how to trade 5.2

8/6/2019 How to Trade 5.2

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Richard OlsenHow to Trade

ISBN: 978-3-9523708-0-3


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IntroductionHigh requency inance, with the analysis o tick-by-tick market data, oersnew insights in how to trade. Beore you continue reading, I want to cau-

tion you that over 80% o the traders in any one-year lose money. O the 20%who ended with a prot, many were just lucky and are likely to lose money

in the ollowing year. Does this mean that it is impossible to make money in

inancial markets? No, deinitely not it is easible to earn money on a con-sistent basis, but it is diicult.

The reason why you can make money is simple: during the course o one

year, the price risk is a lot smaller than the proit opportunity. The pricechange rom say the 1st o January to the 31st o December or a particular

exchange rate is 10, 20 or rarely 30 percent. I you sum up all price move-

ments larger than 0.05% during the course o one year and deduct transactioncosts, then you could, with perect oresight, earn 1600% without lever-

age - that is more than 50 times the risk o 30 percent, so a big opportunityto make money does exist.

Trading is so diicult because o the volume in liquidmarkets is speculative; only 2% is undamentally driven. The 98%, the

speculative volume, is the majo r orce o the market determining the pricetrajectory you need to understand the behaviour o the speculative

traders to make money.

The impact o speculative trading is harder to decipher than undamental

market orces because speculative positions impact the market twice:irst when a trade is opened and then again when the position is closed. This

duality makes it diic ult to correctly analyze price movements. To makethings even more complex, there are dierent groups o speculators, inclu-

ding short-, medium- and long-term traders, traders based in Europe,

the US and Asia, trend-ollowing and counter-trend traders and many more.

Published by THINK ABOUT Press, Olsen Ltd.Zurich, Switzerland

Richard Olsen 2010No rights reserved

ISBN: 978-3-9523708-0-3

First Edition

All parts o this book may be used and reproduced in any manner without

written permission rom the publisher, especially in the context o reviews.

Illustrations and Design by Lisa Wilkens - newillustration.co.uk

98%


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In this small booklet I discuss how traders need to restrain their natural urge

to open large positions. There is an abundance o trading opportunities.

So or any one trading idea, it is better to reserve a limited amount o capitaland to have a contingency reserve in case that the trading idea was premature.

I also discuss apparently irrational market movements that turn undamen-

tals upside down. They occur when an initially small price spike triggers

a whole cascade o price moves uelled by a sequence o margin calls . Whenmarket participants have large unrealized losses, any small price spike

can trigger margin calls; the position closeouts increase the imbalance obuyers and sellers and uel a continuation o the price move, which may

last or only a ew minutes or hours, but can al so take days, weeks or evenmonths.

Finally, I will cover a number o dierent issues rom turning a losingposition into a proitable trade through active management o the position

to implementing stop loss strategy and trade diversiication.

This booklet does not include any technical or undamental analysis. In ge-

neral, the useulness o these methods is exaggerated. You might beshocked to read that I do not have a lot o aith in their ability to be good

predictors o inancial markets. These approaches scratch the suraceand can only spuriously explain the market movements they seem to work

precisely because the coastline o price movements is so long. The toolsare helpul because they provide a rame o reerence and are a means o mak-

ing your trading decisions more consistent: When you get bruised by big

losses or your ego gets ahead o itsel, you should stick to your trading stra-tegy when it prints money.

For ull disclosure, I need to add another remark o caution. Human traderscannot compete successully with sophisticated quantitative trading

models, which systematically process every tick o market data. Why do I say

this? Human traders can be compared to a physics proessor in an air-plane about to take o: in principle, the proessor knows all the principles o

aerodynamics that are put to work in the airplane, but he cannot explainand compute all the equations on the ly. Quantitative trading models have

a competitive edge; they are based on algorithms that aggregate theknowhow that researchers specialized in a number o disciplines have broughttogether, and deploy this embedded knowledge in a systematic and con

sistent manner; quantitative algorithms do not miss a price tick; they do notneed to sleep, eat or go on holidays.

