O ver the last few chapters, we have seen how some of the greats of foreign exchange trading have made their billions. In each case the individuals, or groups of individuals, have had some sort of competitive advantage that they have put to good use to extract riches from the global markets.
Soros developed his own behavioral “theory of reflexivity,” which he applied to a global-macro approach in taking down the Bank of England. Henry researched and back-tested a hundred years of past futures prices to figure out that the markets are people’s expectations and these expectations manifest themselves as price trends. He also restricted his algorithm to avoid human intervention, apart from executing its trading signals, and he followed his model with rigorous discipline over many successful years. Schwarzenbach was an early adopter and original market maker in selling option strategies. Cruddas, Fournais, Christensen, and Stevens were all early adopters and market makers in retail foreign exchange. Simons recruited a superlative multitalented team of quants, and he applied science, artificial intelligence, and lightning speed to take advantage of inefficiencies across a wide range of markets. Fatkhullin focused on delivering a magnificent multifunctional and multiproduct trading platform to the masses and also created a simple programming language to promote algorithmic trading on his platform.
All these men had a vision and a plan, worked hard at implementing their vision, stayed resolute through ups and downs, and came out on top. We can learn a lot from them!
Making a fortune in the foreign exchange market might seem a daunting prospect, and for sure, a lot of good luck is required. But with a well-researched and solid plan, a disciplined approach, adequate capital, and prudent risk management, most people can start off on the right footing. Scaling up a legitimate competitive advantage can lead to the outsize returns that make people millionaires and ultimately billionaires.
DISCIPLINE AND FOCUS
There is no surefire way to extract scalable consistent winning returns, save in a limited capacity from arbitrage trading. There are some who advocate trading only certain currency pairs or particular time zones, and it is possible that there is a logic behind this that may add to improved performance. There are, however, several simpler techniques that we can adopt to make sure we stay in the game and continue to be there when luck shines on us. Chiefly these revolve around maintaining discipline and focus.
The fundamental elements in giving yourself a winning chance come down to doing just that: remain focused and disciplined; block out noise, rumors, and opinions; and follow whatever strategy that you consider your best winning chance. If markets are efficient, then for every winner, there is a loser, which is certainly true in foreign exchange. Remember that over 50 percent of fund managers cannot beat an index. Therefore, confidence in yourself and your plan is as good as any one single piece of advice. Yes, you should do plenty of research, and yes, you should understand some basic economics and technical analysis. But no, it is not entirely necessary to entrust your capital to the skills of another in order to make money. Statistically, you have exactly the same chance, and maybe an even better chance, when you cut out hidden fees and charges, as well as management and performance fees.
Being adequately prepared to make a structured start in beating the markets is where we must focus our attention. I believe that being prepared mentally and physically is a good starting point. And if I were to advise any novice potential foreign exchange trader, I think four to six weeks preparing mind and body before you commit to any trade will be time well spent.
MY OWN PREPARATION FOR TRADING
As I recall my own initiation to foreign exchange trading, I remember it as being quite structured. First, there was a gruff, no-nonsense risk warning of an introduction, almost as if to scare me about the dangers of the market. This was followed by several weeks of on-the-job training and patient answering of my questions about the many peculiarities of how and why people trade.
I cannot say that my arrival at Prudential Bache was met with a fanfare and fireworks. I felt more like a recruit in an army boot camp, such was the unfriendliness of my welcome. My colleagues were not intentionally rude. They were just working at 100 miles per hour. That’s how it was in the 1990s. Full on! All day long! After having been shown around the dealing room and getting a few grunts of acknowledgment from my new colleagues, I was shown my seat, which was second from the right in a line of five dealers.
My colleague on my left, who would become my mentor, briefly took a few seconds off from answering phones to fire a volley of choice words in my direction. “Don’t screw up! If you screw up, tell somebody! And don’t take sick days!” After that, he was back on the phones, barking numbers across the desk, continuing to frantically scribble out trading tickets, only lifting his head momentarily to say, “Oh, by the way, the last person who sat in your seat got sacked!”
“Oh, why?” I responded, instinctively half knowing the answer.
“She screwed up! She ran an error trade. Never run errors! They always screw up!”
I spent the next six weeks, from 7 a.m. until 5 p.m., only taking a break to go get the lunches, with my ear pinned to a phone listening to live conversations between salespeople and clients, then watching the interaction between salespeople and traders, then back to the conversations between salespeople and clients as deal upon deal was struck. There was never a dull moment. It was always busy, and on the few minutes either side of any economic announcement, it was extremely busy. I cottoned on quickly to the FX jargon, how to make prices, how to communicate, how to write tickets, and crucially how not to screw up!
My mentor was at the epicenter of the business. Incredibly sharp, sometimes irascible, but always on top of his game, reliable, intelligent, humorous, and all in—just a great guy to have next to you. Each week, armed with calculator in hand, I would be grilled by the head of sales, who would fire question after question at me, get me to calculate cross-currency prices, swap prices, futures prices, and invert bids and offers, while generally trying to confuse me as much as possible so that I was at last prepared, in his mind at least, to pick up the phones myself and deal with clients in a quick-fire hostile environment.
I must admit to being terrified making my first price to a client and similarly when making a market to much larger clients. Part of it was because I was paid so little, and an error could be as much as my annual wage. Part of it was knowing that the previous incumbent of my seat had been fired. I didn’t wish that to happen to me because I already loved what I did. The group of guys and women I met at Prudential Bache were the funniest and most eclectic, sharp-witted bunch of people I’ve ever had the pleasure of working with. It was the best apprenticeship I could have dreamed of, and I learned so much from them all.
YOUR PREPARATION FOR TRADING
The initial advice I received is probably as good advice as anybody seriously contemplating trading can get. If I can rephrase it in a polite way, it might sound familiar. Be serious about what you do (don’t take sick days!). Stick to your strategy (don’t screw up!). And always cut your losses quickly (never run errors!). Anybody who follows these three tips will have a far better chance than the majority of traders out there.
