trade but gain a better entry, which will make yourrisk/reward more favorable.Note, by the way, that this trade turned out to be a loser, regardless ofhow you traded it. EUR/CHF raced higher, stopping out all approaches toshort it. But that’s not the point here. The key to understanding the problem is that this trade was only a probability, not a guarantee. Furthermore,by using technical analysis we set logical risk parameters for the tradeand, although we took a loss, it was good trade because we reacted properly to market conditions.Trading randomly, however, is one of the quickest ways to lose moneyin FX. Many threads on many Internet bulletin boards have been startedusing the random entry “coin flip” approach and some basic form ofmoney management like risking $1 for every $2 of profit; within a matterof weeks or months, the originators of those threads have found themselves either in deep drawdown or completely broke. Ironically enough,the practitioners of the random entry method inadvertently prove thatmarket action is not random. If it were random, then they presumablyshould perform no worse than skilled traders; but alas, like a lucky idiotwho sinks a half-court shot during a contest but could never win a one-onone game against a professional basketball player, so, too, these novicetraders will fall by the wayside when competing against professional technical traders over any reasonable length of time.So the notion that technical analysis doesn’t matter—it’s just moneymanagement that matters—is, like so many trading myths, completenonsense. Money management alone will not make you a successfultrader. It is, however, a vital complement to any intelligent technical
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setup. Furthermore, money management strategies are as unique aseach trader, and one of the most pernicious myths perpetrated on thegullible public is that money management strategies are sacrosanct andinviolable and thus all traders must follow the same money managementrules in order to achieve success. That is utter nonsense. In fact, thelonger the traders trade, the more flexible, the more complex, the morecreative their money management skills become. Because FX offers retail traders unprecedented liquidity and limitless customization, moneymanagement strategies in FX are truly variable.
THE MYTH OF 2:1Let’s start the most classic money management technique preached byevery trading book ever printed. In every trade your reward/risk ratiomust be at least 2 to 1. You must try to obtain 2 points of gains for 1 pointof risk. This way the trader needs be correct only 40 percent of the timeand will still have a positive expectancy to his trades. On the surface thisidea sounds eminently logical and practical. In real life consider what thismeans, however. It’s quite difficult to squeeze out 2 points of profit for 1point of risk. Try it and see. First look at the price action on the smallesttime frame and see how hard it is to risk 1 point in order to capture 2points. On the smallest level the FX trader faces the overwhelming barriers of the spread. Even in the most liquid financial instrument in theworld, the EUR/USD, the spread is 3 points wide, so in effect the tradermust make 5 points in order to earn 2, thus forcing him to generate an improbable ratio of 5:1 in order to simply meet this goal. Moving on to a 10point increment, a 10-point risk for a 20-point profit still requires a23-point gain and allows for only a 7-point risk of loss in the tightestspread pairs like EUR/USD and USD/JPY; in effect, this means that atrader must generate 3 points of profit for 1 point of risk just to meet the2:1 reward/risk ratio. Expanding the time line to longer time frames, a 100point risk with a 200-point profit target provides much better odds. Herethe spread plays a minuscule part as it requires only 203 points of profitand allows for 97 points of risk, generating very close to a 2:1 ratio.But let’s step back a second. Remember the quiz? What if you were thedownhill racer? What if you were the customer who left the long line at thedrugstore? In short, what if you were simply not predisposed to patientlystay in the trade for the time necessary to see it to fruition? If you were impatient, wouldn’t it be much more probable that you would try to take yourprofits far sooner, perhaps at 100 points in the money or even 50 points inthe money, turning what in effect was supposed to be a 2:1 trade into a 1:1