To be honest, inancial engineering is still in its inancy and is not yet at the

stage o other engineering disciplines such as aerodynamics and computers.

I reckon that inance today is equivalent to computer technology in 1968 andthus has a long way to go.

Even though we, as human beings, cannot compete with quantitative models,

I deinitely ind it useul or us to learn to trade. Financial markets area driving orce o modern society, and it is important that we understand the

dynamics o inanci al markets. To acquire a thorough knowledge o mar-

kets, it is important that we get our hands dirty and learn to trade successully.

It is only through personal experience that we start to really understandhow markets unction. Some o you will enjoy the thrill o trading; it can belike playing sports or another competitive game. But beware; trading,

with all its excitement, can turn into an addiction. Only trade with as much

money as you can aord to lose; i you have not mastered the rules otrading, an unexpected price move can wipe out your account.


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You have timeThe most common mistake that a trader makes is to rush into a position tooquickly and to be too aggressive in his opening trade. There is no need torush into a position and make a big trade; you have all the time in the world.I strongly recommend that you temper your natural impulse o tradingat a high pace with large positions.

Let me explain why I give this advice. The coastline o the sum o all the upand down movements at a threshold o 0.05% has a length o 1600% orevery exchange rate and it is similarly long or other inancial instruments.With perect oresight, it would be possible to earn a whooping 1600% inproits per year ater paying or all the transaction costs. I in real lie a tra-der earns 3% by just trading his equity with no leverage, he is successulby any standard; i he earns 6% during the course o a year with no leverage,he literally enters the hall o ame. I you are able to successully realize0.375% o the 1600% coastline o proit opportunities, which is 6% on an un-leveraged basis, you get into the hall o ame. Hence, there is no need torush into a position. There is an abundance o protable trading opportunities;

choose your battle ground careully and only open a trade that youbelieve in.

The reason that I emphasize that you should choose your battleground care-ully and should believe in the motivation o your trade is simple: Finan-cial markets are ractal. They do not move in straight lines; instead, thereis a continuous up and down. Whenever there is a price movement in theopposite direction o your trade, you cannot be certain that the trend will re-verse. As you sit there and observe the market, you start to second-guessyour decision. I you have opened your position hastily, you will soon eeluncomortable with your trade and will then be inclined to close out yourposition during such a draw down and then open a trade in the opposite di-rection. I you do this, your trading will lag behind the market and you

will be out o step and just accumulate losses.


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Trade in small size

The most common mistake o a trader is to be too aggressive and open posi-tions that are ar too large. I the position is too large and the marketmoves temporarily against your position, you do not have suicient margincapital to pull your position through and are stopped out. You are thenorced to close out your position at the worst possible moment during a tem-

porary down tick.

As human beings, we are inclined to open positions that are too large becausewe are not very good at orecasting the size o tail events. Just try and re-

member when you last dropped a glass and had to collect the glass splinters.I am sure that you were surprised at how widely dispersed the glass

splinters were.

By analogy, the same i s true or market moves. The large market moves are

ar bigger than we expect. At all times, you need suicient reserve capi-tal to cushion an unrealized loss rom your open positions. I conjecture that

the most successul traders excel because they manage to keep exposure

very low; they rarely open positions larger than 10 to 20 percent o equity(at peak time, exposure or any one position will rarely be larger than

one time equity).

You can trade in small size and still reach your prot target because the coast-line o each instrument is so long and there are many dierent instruments

that you can trade in. Ater all, it is paramount to conserve your capital; iyou are stopped out and have lost your capital, you are out o the race.

.


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Beware o unoreseen price cascadesCurrency markets have a daily turnover o spot transactions o approximately1.4 trillion USD; this is a mind-boggling number, equivalent to approximately

10 percent o the annual US GNP. The daily turnover translates into a fow perminute o 1 billion USD, which is still a lot o money. I we go a step urther

and compute the volume per second, then t he turnover collapses to only 16

Mio per second, which equates to 8 Mio buying and another 8 Mio o sell-ing volume or all exchange rates together.

