If you are an intra-day traderand every time you lose you end up taking a 3-5 % hit, then you need to stopimmediately and come up with better money management rules. This is the sametype of analysis that professionals regularly run on their trading, and it proves veryinsightful since the reasons for your underperformance will most often be glaring.
Trading with proper money management rules will not guarantee you success,but it will prevent you from falling into the money trap. The “more I bet, the moreI win” mentality is not for traders but for gamblers, and using their logic is a sureroad to ruin. Avoiding this trap simply means learning to manage your losses byusing simple guidelines:
° Never risk more than 2 % on any one position.. Never trade more than five times leverage on any one position.° Trade multiple lots with multiple entries.
. If you cannot afford multiple 100 000 lots, trade mini lots.Becoming a Great Trader 61
 
If you don’t think trading mistakes will happen toyou, just take a look at what some “pros” did:
 
2003: Shares in now-bankrupt internet firm Exodus surged more than 59000% aftera bank trader accidentally bid $100 for shares that were trading around 17 cents atthe time!
2002: A colossal blunder by Bear Stearns saw the firm sell $4 billion worth of stockat the closing bell instead of the intended $4 million! Fortunately for the firm, theywere only filled on $600m or so of the orders before realizing their goof.
2001: Just before the close of the UK market, a fat-fingered Lehman Bros employeemistakenly sold $500m worth of stock - 100 times the intended amount. The slip-uptemporarily dropped the FTSE more than 2%!
2001: An absent-minded UBS trader hoping to sell 16 shares of Japanese companyDentsu at 600000 yen each mistakenly sold 600000 shares at 16 yen each! Beforehe knew it, the trader was already $120m in the hole..
1998: Perhaps the most classic blunder of all time was made by a now-infamousSalomon trader who is said to have accidentally sold £850m worth of Frenchgovernment bonds......simply by leaning on his keyboard!12Picking the Right Approach
 
Although proper money management guidelines are the foundations needed tosupport any sort of trading strategy, at the core of all trading is the fundamen-tal reasoning, a model or system used by traders to enter and exit positions.Broadly speaking, FX traders can be divided into the fundamentalist and the tech-nical crowd. On the one hand, fundamentalists choose to place their bets basedon macroeconomic factors such as interest rates, GDP, inflation, current accountimbalances, etc., and their relation to a currency’s intrinsic “value”. Much likeequity managers who like to buy “undervalued” companies, fundamental tradersuse economic models to forecast theoretical exchange rates and trade deviationsfrom these.
The technical crowd, on the other hand, cares less about the underlying economicpicture and instead prefers to rely on two things only: time and price. In theirthinking, a currency’s past behaviour is the best predictor of future exchange rates,so they focus on identifying purely mathematical reasons for entering/exiting trades,such as buying a currency after it moves X % in a one direction or using chartpatterns to guide their trading.
Although the fundamentalist approach may seem like the more logical way to go,extensive research into the matter actually indicates that technical trading is a muchmore profitable way to trade FX. Although the “value investor” mindset may payoff in equities, it seems that this line of reasoning is utterly useless in forecastingexchange rates (especially in the short run) because of central bank intervention andother market nuances, and it gets decidedly beaten by using a simple randomizermodel. This may explain why economists’ forecasts are undeniably horrible, and tothe short-term trader it means that they should focus their attention on the technicalside of trading, if only for the simple reason that it seems to be more profitable.That being said, technical trading is no sure road to riches either.64 Beat the Forex Dealer
 
