Currency Secrets

Let’s say you received an email in your inbox this morning of a new forex system and when you went to the website the opening sales copy said something to the effect of…

I have 4 golden rules that I use to determine if a trading method is good for me:

1. It must be a complete method, with setup conditions, entry rules, initial stop rules, and exit strategy rules, leaving no decision to chance.
2. It must include specific risk management, money management, and portfolio management guidelines.
3. It must be based on technical analysis, but it must not be a 100% mechanical system.
4. It must take less than 20 minutes a day to apply after learning how to trade with it.

Impressed so far? Would you continue reading the remainder of the copy?

Well I’d be impressed… I’d be a little niggly on the last two points as I wouldn’t care if a method took 20 minutes or 2 hours (obviously I’d prefer the lesser time), and so what if the system is 100% mechanical, wouldn’t that be a good thing? Sure, all systems break down, we all know that the only thing guaranteed in life is change so you not only need to have a method that works, but you need to have a process where you can adapt to changing conditions (i.e. how do you know a system no longer works? how do you then tweak it?).

But I found there was one even more important element that this person missed from their golden rules. Did you pick it up?

To see if the element I thought they missed in the opening pitch was going to be in the remainder of the copy I continued to read it… and sure enough it wasn’t there! (Okay, so there was one testimonial where one customer claimed to have had 8 winners in a row – they could’ve all been 1 pip profits, or 1000 pip profits, we aren’t told.)

So what was the missing element?

EVIDENCE

Talk is cheap dear friends we all know that – and it’s even cheaper on the internet! The only evidence this copy provided was the web site statistics on how many people viewed their site, and the expense at creating the high class videos that were used to create the DVD course. Both of which I have no doubt on.

But so what!

Sure, your method may use non-technical methods, you may be counting how many pigeons poop on your Porsche every morning to determine whether to go long or short the Euro, but what has been that method’s results? And can they be verified by an independent third party?

Sure, past performance is not indicative of future returns, but they’re a good guide aren’t they? I mean, would you prefer to place money into an asset that loses money 20-30% every year? No? But past performance is not indicative of future returns, next year the asset might make money?? True, but something would need to change for this asset to make money because the probabilities from its previous history indicate otherwise.

And we know you don’t need a 100% mechanical system to be profitable. That’s what demo accounts are for. You can be at the other end of the spectrum and have a 100% discretionary system, that’s fine. Run a demo account for a few months trading your plan (which is written down, yes?) and see how the results go. As you’re trading write down things that you notice with why a trade was profitable or not (did you trade the method exactly? did you notice anything unusual prior to entry? did you notice anything unusual about where your initial stop was? did something unusual happen during the trade? how was your exit?) – by doing this after your testing period you may begin to see a pattern develop with certain trades and find that when your method is tweaked to compensate for this pattern your method improves immensely!

If you have no plan you have no method.

And if you have results but no plan you have no idea on what works and what doesn’t!? So if your trading a demo account but have no plan – STOP!

Then start by doing the following:
1. Formulate a method. Find what indicators/fundamentals resonate with you, or look at some charts and see what patterns you notice. We’re all different here. I’m not a big fan of Elliott Wave, Gann, counting Uranus’ rings, or counting pigeon poop on my car, but for some of you those things will work the best (hopefully not the pigeon poop!). The best system for you is in you. All you need is time and experience to find it.
2. Test your method. If you can get some historical data, and can write computer code then mechanically test it, if you can’t that’s fine, be sure to write your method down and demo trade it.
3. Stick to your method for a set period of time/trades (at least 20 trades, but if you’re doing more than a trade a day I’d recommend trading for at least a month). To stay disciplined I recommend you exercise regularly or perhaps clean your house regularly (trust me your partner will love you for it – even if you don’t make money), because if you cannot stay disciplined in one small area of your life what makes you think you can do it in the hectic world of forex trading? Oh wait a minute you’re a “special case” and these rules don’t apply to you… rrrright.