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or 1:2 reward-to-risk setup? You will do what every trading book preachesnot to—you will cut your profits short by not letting them run. But givenyour personality, can you really be expected to do it any differently?But let’s suppose that you are different. You possess the patience of asaint, you have the discipline to follow this rule inviolably. Imagine the following scenario: You place a trade in EUR/USD. Let’s say you decide toshort the pair at 1.2500 with a 1.2600 stop and a target of 1.2300. The tradeis going well. The price moves your way. EUR/USD first drops to 1.2400,then to 1.2350, and slowly makes its way toward 1.2300. At 1.2335 theprice action pauses and the pair starts to inch back up, first tradingthrough 1.2350, then 1.2375. You, however, are patient. You have nerves ofsteel. You hold on, looking for your 2:1 reward-to-risk. The price starts tomove back down and you are starting to feel vindicated. Back to 1.2350,1.2325; slowly but surely you see the target in sight. 1.2320, 1.2310, 1.2305.Your take-profit order sits on the platform waiting to be filled. The priceticks a few more pips down, reaching all the way to 1.2301—but then itbounces back, first slightly, then violently, until in a matter of seconds it’sat 1.2350, then 1,2370. You remain calm. The price nearly touched yourtarget. It’s bound to test that level again. You won’t make the same mistake others make of cutting your profits short. You will stay in the tradeand follow the classic money management rules!Of course, the price never does see 1.2300. Instead the pair verticalizes and soon reaches 1.2600, easily taking out your stop. You are nowfaced with the idea that you had a 199-point profit and allowed it to become a 100-point loss. Welcome to real trading. How many episodes likethat do you think a novice trader can experience before abandoning allsense of discipline and proper money management? This is the reasonwhy the 2:1 reward-to-risk strategy is mostly a fantasy, an ideal. In practice most traders will modify the strategy in one of two ways. First andforemost, once price moves in the direction of the trade by the amount ofpoints risked, professional traders will move their stop-loss to the breakeven point to assure themselves that a winning trade will not become alosing trade. So in the case of our EUR/USD trade the trader would movethe stop to 1.2500 once the price breached the 1.2400 level. This, however,still presents a dilemma for most traders. Suppose the price decided to retrace and came all the way back to 1.2500, stopping the trader out. Therewould be no losses, but also no gains. The trade would be a scratch. Intrading there is nothing more frustrating and psychologically unnervingthan to be right on direction and walk away with no profit. It’s the equivalent of working very hard all day long at your job and then losing thatday’s pay through a hole in your pocket.For this reason many traders practice a scale-out approach. Typicallytraders will let go of half of their position once the gains match their risk
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value. In our tried-and-true EUR/USD example the trader would sell half at1.2400 and then move the stop to the break-even point, assuring himself ofharvesting at least some profit out of the trade. This approach allows thetrader to remain in the trade for as long as necessary because it satisfiesthe most basic desire of trading—the need to get paid. By selling half of theposition at 1.2400 and half at 1.2300, the trader is able to harvest only a1.5:1 reward-to-risk ratio, which of course is mathematically inferior to 2:1.However, trading is not a game of mathematics but one of psychology, andfrequently what is mathematically optimal is psychologically disastrous.Professional traders recognize this fact well. They also understandthan market dynamics are fluid and will rarely conform to rigid reward/riskratios. By constantly monitoring their positions and adjusting their riskparameters to the reality of the markets, professional traders are able tonot only generate positive reward/risk ratios but also produce more profitable trades.
KILLER INSTINCTDo you have the killer instinct? Can you press the trade? Then this trademanagement technique may be for you. If you ever want to hit home runs,if you ever want to make a huge score in trading, then this is the only wayfor you to trade and FX is the single best market to effect this strategy.Let’s take our EUR/USD trade. Again you, the trader, get short at 1.2500but this time your strategy is different. If the pair trades up to 1.2550, youcut your loss quickly and await the next opportunity. If, however, the trademoves your way, you do not automatically take half the position out of themarket. Rather you wait patiently and watch the price action. Imagine theprice has now moved to 1.2200, fully 300 points in the money. Instead of taking profits, you add another unit to the trade. If the price begins to retraceall the way back to 1.2350, you cover the whole position for a scratch. Youhaven’t lost anything on the trade, but neither have you made a profit. If,however, the price retraces only slightly but then resumes direction, youstay in position and again monitor price action carefully. The price has nowreached 1.2000 and you sell yet one more unit at that price. You now havesold three units altogether for an average price of 1.2230. As long as theprice remains below this level, you stay in the trade. Your patience pays offand the price collapses to 1.1700, at which point you finally cover the wholeposition. Let’s review the total profits from the trade:1 unit at 1.2500 covered at 1.1700 results in a profit of +800 points.1 unit at 1.2200 covered at 1.1700: +500 points.
