On reactive trading and why I don’t make market forecasts anymore

It seems to me that the popular trading blogs have one thing in common. They all make some form of forecasts about the market, or even better, calling out to a particular stock or currency pair. My guess is that there’s a lot more people looking for trading ideas for quick profits than actually interested in the mundane mechanics of trading. Well, that and because of the fact that some of these blogs are written by respectable professionals that do provide good insights (my recommendations are linked to in my blogroll, near bottom of the sidebar to the right).

I used to publish my predictions on the market on a frequent basis. It was my way of taking notes and keeping record for the week or month. Ever since my embarrassing, and costly, attempt to call for the bottom in October 2008, I have learned to keep my views to myself for the following reasons.

1. I suck at forecasting, terribly.
2. I wouldn’t want anyone to trade on my guesses.
3. There are plenty of other, much wiser, traders posting their views online.
4. I changed my strategy by trading on reactions and not predictions.

Point #4 is what I’d like to discuss in this post.

The main problem I have with making forecasts is that I get stuck to one perspective. Say if after a weekend analyzing session, I conclude that the market is up for next week. I would keep looking for opportunities to go long in the market the following week. That works well if I am right. Yet, as I always say, I am wrong just as often as anyone. So the chance of success is at best 50-50.

On an equal chance that if I am wrong. I lose not once but twice. First from being in the wrong side of the price move. Second from missing that opposite and correct move. As such, I have since adapted to a reactive trading strategy rather than a predictive one.

Essentially, I analyze the markets to come up with conditions for different scenarios (usually just three cases: up, down, and no idea) that will play out. For example, if GBP/JPY is above 144.50, I go long.

One of the trading skills I am still struggling to execute consistently is to be deliberately one step slower than most people on entering a trade. Being reactive is simplistically being a step slower than everyone to ride an obvious setup. It goes like this ideally.

When the writings are on the wall and more aggressive traders have taken their position, I wait even more. Then once those trades are still left standing (i.e. not stopped out), that’s when I would strike.

On the other hand, if the signs are not clear as crystal, I need to have the discipline to step to the sideline.

This strategy has been very useful to me as I have recorded some good trades because of it.

My ideal strategy certainly is less glamourous than a buy low, sell high motto. Yet, having been through a few too many ups and downs in my account over the years, I have learned to appreciate the art of not gunning for every penny out there but aiming to keep every penny in my pocket.

Much like how you would survive in a battle, the secret is to not be the first one out the line and then only go for the easy kills. Cowardly, yes. But unlike war, being brave in trading does not earn you any medal.

Barred from Trading at Work: A curse or a gift?

Well, they’ve done it. The IT guys at my day job have blocked access to streaming market data. I can’t trade at lunch anymore or even doodle on charts! Yet, this event merely pushes my agenda forward as I’ve never intended to trade actively at work (i.e. no intention of getting myself fired). Although I have honestly been pushing my luck these weeks.

For the longest time, I’ve traded stocks, options, and even dabbled in futures (not while at work!). On a whim in September 2009, I decided to try out the foreign exchange markets with a demo account just to see what the fuzz is about.

Since then I have not looked back… Nah! But no, trading stocks still remain my main staple. I am just curious about forex and it never hurts to broaden my understanding of the capital market. I must admit though, forex suits my trading style. I fully intend to incorporate it in my portfolio in the long run.

So what is my plan about forex trading? What do I want to achieve with my obsessive paper trading lately?

My paper trading objectives:

1. Identify my trading weaknesses
2. Identify my strengths
3. Experiment with various trading signals and strategies
4. Get a feel of trading the forex market
5. Understand the dynamics between currencies

I’d be a fool to claim that I have achieved my objectives. Trading is a never-ending learning process. This is nothing but the first stage in my forex trading sojourn.

The next stage now, as I have intended from the beginning, is to automate some trading processes from what I’ve learned. Such that I can remain active in the markets even when I am not around. Not for more profits, but to reduce risks. This need became blatantly obvious to me as some of my positions were left running through Asia and early Europe. Profits were sometimes turned into losses. If only my stops were moved.

