What role do traders have in the market?

I got into a bit of a heated thread over at Babypips, regarding the role that traders play in the market.

 

There's a school of thought that traders and speculators serve no useful function since trading is a zero-sum activity and thus no wealth is actually being generated. This is somewhat misleading. If there are ONLY traders within a market, then yes, I believe it is a zero-sum activity and any wealth generation is arguable.

 

Of course, traders are not the only players in the market. We have corporations who participate in the market for operational reasons, whether it be to raise cash via an IPO, hedge their risk, or supply the market. We have mutual and retirement funds seeking long-term investments. We have debtors liquidating assets to balance their sheets. We have governments and central banks pulling fiscal and monetary levers to direct the economy.

 

Bearing this in mind, I believe the trader serves three useful functions in the market:

 

1) We increase liquidity. An illiquid market means higher transaction costs and longer times for orders to fill. By adding our liquidity, we decrease both and ensure a smoother, quicker and efficient market.

 

2) We provide risk management for risk-averse companies. It may be tedious, if not dangerous, for a company to see fluctuations in the price of raw materials or currencies. To hedge this risk, a company may lock in a futures contract, guaranteeing a stable price for the foreseeable future. Traders serve as a counter-party towards this hedge. Without traders, there may be no counter-parties, and thus no hedge, and companies will be disadvantaged.

 

3) We bring the market closer to equilibrium. Without our input, markets may be manipulated or distorted beyond reason. Our goal, as speculators, is to define what we consider "fair value" and bring the market towards this level. If we believe something is cheap, we buy. If it's too expensive, we short. We exit when price is at "fair value", having completed our duty in punishing any unwarranted hysteria or panic.

How the filthy rich handle drawdown

I'm halfway through reading Theo Paphitis' (BBC Dragons' Den) autobiography and noticed that the self-made ultra-rich have something in common. Almost all of them came perilously close to bankruptcy at some stage, usually early in their "career".

 

In trader parlance, you can say that their drawdown came close to 100%. In fact, many of these millionaires / billionaires took on astronomical levels of debt at the lowest point of their careers, so you can say that drawdown exceeded 100%.

 

Can traders learn something from this? Trading is just like any other business. You have suppliers and customers (both from the market), you buy low and you sell high, you use other people's money (OPM) via leveraging and you have overheads that you want to minimise (spread and overnight swap rates).

 

Quite often these self-made entrepreneurs would fully invest themselves in a single enterprise. That would be the equivalent of putting in 100% equity into a single trade. A big no-no.

 

So are entrepreneurs like Theo Paphitis and Richard Branson stupid? Did they fail to manage their risk? Or perhaps the risk they took fits their psychological profile?

 

I'm not saying I have the answers. But drawing a parallel between entrepreneurship and trading is interesting and I think valuable lessons can be gleaned from this.

 

To be fair, these entrepreneurs began to manage their risk better as their wealth accumulated. These days Richard Branson segregates each of his businesses into autonomous units so if one blows up, it doesn't affect his business empire. That's like risking 1% equity per trade. It's a very managable level of risk. Reading their biographies, you realise that many of these entrepeneurs were somewhat naive when first starting out and I guess got "lucky" when their 100% equity trade won. We don't read the biographies of those who lose everything.

 

The journey to wealth usually goes like this:

 

1) Risk big early on

2) Hit a home run or lose everything

3) Once you're rich enough, slow down and manage your risk

 

"Losing everything" isn't the end-all, be-all. I guess these entrepreneurs accepted such a possibility. As long as you have two hands and a brain, you can always regather some skin to get back into the game.

 

But no-one ever got filthy rich by being conservative. If you do play it safe, you may end up as a single-digit millionaire by retirement. It's not a bad position. But to get into the hundreds of millions and above as a self-made man, I don't think there's any way around taking large risks.

The future: managing my own money, or other people's money?

I spent the last week having a good think about my future's direction. As a professional trader, I have two options:

 

1) Manage my own money

 

2) Manage other people's money

 

I've been reading CASHFLOW Quadrant from the Rich Dad Poor Dad series, and according to Robert Kiyosaki, most wealthy people obtain their wealth by utilising other people's money (OPM) and time (OTM).