USING TECHNICALS
Since the advent of trading, the trading community has been obsessed with waysof predicting or forecasting the future through their use of models. As computa-tional power increased over time, so did the popularity of technical or quantitativetrading models and now a wide variety of these are used, ranging from sim-ple moving-average systems to complex neural network algorithms. Unfortunatelymost, if not all, models have built-in biases, so an unquestioning belief in themis extremely dangerous. To prove this point, a famous study was conducted wherethousands of different indicators and technical tools were tested in an effort to findthe best forecaster of US GDP growth. After an exhaustive search and countlessregressions, one leading indicator was found that seemed to fit the data perfectly:buttermilk production rates in Bangladesh! Yet I still have not figured out how toget that on my Bloomberg.
Most risk models still in use today consider the one-day October 1987 mar-ket crash to be a one-in-a-billion event, or the statistical equivalent of getting hitby lightning and being attacked by a shark at the same time. Long Term Cap-ital Management and other seemingly advanced hedge funds were done in bythese “sigma-nine” events, something that probabilistically speaking is so unlikely(according to their risk models) that it simply does not happen. If that is the case,then how is it that we keep witnessing these “impossible events” over and overagain?! It is certainly not due to a lack of intelligence or computing power ontheir part.
In order to understand better why all probability-driven models have limitationsthat will eventually lead them to fail spectacularly, it is useful to look at a verysimple example. Imagine yourself sitting at a stop waiting for the bus to come. Youknow the frequency of the bus service (every ten minutes), but not the actual arrivaltime. If the buses run according to schedule, then the probability of a bus arrivingin the first minute of you getting to the stop is one in ten. The longer you wait, thehigher the chances of the bus arriving any minute, and if you have been sitting atthe stop for nine minutes then you can be pretty sure that the next bus is around thecorner (at least that is what the model predicts). More sophisticated models maytake into account the average time it takes for a bus to arrive, or externalities suchas weather and traffic, but either way the model still essentially says that the moreyou wait, the higher the probability of the bus arriving. Of course, the averageperson has enough common sense to begin to distrust the model once fifteen ortwenty minutes have passed, and you begin to ask yourself, “Is this bus ever goingto come?” Maybe it broke down or had an accident. Rest assured that after asufficient amount of time has passed, there will be no one left at the bus stop — no
"Hedge fund managers have long made fun of the quant models, and often joke “This is terrible! TodayI just had a loss that’s a nine sigma event! That’s the third time this year!” (even though it should onlyhappen once in ten thousand years or more).Picking the Right Approach 65
 
one except the model, that is. People are smart enough to realize when the rules ofthe game have changed (the bus schedule becomes useless after a certain amount oftime has passed), while probability-driven models never take into account the factthat the model itself may be wrong and thus continue to wait for a bus that may, ormay not, come. This critical flaw is essentially what makes model-driven tradingapproaches blow-up spectacularly, and common sense dictates that the world issimply a lot more complex than any risk-model builder would have you believe.
Technical trading proves especially attractive to retail traders because it offersa way to “make sense” out of a sometimes senseless market, and many find thepossibility of discovering the “holy grail” of trading systems simply too good topass up. Yet those obsessed with trying to find the indicator or trading system wouldbe better served in spending that time trying to understand the market instead oftrying to outsmart it, since the only money-making machines that I know of areowned by the central banks of the world.
The clear benefit that systematic trading gives us is order. Having a clear, orga-nized, and coherent strategy is fundamental to trading success. Although in the endyour “system” may or may not prove to be profitable, you should always have aclear understanding as to why you are entering the position, and technicals helpus tremendously in this regard. Generally speaking, the simpler the model, themore elegant and useful it becomes, since charts filled with lines, indicators, andall kinds of technical tools only serve to distract the trader away from the crucialprice action. At a time when quantitative trading has been finally accepted by thegeneral trading community, the intrinsic virtues of technical analysis are hard todiscern since often it is traders’ combined actions that turn them into self-fulfillingprophecies. If everyone follows the same indicator, then when it flashes a buy sig-nal everyone will go ahead and buy ... and surprise, the price goes up! A kind of“chicken and egg” scenario has emerged and, more importantly, the retail crowd’slove of technical analysis has also turned “obvious” technical levels into a mag-net for stop hunters. Many funds (including ours) actively front-run other people’smodels by anticipating the trading signals their systems will generate and thenpositioning themselves for the slight pop created by their execution. If anything,you should make a point to stay away from any clear technical levels, since theprice action around these are bound to be full of dealer manipulation, which iswhy it is never wise to trade breakouts in FX. With the amount of price “‘manage-ment” that goes on in the forex world, false breaks are more often the norm thanthe exception. Chances are that other traders will have also identified the sameimportant support/resistance levels that you did, and set their stops accordingly.Dealers know this, obviously, and routinely go after them, thus creating the falsebreaks.
Learn to use technical indicators, but also learn when to ignore them. Findsomething that works for you and stick with it. We know that no strategy isalways profitable, so the key for technical traders is to identify and understand66 Beat the Forex Dealer
 
