiobetween my proﬁt objective and my stop loss?• Is the market environment (volatility, directional movement,thickness) suitable to me? How have I done in previous tradeswith the same ME proﬁles?• How have I done in the past in this market (i.e., EUR/USD)?• Have I been planning this trade or did it just attract me this trading session?• Am I excited or calm?
When you enter a trade, even if it is a go from the perspective of tradingtechnique and style, it should be a no-go if the money management ratios don’tlook right and in alignment with your trading profile. This is where sitting onyour hands separates the pros from the amateurs. It is not easy to pass up atrade that looks good simply because the risk/reward is poor.
ExitExiting a trade is often a more complex matter. Determination of the timingmay or may not come solely from a trading technique; many techniques do not
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have exits built in, and some degree of ad hoc measures is needed. There isnothing wrong with this, but unless your trading tools tell you when to exit,you need to have your ratios ready and waiting.This is another reason to select your trades wisely. When a trade is active,your flexibility as to decision making falls dramatically.The simplest form of exiting is a stop; correctly placing a stop requiresthought and effort.
StopsStops are an unfortunate necessity of trading life. FOREX markets move soquickly that you must enter stops when you enter your trade. Most tradingplatforms today offer this capability, including scaling stops, and the techniqueis easy to learn and manage.Basic Stop-Loss TechniquesThe type of stop-loss orders varies from one broker-dealer to another. It is important to remember what standing orders you have in the market at all times. Mosttrade stations show you a record of all your open orders in the market.Stop-losses may be entered in one of three ways:1. As a function of price alone. This is the simplest for new traders. Useyour trader profile ratios to set a stop-loss as a function of your profitobjective.2. According to the tenets of your technical trading method(s).3. Above or below support and resistance points.If you use the third method, remember that many traders use some formof support and resistance analysis. Despite the variety of support and resistancemethods, most of them cluster in very similar price areas. Professional tradersoften use those areas to make contrarian trades—they are buying and sellingwhen your stops are being hit. See Figure 3.1.No one enjoys having stops sitting in the market, just waiting to be hitby a market whipsaw. It happens, and to everyone. If it happens too often, youwill need to make adjustments somewhere in your ratios. Perhaps your stop istoo close, in relationship to either your trade profile or the volatility of themarket. If a market is moving 20 pips in five minutes, a 5-pip stop may beunrealistic.You don’t need a computer or a calculator to place stops effectively; common sense trumps everything. See Figure 3.2.
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ProfitObjective
EntryStop Loss
FIGURE 3.1 Basic Stop-Loss Techniques: Using Ratios to Calculate Stops.
FIGURE 3.2 Whipsaw.In market environments with low directional movement and high volatility,it is very difﬁcult to set rational stops. These markets should be tradedsimply by their inherent rhythm—or avoided. Stops in this example wouldbe impossible to set rationally.
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Traders easily panic when stops get hit too frequently; that’s when emotions can take control of your trading. That may be the time to walk away fromtrading for a while.Traders tend to be more objective when entering a market than when exiting. Exiting means your money is on the line and your emotions are morelikely to want a say in your decision.The market is always attempting to get us to second-guess ourselves. Ifyou catch yourself second-guessing too often, stop trading. The market has youwhere it wants you and is ready to pluck you clean. Your emotions are runningthe show, and that spells L-O-S-E.
Capital AllocationGive yourself a chance to win. Allocate your trading capital over a series ofcampaigns, each containing a fixed number of trade opportunities. This, too,needs to be realistic and in conformity with your trading profile. Don’t expectto have 30 opportunities to make 100-pip profits with a $300 mini account.If the math and ratio calculations are confusing at this point but you areitching to trade, don’t panic. You can allocate your capital in advance in fixedproportions and at least not hurt yourself too badly. I am grateful to BruceGould, world-renowned futures trader, for this basic concept. His Bruce GouldOn Commodities offers a plethora of commonsense money management ideas(www.brucegould.com).Allocate your capital into two or three campaigns of 10 trades each.• If you are a guerilla, set a 2:1 profit objective to stop-loss.• If you are a scalper, set a 3:1 profit objective to stop-loss.• If you are a day trader, set a 5:1 objective to stop-loss.I do not recommend beginning traders attempt the position trader profile.
SummaryThis is just a broad-strokes look at money management to introduce the keyideas and get you thinking in risk-avoidance mode. The key elements are yourtr