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1 unit at 1.2000 covered at 1.1700: +300 points.Total profit: 1,500 points.Total risk: 50 points.For those traders who can implement this strategy, this is clearly thebest way to trade. Dennis Gartman (the famous investment newsletterwriter), an old pit trader himself, calls this method “doing more of what isworking and less of what is not.” It is no doubt deceptively simple and seductive. In fact, here is a description taken from Elite Trader bulletinboard of another famous pit trader, Richard Dennis, employing just such astrategy in the bonds.As someone who has seen the likes of Rich Dennis and Tudor Jonesoperate, those “5%” winning trades involve add-on after add-on.Case in point is Dennis in the 1985–1986 bull market in bond futures. He would start with his normal unit of 500 contracts and getchopped for days. Buy the day’s high, put ’em back out on a newswing low etc. Every once in a while he’d wind up with 500 thatworked. Then he’d start the process higher, all over again. Work ’emin, work ’em out. After maybe a couple of months the market hasrallied 10 pts. from where he started and he has 2,000 on (meaning2 million a point). Now the market is short and ready to pop on anysize buying and he’s there supplying the noose. Bidding for 500 onevery uptick, he finally gets to a point where for the last month of themove he has 5,000 on. T-bonds rally 20 pts. in just over a month andhe’s up $100,000,000 on a trade that started out with him just testing the waters, losing $100,000 a few times before he could establisha position worth doubling up on.Wouldn’t we all want to own that trade? One trade, $100 million inprofit. But let’s remember what’s required to get there.• Accurate directional entry into trend.• An intense, multi-hundred-point trend with little or virtually no retracement along the way.What are the chances that this type of strategy succeeds? Minimal atbest. Note that the writer described these as “5%” trades, meaning thatthey occurred only 5 percent of the time. In fact, the perfect confluence ofevents to generate such profits probably happens less than that.Far more than the fortuitous market conditions necessary to producesuch windfall profits is the unbelievable psychological pressure such trad-
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ing will generate. The term “pressing the trade” is most apropos to describe this dynamic. Not only is the trader pressing the market by addingmore and more units as they go deep into the money, but he is alsopressed by the market as his profits pile up. Put yourself in Richard Dennis’s place. Would you be able to stay in the trade once it hit $1 million?How about $10 million? $50 million? At each level the intensity is enormous, and for most people the pressure of winning can be far worse thanthe fear of losing. Forget Richard Dennis and just think how you wouldhave felt if after selling the third unit at 1.2000 you had to cover at 1.2233as prices retraced, and you had to watch a certain profit of 700 pointsevaporate into nothingness.For those unconcerned with such issues, for traders who are morethan willing to suffer a long series of losses and empty trades for a chanceto score big, FX offers the best opportunity to do so of any financial market in the world. Why? Leverage and liquidity.Here is how this strategy would work. Assume that you have $10,000of trading capital.Deposit only $2,000 of capital with your FX dealer. Keep the rest inyour bank account. With 100:1 leverage, which is standard in the FX market, you will have 100 points of leeway before you get a margin call inEUR/USD. (Trading other pairs the margin requirements might be different, so consult with your dealer before attempting this idea on other currencies.) If the trade moves against you, an automatic margin call willinstantly take you out of the market. Dealers will not call you in advanceand warn you of an impending margin call like they may do in exchangebased futures markets. Rather, the dealer’s software program will automatically liquidate your position. This may seem a bit brusque, but the upsideof such an arrangement is that your account should never experience negative equity and your total risk should be limited to the amount you’ve deposited. The margin call will then act as a de facto stop on your account.If a margin call is triggered, your account should have approximately$1,000 of equity left.$2,000 initial deposit – $1,000 loss on trade($10 × 100 points at 100:1 leverage) = $1,000Deposit another $1,000 from your bank and trade again once your setup istriggered. You can repeat this process up to nine times before you run outof your trading capital. Will you lose most of your money? Perhaps. Remember, this is a very low-probability trade. But at least by subdividingyour capital into 10 equal pieces you’ve given yourself the best opportunity to succeed. This strategy is basically a more intelligent variation onthe old trader saying, “Have a hunch, bet a bunch.”