On a second by second basis, the volume is a mere trickle; this is a huge

contrast to the mind-blowing number or a ull 24 hour trading day. For theindividual exchange rates, the second by second volume numbers are a

lot smaller: or EURUSD with the biggest turnover, the volume per second is

3.5 Mio USD and, or a minor exchange rate, such as USDCAD, only a trileo 250000 USD per second. The trickle volume on a second by second basis

is also true or other markets, such as equity and ixed income markets.There the situation is even more extreme; the volumes in these other markets

are 10 times smaller or the i xed income and 50 times smaller or the

equity markets.

In oreign exchange, the spreads are low; or EURUSD, they are as low as0.006 percent. The size o the spread is small when compared with the

average daily price move o 0.6%, so the risk as market maker is high. I themarket maker cannot sell his inventory, then he risks incurring a large

loss. He can only generate a proit i he careully manages risk. He needs to

aggressively skew his prices up or down to minimize his exposure. I hedoes not do this, then a small imbalance o buying and selling will result in

a large exposure, where he risks incurring a loss. This implies that evensmall orders have a big price impact.

Compared to the trillions that are traded every day, it is thus paradoxical

that already small market orders can move the market. For minor cur-

rencies, 50 Mio is enou gh to move the exchange rate by 0.2 percent. For the


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Butterlies cause avalanches o cascading

margin calls

Price spikes trigger closeouts rom traders who have already accumulatedlarge unrealized losses and whose positions are hovering close to the stop;be it the voluntary stop o the trader or the margin call at which the market

maker will close the position.

I a price spike triggers the stops o traders and orces them to c lose theirpositions, the closeouts urther increase the imbalance o buyers and sellers

and induce the market maker to skew the price even more uelling a con-tinuation o the price move with more margin calls. Starting with a small

price spike, there may be one margin call triggering the next and turningan initially innoc uous price spike into a longer-term trend.

You need to be on the continuous lookout or likely avalanches. This iscomparable to a meteorologist looking at actors, such as the amount o snow

on the ground, to predict snow avalanches.

The open positions o traders around the world are the equivalent o thesnow on the ground. For a ew markets, there are services that publish

inormation on position inormation, examples are http://xtradeinocenter.

oanda.com/orderbook/open_orders_and_positions or rom the CME, thedata o open interest. From the price action, you should try to i ndependently

iner how market participants are positioned.

major currencies such as EURUSD, the necessary amount is roughly 100to 200 Mio depending on the time o day; these numbers are peanuts in the

bigger picture. To move the EURUSD by 0.2 percent, a trade o 200 MioUSD needs to be made, which requires as little as 5 Mio USD in terms o equi-

ty. It is astounding that an economy with a GDP o 14 trillion can have

its exchange rate moved by 0.2% due to the actions o a trader with 5 MioUSD o equity.

Because a small market order can move the market, there is no certainty o

the direction o the next price move at any time, there may be an unex-

pected price spike, up or down. It is suicient i just one person anywhere inthe world decides to buy or sell in size or a price spike to occur. Under

speciic circumstances, such a price spike can lead to cascading margin callsand bring about a price avalanche.


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Passive herding:how traders get locked into the same position

A characteristic trader behaviour is that traders tend to hold on to losingpositions but to take proits early with winning positions. Wheneverprice trends occur, traders on the right side o the trend closeout their posi-

tions, whereas the traders with the losing positions stick to their pos-itions. As the trend progresses, the ratio o trend ollowers and counter-trendtraders tends to become ever more one sided, and eventually 70 to 80percent o the open positions are counter-trend. This is passive herding; thetraders opened their positions or dierent reasons, some o them wereollowing technical indicators, others ollowed some undamental signal,but they now have something in common they sit on losing positionswith an unrealized loss and the likelihood o a margin call, i the trend con-tinues.

