Trading the EURUSD and some thoughts on technical analysis.

One of my active strategies is a mid-term EURUSD trending system which is currently being whacked by how this cross has been trading in the past couple of months. Even though there is a risk that my money management rules will force me to close it down I still keep on placing the orders and watching the whole Euro story develop. I do live in Euro-Europe so I do have a vested interest. Since May the EURUSD has been forming a symmetric triangle and we are not that far away from the vertex. I am not a big fan of technical analysis but I believe that certain chart patterns, even with little predictive value, do tell us something about the market’s psychology. A triangle is an interesting one because it suggests an escalating degree of disagreement between bulls and bear buying/selling at a higher/lower price. This situation is of course not sustainable and sooner one party or the other will be taking control and my trend following system shall be redeemed. Or will they?

Gideon Rachman recently suggested that the USA and the EU are going together down the sink, not a great prospect for a trend follower. Also we have the issues regarding the stability of the Euro and the end of the deficit-spending era in America. A trend following system requires sustained moves in one direction. I am starting to be concerned with the fact that we may not see that kind of moves in the EURUSD in the coming months.


Mapping seasonal trends in agricultural commodities

One of my research areas for developing new trading systems is seasonal patterns in futures. Even though I haven’t done any reading in the academic press regarding this topic I believe that there are good reasons why seasonal price patterns could exist in certain futures. If you are aware of some interesting paper on this subject I would much appreciate your recommendations. I expect to find seasonal trades particularly for agricultural rather than financial futures because of its perishable nature as well as seasonal production / consumption patterns and therefore these are my prime candidates. I am also optimistic about metals and energy futures but that will come later.

There are various web sites specializing in futures seasonal trends and after some research I’ve decided to use MRCI for a first qualitative assessment. (Disclaimer: I am not associated to MRCI). My goal was to qualitatively scan the data looking for preliminary evidence of seasonal trends and to identify the most promising area for further research.  MRCI provides seasonality studies for both outrights and calendar spreads but in this first phase I’ll be focusing on the former.

Based on MRCI seasonal charts I constructed a visual map per commodity and contract of bullish or bearish trends that are clearly visible to the naked eye and that are also consistent across the 3 time windows available (typically the last 5, 15 and 30 years with some exceptions). The result of this preliminary exploration is attached. Bullish trends are in green and bearish trends are in red. No colour means that either the market tends to range or that there is discrepancy between the time frames.

One of MRCI services is to post 15 monthly trades of the “enter in this date and exit on that date” type which they claim have shown high consistency during the last 15 years. Holding periods can vary from a few days to a few months. Of course it is very naive to belief that such an approach can lead to a profitable trading systems if taken “as is”. An hypothesis  that is somehow confirmed by the fact that MRCI’s published database of previous trades only goes back a couple of months in time. In any case my initial assumption was that there could be somewhere between 3 – 15 yearly interesting seasonal trades candidates a figure substantially bellow the 180 trades suggested by MRCI.

I believe that this preliminary results point in the direction that there could be around 5 to 10 yearly seasonal trades in agricultural commodities. During the next weeks I expect to conduct a quantitative analysis and start looking for trading rules for back testing.


A business approach to trading.

Trading can be many things to different people but my personal take on it is to approach it as a business. There are 2 basic business models in this industry, either you attempt to make money trading or you attempt to make money by selling products and services to people that try to make money trading. My personal interest is in making money trading and not selling so I will only discuss this business model in this post.

Regardless of whether you are trading your own micro account or you are trading for a multi billion hedge fund the specific basic process that lead to trading remain the same and these are: 1. Idea generation: research and back-testing 2. Trade implementation: brokers, platforms, api 3. Risk management: capital allocation, trade size, controlling losses (Of course other standard business processes like human resources, purchasing, site management, etc… can be present depending on the set-up.)

In the case of an independent self-financed trader the default option is to take responsibility for the 3 basic process him or herself. This situation is of course a consequence of size and surely most of us started this way. There are however enormous risk associated to this setup a maybe this could be one of the main reasons independent self-financed traders blow-up with very high probability.

Limited resources to idea generation produces a reduced set of trading strategies most probably highly correlated among them. Poor trade implementation design leads to missed trades, badly executed trades and high commissions and slippage. Finally, poor risk management leads to excessive risk and high risk of ruin.

So the interesting question is if you are small and alone in this game how do you grow your business to achieve a good diversification of strategies and of course a reasonable risk adjusted return? Which of the 3 process could or should be prioritized and receive additional resources? I am looking for my own personal answer right now and I tend to believe that process No 1: Idea generation could be the easiest one to upgrade by outsourcing it partially. What I mean is that for a single person, even working full time, the amount of work necessary to develop and implement >5 uncorrelated trading systems necessary for appropriate risk reduction is quite a task. Indeed the web is full of system sellers and letter writers with prices varying widely but I wonder whether there may be out there some sensible information that I could use in my own trading. The challenge clearly will be separating the data from the noise and therefore back testing will remain in-house.

So far in my trading career I have relied on my own research for developing trading systems but during the next weeks and months I am planning to scout the web looking to outsource part of my idea generation process… will be interesting to see what I will find!