your system’s strengths and weaknesses. This lets you limit your exposure in tradi-tionally bad times and double-up in the good ones. Does your system work best inhigh-volatility or slow markets? Does it work best in ranging or trending environ-ments? Does it work best for USD pairs or others? These are the types of questionsyou should be asking of your system, since just like the blackjack player you wantto end up betting only when the odds are in your favor. In isolation all technicaltools are essentially the same, and only in their application will you find the truedifferentiator. This is why I think it is vital to keep a discretionary element to yourtrading, even if it is simply knowing when to turn your system “on” or “off”. Weknow that the only instrument that can consistently beat the market is the humanmind, so make sure to use it.
DISCRETIONARY TRADING
Purely discretionary traders rely on their experience, gut feeling, and reading ofthe price action to make trading decisions, and for FX traders this means comingto grips with what makes the market tick. Intra-day FX prices are shaped by flows,and as we know these flows may be the speculative bets of a large hedge fund orthey may simply be the hedging activity of an exporter. Either way, supply anddemand is what sets short-term prices, which is why we say that in FX there is nosuch thing as a fair price. Even if the macro backdrop favors a dollar decline, alarge buy order will disrupt prices in the short run and drive the dollar higher untilthe demand is satisfied. For the intra-day trader the thinking behind these flows isnot important; price is all that matters.
Getting a proper “feel” for the market comes down to understanding the priceaction. Price action is that magical thing that scares traders out of their positionsand lures them into traps. Watching the bids and the offers get hit is the equivalentof the old-time tape reading made famous by Jesse Livermore and other “punters”,who used to read the ticker tape attentively in an effort to gauge short-term pricetrends according to price and volume. Price action reflects the tug-of-war that isconstantly going on between the buyers and the sellers in the market, and to theexperienced trader it can also be a window into the market’s footing.
Since short-term price movements are largely dictated by the maneuvering of the“big boys” in the market, it is in the interest of every small speculator to closely fol-low the price action in order to find the “footprints” that all large players inevitablyleave behind. Needless to say, reading price action is easier in exchange-tradedmarkets, where volume information is available and institutional block orders aremore easily detected, but in FX those with no flow information can still gleanthe market’s intentions by looking at the order flow information left behind in theform of chart patterns and noting how prices react near important pivot points.Correctly reading price action is not something that can easily be taught, and overtime traders find that it is more of an art form than a science.Picking the Right Approach 67
 
EURGBP pay Chart
Agi \ i ‘
if
 
i gy
Results of one of MIGFX's sm00;proprietary trading models e000applied to a market with large balswings. Results (right) prove sa.to be very acceptable during ; 4000)this time frame. 000
2000:
 
1000
 
ob
 
 
1000
 
Trade Number
source: graph and results calculated using Tradestation 8. All rights reserved.
 
All mechanical trading systems have built-in biases and flaws that you must be aware of.
One way to properly gauge the state of the market is by studying charts. Charts areso valuable to the intra-day trader because they paint a graphical representation ofthe price action, and over time telltale patterns emerge that can give us an insightinto the market’s footing and intention.68 Beat the Forex Dealer
 
EURGBP Daily Chart
Ye” han”
 
The same model applied toa trending market, withterrible results (right). Thekey now becomesrecognizing when a marketis trending or ranging.
 
4000:80002000
10000
 
 
 
120000 20 OO
Trace Nabersource: graph and results calculated using Iradestation 8. All rights reserved.
 