You don’t need a special top secret course to tell you what you already know on how to be profitable in the forex market. You just need to get off your lazy glutes and do the work yourself.

If success were easy everyone would have it – and what would special about it then?

So if you’re buying this course then I believe you do so on faith. Nothing indicates to me that the method even works, which means clients may be very disappointed at the actual results when they come to trade it. I have no doubt that this organization will offer tremendous support, or help educate the customer on what the forex market is, but can’t all this be done for free from a popular forex forum??

It seems from what has come across my desk over the last month or two that the easiest way to make money out of the forex market is to sell an ebook or DVD course catered to forex traders (i.e. the forex market).

One such forex course that came across my desk not too long ago stated in their copy that users COULD make US$300 per day trading their method, with only 20-30 minutes day of work.

What shocked me though, as I read through the copy, was that the claim was backed on mere hearsay.

That’s right there was no substantive evidence confirming that a user could make US$300/day – just someone’s opinion!

Yet this course sold for US$2,000 and many bought into the hype.

When I asked how such claims were derived (i.e. from hypothetical backtesting, or from actual trading – whether it be from the person selling the course or from a customer) no such response was given (which didn’t surprise me).

In this internet age things such as this will become more prominent.

Forex trading is a skill. There’s nothing wrong with purchasing ebooks or courses if you believe purchasing the course will enhance your forex trading skills, but try to remain objective whenever you come across such emotive sales copy that has been written by a trained copywriter who is expert in exaggerating claims and enhacing the course without stretching the truth too much.

You may even want to employ tactics that I use before I purchase a product (I’m going to assume that the product being pucrhased here is an informational product, you wouldn’t likely be able to use these tactics if purchasing a signal service, or something more tangible such as forex data):

First thing I do is look for claims in the sales copy of what this product will give me and I try to reverse engineer from the sales copy! What I try to look for are bullet points as these usually contain small snippets of information about what the product will provide. What I do with each bullet point is to try and figure out for myself what each bullet point’s answer is – it will be test of your own knowledge and also your creativity. As an example a sales copy might say:

• Know which direction a currency is likely to trend in the short-term AND medium-term in TEN SECONDS.

Now if you had to think of what this could be what answers would you come up with? Stop, think about it for a minute. Try it for a few seconds and see what you’d come up with.

If I had to have a guess on copy that said something like that I’d probably guess that the course would be either peddling some sort of trending technical indicator (such as moving averages, trend lines… etc) and employing them on different time frames to gauge short and medium-term trend, or perhaps looking at carry trades by assessing which pair has the higher interest rate (for medium-term direction), or perhaps looking at announcements to see whether an economic report will be favorable or not to a currencies short-term direction.

Sometimes brainstorming like this has produced new ideas… all thanks to a product I never bought!

If I come across a bullet point that I cannot answer I write it down and come back to it when I’ve gone through the copy. When I’m done I then go back to all the bullets and determine whether the bullet point will indeed enhance my forex trading. For those bullet points that I believe MAY enhance my forex trading skills I look at the price of the product and make one last final determination on whether the price fits the value (that I deem) for me to increase my forex skills.

Sometimes I’ll even search on the internet to see if I can try and find the answer to it before buying the product, because you never know if the seller may have pinched it from somewhere else!

So, one of your main priorities when purchasing any forex product should be: will it enhance my forex trading skills. If it doesn’t don’t be afraid to say no and move on – spending money on forex material is an EXPENSE and will affect your overall profit and loss at the end of the financial year.

Signal vendors come and go, methods have their season, but if you have purchased products that have enhanced your forex trading skills then you’ve got something that will last you a lifetime.

If you’ve created a system before you would’ve no doubt arrived at a point where you would’ve needed to test certain variable(s) to see which figure(s) would be the most appropriate to use.

As an example, if we were testing a simple moving average crossover system on closing prices we would test which moving average periods would be the best to use – these moving average periods are what I term as variables.