While the noise of working in a busy dealing room with the additional pressure of making markets in millions of dollars can fine-tune concentration levels, it also pays to stay focused when trading online on a computer. It is quite easy to become laissez-faire, particularly if you have had a few quick victories. Markets have a tendency to move savagely against the unaware. I have touched upon the trading characteristics of fatal overoptimism—namely, overriding, overtrading, and overleveraging—in the previous chapter. We can add overconfidence to that list. Always remember that the risks are ever present. Stay alert!
Having gotten the don’ts out of the way, it is now time to focus on the dos. It’s a great deal harder to make money than people think. And learning with hindsight is not a very satisfying experience, particularly if your account equity has halved. It is a far better starting point to go into trading fresh and prepared. And just as if you were preparing to run a marathon, it is important to get some pre-trading training. It’s called “doing the work.” Or, in other words, preparing self and strategy.
Six weeks should do it. You can learn a lot about yourself in six weeks. In particular, you can assess your ability to follow a regime, whether it be a diet, a fitness regime, a course of study, meditating, getting up on time or half an hour earlier, reading the financial section of a respected daily newspaper, or giving up a bad habit. I would suggest you do all of these. It will all help you prepare mind and body for the hard work that follows. If you falter on any one thing that you set for yourself, you may well have to ask yourself whether you have the discipline or aptitude to be a successful trader.
This is not about creating superheroes. It is about testing oneself. All the above activities can and should be pleasurable, and they need not eat horrendously into your time. Meditating might not be everybody’s idea of fun, and it’s certainly not compulsory, but simple meditations can last for just 20 to 30 minutes. They can open up your mind (and soul) and significantly increase the positive sense of well-being. Similarly, committing to exercising for 40 minutes to an hour a day (or every other day) will boost energy levels. A diet doesn’t have to be overly constraining. Avoiding one or two obviously unhealthy eating choices or even just organizing your eating habits in a different way can reduce weight and aid considerably in general energy levels and concentration.
There is wisdom in the saying “Eat breakfast like a king, lunch like a prince, and dine like a pauper.” If you have meditated or if you have done a workout first thing, then a good breakfast will set you up for the trading day. Small healthy snacks will maintain energy levels. Take a break—some air and something nourishing—for lunch. Avoid excessive carbohydrates and heavy foods at night. You will sleep better for it! Similarly, the weekend starts on Friday in most countries, so avoid excessive partying on Thursday night (or any other night that precedes a trading day). Reading a good-quality financial newspaper over the weekend and keeping abreast of important political and economic events should become your focus.
At the beginning of the six-week period, I would suggest that all budding traders open a live demonstration account. I would also suggest that this demonstration account be opened before the beginning of the first week of any given month. Next up, download an economic calendar for the month, which is something we’ll come back to. Make sure it covers economic announcements in the United States, the eurozone, the United Kingdom, Japan, Australia, New Zealand, and Canada. The second part of our preparation phase is to follow the markets’ reaction to the release of economic data. The six-week period should cover at least two nonfarm payroll employment announcements, which are released on the first Friday of the month at 8.30 a.m. Eastern Standard Time.
FORMULATING GOALS AND STRATEGIES FOR TRADING
Before we rack ourselves with worry about becoming the next economic guru, it is time to take a step back and think for several moments, hours, or even days about what type of strategy we wish to follow. The first element of our plan is for us to think about what and how we want to trade. What are our objectives? How much capital do we envisage commencing with? What are our profit expectations? How much are we prepared to lose, if it starts off badly, in pursuit of those profits?
In the preceding chapters we have several examples of billionaires who adopted different strategies in making their millions and billions. Can we replicate any of those strategies? What barriers are there to entry? What more do we need to know? What, if any, competitive advantage do we have? Is it scalable? What strategy would make us feel most comfortable and not stress us out morning and night? How serious are we about all this?
Whatever type of strategy you adopt, whether it’s spot trading, pairs trading, technical trading, trading specific time zones, market making, futures trading, or options trading, it is important to follow at least one monthly cycle of economic releases before you commence, which is the second element of our preparation plan. There are some announcements that are considered timelier and to have greater impact on the markets than others. It is an extremely interesting activity to watch a trading system when economic numbers are released. It will give you an idea of how markets move and in what magnitude. It will start to attune your instincts to the sensation of “noise” or lack of it.
The important thing to achieve here is to start to get a feeling for the market. You may well have a temptation to trade. But do not do so just yet! Unless you have real-time information, the best you can do for now is watch how the market reacts to economic announcements. By following an economic calendar, looking at a particular set of data that is due for release, and studying the consensus view of the many economists who dare to predict an outcome, and only then turning your attention to your trading platform, you can compare where the market was prior to the announcement and its activity during and after the announcement. It is well worth keeping a diary during these few weeks. After each announcement, you should take time to record what you have just witnessed. It is something you can consult in the months going forward.
The third element to our preparation plan is to read up as much as possible about FX and trading in particular. There are some great books out there, and depending on your focus and strategy, you can attune your reading list to point you toward the trading style you wish to adopt. I would advise you to read some books of a more humbling nature. You can learn a lot from other people’s failures too. You may also choose to read books on behavioral economics. They will give you an idea of how humans tend to react to stimuli, both good and bad. Make sure you have a good book at hand for the next six weeks. Try to set yourself a target of reading one relevant book per week. That’s about 40 or 50 pages of reading per day.
So in the next six weeks we have the following schedule to pursue and several targets to achieve:
1. Commit to a fitness, diet, and well-being regime.
2. Download an online trading demonstration platform.
3. Download an economic calendar.
4. Buy a diary.
5. Buy six good books on the financial markets.
There is no gauge of success or failure in this preparation phase. If you break your regime, you can always start again. But try to understand where you went wrong. If you need more time, then so be it. Take the time that you feel is necessary.