Whenever positions o traders are very much one-sided with only long or

short positions, the likelihood o a small price spike triggering a cascade

o closeouts increases. This is typically the case when the price has reached

a new extreme. In this situation, traders need to be careul and readythemselves or a likely avalanche due to cascading margin calls.

The herding behaviour is even stronger when the market has been trending

strongly and then rapidly changes its direction. Many traders will thenhave the alse expectation that the trend will just continue. They go on ope-

ning positions in the direction o the previous trend oblivious to the actthat the sign o the trend has changed. They are reluctant to realize losses

and thus there is strong passive herding. This is particularly dangerous;a minor event would be suicient to trigger a particularly violent cascade

o margin calls aecting all the traders who have been herding. The price

will then shoot o in the new direction starting a particularly strong new trend.


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Cascading margin calls turnundamentals upside down

Especially when undamental actors seem to avour a part icular direction,the likelihood o cascading margin calls increases. Traders are conident

that the undamental actors will prevail and establish aggressive positions.

They will even, more so than usual, underestimate the likelihood o pricespikes in the opposite direction. I a price spike then materializes, they get mar-

gin calls and have to liquidate their positions. As this happens, this willurther ampliy the price move in the opposite direction o the undamentals

and trigger margin calls with even more undamental traders orcingthem to closeout their positions and urther uelling the price move. The unda-

mental traders get decimated. By realizing losses, their equity shrinks and

thus their iring power to open positions is reduced. The overall balance otraders tilts away rom the undamentals, and traders with the opposite

view win the day. As this happens, the price moves counter-undamentals,providing an even bigger incentive to bet on the undamentals creating

a trap or undamental traders who continue to bet on undamentals and

lose a load ull o money. The price moves in the opposite direction othe undamentals, not just or a ew hours, but also or days, weeks, months

or even years. You need to be on your guard and to always keep in mindthat cascading margin calls can turn undamentals on their head.

Daily, weekly seasonalitypowers avalanches

There are other actors that need to be considered to determine the likelihoodo a price avalanche: at the end o each day, when US trading comes to

a close, traders want to get home and close out their open positions. They

will irst tend to close out proitable positions, so the current trend willpartly reverse itsel, but this price reversal is relatively small because proit

taking is not time critical and thus spread out over time. Losing positionswill be closed out at the very last moment; until the end o the day, traders

hope that the trend will reverse. I this is not the case, then shortly beore5 PM EST, traders with unrealized losses will start to close their positions

their positions are necessarily counter-trend, thus closure o those positions

will uel the existing price trend. So trends tend to accelerate at the end othe day, which then can trigger stop losses with traders who did not intend

to close, thus providing a urther price boost. The same phenomenon is evenmore pronounced on Friday aternoons. Traders do not want to have open

positions over the weekend; they want to relax and not worry about losing

money. So many traders tend to close out open positions on Friday ater-noon. This leads to an acceleration o the price trend on Fridays. Frequently,

the price trend persists until Monday morning, and in this sense, the newweek only starts in the latter part o Monday. Again, the same closeout phe

nomenon applies or end o month or end o quarter price action. I end omonth is on a Friday, then the end o week and end o month eect coincide

and thus multiply with each other.


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Importance o contingency reserve

There is no way to correctly anticipate the behaviour o all traders aroundthe world. For this reason, we need at all times to be ready or an unex-pected price spike that may trigger an avalanche o orders turning a seemin-gly innocuous price spike into a trend that can dominate the market or abrie moment in time or or much longer; this may last one day, one week or

many months.To prevent being caught by such an avalanche, the trader should maintain

a large cash reserve o ree margin capital. I recommend that you set aside50% trading capital as a reserve to oset unrealized losses and as a cushion

or unoreseen events. The remaining capital may be used as active margincapital to und positions. You need to deploy this capital wisely. A small per-

centage, such as 15% o the capital, should be used to und current posit-ions; the remaining 35% can be used as a reserve to increase the positi on

under special circumstances and to improve the price average to turn a

losing position into a proitable trade.

