Trading: The Game of Life
How to produce better than expected profit.
In a week where data was light, the combined effect of the worsening trade war (now encompassing Mexico) and seasonal Sell in May sentiment kept stocks and risk appetite currencies pair weak.
Although the trade war has serve to keep currencies and stocks within 2018 ranges and currency volatility depressed at historically low levels, there are signs some leading USD pairs are about to change. USDJPY broke 109 to maintain the historic bearish earthquake template. USDCAD hit our terminal wedge target levels enabling us to exit longs and sell. GBPUSD produced the new low that is consistent with the PM resignation fractal and allowing us to buy below 1.26 in two time frames for a short and medium term opportunity. Similarly EURUSD gratified an additional short term long even though the January effect still suggests the 1.1520 2019 high will cap until June 30th at least. But what is really interesting is the collapse in forex and in particular EURUSD volatility.
The only two occasions when the Euro went previously below 5%, 1-month implied volatility saw a return to volatility (13% implied) within 12 months. We have a clear and confident strategy how to combine both the January effect and the volatility play by legging into buying a longer term straddle but also possibly part funding this by selling short term straddles in the interim (the late 2017 VIX=VXX strategy before the early 2018 stock top). Confidence and the management of expectations are two important factors in trading success and are the basis of the last section in ours series of emotional trading.
To make money from markets consistently in the longer term we need to able to rely on rigorous analysis of one or better still all four FITS market pillars (fundamental, intermarket, technicals and sentiment). To exploit such analysis fully we need sound risk management and avoid being derailed by emotions – we need the 3 Ds of trading. Detachment, discipline and desire are key components of trading success and the subject of previous articles. They not only provide us with the ability to meet expectations and but the ability to meet our own expectations will, in turn help build confidence so that we can remain detached, disciplined and full of desire. This week we focus on management of expectations. Next week we suggest ways how and why we can improve our ability to manage expectations and therefore success.
The ability to meet our own expectations is true of success or happiness in many aspects or life not just trading. In the longer term it is also a source of the confidence that Jack Schwager highlighted as a common trait of all successful traders. It can usefully be broken down into the three parts: expectations, mental and physical ability.
Expectation is important not just to market direction but also our success. The two are inextricably linked in several ways. Our and others expectation about future market trends or ranges (particularly if they are different) are a significant determinant in identifying high probability trades. Our (and occasionally others) expectation about the success of future trades is also important.
Self Control about Uncertainty.
Staying positive about future performance is essential. We are not only as good as our last or current trade nor the next but the series of next trades. And yet we operate in a world of uncertainty.
A world where we have little control and where short term moves may be a reflection of temporary shifts in sentiment (noise) that do not affect underlying (value) trends.
Being cynical about markets, that is contrarianism helps identify significant market tops or bottoms where sentiment is extreme such as the recent stock run into Sell into May.
But in the shorter term it also helps identify opportunities to join trends when others are leaving an immature trend.
Our ability to maintain control in an uncontrollable environment requires several attributes beyond rigorous analysis, detachment, discipline and desire.
The ability to recognise markets may move unexpectedly and act or not accordingly with respect to individual trades and our general approach. A cliché perhaps but one that is abused without sound analysis. There are occasions where traders may flip trades because buying didn’t work so try selling instead – a strategy that is based often more on option than analysis. I find stepping back and reworking analysis is often produces better results than the first approach. Volatility often provides greater clarity even if it doesn’t affect our overall strategy.
By being flexible, recognising short-term price movements and the performance of trades in the shorter term may have little bearing over market or our success in the longer term.
The crux is obviously recognising when the environment has changed. Others may temporarily be thinking or rather panicking that it has changed following a sharp price movement but will quickly change back when it rejoins the trend. The key is whether more than one of the four FITS pillars has changed. One is not sufficient.
Fundamentally the first five months of 2019 saw stocks rally despite deterioration in US economic data. Intermarket. The USD remained stable to strong in this period despite continued weakness in US bond yields due to relatively poor economic data. The sentiment driven stock and USD rally that took SPX NDX and DXY to new highs was not sustained beyond allegedly key technical levels.
Why? The environment has not changed. Trump’s banning of Huawei, the Chinese tech giant and also Mexican tariffs this week could represent a significant escalation of the trade war if they are maintained. And yet German auto tariffs were withdrawn and the impact of individual tariff measures has not been sustained. Previously the effect has only had an impact beyond 5 days when it has filtered through to economic or corporate performance.
Our ability to maintain self-control is partly a function of setting realistic expectations about markets and our own performances. Again this can and should involves some flexibility and time frames. Our flexibility then should be driven also by sound analysis of ourselves, our trading performances and markets not an emotional response.
Given variable short term volatility we need to be realistic about sometimes erratic markets. For some instruments such as DAX we almost have to expect it. Other markets we have to accept markets can be wilder than we expected due to liquidity issues or misinterpretation of news even without any longer term implications. After all we can always get back in (aka Paul Tudor Jones) or make several attempts at a trade before it is successful (aka Bruce Kovner).
We also have to recognise markets go through different phases.. For 2012-2015 stocks were driven by significantly improving fundamentals. From late 2016 economic performance has slowed with stocks driven more by expectations and sentiment than sustained higher rates of economic growth. We therefore should rely on indicators that best reflect the drivers than ones that have necessarily performed well in other phases and be sceptical of any apparent trend that does not have fundamental justification. Trend following tools in a down trending USD in 2017or up trending in 2018 have of helped in volatility declining ranges in 2019 where forex moves of 2% are exploited more by anticipating reversals than joining a trend. That will however change again and possibly soon.
Traders’ expectations of future performance should clearly reflect the type of market they anticipate - ranging, trending, reversing – and the volatility and clarity that implies. However in the longer term it is clear that extreme expectations often destabilise. An underperforming trader is at greater risk of trading their P&L than the market and prone to emotional mistakes. So too an overly optimistic trader – most notably new get rich quick traders are also likely to be derailed.
Setting realistic P&L expectations is almost a cliché for success as it will significantly reduce the risk of emotional trading. At Matrix we studiously vary the probability of success for a trade based partly on the historical success of that particular set up but also on our current performance.
With our probability x return/risk approach we necessarily trade more when our performance is good and less when we are underperforming and that is compounded by market conditions.
Recognising that such expectations should reflect market conditions and how that changes over time is also essential. Just as apparently in life, planning less and achieving more is conducive to greater longer term satisfaction. Setting perhaps lower short term trading expectations is more likely to reduce the risk of emotional derailment in both the short and long term but also yield better longer performance. Of course such an approach does depend on the emotional make up of the individual and their ability to exercise self control.
As traders, we are our most important element for success or asset in our trading business.
Next week we investigate reality: how improving our mental and physical strength will make us more powerful assets and lead to better trading results.
Here’s to making the very best.
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