If you are struggling with any element of your schedule, it can sometimes be helpful to have a “will-do list” at hand. A will-do list obliges you to do something. It is stronger than a “to-do list,” which is effectively a wish list. Write down what you will achieve the next day. Consult your list frequently, and if the first thing on your list is getting up at a certain time, consult your list last thing at night. At the end of this six-week period, you might find yourself mildly surprised at your progress. One thing is certain: if you haven’t traded, your cash will still be safe—and you may know a little more about the markets and a good deal about yourself.
One of the things I have found inspiring about researching the traders who are mentioned in this book is that they all come from different backgrounds and cover the spectrum of education levels from having no academic qualifications through to having PhDs in math. All of them specialized in a distinct element of the FX business, and they all had different capital commitments to back their foray into the foreign exchange market. Peter Cruddas started CMC Markets with just GBP 10,000, and John Henry launched his firm with $100,000. Urs Schwarzenbach originally traded a small amount of capital for his father. George Soros started Quantum Fund with under $5 million.
It took Henry about 12 years to be running over $1 billion in assets, and it took Soros about 16 years. FXCM listed on the New York Stock Exchange with a value of $1 billion just 11 years after the company was formed. Peter Cruddas had an estimated net worth of over $1 billion in 2005, 16 years after setting up CMC. Saxo Bank, arguably, has a value in the billions of dollars. MetaQuotes was set up in 2000, and I believe it must have a valuation in excess of $1 billion. What that says to me is that it is possible for anybody with an innovative scalable strategy to start from a relatively small capital base and—provided that he or she has a modicum of luck, appropriate investment, and time—become an FX billionaire. It’s worth thinking about!
Unfortunately, that will not be all of us. If destiny is not calling us to be the next FX billionaire, we can at least try to avoid some of the common pitfalls that can eat into our capital, confidence, and well-being. It is absolutely essential, therefore, to focus on your own FX strategy. You can do this alone or as part of a group; there are merits to both. However, if you trade with a group, it is important that your vision is aligned with that of the other members of the group and that you all follow the rules that you set yourselves. Remember, the human tendencies are to be lazy, greedy, and impatient. Be doubly sure with whom you partner. And set yourself achievable targets.
Back to economic announcements! Most people, unless they adopt a specific pairs trading strategy, will inevitably trade something against the U.S. dollar. And so being abreast of what is going on in the United States with regard to its economy is a useful starting point in commencing to trade FX. Obviously, world events, other economies and markets, and particularly commodities markets can affect how currencies move against each other, but a few basics about what drives the U.S. dollar are highly relevant in helping you form an FX strategy.
Common to all countries is the way in which growth and inflation interact to affect interest rates. In simplistic terms, growth is good for a country, and coupled with a small amount of inflation, interest rates can be set to maintain a sustainable trajectory that keeps growth and inflation in balance. If an economy grows too fast or inflation starts to get out of control, interest rates can be raised to control inflation. Similarly, interest rates can be depressed to stimulate growth and inflation. Cheaper borrowing costs imply that money will be invested to start or fuel business growth. In economies in which interest rates are low, a small sign that those economies are starting to enter an expansionary phase is that small incremental increases in interest rates may follow. Foreign investment may flow into those economies, attracted by rising equity markets and business opportunities. Cash will earn interest.
Currency traders look to compare how economies are faring against each other. Among other things they will compare growth, inflation, and interest rates and what factors drive these variables. Smart money tends to flow where it will grow. Economic indicators can provide traders with clues to the strength or weakness of certain economies and therefore how best to invest their money.
U.S. ECONOMIC ANNOUNCEMENTS
In the United States, over the course of a month, a good deal of economic information is released. Most reports, surveys, and indicators are released monthly, but others, most notably gross domestic product (GDP), are released quarterly. During the month, bit by bit, information is released that can be pieced together to assess how the domestic economy is doing. Remember, we are looking for signs of growth and inflation that will ultimately influence the direction of interest rates. Higher interest rates, in general, tend to draw money from investors. Interest rates that are higher than the rate of inflation mean that the value of money grows in real terms. Currency investors will look at interest rates of pairs of currencies. If a currency pair is trading at a certain level at current interest rate differentials, then all things being equal, an interest rate increase in one currency relative to another will tend to strengthen the currency in the country where the interest rate hike occurs.
By focusing on the beginning of the month in the United States, we encounter four timely growth indicators straight off the bat. These are the Institute for Supply Management’s (ISM) survey of U.S. manufacturing activity, or the ISM Manufacturing Purchasing Managers Index (PMI) on the first business day of the month; nonfarm payrolls on the first Friday of the month; and the ISM nonmanufacturing PMI survey on the third business day of the month. The fourth indicator, the ADP Research Institute’s nonfarm employment report, sneaks in two days before the Bureau of Labor Statistics nonfarm payrolls report Both employment reports and the corresponding unemployment percentages give clues to whether the economy is in expansion or contraction mode. In general, the more people who are employed, the higher the confidence numbers and the larger the retail sales. All good signs for growth in GDP.
The ISM indexes are business activity indexes. They are diffusion indexes based on responses to questions to purchasing and supply executives of over 400 companies in the case of the manufacturing PMI and 370 companies in the nonmanufacturing PMI. The diffusion indexes are calculated as the percentage of respondents reporting higher activity, plus half of the percentage reporting no change. A reading of 50 means there are equal numbers of respondents indicating higher or lower activity. A reading above 50 is considered expansionary and therefore positive for GDP and the U.S. dollar.
The excitement that heralds the nonfarm payrolls announcement is the financial markets’ equivalent to that of spectators waiting for the start of a major sports event. The flurry of noise and activity that blasts through the market in the first few seconds after the announcement can make for joy or misery for those bold enough to trade the numbers. As well as the headline number, it is well worth watching out for the unemployment rate percentage and any revisions in the previous month’s number. If there is an extreme variation from what was previously reported and the headline number is benign or as forecast, markets can move equally viciously. Payrolls are great fun to watch, but they are tricky to trade. The safe option is to be a spectator!