Systematic trading systems are all bound to fail systematically sooner or later, which is whykeeping a discretionary element is vital.
Familiarity with price action reading is the key to discretionary trading and allowstraders to time more accurately their technically or fundamentally inspired entriesand exits. The point is not necessarily to trade off the price action directly, but ratherto learn to “predict” moves so that you can anticipate the market reaction and planyour response accordingly. With the help of a fast feed traders can learn to interpretthe price action by simply looking at the way prices react near important levels.Picking the Right Approach
69
 
—<i———- No demand
—=— = Nosupply
DOJI
Nobody Is willing to buy nearthe highs or sell neat the lows,thus the market settles on anequilibrium point. Should beregarded as a warning signthat a change In direction maybe Imminent. Bids and offersare equally weighed at thispoint and pressure may
~t———— High of the day
~#————— Opening price
~<¢—— Closing Price
NN
Shooting StarComing at the end of an uptrend,the price action shows that themarket Is lacking the momentumto sustain higher levels (new highprinted but sold off) and that profittaking is entering the market.Should be taken as a warning signthat the trend may be near its end.
Low of the day
come from either side
 
Ty
Hanging Man
If seen at the end of an uptrend (called a hammerIn a downtrend) it should be taken as a sign of weakness.The market Is unable to record new highs and immediatelysells-off. Although the sell-off Is bought into (possiblybuying the top?), the price action Is telling you thatpeople are keen to take profits and that a secondsell-off may force the long's hand.
 
Candlestick reading is a great way to visualize the price action and identify meaningfulsetups instantly.
For example, if a large option is rumored to lie near a big figure, the price actionnear the figure will usually let you know exactly what is being protected, and howvigorously. If the pair is sold off as it approaches the big figure but is then quicklybought back 10-20 pips lower, that may be a signal that the option protectionguys are re-loading (selling near the figure and then covering their shorts). If thishappens several times then you can be pretty certain that they are indeed protecting70 Beat the Forex Dealer
 
 
jr FJEURUSD 15m Chart
   
REAL-MONEY MOVEPRICE ACTION PATTERN (STAIR CASE)TELLING YOU THAT SHORTS ARE HOLDINGONTO THEIR POSITIONS, EXPECTINGLOWER LEVELS. MOVE IS LIKELY TOHAVE SOME LONG-TERM IMPACT.
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Footprints that real-money driven moves leave behind.
 
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Typical speculative price action.
 Picking the Right Approach 71
 
their option, and you should keep an eye on the London or NY options cut afterwhich the selling may disappear and the rate may be free to move higher.”
In order to read the price action properly, start by asking yourself these types ofquestions:
e What does the market do immediately after news is released?Initial move higher, followed by a rapid sell-off (dealers are fading the move:no real demand).
e How is the price behaving on approach to an important resistance level?Dips seem to be shallow and little retracement is seen (real money demand:dealers are working a mountain of buy orders and buy every dip).
The answers to these types of questions will give you an insight into the market’spositioning and let you adjust your trading accordingly.
Those looking for more detailed trading techniques will find them in theAppendix of this book, where things such as how to enter/exit positions, set stops,and use price action effectively are addressed.
2A common option structure in the FX market is the “one touch” or “no touch” digital options, where aplayer bets that the price will (or will not) trade at a certain level before expiry (London or NY optionscut). Thus, if the option buyer is betting on a certain level being hit, if they are large enough they willusually pro-actively gun for that level, while the option writer (typically a bank) will try to protect ituntil expiry so that they do not pay out. 
FX TRADING TIPS13Adapting to the FX Market
 
