Friday, March 6, 2009

Forex: Don't Sweat the Risk

Jim Martens, EWI's Senior Currency Strategist, regularly posts his thoughts on the business of forex trading in the "Market Insight" section of his intensive Currency Specialty Service. Here is an adaptation of Jim's latest "Insight."

Market Insight, February 22, 2009
By Jim Martens

Don't know about you, but for me, being away from the markets for a few days is rarely relaxing. The entire time I’m wondering what prices are doing; is my outlook on the euro-dollar exchange rate, for example, proving correct or incorrect?

What mainly concerns me is how much work I may have to do when I return. If the EUR/USD and other forecasts prove correct, I can jump right back in; if not, I may have to play a lot of “catch up.” But my concern is usually not about the risk associated with the forecast. Let me explain.

In my daily commentary, I have frequently spelled out my lack of concern regarding market risk – which is, that as someone who analyses and forecasts currencies each day, I have already accepted that risk. If prices violate a “critical” level that I've identified for my Currency Specialty Service subscribers, by the very nature of Elliott wave analysis the associated loss was already known in advance and considered reasonable relative to the potential profit. If my “critical” price point was not broken, then my outlook still stands – so, again, where is the worry?

What helped me to adopt this approach to risk is a book I read early in my study of markets and trading. For the life of me, I can't remember the author's name or the title – BUT I do remember two main points the book stressed:

One: To succeed as a trader, you must understand at least the basics of the markets you trade. In one example the author described an analyst who suggested that coffee futures had gapped its limit because it was winter – he saw snow falling outside his New York office – and so a freeze must have damaged the coffee crop. The problem was that it was summer in the coffee-growing areas. Fundamental analysts' sole focus is on events related to the markets, but even a technical analyst must understand his or her market's basics: what, where and how.

Two: Once you reach an opinion on the market, the risk must be reasonable relative to the potential reward. A disciplined trader should stay with their opinion until either a) it was proven incorrect, or b) the market offered new evidence sufficient to over-ride the original opinion. Bottom line, once committed stay committed – until the market tells you it's time to un-commit. Emotion should have no part in this process.

The book gave sailing as the metaphor for the ideal trading scenario. Once you complete your analysis, identify the opportunity and place the orders – "board" your "sailboat" and sail along the coast. Every few days you could "pull into port, restock supplies," update your data and see which of your orders have been executed. Back at the "boat," you update the charts, make any adjustments to existing orders and enter new ones, as needed. Then you "shove off" your fictional boat until the next "port" – and repeat the same sequence.

This approach, as well as taking time away from the market, removes the temptation to change your opinions with every tick. It reminds me of the days before the internet and real-time quotes were available to everyone. Back then, the lack of instant information made it easier to stick with your analysis and ride out the short-term swings. Maybe I should work just one day a week and sail the rest… How does that sound to you?

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