The middle of the month brings one more significant “growth” number and several “inflation” gauges. Retail sales reports are often anxiously awaited. They are the foremost indicators of consumer spending or consumption, and retail sales makes up about one-third of GDP. We are looking for positive readings or surprises that will contribute to dollar strength. The University of Michigan Index of Consumer Sentiment and the Philadelphia Federal Reserve manufacturing index also help build the picture of how robust the U.S. economic situation is. Add to this the reports on new and existing home sales at the end of the month, as well as the durable goods report, and most people can get a fair idea of whether the prospects for GDP are good.
On the inflation side, the Producer Price Index (PPI) and the Consumer Price Index (CPI), released midmonth within days of each other by the Bureau of Labor Statistics, are two of the foremost inflation indicators. The PPI measures the change in the prices of goods sold by domestic producers. The CPI is a monthly index for prices paid by consumers for a representative basket of goods and services. Positive percentage changes mean that there is some level of inflation in the economy. The PPI can be affected by energy prices. Lower energy prices should in theory lower the cost of production, which can then be passed on to consumers. The converse is also true insofar as cost increases will inevitably find their way to consumers. Any strong inflationary number will indicate that an interest hike is in the cards, and so generally the dollar will appreciate.
Other U.S. inflation announcements include the Personal Consumption Expenditure (PCE) Price Index, at one stage considered the favored measure of inflation used by the Federal Open Market Committee (FOMC) of the Federal Reserve Board, whose role it is to determine monetary policy. Core PCE excludes volatile food and energy prices. The PCE Price Index is also the largest contributor to the GDP Price Index. Inflationary employment costs can be gauged in the Employment Cost Index (ECI) report, which is released quarterly on the last Thursday of the month following the survey month. The report includes the most up-to-date costs as of the 12th day of the survey month. So the December 12 data will be included in the January report. The ISM Prices Paid report, which represents business sentiment regarding future inflation, is released on the first of the month, and the average hourly earnings report, released at the same time as nonfarm payrolls, help complete the inflation picture.
In the United States, there are several important numbers atthe beginning of the month, in the middle of the month, and at the end of the month. The periods in between tend to be a bit quieter, although the FOMC meets eight times per year and releases its minutes about three weeks later. In addition, GDP is released quarterly, and there are monthly announcements about advanced estimates.
For those who wish to trade in the quieter moments using a pairs strategy and hoping for nothing more than a meandering trading range, a study of relevant announcements in the countries of your chosen trading currencies may point toward potential periods of higher and lower volatility. Range trading pairs in periods with an absence of economic releases may have more likelihood of success.
Having said that, there are many external factors that affect currencies irrespective of domestic announcements, and the global calendar is incredibly full. In all countries we are looking for clues about growth and inflation and how they will impact GDP and interest rates. Interest rate announcements are exciting in themselves, especially if there is a hint of a potential move. Minutes of meetings are also potential market movers. If there is discord on a board or committee as to the direction of interest rates, it is something that may have more influence in future meetings. We should also be looking for relative moves in interest rates. A half-point drop in a country with interest rates at 10 percent is only half as much as a half-point drop in a country with interest rates at 5 percent.
OTHER COUNTRIES’ ECONOMIC ANNOUNCEMENTS
We have covered the U.S. dollar, but for what are described in foreign exchange vernacular as the other “major” currencies—namely, the Australian dollar, New Zealand dollar, British pound, Canadian dollar, Japanese yen, Swiss franc and euro—there are many similar announcements to those that are released in the United States. Below are some of the more important announcements to watch out for.
Interest rate announcements are top of the list. The United Kingdom and Australia announce interest rates once a month (Australia skips January); the United States, Canada, Europe, and Japan, eight times per year; New Zealand, seven or eight times per year; and Switzerland, four times per year. In any given month there may be anywhere between two and eight announcements among the majors.
GDP is reported quarterly in all of the above countries. And similar indexes with regard to retail sales, inflation, manufacturing, confidence, and housing are all released either monthly or quarterly. In the eurozone, it pays to keep an eye out for German economic indicators and also the ZEW survey, which is a monthly survey of economic sentiment from 350 or so German economists.
In Japan, the quarterly announcement of the Tankan survey released by the Bank of Japan is a much awaited poll of business growth. The “large manufacturers’ index” element of the Tankan is considered a leading economic growth indicator. Any speech by a central bank leader can also cause market volatility. Other significant market moves usually follow economic announcements from China. Several economies, particularly those that export commodities to China, will see their currencies bounce around when China reports its growth numbers. Any net importer or exporter of oil can see its economy and currency affected by changes in the price of oil.
There are thousands, if not millions, of people trying to predict the course of market movements on the back of economic announcements and the future course of interest rates. Many people will have their preferred statistics or batch of statistics that they use to formulate trading decisions. It is arguable to whether we can derive any immediate competitive advantage from studying them. A great many hindsight traders can say that they correctly predicted a move after an event but didn’t trade it; and after a period of strongly trending economic figures, a great many traders can comment about how obvious a particular currency’s strength is as a result. But ask these people to tell you which way a currency is going to trade in the next day, month, or year, and we’re back to a 50:50 bet. Depending on your trading style, you might never look at an economic announcement at all. Some people try to combine economic analysis with technical analysis to choose better entry and exit levels for their trades.
Whatever methodology you use, there are three possible outcomes for a currency pair immediately after an economic announcement is released: it can go up, go down, or stay where it is. Frequently, markets jump and then revert to where they were before an announcement was released. It is well worth monitoring this because it can form a trading strategy in itself. James Ax, one of Renaissance Technologies’ original traders, was a proponent of a mean reversion strategy, especially if markets had moved sharply on the open from the previous night’s close.