A very interesting book about the psychology of financial risk taking

Trading books are always a significant part of my reading. Unfortunately the trading books printing industry is full of items that are not worth even the paper they are printed on, so the task of finding meaningful and interesting reading material is by no means a trivial one. During the years I have developed a methodology I apply whenever a new book appears in my radar screen. It usually starts with a review of online comments were usually I tend to focus myself on negative or critical comments rather than the glowing references of dubious origin. Once the book arrives I would usually skim through it reading bits and pieces here and there trying to figure out what the key contents are. The usual pattern I find during this phase is that some key innovative ideas are covered in detail in some pages, maybe even a chapter while the rest is just there as a filler to reach some minimum page count. However, every now and then I come across a book that really catches my attention because of the quality or quantity of its ideas or maybe because of the way key concepts coming from different authors are presented and meshed together. When this happens I will usually come back to the beginning and study it maybe even taking some notes for further reference.

The book written by Mike Elvin is certainly one of the latter. True most of the contents are not new but certainly the way in which ideas from Elder, Goleman, Douglas and many others are presented makes it a reference work on the complexities of the human mind when dealing with financial risk. When I started trading more than a decade ago I was certainly not aware of the impact that emotions, perceptual biases, stress management, self-sabotage and other intricacies of my mind could have in my trading results. I believe this to be quite common among beginners. Now, after having gone through quite a few painful and stressful experiences in the market and having read most of the authors available on this topic , I am convinced that psychology, or “Mind” to put it in Elder’s terms, play the most important role in determining my bottom line. “Method” and “Money Management” are of course indispensable but it is in our inner self where the biggest risks really are.

I can only highly recommend this book both to beginner as well as seasoned traders and I will certainly include it in my list of books I come back from time to time.

Disclaimer: I am in no way affiliated to Mike Elvin neither do I receive any income from the sales of his book.


Gambling and Speculation

One recurrent topic in trading is differences and similarities between gambling and speculation. After having reads quite a few ideas on this I came up with the following definitions that work fine for me.

Both gambling and speculation share the same common ground and this is risk. Risk in turn has to do with the uncertainty of the outcome of future events so basically both gamblers and speculators have in common that they take risk with the objective of making a profit in the future but with the possibility of  making a loss.

Even though both gamblers and speculators must take a non zero risk of ruin, a gambler is someone that takes a bet whose outcome has a negative expected value while a speculator takes risk only when the event has a positive expected value outcome or “edge”. There are many ways how speculators gain this “edge” but for automated traders usually it is based on studying the past (back-testing) and trading accordingly as long as they believe the fundamental process underlying is still in place.

Sometime ago I came up with the idea of the gambling / speculating matrix to visually represent the edge of any trading strategy. It is basically a two  dimensional space where any risk game can be plotted and can fall in 3 distinct regions: gambling region, speculation region and neutral the latter being a game with a 0 expected value outcome.

Given a risk game X with a binary outcome, a probability Pwin of a positive outcome and a payout ratio R then a game will be

neutral if R = 1/Pwin – 1

a gamble if R < 1/Pwin – 1

a speculation if R > 1/Pwin – 1

The following is a plot of the neutrality line to show how it divides the graph into the to above mentioned regions. Please note that the y axis is plotted on a logarithmic scale. I find it very helpful to plot the expected parameters Pwin and R of my trading strategies in this graph to quickly compare them visually. Clearly the more north-east the better.


Decision Biases

Which line is longer?

Success in trading depends among other things in compensating for our own human cognitive biases in our own models. Certainly easier said than done…

The following are some of the best known ones. In reading through the list keep in mind that cognitive biases are based on computational limitations of our brains and have an impact in all aspects of our life including of course trading.

  1. The disposition effect (I believe originally discovered by Tversky and Kahneman) which is the reason why we perceive profits and losses differently and as a consequence we sometime make trading mistakes like for example sticking for to long to a loss.
  2.  The “2 Overs-“ optimism and confidence. Basically when we asses our own odds and future scenarios we are not well balanced and we over-weight frequently for whatever reason. The impact in trading is then very clear.
  3. Cognitive Dissonance. We try to avoid considering certain hypothesis or scenarios because we are afraid of them. As a consequence these scenarios get under weighted… or even worse… we may even consider them impossible… P(event) = 0
  4. Anchoring , availability, and the representativeness heuristic. When our brains are in uncharted territory and needs to make some quick decision with an outcome that will have some impact on us, it will grab whatever point of reference it can find in our memory. I believe it is part of some basic self perpetuation mechanism since clearly remaining idle while our brain goes through a prolonged computational loop didn’t provide a great comparative advantage to our species long time ago.

And of course we all know that the 2 lines are of the same length even though we perceive it differently. Becoming aware about our cognitive biases are the first step in keeping their impact in our trading in balance. We cannot completely remove them but we can model them.


Best entry level books for traders

Today I was talking to an old friend of mine who is getting started with trading and thought about recommending some introductory level book. After some thought I came up with 2 excellent books which did in fact help me quite a lot during my early days as a trader.

Come Into My Trading Room by Alexander Elder

 

 

 

 

 

 

 

 

 

The Disciplined Trader by Mark Douglas

 

 

 

 

 

 

 

 

 

Both books are an excellent primer into what is probably the most important element for successful trading and usually overlooked by novice traders: trading psychology and cognitive biases.

If you were in a similar situation what book would you recommend to a novice trader for a primer?