Fortunately, the vigorous paper trading in the past few months does have its advantage. It has given me ideas for 3 new trading systems. I have disclosed one concept with my post on FTC setup.

As I was saying, being blocked from trading at work merely pushes my agenda forward. I haven’t touched a single line of code for 5 months. Now I have no choice but to work on developing some semi-automated trading systems to continue my forex paper trading.

My ultimate goal is to let myself do the high-level decision making, such as which pair to trade, which side of the position, and when. Then let loose a simple algorithmic trading system to take care of the timing for entries and exits, and some basic risk management.

My forex trading life continues.

How to stockpile a trade position one step at a time

Arguably the single most important skill a trader needs to master in trading any market is to cut your losses short and let your profits run. This is simply another saying of managing risks and maximizing opportunities. However, this is easier said than done. Ever tried to cut your losses short but only to see the price run in your favour soon afterward? Or, that you’ve built a sizable and profitable position only to see it turn into a loss? As with much of other trading skills, managing your trade is not an exact science. That is why you need to have probabilities in your favour on every step. You enter a trade because it is likely to be profitable. You exit a trade when it is not. If you can apply this axiom on every trade you do, it is likely that you will be profitable, with all things being equal. So what does this have to do with cut your losses short and let your profits run? In this post, I will discuss one trading strategy which I use to do exactly that.

The key to this strategy is divide and conquer. Instead of taking one trade for each position, consider taking multiple smaller trades by scaling in and out of a position. That way, you can have more freedom in your trade by using your position size to your advantage. Here’s the gist of the strategy and the rationale for it.

The rule is simple: increase a position by scaling in as the probability of success increases; and decrease a position by scaling out as the probability of success decreases.

One way to do this is to add on a position as the price breaks support on a faster timeframe. You keep adding on this position as long as your trade setup (on a higher time frame) is valid. At the same time, you limit your risk by lowering the stop of your previous trade to breakeven. That way, even though you are stockpiling a position, the overall risk stays the same. This is an essential step in the technique. Otherwise the risk would just multiply. It is as much managing the entries as well as the stops/exits.

Let’s put this into perspective with a real-world example. Figure 1 shows the support levels for my EUR/CHF short on a 3-hour chart. I identified this trade using my FTC setup on the daily chart. The failed break above 1.4800 on January 14 was the signal for entry. I took an initial short position risking 0.20% of my account as EUR/CHF reverted back below 1.4800 (first support, not marked).

Then I kept adding on to this position below 1.4787, 1.4761, and 1.4742 supports as shown in Fig. 1 with the horizontal dashed red lines. On each subsequent new entry, I move the stop on the previous entry to b/e. I only risk 0.1% on each of these additions with half the position size after the initial entry. As I keep adding, I keep moving the stops one step behind. So on my third scale-in, my initial stop have locked in some profits at a price level between my first and second entries.

Figure 2 is the same chart but with the actual filled orders (yellow triangles) and current stops (red lines) marked. As you can see, I have effectively accumulated a sizable position size in this short while limiting my risk to just a fraction (0.2% versus 1.0%) if I were to enter my maximum size all at once. Furthermore, my confidence and probability of this trade increase gradually as I see the short-term support levels break one after another.

EURCHF, 3-hour, showing supports

EUR/CHF, 3-hour, showing orders

There are limitations to this strategy. First of all, this strategy is mostly suitable for trading setups with an expected high reward/risk ratio. You might not want to use this for a range trading strategy as there’s probably not enough price move to break the trade into steps.

Secondly, this technique is mostly for an automated system or longer term manual strategies (hours or more). Just so you have sufficient time to manage all these extra work without adding on an unnecessary amount of stress.

Lastly, an obvious downside to this approach is that your account will take a hit from the spreads and commissions for each move. So do take those costs into account in building your own adaptation to this concept.