In other cases, if, for example, an interest rate change occurs that is largely expected by the market, the market can move up in the days, hours, and minutes before the announcement and then trade lower soon afterward. This fits into what traders call “buy the rumor, sell the fact.” Before the release of any important announcement, it is worthwhile to read up on what the consensus estimate is. Remember, though, that this is generally a consensus of economists and not traders and also that the sample is still small relative to the absolute size of the market. The market, if it is efficient, has priced in all knowledge about economic events and therefore trades at its current level because it has absorbed all news, views, and positioning.
Announcements, unless way out of line, in reality should not disturb the status quo of the market. That is why we should take time to watch how currency pairs move when economic announcements are released. In the course of six weeks, we can get plenty of practice. And writing down the market reaction immediately after any announcement may inspire many future potential trading strategies. Trading directionally on individual data releases can be hit or miss. I would urge caution. With economic announcements, it pays to be aware of when they are due for release, and they can certainly help in reinforcing a macroeconomic view. There are many numbers to trade over a month, but trading all of them is not advisable.
Trading non-U.S. dollar pairs of currencies can be an effective alternative strategy—for example, limiting trading to, say, EUR versus GBP or AUD versus NZD or any other pair of currencies. The influence of the U.S. dollar can be virtually removed, therefore allowing the trader to focus full concentration on just two currencies and their economies. It is still important to monitor what’s going on elsewhere because moves in the yen and dollar can effect cross-currency pairs such as EUR/GBP and AUD/NZD. In periods of bond or equity market turmoil, the yen strength is sometimes a factor, as it certainly was in 1998 (Russia default) and 2008 (global financial crisis). As yen crosses were sold off, both EUR/GBP and AUD/NZD appreciated.
On the subject of the Japanese yen and the New Zealand dollar, there have unfortunately been a number of devastating earthquakes in both these countries. The 1995 Kobe earthquake and the 2011 Tohoku earthquake and resulting tsunami brought tremendous pain and suffering to the people of Japan, as did the 2010 and 2011 Christchurch earthquakes to the people of New Zealand. The resulting currency moves were initial weakness in local currency followed by strengthening of the currency due to repatriation of yen and New Zealand dollars to rebuild infrastructure. As ghastly as wars may seem, the Swiss franc tends to be a winner in such situations. The Swiss franc is known as a safe haven currency, and it strengthened notably during the buildup to the first and second Gulf Wars.
SHORT- AND LONG-TERM STRATEGIES
For most traders new to FX, attention will typically be drawn to trading with some sort of technical strategy or delegating trading authority to a third party that uses some sort of technical strategy. My view is that economic cycles happen in years, not in minutes or ticks; therefore, technical trading strategies, which in some ways tend to reflect economic fundamentals, will evolve over years too. That is to say, any technical indicator that is applied to monitoring short-term ebbs and flows in the market is merely monitoring noise. If somebody tosses a fair coin and heads turns up eight times in succession, the odds of heads turning up a ninth time are 50:50. Similarly, if EUR/USD ticks up eight seconds in a row, or eight minutes, or even eight hours, it’s totally possible that this can continue for eight days. Trading short time frames with any accuracy is a game of chance. All the pretty charts and fancy jingles are just color and noise.
Trend following is a longer time frame strategy that involves huge amounts of patience and discipline. It is also worthwhile to note that longer-term trend following strategies should also utilize less leverage due to the fact that drawdowns can be large. Successful traders and their systems, such as John Henry and Turtle trading, initiated trades with low amounts of leverage, and they incrementally increased leverage as successful trades moved more into-the-money. At any one time, it is unlikely that they had capital leveraged by more than 8 to 12 times. Once a trend was caught and it was in force, they traded with trailing stop-losses. They let their winners run and didn’t take short-term intuitive profits.
What does this mean for any would-be trend follower? It means we can do the same. First of all, if you are looking at charts, focus on longer time frame charts, such as monthly, weekly, and daily. Choose the currency pair you wish to trade. Look to see if there are any economic fundamentals that might influence your trade (although strictly speaking, they should be ignored). Have a strategy in place for initiating your trade, adding to it, and stopping it out if the trade goes wrong. Do not overleverage or double down on losing trades. Have the courage to run winners, which means that you have to have a written exit strategy in place and stick to it.
On the subject of drawdowns, John Henry had several peak-to-trough drawdowns in the region of 20 percent to nearly 40 percent. These normally followed periods of superlative out-performance. It makes sense that by incrementally ratcheting up leverage as performance improves, both gains and losses can be magnified. But a stop has to be in place, whether that be on initiation of the trade or a trailing stop. Once the stop is elected, the trade is over. If the stop is not triggered, toughing out a drawdown is part of the deal for any trend follower.
Trading options can be difficult as a retail FX strategy, primarily because you will overpay for the options you buy and you will not receive enough premium for the options you sell. The overriding advantage of buying options as part of an FX strategy is that if one is long an option, the temptation to trade in and out of the spot market can be negated. Therefore, while buying an option may be expensive, it may work out to be cheaper in terms of transaction costs than continually trading spot.
If you have a propensity to overtrade—and many people do—trading options may be the tool you need to instill trading discipline. Options give your position time to move in the direction you want, and so they can also take away part of the trauma of being stopped out. But remember the dual value killers of overpriced volatility and time decay! Implied volatility is higher for out-of-the-money options than for at-the-money options. Time decay starts to increase more rapidly from about six weeks out until option expiry. Short-term options can quite quickly lose their value, and so it may be best to purchase options of longer duration. Selling options has its dangers, and it requires deep pockets if a naked selling strategy is adopted. A big move against you can quickly wipe out all premium and leave you substantially out of pocket if the option is in-the-money and is exercised.