As a disclaimer, I have proposed some percentage numbers o how to

split the capital; the concrete numbers very much depend on the tradingstyle and are thereore indicative only.

How to measure volatility?

To size positions and budget or unrealized losses, to set prot targets and stoplosses, you need a good sense o volatility. The simplest method is to mea-

sure the price range between the highs and lows or intervals o one hour, oneday, one week and one month. You do this by scrolling back in time by

one month or even one to two years to get a sense o the likely size o the price

ranges between the highs and lows or these dierent intervals. The highsand lows are the bounds where margin calls are triggered. You should use the

price range between the high and low to calibrate the key parameters oyour trading strategy.


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Diversiication

There is no such thin g as perect oresight; an unexpected price spike due to alarge market order or news event can occur at any time. You need to diver-siy your risk and trade not just one, but at least two or three ideas at the sametime. It is through diversiication that you can improve your risk proile when one trading idea is protable, the other runs a loss and vice versa. Over-

all your perormance is smoother and, more importantly, this approachreduces the pressure to perorm. You are then more relaxed and less emotionalin managing the exposure o your trades.

How to size positions?

Whatever your underlying trading ideas are, the method o executing an idea

and realizing a proit is always quite similar. First, you should deine a bud-

get in terms o capital that you intend to commit to the trading idea. It is bestto divide the budget into targeted position size and additional capacity

that you intend to use in case the market turns against you. I advise that the

targeted position size should be only one third o the overall budget o thetrading idea large two thirds are additional capacity that is kept in reserve.

How to open positions?

When you open your position based on your trading idea, you should splitthe initial trade into three tranches because there is no way to know the

optimal timing or opening a trade. Thus, it is better to diversiy this risk intothree opening trades. Dene a time period in which you want to open your

position, and speciy the price reversals at which you will be buying. To open

your position on price reversals is not penny pinching; your entry pricedetermines the price level at which your position turns into a proit i you

are not careul, you can open your position at a worse price and will haveto stay in your position longer and thus increase your risk. At all requencies

there are imbalances o supply and demand, whic h cause temporary pricereversals; use them to your advantage. I the price zooms o and you did not

get a chance to buy, do not worry as the price will most likely suddenly

revert and you will have another chance; i not, then there are many otheropportunities.


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How to manage a trade and turn a losingposition into a proit?

I have explained that you need to continuously lookout or unoreseen events

that can trigger a cascade o margin calls. When such a cascade occurs,any trade can turn into a losing position, where the entry price is so ar romthe current price level that the proit target is out o reach.

A losing position can be turned into a winning trade by turning the negativedevelopment into a positive and taking advantage o the new price level

to add to the existing position and thus improving the price average o thewhole position. In so doing, you shorten the distance between price aver-

age and current price, thus increasing the likelihood o a price bounce thatis suiciently large to turn your position into a proit. I you double the

size o your position, you halve the distance between the current price and the

original average price o the position and increase the likelihood o a pricerebound by a actor o our. As a word o caution, since you also double your

risk, you should only do so when there is a high likelihood o a price rebound.

Reducing position size

I you have increased your position size to improve the average price o yourposition, you should reduce the size o your position at the next opportunity

o a price rebound. Increasing the position size is like accelerating a car whenin danger. Just as in driving it is important to slow down as soon you havepassed the danger zone, you need to ree up capital and reduce your positionsize. I you ree up margin capital, you can later increase your position whenthe price alls back again. By careully managing the position size during theups and downs in the price, you earn an incremental proit that turns alosing position into a winning trade.

Why prices revertIn liquid inancial markets, up to 98% o all the trading is based on specula-tive positions and the hedging o those positions. These positions, being

speculative, are temporary, and any opening trade will need to be closed.The closing trade has the eect o inducing a price reversal. Due to the du-

ality o the opening and the closing trade, the price movements are never

ully one sided. At some stage, sooner or later, positions will be closedand then the price rebounds will occur.

