Morning!
Seriously, it’s the European morning. I actually got my piece finished early today!
Yesterday, I took a trip down memory lane of Movembers past. I also finished up with a disappointing ending fit for an eighties porno, by talking about that untradable anticlimax of a currency pair known as Euro/dollar. If you stumbled upon my post by accident after typing “Euro Porno” into Google, then hahahaha! It should go viral any day now.
Time to get serious again, though. 1985 called, asking me to return it’s moustache.
Risk management
There’s a few methods people have of managing their risks, and making a pig’s breakfast of it is the easiest way to lose money. What are my thoughts?
I prefer to manage exposure based on actual cash gains/losses, rather than using pips. The value of a pip is not identical between currencies (what’s the denominator?), nor is the probability of any given movement sized in pips (volatility, which way round is the pair quoted, etc).
Two trades are not alike, though. I adjust position size based on distance to stop loss (remember I’m basing decisions on actual spendable money), the total risk reward (or profit factor – distance to take profit divided by distance to stop loss), and how much conviction I have about a trade. Of course, low conviction trades will generally not get entered. However, I may make a smaller or shorter term trade as a soft hedge on another significant exposure.
Minimum risk/reward ratios I accept need to be periodically measured against my overall profit/loss ratio over time, to ensure they are large enough to maintain profitability. As a longer term trader, I also reduce risks by moving stop losses in stages and/or taking partial profits on major trades at early support/resistance points. This allows me to remain positioned for potentially significant moves, without snatching losses from the jaws of profits.
This is simple stuff, but the challenge is having the discipline to follow this in an unemotional way. I think, the best way to describe it would be to use a betting shop analogy. Think like the bookmaker, not the mug punter. It’s all maths, maths, maths. It’s only basic arithmetic, but it’s important. If you want to get fancier and do advanced quant algorithms, be my guest. The basic maths I described is a minimum requirement, not a maximum. Any maths that increases you profitability is a good thing.
Of course, as an account grows, so does the opportunity to increase trade sizing. Percentage of account is one way this is often done. This is perfectly good, but with one caveat. I refuse to include paper profits in the calculation. Unrealised profits don’t count. They might as well be Monopoly money. I prefer to set the unadjusted base trade size in currency rather than percentages. I then review it several times a year (using percentages as a guide), rather than letting trade sizes go up and down like a yoyo every time a profit or loss affects my account size. The next point also affects the calculation.
I also have an opinion of what constitutes “risk capital” which is independent of account size. Profits don’t automatically get added to my risk capital. When I make my routine review of trade sizes, I may choose to add them to the risk capital pot (and hence allow them to affect trade sizes), or I may choose to withdraw them. Until then, they remain outside the my risk calculations, for all intents and purposes.
In addition, money does not have to be in my brokerage account to be part of the capital I am willing to risk. The entire pot is never going to be on the line at once. Whatever isn’t required (or likely to be) for margin or to cover potential losses might as well be earning interest – and the best at call interest available. If it’s not getting that in the broker’s account, it’s better off somewhere else. It can always be used to top up the collateral at the brokerage later, if need be. Just leave a big enough buffer in there.
Then there’s the issue of margin and leverage. I calculate collateral and risk requirements based on the amount I will lose if the stop loss is hit. For me, this is greater than my margin requirements. So, the margin required by my broker becomes irrelevant. If margin required is higher (for example, if you are a short term trader), I would use the higher figure. In that case, I would shop around for high leverage also (but don’t move to high commission or dodgy handling of collateral to achieve it). Remember, risk capital not currently required can be earning interest elsewhere (just remember a buffer, and what you might need for next week’s trades).
Most important thing: Make sure your broker is registered and domiciled in a well regulated jurisdiction, with good practices for handling client funds. Also look at their business model. This is a massive risk factor. Profits are useless at a broke broker (I wonder if the Broke Broker could be performed to the tune of The Jean Genie).
Income management
This is more maths. It also makes use of some of those economic numbers we keep getting fed. Let’s assume, for a moment, that all those economists’ assumptions are actually possible to replicate here on Earth. I understand that it’s a stretch.
If we assume a static pool of risk capital, and trading results that deliver similar average performance over time (that is ignoring short term fluctuations, and looking at the long term average), then we end up with a static income in nominal terms. This was probably fine if you lived in Japan before Messrs Abe, Aso, and Kuroda started firing arrows into that income management plan.
It results in a falling real income for everyone else, however. So the key for me, is to grow the pot at a higher rate than my estimate of long term inflation. Pick your favourite measurement here. If you want a real pay rise over time, this needs to be taken into account also, and the amount added to you risk pool (that is, not withdrawn and spent). After this calculation, the remainder is your income. You may choose to allocate a portion to other types of investment (For example, a fixed interest portfolio from which you draw a smoothed income for general expenditure – you’re making the big bucks if you can do this, though. Good for you!).
Lumpy income is another challenge to deal with. You may have to accept large irregular payments, which requires management of your spending. This is a different paradigm to weekly or monthly pay cheques. It just requires application the same discipline that causes successful trading to be applied out there in real life.
Lastly, do you have big goals, like buying a nice big house, or car, or emigration, or kids’ education fund? This is the time to focus on just building the pot and taking as few withdrawals as possible. This is the phase I’m in. Of course, you could just get a bigger mortgage. However, investment loans are more likely to offer a tax benefit. Good luck getting that on a residential housing loan, for example. Personally, I think we all have quite enough leverage already.
If you are exposed to a currency other than your home currency, take that into account also. I like the idea of maintaining accounts denominated in each of those currencies – whether it be brokerage accounts, regular savings accounts, or both, depending on how you are managing our risk capital allocation. The “basket” would then need to be weighted. This would apply mostly to expatriates who maintain links to home, or to people from countries such as Ireland (which has two currencies, Sterling and Euro) who live/shop/work near a national border (or reserve the right to do so).
Of course, don’t forget to review the best trading conditions on offer as your volumes and balance increase.
The Trade: AUDCAD
All change, all change, The next stop is the big bucks? The area between 98 and par has held a resistance or a support since 1999 (possibly earlier, don’t have the data).
From 1999 to September 2010, it held the upside for all but all but half a year. It has several tests. The declines after these tests from 98 were (rounded down to the nearest big figure): 21, 7, 16, 23 (26 if you count the wick on the spike low), and 12. That’s an average of 15.8 big figures peak to trough.
Between October and March 2010 the price moved from below to above this 98 to par zone. From October 2010 to May 2013, the zone successfully held the downside (without fail). We were rejected there on four occasions. We had three rallies of five big figures, and two rallies of seven.
We have now broken below the zone again. This is where the bigger moves were. If this zone maintains its role, and we have not made a false break, this zone is a good place to look for a sell. I’ll be selling on any moves towards 98, with stops above par. Targets? I’ll look at them on a case by case basis. Save to say, there’s room to leave money on the table for some big moves, in my opinion.
The fundamentals are fine. Australia’s main export to China, metal, is in the doldrums. Australia’s main export to Europe, annoying gits on temporary working visas pulling pints, is struggling under the weight of obscene house prices (and expensive everything else too). Canada’s main export, shown in this chart, is in much better shape.
If war fears are calmed by further Canadian government apologies for Bryan Adams, Loonie fundamentals could see a dream run. Ride on the peace train, I say!
Join me tomorrow for Casual Friday!
Comments Welcome!