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Let‘s imagine, however, that on one of the trades you were successfuland caught the large directional move. If that’s the case, you could employthe trade management strategy discussed before and continuously add toyour position as prices move your way. In the best of all possible scenarios the trader could eventually build up a large position, perhaps 10 lots ormore (with notional value of $1 million), that could be 1,000 points in themoney. In that case the profit on the trade would grow to $100,000. Notbad for $1,000 of initial risk.As I’ve already noted, this strategy is not for the faint of heart. This is avery high-risk, (potential) high-reward strategy that requires a unique mindset and proper trade management techniques to succeed. Fortunately, FX isperhaps the single best market to put these ideas into practice.For those inclined toward a more steady approach, here is a completely different trade methodology and one that I employ myself.
TAKE A NIBBLE, NOT A BITENever add to a loser.Never double down.These old trading maxims are treated as sacrosanct truths by mosttraders.What a bunch of nonsense. I add to losers all the time, and so do someof the most successful traders I know. Why? Because what most booksnever tell you is that almost all trades start out as losers. It is extremelydifficult to time the entry so well that it immediately begins to move in thedirection of your trade. Sometimes trades will move only a few pointsagainst the position but occasionally prices may retrace several hundredpoints away from initial entry only to eventually turn around and becomeprofitable. Trading is the art of accurately forecasting direction and timing. Between the two, timing is far harder to handicap, especially if pricesseesaw back and forth for a while before ultimately moving in the right direction. Traders who trade highly leveraged positions with tight stops willbe eviscerated in such an environment, as they will continuously getstopped out. Far worse than even the hit to equity is the psychologicalpain of “death by a thousand stops.”That is why traders who do not like frequent stop-outs prefer thescale-in approach to price entry. This strategy is almost diametrically opposite to the strategy discussed in the preceding section. Using the scalein approach assumes that the first entry will almost never be the bestentry; as a result, the approach requires very low leverage in order for thestrategy to withstand the adverse price moves. In this strategy the trader
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continuously adds more units as prices move against him, trying toachieve a blended price that remains near the current price. If prices doeventually turn, the constant averaging of price levels will make the position profitable much faster than if he expended all of his trading capital onthe first price entry. While this can be a successful trading strategy, it canalso be highly dangerous if the trader does not follow two key rules:1. Set a hard stop for the whole position.2. Trade in very small increments.