Selling options could be incorporated as part of a strategy if a spot position has significant profits. Say, for example, you are holding a long AUD/USD position that has 500 to 600 pips profit. A short duration out-of-the-money AUD/USD call could be sold to benefit from collecting premium. The hope would be that the spot price would move higher than, but not as far as, the option strike. If the option expires worthless, you collect the premium. If the option reaches the strike and is called away from you, it will act as a take profit on your spot position.
NON-DELIVERABLE OPTIONS (NDOS) AND NON-DELIVERABLE FORWARDS (NDFS)
A market that is evolving is the non-deliverable options (NDO) market, which is effectively a market based on non-deliverable forward currencies such as the Indian rupee, the Malaysian ringgit, the Chinese renminbi, and the Brazilian real, among others. Arbitrage opportunities exist in some of these options versus their exchange-traded counterparts. To effect any arbitrage, however, generally at least two brokerage accounts need to be held and sufficiently funded. Brokers and banks in many cases are somewhat reluctant to allow clients to write options. Any option that is traded needs to be in a market amount, and so it is unlikely also that unless an option is of sufficient size—a minimum of, say, $500,000 to $1 million—a broker will be prepared to offer this facility. As account size gets bigger, a meaningful brokerage relationship is formed, and clients demonstrate the necessary expertise, options can add a useful alternative means of trading.
Non-deliverable forwards (NDFs), in my opinion, are as yet little-known trading products that clients should consider trading as part of an FX portfolio. There are risks of course, and the chief one is volatility. Anybody who witnessed the collapse in the Russian ruble in 2015 or the significant devaluation in the Brazilian real would understandably advise trading such currencies with extreme caution. I would urge the same; while both Russia and Brazil have interest rates in excess of 10 percent, their currencies can weaken by more than 10 percent in a month.
Having said that, in defense of trading non-deliverable forwards, I would argue that they offer exposure to BRIC and emerging market economies via a currency play, and they offer attractive rates of interest. Furthermore, nowadays most western equity markets take their cue from growth in emerging markets, so trading NDFs is an easy way to access these countries without having to buy into a fund. Trading EUR/CHF with 400:1 leverage to earn a pitiful positive interest rate carry turned out to be one of the riskiest trades of the century. Perhaps trading Indian rupee or Chinese renminbi with very small amounts of leverage of only two or three times may offer a slightly less risky alternative with commensurately better returns.
I do not advocate excessive leverage in any form of currency trading unless the competitive advantage is legitimate, clear, and properly risk managed. But in all markets, in the current climate, in order to make returns of even 5 or 10 percent, some degree of risk, or in other words an acceptance that losses are now part of the game, must be incorporated into the strategy. Equity markets are a case in point—single stocks can move in excess of 10 percent in a day, up or down, and indexes can move by as much or more in a month.
Currencies are no different, and in fact, in many cases, they are much more stable. A clue to how risky it is to trade individual NDF currencies lies in the interest rates they offer (Table 9.1). If a long NDF trade moves in your favor, the benefits are capital appreciation and positive interest rate carry. The downside risk is that in some instances certain NDFs can halve or more in value over the course of a year, which makes some NDFs as risky to trade as crude oil. The upside is that they can therefore appreciate by similar amounts. Before trading any currency pair, it pays to be aware of the risks. It is probably useful to check trading charts to see where a currency is trading with respect to its historical trading range. Try to work out what significantly affects a currency’s strength. Always trade with sensible amounts of leverage. Especially with NDFs.
Major NDF Currencies as of September 2016
Access to NDFs may be difficult to obtain in all but a few brokerages. Futures are offered in some of the above currencies and can be traded on exchange. There was a big push by several exchanges, notably the CME in 2012 and the SGX in 2013, to offer INR futures due to their popularity in Dubai and the fact that there was an arbitrage between the exchange-traded INR and the NDF. There are certain reporting requirements to trade NDFs as they are considered derivatives. Whether they can be traded as a contract for difference (CFD) is open to debate.
QUESTIONS TO ASK YOURSELF BEFORE YOU TRADE CURRENCIES
Five important questions to consider when thinking about trading currencies are (1) how serious are you about making money, (2) how much capital do you wish to commit in terms of margin, (3) how much money do you wish to make and (4) over what time frame, and (5) how much are you prepared to risk (or lose) in pursuit of your profit objectives? Answering these five questions will help you form part of a workable trading strategy.
If we analyze the returns of George Soros, John Henry, and Jim Simons, who are among the best of the best, we can see that consistent annual returns of 20 to 40 percent can compound to enormous gains over time. Nobody should be of the opinion that they can make 50 percent or 100 percent several years in a row. Making an enormous return may happen as a one-off, but it is unlikely to be sustainable without commensurately taking huge risks. Neither Henry’s funds nor Soros’s were impervious to losses either. Soros’s fund took a hit in 1981 of nearly 23 percent after achieving returns of nearly 103 percent in 1980.
Henry regularly had drawdowns of 20 percent and more and once racked up 9 months of consecutive losses in a period of 14 monthly losses out of 15. The fact is that both men controlled their risk and leverage, and so the drawdowns were relatively small compared to the outsize gains they both made. As a rule of thumb, in FX trading, we should be prepared to risk about half of what we expect to earn. So if 30 percent is your target, then be prepared to risk 15 percent. People who trade equities are getting used to 10 or 20 percent drawdowns in the value of their portfolios, and so it should be no different in trading currencies.
It is up to each individual to set his or her capital and risk levels. If the capital-at-risk limit is hit for any one year, then it is advisable to stop trading and take time out to reassess both strategy and aptitude for trading currencies. A break will do you good. It may also be a good idea to reduce capital employed in trading by an amount similar to your loss. For example, if you lose 10 percent of your account equity, it may be advisable to trim off another 10 percent of account equity and recommence trading with 80 percent of your original investment. This is a tactic that was employed successfully by Richard Dennis’s Turtle traders. If, of course, the strategy is successful, the gains can be reinvested and compounded.