 

If you're a professional trader / investor with a solid track record of profitability and low drawdown, investors will throw money at you. If you do decide to manage other people's money, your main source of income will come from fees. An advantage of managing OPM is scalability. There's not much difference in effort when investing $1m or $100m. Your investment or trading system(s) should be very similar in both cases. However, in the latter case, your income increases a hundred fold. Not bad at all. If you're a profitable trader using your own money, why not charge investors a fee to piggy-back on your success?

 

On the surface, this looks like an attractive proposition. But here are my reservations:

 

1) It becomes almost like a job. You're no longer answerable to yourself, but also to your investors. You'll be required to meet all sorts of regulations, expectations and KPIs. Most traders become so because of the freedom, and this sets you back in the corporate world, albeit you are your own boss.

 

2) Your psychological profile may mismatch with investors. Now, this can be partly remedied by being selective about those who invest with you. Most passive investors seek steady and reliable returns. In contrast, most traders want to strike it rich and retire as early as possible. Different goals. Many investors will balk at the prospect of losing 10-20% equity in a short-term drawdown, but traders know that such drawdowns are expected during long-term wealth creation.

 

There's prestige in finding your own hedge fund. Pyschologically, though, I don't think it's for me.

Recommended resources (Dec 2012)

Over the last year I've gathered a few sites / resources that I've found to be very useful. Some of my recommendations:

 

BabyPips

 

For anyone new to trading, I recommend BabyPip's "School of Pipsology". It's a FREE online course on basic trading. I've read a few introductory forex / trading books from bookshops, and found the School of Pipsology superior. The online community at BabyPips are also generally helpful.

 

Mercenary Trader

 

Mercenary Trader covers trading in general, not just forex. It's main emphasis, in my opinion, is on trader psychology. Mercenary Trader routinely releases newsletters that I've found inspirational and insightful. I tend to ignore the market commentary, although that is available as well.

 

Mechanical Forex

 

The owner of this blog / website, Daniel Fernandez, is a pure mechanical and automated trader. I'm a mechanical trader myself, and would like to become automated in the future. The site provides a free e-book which I can currently perusing. There's a noticable absence of quality information regarding automated mechanical trading. This site is one of those rare gems of expert knowledge that you'll find once in awhile.

 

Trading Heroes

 

I enjoy this website because I find the webmaster, Hugh Kimura, refreshingly honest and down-to-earth. I also believe that we're both at a similar level of development. The site doesn't contain much, strategy-wise, but it's most useful resources are the podcasts and interviews with professional traders. Getting an insight into the world of other traders is fascinating.

 

Pepperstone

 

My forex broker. I used to be with GoMarkets but found the spreads on Pepperstone to be much better. Many Australian traders seem to prefer Pepperstone. I've been with them for half a year and haven't encountered any critical problems so far.

An interesting few days...

EURUSD

Monday provided a gush of low-volatility entry signals on the EURUSD, NZDUSD, gold and silver.

 

I decided to trade the EURUSD, being the most liquid, and both a long and short were triggered on the break of Monday's high and low.

I initially aimed for a 1.75:1 reward:risk ratio. As you may see, my long didn't go far before I was stopped out. Price broke downwards and after triggering my short, I began to lose confidence about my trading plan and closed my trade with a reward:risk ratio of 0.3:1.

 

Price continued to move down and would've hit my initial profit target. It then reversed, producing a bullish pinbar this morning.

 

The main lesson here is psychological. If I had maintained my faith, I would be in the green right now. My trading plan is complete. I just need to stick with it. Trading is 10% technique, 90% psychology.

General rule: don't talk shop with non-traders?

I generally spend 4+ hours per day doing something trade-related, whether it be research, backtesting, reading or setting up orders. So understandably it's something I enjoy talking about.

 

There's a peril with talking shop with non-traders, though. They usually have a different understanding of the market than you do.

 

When I put on a trade, I try to think in terms of profit factor. Every trade I put on, I win the amount I risk * profit factor, regardless of whether I actually win or lose. It's the long run that matters, and with a thoroughly tested system, your long-term result should be similar to your backtest result.