To understand just how destructive this strategy can be, let’s examinewhat happens if the trader uses this method employing the standard allocation of 2 percent of capital per trade. Imagine that the trader with a trading account of $10,000 initiates the first trade in the EUR/USD currencyusing two mini lots. Prices move against his entry by 100 points and henow doubles his allocation to four mini lots. Again prices continue tomove against him by another 100 points and he doubles his position yetagain to eight mini lots. Prices continue to follow this adverse pattern andmove against him by 100 points more. Finally, the trader gives up and covers his position in dismay. What is his total loss? A whopping 22 percent ofhis total capital!–$600 on two mini lots (prices moved 300 points away from entry).–$800 on four mini lots (prices moved 200 points away from entry).–$800 on eight mini lots (prices moved 100 points away from entry).The irony of the matter is that after an uninterrupted 300-point moveagainst the position, chances are quite high that the trade may turn aroundand could quickly become profitable. But by overleveraging the positionthe trader is unable to withstand the drawdown.Imagine the same scenario but instead of using mini lots with thevalue of $1 per point, the trader uses micro lots with each point having avalue of only 1 dime. In FX, where many dealers offer such small lot sizes,this strategy is eminently possible. In that case the drawdown would be afar more manageable 2.2 percent of capital and the price would need tomove back only 150 points instead of the full 300 points in order for thetrade to become profitable.This type of scaling where the trader doubles the size of the positionat every interval is called geometric scaling. Unlike regular average-inscaling that cuts the break-even point by 50 percent, geometric scaling requires that prices retrace by only 33 percent to reach the break-evenpoint. While this can be a very effective way to quickly make a losing trade
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TABLE 9.1 Geometric versus Arithmetic ScalingArithmetic
Long Every 50 Pips Down 1.25001.2450Starting Account $5,000 1.2400Unit = 1001.2350Pip Value = 1 Cent1.23001.22501.22001.21501.21001.20501.2000Hard Stop1.1950Break-Even ValueMaximum Loss in PipsMaximum Loss in Dollars
1002003004005006007008009001,0001,1006,6001.2166–143–143
NotionalValueGeometric
NotionalValue
$ 125$ 249$ 372$ 494$ 615$ 735$ 854$ 972$1,089$1,205$1,320$8,030
$125$249$496$988$ 1,968$ 3,920$ 7,808$ 15,552$ 30,976$ 61,696$122,880$246,658
1002004008001,6003,2006,40012,80025,60051,200102,400204,700
1.2049–2,041.5–2,041.5
profitable, the strategy can also spiral out of control. A better compromisebetween the straight average-in method and the geometric scale-in is thearithmetic scale strategy. Instead of doubling up the position at every interval, the arithmetic scale calls for an increase of the position by a fixedamount. Table 9.1 shows the key differences between the geometric andarithmetic approaches using a hypothetical scale-in strategy in EUR/USDstarting with entry at 1.2500 and a hard stop at 1.1950.Note that in the worst-case scenario the geometric strategy losesmore than $2,000 on a $5,000 account while the arithmetic strategy losesonly $143. At the same time the break-even point on the arithmetic strategy is 1.2166, only slightly higher than the 1.2049 break-even on the geometric approach. The data clearly shows that for multiple-interval scale-inapproaches the arithmetic strategy is the best bet.
THE 10 PERCENT SOLUTIONAn interesting trade management compromise between the low-probability,(potential) high-reward method of scaling up into a position and the highprobability, low-reward technique of scaling down into a trade is somethingthat I call the 10 percent solution, which I picked up from a trader on one ofthe FX trading bulletin boards. Here is the basic strategy for this method.
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Let’s suppose once again that we would like to short the EUR/USDpair at 1.2500. For simplicity’s sake we are willing to risk 100 points andseek a 100-point target on the trade. In other words, our stop is at 1.2600and our target is at 1.2400. Let’s further imagine that we will trade 10 minilot contracts with total notional value of 100,000 units. We place our shortat 1.2500. However, here is the rub. Instead of stopping out at 1.2600 withthe whole position, we place stops at 10-point intervals for 10 percent ofthe position. So, if the trade moves against us by 10 points we would sellone mini lot, leaving us with nine mini lots (90,000 units) in the trade. Ifthe trade moves 20 points counter to our entry we would sell one moremini lot, leaving us with 80,000 units—and so on until the price reachedour ultimate stop-out value of 1.2600, at which point we would only haveto liquidate one mini lot left in our inventory. On the opposite side wewould maintain our target of 100-point profit regardless of how many lotswe had left, so if we got stopped out on three mini lots but prices thenturned in our favor we would harvest a 100-point profit on the remainingseven lotsThink about the implications of this strategy for a moment. In theoriginal trade we risked 100 points on 10 mini lots or a total of 1,000 