A quick look at compound interest can also help in setting a reasonable time scale for achieving required returns:
A compound return of 5 percent will double capital in a little over 14 years.
A compound return of 8 percent will double capital in about 9 years.
A compound return of 10 percent will double capital in a little over 7 years.
A compound return of 15 percent will double capital in 5 years.
A compound return of 26 percent will double capital in 3 years.
Once you have an idea of your target annual return and your overall goal, you can now break down your trading strategy to work out how you might best achieve your targets. For example, if you wish to make 15 percent annually, it might amount to five winning trades making 3 percent or just one of 15 percent. (A 3 percent move in a currency with five times leverage can achieve this goal.) It may be several smaller trades. Pure trend followers will have to keep a figure in mind and ride the trend both upward and downward. If you wish to make 15 percent, be prepared to lose 7.5 percent. If you wish to make 26 percent, be prepared to lose 13 percent. Just by doing this exercise, you will see that you do not need to trade every single day or on every economic announcement each month in huge multiples of your capital.
Setting an overall loss limit that is acceptable to you will help you be mindful of your capital and hopefully avoid the disaster of exaggerated losses. A loss of 50 percent of your capital means you have to make 100 percent to get back to even. A loss of 75 percent means you have to make 300 percent to get back to where you started.
On the subject of getting back to par, there are some advocates of what is known as a Martingale strategy—that is, doubling down exponentially to double your original stake. For example, a gambler bets on the toss of a fair coin. He bets 1 unit on tails, and it comes up heads. On the next toss, he bets 2 units, then 4, then 8, 16, 32, and so on until tails comes up. On his bet of 32 units, he wins 32 units, which covers his loss of 31 units and gives him a 1 unit profit. This is a strategy for the bold who have deep pockets. Whoever uses it must also assume that currency trading ranges revert back at least to where they started. It is not going to work in trending markets if you are on the wrong side of the trade. If you consider the sequence 1, 2, 4, 8, 16, 32, 64, 128 and replace the word “unit” with “times leverage,” you will quickly see that risk and danger quickly mount. Thus 128 times leverage requires less than a 1 percent move against you to wipe you out.
DECIDING HOW MUCH CAPITAL TO INVEST
A large question that should be on everybody’s mind is exactly how much capital to invest in currency trading, and there is no straightforward answer to this. It really depends on what you are looking to achieve and what sort of commitment you wish to focus on the project. Is your idea to earn some extra income, earn a living out of trading, become a fund manager, write trading programs, or run your own brokerage?
FXCM’s statistics support the notion that small accounts of less than $10,000 tend to perform less well than those of more than $10,000. Billionaire Peter Cruddas started what became CMC Markets with a GBP 10,000 investment, although it has to be said he was somewhat of an inter-dealer broker with a good client base before becoming an online currency broker. John Henry had an initial investment of $100,000 and made 9.93 percent, 20.66 percent, and 61.55 percent in his first three years of trading. If you have an audited performance of three years of positive returns, then in many instances, you have a marketable track record. Henry’s assets under management grew 15 fold in his fourth year of trading.
Trading giants Ken Griffin of Citadel and George Soros started trading with assets of between $4 million and $5 million. They have made billions. My view is that whatever capital you commit to trading, you should use it as capital to win. If you wish to be frivolous with your money, then don’t trade. You can use it for better purposes. As Ed Seykota once remarked, “Win or lose, everybody gets what they want out of the market. Some people like to lose, so they win by losing money.”1 I once took a friend of mine to the casino in Monaco. He said he had 200 GBP to lose. Sure enough, he lost it. Try not to make the same mistake trading FX.
If becoming a market maker or broker is your wish, $1 million might capitalize your own brokerage in certain jurisdictions, but then you will have to commit as much and more to staff it correctly and market your brand. A $5 million to $20 million investment may bring you into the realm of being a small brokerage with your own prime broker in better-known jurisdictions and enable you to offer a greater array of products. You will have plenty of competition and regulatory scrutiny.
ALLOCATING YOUR CAPITAL
If professional trading is your goal, I think you need sufficient capital to diversify your risks. I believe you need access to a whole suite of products—namely, spot, futures, options, NDFs, and NDOs. This may mean you need to have more than one brokerage account. Be mindful of whether your broker acts as agent or as principal to your trades—that is, does the broker pass your trades straight through to other market makers, or does he or she take the opposite side of your trades? The choice is yours. Larger accounts tend to prefer a straight-through process to avoid conflicts of interest in pricing from their broker.
There is certainly money to be made in FX, and all styles of trading have their moments of success. A diversified portfolio with percentage allocations to different strategies may offer a path to superior performance. It will in some ways aid in stemming volatility compared to one single trading theme. For example, you might allocate 20 percent of your capital each to five different strategies, such as a macroeconomic view on a pair of currencies, trend following, carry trading, mean-reversion trading on economic figures, and non-U.S. dollar pairs trading. If you apply leverage of 2 times capital to each strategy, you will arrive at 10 times leverage for the whole portfolio, which is an ample amount of risk to take.
If you have sufficient capital, training, and expertise, strategies involving options, NDFs, and NDOs can be embraced. It can be a very useful undertaking to diarize your trades before and after trading. What is the logic behind the trade? What are the profit objectives, and where is the stop loss? How did it work out? What lessons did you learn? It might seem like a pain to do this for every trade, but it will instill trading discipline and check the temptation to overtrade.
Arbitrage has proved to be a successful strategy for many who have the resources and speed to capture price anomalies between exchanges and the spot or NDF market. Arbitrage requires either intense concentration or a speedy computer algorithm, normally connected via API. It is highly unlikely that a broker will allow you to connect to his liquidity via API if your tactic is to arbitrage. Picking off the banks in a latency arbitrage strategy can quickly lead to no liquidity at all. If a trader engages in an arbitrage strategy, it must be properly risk managed to monitor trade rejections that do occur from time to time.