Traders entering FX from other capital markets quickly realize that trading cur-rencies is a quite different beast altogether and that their tried-and-true techniquessimply do not work as well as they did with equities, for example. This is becausethe forex market’s unique structure sets it apart from the major exchange-tradedmarkets around the world, and requires most traders to go through a period ofadjustment.
Perhaps the most obvious distinction (and difficult to handle for individualtraders) is the fact that the foreign exchange market trades continuously 24 hoursa day, seven days a week. Global commerce does not take time off, and neitherdoes FX. With the help of technology, trading now takes place around-the-clock,and although your broker may not accept orders over the weekend, you can restassured that the FX market is awake and that someone, somewhere, is dealing.
TRADING DIFFERENT MONEY CENTERS
This continuous market action makes it difficult for new participants to adjust to,and new traders will find that their trading style and technical analysis often needssome tweaking in order to function properly. Since there is essentially no market“open” or “closed”, technicians struggle to use their candlestick reading techniques,which are often not readily applicable. After all, everything is relative in FX, anda trader’s open in Tokyo is not the same as a trader’s open in London. Insteadof relying on exchange-mandated hours, traders have to therefore find alternativeways to break down the day’s trading.
A clever way to do this is to treat each trading session independently using4 hour charts, which lets us divide the trading day into three eight-hour tradingsessions. By doing this, we are better able to see each region’s risk appetite and thelong trading day now becomes more manageable. Since three major money centersare responsible for the vast majority of FX turnover, this lets us accurately divide76 Beat the Forex Dealer
 
it into the Asian, London, and New York trading sessions, and each of these hasits own unique characteristics and trading style.
Asia
The majority of the turnover in this time zone is handled by Sydney, Tokyo, HongKong, and Singapore. Because each center’s banks are in active competition witheach other, this creates a more fragmented market when compared to the othersand translates into jumpy price action and unsustainable moves. The main playersin the Asian session are commercial names (exporters) and regional central banks,both of which love to enter the market in order to dampen volatility.
London
London’s “City” still holds its traditional role as the FX capital of the world,having a deep, well-developed market and the ideal time zone for FX trading.Along with London, a host of other European financial centers such as Geneva,Paris, and Frankfurt add further liquidity to the market, creating a deep marketacross the board with every major FX player in operation. The moves that takeplace in London are generally “real money” inspired (supported by large corporateflows or M&A activity), which can have big impacts on intra-day price action,especially around the time of the London fix. All of this liquidity means thatthe moves generated in this session are all-important, since the amount of moneyneeded to move a market this deep can tell us quite a bit about market sentimentand positioning.
New York
Although New York comes in second to London in terms of volume, trading fallsoff precipitously after 12 pm. The market is at its deepest and most active in themorning “overlap” hours, when the big boys like to make their opinions known bytrading yards at a time. Liquidity for Latin American currencies and the Canadiandollar (when Canadian banks are open) is also at its deepest here, meaning that ifyou are trading the Loonie, then you must trade these hours.
PASSING THE BATON
Although each of these trading sessions is in fact unique, their interplay createssome typical trading patterns that traders should be aware of. Starting with Asia,the day’s trading characteristically opens with a flurry of early activity as dealersAdapting to the FX Market 77
 
move rapidly to process their backlog of outstanding orders. To the yen or Aussietrader, the first couple of hours after Tokyo opens are all-important since theyusually feature most of the fireworks in this session. The lack of market depthmeans that, more often than not, you will find Asian players testing the limitsof any previous range (possibly recording marginal highs/lows), only to fall backand consolidate the move for the rest of the session since volatility-hating centralbanks and exporters love to turn this session into the day’s consolidation session(especially if big moves were seen earlier in New York).
London, on the other hand, has always been the market trend-setter, and not justin fashion. Although the initial moves may not begin in London, this is where thelarge players operate and get a chance to swing their big sticks. Moves initiated andextended in London should be taken seriously since it is the only money center withdeep enough pockets to overcome any “artificial” interference such as central bankinterest. Thus you typically see mighty London picking a direction and stickingwith it until New York enters the fray, making fading moves a dangerous sportduring these hours.
 