Now that I’ve discussed my scaling-in technique, what do you think?

Update January 22: I’ve closed this position and it turns out to be one of my best trade ever.

Why I shorted CAD/JPY @ 88.57 instead of long USD/CAD @ 1.0251

CAD/JPY failed a major resistance level at 90 and has edged out an obvious intermediate-term downtrend (Fig 1). USD/CAD is also bouncing off a major support at 1.0200 (Fig. 2). And crude oil is below $80 on a slippery slope. As such, shorting loonie seems like a good move at the moment according to my FTC trading setup. Yet, here is why I am opting to short CAD/JPY and not long the more popular USD/CAD currency pair.

Figure 3 shows a 5-year, weekly chart of CAD/JPY (top) and USD/CAD (bottom). Evidently, the exchange rate of CAD/JPY is still in a depressed mode since the fall of September 2008. It’s also clear on this chart that why I say 90 is a major resistance level. Beside from being a nice round number, CAD/JPY has failed to break above 90 twice since August 2009.

As for USD/CAD, the picture isn’t as clear. 1.0200 is definitely a very strong support because it marks the top of a 6-month range in the first half of 2008. Yet, the downward slope in the long term since 2005 is not to be ignored. As such, I do not dare to bet on a bounce on this pair at this price.

Moreover, the intermediate-term move on both of these pair is giving us a confirmation. CAD/JPY is now testing a falling trendling (Fig. 1). Whereas USD/CAD is testing a falling support. Thus, I am shorting CAD/JPY under pressure. Going long on USD/CAD now would be like betting it to bounce on a slippery slope.

CAD/JPY, 3-hour

USD/CAD, 3-hour

CAD/JPY and USD/CAD, weekly chart

Early bird does not get the worm in forex trading

[This post was updated on January 13, see addendum below.]

I have discussed my enthusiasm in shorting the Aussie a few times this week. First trade was shorting AUD/JPY at 84.53. After that got stopped out, I re-tried at the same level the next day. My trade history in this currency pair is shown in Figure 1 below. Evidently, I am early in my trades as the recent upward momentum is still going. But that’s just speaking from hindsight advantage. What is actually wrong with this play is that I was too eager at the first entry when the price was just at a minor resistance (short-term trendline of Fig 1). In turn, that caused me to lose my confidence and not be as aggressive as I should be when the price reached a major resistance at 85.50.

Referring to Fig. 1, I made 5 attempts on the minor resistance below 84.60 in the first round. What’s worse is that I didn’t have enough patience to wait after these shorts failed and I tried again at 84.52. Even though that resistance level is voided already.

But here comes the kicker. I actually noted the important 85.50 level before my first attempt. It was clearly on the chart and I even mentioned about its significance. I just figured that it wouldn’t be touched. How wrong I was.

As I said, another problem with being early in a trade is that it stripe you of your confidence prematurely in a good setup. My setup to short AUD/JPY is as good as ever now. I am drooling over that negative RSI divergence shown in Fig. 1… But since I’ve already taken a beating in this pair this week, my account drawdown dictates that I limit my risk. As such, I can’t back up the truck to pile in on this trade at this point. But why not?

I won’t break one rule to compensate for another. Although I am light in this trade now, I will not compromise my risk management rules to compensate for my own mistakes. That would just open a whole new can of worm. Besides, I can’t say this often enough — risk management is always the top priority in trading.

In any case, there will always be other opportunities.

The moral of the story is this. Do not be too eager to get into a trade. Secondly, adjust your position size accordingly to the significance of the setup in play.

AUD/JPY, 3-hour

Update January 13:

Figure 2 below shows an updated view of AUD/JPY a week later. The red dot on the 9th was my last stopped out entry. As you can see, I missed the smooth 200 pips ride down. This experience is proving to be better than I expected to illustrate how being early in a trade can really hurt your account.

A week later in AUD/JPY, 3-hour chart