Whatever your approach to trading and however much your initial investment, one thing for sure is that you will have a better feel for the risks you are taking if you manage your own money. The more “skin” you have in the game, the more acutely you are likely to feel the joy of winning or the pain of losing. Strictly speaking, you should keep your emotions in check and stay focused on your strategy because if emotions creep into the equation, it can change the dynamics of your trading tactics, and you may become less rational in your trading decisions.
At the outset, your initial investment and your stop trading limit should be of an amount that you are comfortable managing. And your profit objectives should be realistic and attainable. If they are not, then you are likely to be stressed before you start, and your decision-making processes may become impaired. As your account grows, you must continually try to stay focused and rational and apply the same discipline to your trading however much money you are managing. For some people it will come more naturally than to others. Two of the greatest traders for managing pressure are George Soros and John Henry. Huge P&L swings can unnerve all but the best traders. These two men traded colossal amounts and had P&L swings in the multimillions, but both came out on top. It’s an entirely different skill set to contend with, but staying focused under pressure is no less relevant to small than to big accounts.
BEING GUIDED BY THE FOUR PRINCIPLES
At the beginning of this book, I suggested that there were four basic principles that when followed contribute to trading success in the foreign exchange market: do the work, cultivate a competitive advantage, work out how scalable your trade is, and manage the size of the risk so that it is appropriate and effective for the size of your trade.
This chapter, in essence, has been about applying yourself or setting yourself up to do the work. Previous chapters have described styles of trading or innovation successfully employed by the Currency Kings and other smaller market participants to reap untold riches from the market. I hope that they will inspire budding traders or entrepreneurs to focus intensely on ways they consider they can compete with and beat the market. By “beating the market,” I mean winning and adopting a serious attitude to winning. A competitive advantage should not be confused with a lucky streak, and we should all be humble enough to know the difference. That said, if anybody has a legitimate competitive advantage, it should be scaled up for maximum effect.
The dangers in the market are clear, and the most glaring danger is the individual trader to himself or herself. Overleveraging and overtrading go counter to effective risk management. If there is such a thing as a traders’ graveyard, most of its occupants got there by doing the above or letting bad trades ruin them.
Many brokers have done their homework, and they have made their money by taking the opposite side of trades of foolish investors. There are of course many other leakages in the system that can contribute to underperformance, and these include spreads, commissions, and financing charges. Slippage or poor execution of market orders that can be exacerbated by the influence of high-frequency traders can also degrade overall returns, which therefore make the chances of winning less than 50:50. Delegating power of attorney to Expert Advisors or trading robots is unlikely to yield superior returns in terms of either the likelihood of winning or the scalability of winning. It is arguable that any single trader has a better chance to win than by passing that authority to a third party, especially when management and performance fees are included.
It is imperative that we go into foreign exchange trading with our eyes open. If we choose to self-trade, then we should do so with a well-thought-out strategy. Currently the statistics are poor among retail traders, with only about one in five making money. I hope that by reading this book, many new budding traders shift that winning percentage to 40 percent and above. It can be done!
While I have been inspired by many of the greats of trading, I have also taken inspiration from the many humble smaller traders I met during my time in Dubai. In many ways, these people did everything right in their application of the four basic principles mentioned above. They discovered a market where they had a competitive advantage and exploited it to the fullest. In their case, it was an exchange versus NDF arbitrage. What it tells me is that there are some very smart, intelligent traders out there who can become the next great FX giants. Everybody has to start somewhere, and without doubt there will be many more self-made currency millionaires and even billionaires.
There are several other great traders who could quite easily have made the grade as Currency Kings and whom I have not mentioned in this book. These people have also utilized trading styles and run businesses similar in type to those mentioned in the previous chapters, whether it be global macro trading, futures trading, trend following, option trading, carry trading, arbitraging, building software, or running brokerages. While I admire the courage and determination of the big hitters, I’m no less in awe of the operators who make small relentless profits, and I also respect the brokers and software providers who create a market where millions of people can try their hand at trading FX.
My single biggest hope is that the market remains fair for all participants, and in that respect, I believe people should be properly briefed and aware of the risks before they start to trade. I believe the onus is on brokers to provide a fair market and regulators to work with brokers to make sure this is the case. I’m firmly of the belief that more FX education would be helpful, and I urge budding traders to seek it out. FX is a fascinating market and there are many ways to access it and to make meaningful profits.
Preparing, mind, body, and strategy will certainly aid with the mental challenges that lie ahead. Preparation is one thing, discipline is another, and perhaps for those who make it big, luck plays a part. What sets the Currency Kings apart is their unrelenting pursuit of excellence. Courage, tenacity, willpower, and perseverance are all key traits. Tactics, competitive advantage, discipline, and risk management are others. What made these men billionaires was scale, and that can be seen either in Soros’s blockbuster GBP trade or in the prevalence of Fatkhullin’s MT4 platform. Ultimately scale is the differentiating factor between small and large gains.
It is worth repeating John Henry’s maxims because they are inspiring and relevant:
• One must have a valid personal philosophy.
• There is no Holy Grail to trading.
• Discipline is more important than genius.
• Persistence is more important than talent.
• Performance is more important than capability.
• Ability to create value is more important than ability or creativity in any realm.
• Continue to look for ways and to think about how you can create value.2
It tells me that it is possible for anybody with the right attitude to become a successful trader. The last maxim is akin to George Soros’s maxim to “stay ahead of the curve.” Innovation, looking for value, and looking for ways to win must always be present in any successful business or trading strategy. We have plenty of products to trade.
We also now have an idea of how the Currency Kings started, how they applied themselves, and how they made their money, whether that was in speculating, market making, arbitrage trading, or building software. They are all inspirational, and they have made the market what it is today. Now it is our turn. Good luck, and good trading! I look forward to reading or writing about the next Currency King!