Liquidity map. Light sections indicate deep liquidity, darker ones are “thin” market hours.
By the time North America opens for business, the FX baton has been passedaround and by this time most intra-day bets have already been placed. This makesNew York a tricky time zone trade, since large amounts of speculative moneycombined with important economic releases turns New York into the prime78 Beat the Forex Dealer
reversal session. In the first hour of trading, New York traders high on tripleespressos will typically take it upon themselves to extend any moves initiated inLondon, trying to squeeze out the last pips from the market before the economicnews hit the screens. However, because these releases can have dramatic effectson the dollar this rapid re-evaluation combined with dealer manipulation createssome difficult situations for day traders.
You often find reversals starting in this way: at around 10am New York time,the major news releases have been out and traded on, leaving London traders witha day’s worth of profits or losses to manage. Now, if you are a trader in Europewho is about to head home for the day, you know that liquidity dries up fast afterthe London fix so you will begin to slowly close your books around this time.You are careful to tip-toe your way out the door instead of rushing for the exits,since you know that any rush (meaning that the original move was artificial) willflood the market with supply and turn your winners into losers in mere minutes. Ofcourse, everyone is thinking the same thing, and the greater fool theory takes overto get the ball rolling aided by the liquidity crunch. This creates a sudden rush inactivity that can easily turn winners into losers or losers turn into disasters, whichis why you want to make sure that your profits have been booked by the time thefix comes around. To the nimble intra-day swing traders these late morning NewYork reversals are a goldmine, especially since the remainder of the day is simplyspent by New York dealers handling modest flows and jockeying with the IMMguys in Chicago until Tokyo comes back on line.
                                   
Important times of the day that alltraders should be aware of
 
(GMT)00:00 | Sydney Open (good time for an ambush)
11:00 | LIBOR Spot Fixing (manipulation)
15:00 | London FIX (corporate and “must do” flows)17:00 } NY options cut (manipulation)
18:00 | Europe closes their books (reversal time)
19:15-4 Close of the IMM (last minute positioning19:30 | by Chicago traders)
Manipulation and abnormal moves
are common during these times, sokeep your eyes peeled and watch yourstops!
 
Check your own local timeAdapting to the FX Market 79
 
USING A ROLLING PIVOT POINT
One of the best ways to counter some of the technical problems discussed previ-ously is to use a pivot point for each one of the day’s trading sessions. A pivotpoint is that special line in the sand where most traders turn from being bearishto bullish (or vice versa), and just like in sports when you feel the momentumshift from one team to another, these “shifting points” can be used in FX to tell ifsentiment has switched to being positive (long) or negative (short). This lets youget a feel for the market sentiment, and basically means that if the price is tradingabove the pivot, you want to play only the long side, and if below, the short side.There are several ways of calculating pivot points, with the classical one used bymost Chicago boys being:
(High + Low + Close)/3 = Pivot
We can use the 4 hour chart to calculate the next pivot point, so all that is requiredis simply to plug the values of the last 4 hour bar into the pivot formula to findthe next session’s pivot point, thus giving us two pivot points per session (six pertrading day).
 
 
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Once you have your pivot point, play the market from the long side if the price is abovethe pivot and from the short side if below.Beat the Forex Dealer
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 Adapting to the FX Market 81
 
The thinking behind pivots is simple yet powerful: if buyers are willing to paymore for the same thing today than they were yesterday (or four hours ago), thenat least for the time being flows must be positive. Although you should not tradethe break of this pivot, it is, however, a nice way to manage the continuous marketaction by breaking down each money center’s risk appetite and integrating it withyour other analytical tools. By applying this filter to our technical signals, we areable to only accept “buy” entry signals if the price is trading above the pivot, andonly accept “sell” signals if below, etc.
TIME MANAGEMENT
Although the FX market can accurately be described as a 24 hour market, no tradercan possibly hope to keep up with this nonstop action. All FX traders suffer theconsequences of following the market, and you can usually identify them by thebags under their eyes and the Reuters machine next to their bed. Depriving yourbody of much-needed sleep is something that many new retail traders overlook totheir detriment, and understanding when not to trade can be just as important aswhen to trade.
Professional FX operations keep up with the market by employing 24 hourtrading desks with two or three shifts, splitting up the day’s time between traders.Although they may keep some odd hours, FX dealers still wake up, go to work,and go home. Similarly, a retail trader cannot possibly hope to keep up with thewhole market and must learn to manage their time accordingly (especially forthose trading from home). Spending 20 hours a day in front of the screen is simplynot a good way to foster long-term success, since it will eventually eat into yourdecision-making (and social!) skills.
New traders must become comfortable with the fact that moves will occasionallybe