You can use these reversals to turn a losing trade into a winning positi on by

increasing the position size and improving the average price o your position.In so doing, a smaller price rebound is required to turn your losing position

into a proit. There are, however, big disadvantages to this strategy; by in-

creasing your position, you also increase your risk and, i the price continuesin the unavourable direction, your losses will mount making things worse.

It is thus important that you wait a long time beore increasing your position you need to wait or the extreme event; this requires patience.


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Smoke and mirrors

Human beings do not ind it easy to correctly identiy price extremes. We ty-pically interpret relatively small price moves as extremes, where the movesare actually only moderately larger than average. This deiciency is evenmore pronounced when a trader aces mounting losses. When under pres-sure, the traders internal clock tic ks aster and he poles the market price at

a higher requency. Time will seem to move more slowly; minutes willeel like hours and days like weeks. Under these circumstances, the tradersnatural instinct is to time his trades in terms o his internal clock, but thisis wrong. Unaware, he will ocus on smaller-scale price movements that areout o step with his overall trading strategy. He will decide to increase hisbet too early. There might be a bounce back, but this will not be enough orhim to exit his position with a prot. I the price resumes its slide, the traderwill accumulate losses even aster than beore because o the larger position.

You need to take into account that your sense o ti ming is skewed when

under pressure: you need to lean back and slow your natural instinct and wait

or a price overshoot that is in sync with your regular trading requency.

Trader deep reeze

The biggest danger or a trader is the so-called deep reeze mode: a trader,

who is close to a margin call, reezes up and does not have the mentalenergy to take decisions and blindly hopes or a price rebound. He can be

lucky once, twice or three times, but not on an ongoing basis. Similar toa mouse that is hunted by a cat and cannot move or right, the same hap-

pens to the trader. It is important to pre-empt this situation. The trader

has to set himsel a stop loss, where he will get out o his position, whatevermay happen. Ideally, the stop loss is never triggered and he is able to

manoeuvre out o any unrealized loss by increasing and decreasing his posi-tion size in response to the local highs and lows o the market.


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How to set the stop loss?

As soon as you have started to use your contingency reserve, you are advisedto take pro-active steps to reduce exposure, be it through a partial close-out or a ully-ledged stop loss. It is preerable to do a partial closeout andthen wait or a rebound to reduce the position even more. Set your stoploss at a level where you expect a price avalanche to be triggered. Price

avalanches tend to be bigger than expected, so set your stop as close tothe start o an avalanche as possible. You save yoursel a lot o money i youcut your losses early; so be pro-active and do not uss over spilled milk.

How to take proit?To make money, proit taking is as important as managing losses. Do not get

carried away with the success o your trade; you need to realize a proit.

Set yoursel a proit objective at the start, and do not change the plan. Alltoo requently, traders waver and ail to take proit when t heir proit tar-

get has been reached. They are then surprised to see their proits vanish overnight and then need to scramble to closeout at break even. Another com-

mon mistake is the ollowing: traders with too large positions need to redu-ce exposure to ree up margin capital. Typically, they close the winning

position; this is wrong, keep those positions open. You should instead reduce

or close your losing positions. As soon as your proitable trades havereached their proit objective you close them and re-establish the positions

that you had to reduce or close. This is a better strategy because yourlosing trades may be caught in an avalanche, whereas your winning trades

may be lucky and sur on an avalanche.


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Summary:

Trading is not easy. Price movements are ractal with lots o price exaggera-

tions in both directions making it diicult to keep things in perspective.You should remember that you have time and that there are lots o proitable

opportunities, so do not eel rushed. Be selective in choosing your strategy.

There will be good and bad days. Market movements are diicult to predictbecause cascading margin calls can turn undamentals upside down, so

make sure that you have a low exposure and can stomach adverse price move-ments. At all cost, manage your exposure and be pro-active. I you are in a

losing position, try to use the many up and down price moves to improve youraverage price; always protect yoursel with a stop loss. This is the best

recipe to prevent trader deep reeze. Finally, have un, but never risk more

than you can aord to lose.


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how to trade 5.2

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