 

The peril lies when you speak about losses to non-traders. No-one likes losing, but traders (should) understand that a loss is nothing more than an overhead. As long as you're profitable overall, losses should be regarded as a cost of business.

 

Non-traders usually don't understand this, though. When you speak about losses, they may project their own beliefs onto you, e.g. "no-one can beat the market", "the market is rigged", "you'll never win" etc. This is toxic stuff.

 

There's a similar danger when you speak about winners. Non-traders may come to see you as some sort of "guru" who can't possibly fail. Their projection can feed your ego, and make the inevitable loss difficult to accept.

 

And then of course, you will meet individuals who disagree with capitalism, trading and speculation altogether.

 

When conversing with non-traders, it's probably best to be light on the details and protect yourself from outside projections.

 

(and yes, I suffered a loss on the GBPUSD today!)

 

Monday breakouts

 

Spent some time today backtesting the break the Monday's highs and lows. So far I've tested the EURUSD from 2001 to late 2002. Only 81 samples have been collected, but with a stop loss of 0.5 * ATR(14) and a reward-to-risk ratio of 2.5:1, profit factor is 1.32. It's enough to keep me interested in continuing my backtest.

The problem with an infrequently-traded system...

... is that you lose touch with the market. A low-volatility candle appeared on the AUDJPY a few days ago.

 

 

 

If you tried to trade the break of both the high and low of the candle with anything greater than a 1:1 R:R, you would've been whip-sawed out.

 

(Un)fortunatelly, I decided to ignore the market that particular day and simply focused on my research and backtesting.

 

That is the trouble with an infrequently-traded system. If you're potentially waiting 2+ weeks for your next entry signal, you can forget that you're trading live. I feel very much as if I'm back in "demo mode".

 

I will notch this up as a lesson in trader psychology. As a trader, you have to understand your psychological profile, and I believe I'm one of those traders who needs to be in the market frequently to remain engaged.

If you want to be inspired...

... go on Youtube and look up "Shark Tank" or "Dragons Den". In these two shows, budding entrepeneurs pitch their business ideas to ultra-rich investors and venture capitalists. This is capitalism at its finest.

Lessons learned

Lessons learned so far. As time goes by, I hope to expand this list.

1. Respect first support / resistance areas. Set possible TP here.
2. Remain faithful to your original order setup (SL and TP), especially if they have been well thought-out. Avoid impulse trading. Exception: release of big news
3. Do not overtrade. Trade quality setups only.
4. Entering at the end of a retracement presents the best opportunity to maximise R:R and probability. 
5. Do your own homework
6. Question EVERYTHING, even if it comes from Dr. Alexander Elder (i.e. the 2% rule)
7. Use context-sensitive, self-adjusting rules rather than hard, arbitrary rules
8. Equity curve growth rate is influenced by profit factor, equity risk % and frequency of trades.

How to Handle Losses

HOW TO HANDLE LOSSES by Kevin LaCoste

1. Do not live and die with each trade. A single trade is insignificant in the overall scheme of trading.

2. Regard each loss as a single event. If you experience a string of losses, each loss is an independent event. Consecutive losses are nothing more than coincidence. The market is impersonal and not out to prove you wrong.

3. Take a break from trading if you find yourself too emotional, or reduce your position sizes (preferably to minimum) until confidence is regained.

4. After a loss, do something productive or take a walk to gain some perspective.

5. Have faith in your trading system. It is logical and has been backtested extensively.

6. Look forward to your next trade and move on.

7. Remember your long-term goal - financial independence. The pain is worth it. You will look back and admire your resolve.

8. Analyse every loss and salvage lessons. Lessons create future profit.

9. A loss is a stepping stone to future success.

10. Every trader experiences losses. You cannot avoid them.

11. When using a valid trading system, a loss is nothing more than a cost of business.

12. Coping with losses creates mental muscle and discipline. Bear the pain and become a stronger trader and person.

4 Minute Drill for Traders

I found this nifty psychological resource on Youtube for traders, the 4-Minute Drill for Traders. Once you've got your trading system defined, the next obstacle is psychology. Check it out!