points(100 × 10 = 1,000). Using this compromise stop-out approach we were ableto winnow down the total loss from 1,000 points to only 550 points if thetrade became a complete bust. However, if the trade turned in our favor atany time before reaching the eighth stop-out, we would still have beenable to bank a gain. The attractiveness of this approach is twofold. It automatically reduces risk if the trade moves against you, but it allows thetrader to partially remain in the trade up to the very last moment. Not onlyis this a good practice of risk management but it is also a very clever wayto get the trader to actually accept his stops. Just like a mother who feedsher baby medicine in tiny little portions in order to make it more palatable, this technique forces the trader to do what is best for his accountwith minimal psychological damage. Steve Cohen, probably the greatesttrader in the world today—so good that he is able to charge 50 percent ofgross profits in his multibillion-dollar hedge fund STC Capital—once saidin an interview with Jack Schwager in Stock Market Wizards (HarperCollins, 2001), “What happens when you are short a stock that is movingagainst you, and there is no imminent catalyst? I always tell my traders, ‘Ifyou think you’re wrong, or if the market is moving against you and youdon’t know why, take in half. You can always put it on again.’”When I first read that comment it went “in one ear and out the other.”But upon further reflection I realized that Steve Cohen was practicing justthis type of risk control methodology for all of his trading.The 10 percent solution strategy is only a template. We need not scaleout at every 10 percent of the distance to the ultimate stop. We could use
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TABLE 9.2 Ten Percent Solution StrategyNumber of Proﬁtable Lots(out of 10 Total)
Total Pointsat 10 Percent
Total Points at 10 Percent withAdjustable Targets
109876543210
1,00089077064050035019020–160–350–550
1,000810610430260100–50–170–300–420–550
20 percent, 25 percent, 33 percent, or any other type of ratio that makessense. The strategy can also be refined further to enhance the probabilityof success, though at a cost to profitability. For example, instead of keeping the profit target at a static 100 points from original entry, we could adjust the target in response to price action. If the price moved 10 pointsagainst our position we could reduce the profit target by 10 points, sothat instead of 1.2400, we would decrease the profit target for our shortto 1.2410; if the price moved 20 points we would decrease the profit target to 1.2420. Table 9.2 shows what happens when the system is adjustedin such manner.Note that while the profitability of each trade is somewhat reduced,the probability of the success for each trade is likely to be better as itneeds to travel less and less distance in order to reach the profit target.
CONCLUSIONWhenever I teach new sales traders at my firm about proper trade management in the currency market, I often start out with the example ofRichard Dennis and the method of pressing the trade. Before I evenhave a chance to finish, some overeager rookie will inevitably jump upand confidently proclaim, “Yes! That’s the only way to trade!” I hopethis chapter has convinced you of the fallacy of such thinking. In trading there is no “only” way of doing anything, especially money management. One of the great strengths of trading is that it is an art, not ascience—and there is a highly flexible discipline that allows for numerous individual modifications.
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Are you comfortable with the classic 1:2 risk/reward approach? If so, itcan be quite profitable, especially if you modify it as most traders do byscaling out of half of the position at profit distance equal to risk and trailthe rest with a break-even stop. Do you have a killer instinct? Can you easily give up small to medium-sized gains in quest of one huge win? Thenpressing the trade by constantly adding to a winning position may be thebest strategy for you. What if you like taking small, frequent gains and canaccept an occasional large loss? Then arithmetic scaling may be just theright approach for you to succeed. Finally, what if you are a true moderate,neither seeking remarkable gains nor afraid to absorb a series of smalllosses? Then the 10 percent solution may be just the “solution” for you.As you can see, risk management trading is truly contingent on thetrader’s personal preferences. The currency market makes the task immeasurably easier by allowing retail traders to customize the size of theirpositions without incurring any marginal costs. Whether the trader wantsto deal 1 million units of EUR/USD contract or only 100 units, the transaction cost among most of the reputable dealers will almost never exceed0.03 percent. This fact allows even the smallest traders to implement anyof these sophisticated risk management techniques on the exact sameterms as the biggest interbank FX traders. However, the one inviolabletruth that no trader, big or small, should ever forget is this: Everybodyloses in trading at some time in their career. The difference between thosewho survive and those who do not is that winners honor their stops whilelosers make excuses.
CHAPTER 10
Setups!Set