Unfortunately most new forex traders test every number known to mankind and proceed to test all of these numbers over their entire historical data. Once the computer has churned out a database of results the trader looks at which variables produce the best Net Profit and then trades those “best” variables.

And the money just comes rolling in by the bucket loads, doesn’t it?

Hardly.

I wonder what the trader would’ve been using had they ran their optimization last month? Or maybe 3 months ago? Would the variables have been the same?

What then does the importance of NOW have over one month ago? Or three months ago?

The only real difference between now and back in the past is more historical data to test over, but what of the future? What if one week from today the best variable(s) to use are different? How often should one change their system’s variables? Every time? Even during a trade?

As you can see optimizing can be very detrimental to your forex system – just when you thought you were safe in finding the best variable a whole bunch of new ones enter!

So what do we do?

One solution is to conduct a walk-forward optimization (WFO).

A what?

In its simplest form WFO allows users to test their system by allowing the computer to automatically test the variables used and, according to the system’s results over the testing period, use the best variable(s) for a predetermined period before re-testing again.

As an example, if we have a WFO on our moving average crossover system, we would test a whole different bunch of numbers for the moving averages over a period of say 3 years (if we’re using end-of-day data) and we instruct the computer to use the best variables that returned the highest Net Profit over the sample period to use over the out-of-sample period being the next 3 months. In 3 month’s time we then repeat the process again: test the system over the last 3 years, locate the best variable(s) that produced the highest Net Profit, use those variables to trade over the next 3 months.

Okay so now the money should start rolling in, right?

Well, the great thing about WFO is that it tests your system’s foundation – as too many people place far too much emphasis on finding the right “magic” number rather than putting in that effort on the method used.

But WFO does have its problems and if you ever do use WFO on a system you’ll more than likely find your systems results rather dismal.

There are several reasons for this with the most obvious being that the system needs 1 in-sample period where no trades will be conducted. Depending upon how large your in-sample testing period is as compared to your overall historical sample you could find that 20-30% could be lost. As an example, if you have a large in-sample testing period, of say three years, and the entire historical sample of your data is 4 years in length then 75% of your data will not be traded, therefore your results will be reduced by 75% than an otherwise simple optimization over the ENTIRE period would make!

Another not-so-obvious reason is that WFO’s (such as those created in Wealth-Lab Developer) only allow one constraint. This means that if we tell the WFO to use the best variables for our trading period those that produce the highest Net Profit (or whatever constraint we use) during the testing period if there just so happens to be a variable that produces one trade yet luckily enough ends up producing the highest Net Profit the WFO will use those variable(s) for the trading period.

“But who cares?” you might say, “it produced the highest net profit.”

Well would you really want to trade a system that had ONLY 1 trade??

Of course not!

So why should your WFO tests be any different?

And this is where WFO testing falls down – it’s lack of additional constraints.

Unless you can tailor a WFO to contain constraints that you personally use when selecting whether a system is feasible or not I’d be very wary of using it.

Last week I took a trip to Melbourne with friends to watch U2 play live in concert.

While the concert was something that I’ll never forget, but one odd memorable moment of the weekend was spent in the Crown Casino.

After wandering through the casino and seeing the multitudes of pokie machines and playing tables we sat down for a coffee.

As the conversation talked about our immediate surroundings it soon turned to what I did.

“Ryan, you say that forex trading is different from gambling, how so?”

“Well let’s have a look,” I answered, “and compare both.”

We looked out at the old ladies pushing the flashing buttons and began.

“We both need money to play, right?”

One friend nodded.

“We both have an element of risk. For a forex trader this can either be their stop loss for each trade or their entire account. For the pokie player whatever they put in they are prepared to lose.”

“Yep,” they all agreed.

“We both have an uncertain element of reward. Even if a forex trader uses limit exits they don’t know whether that will ever be hit. Same for the gambler.”

“Mm-hmm.”

“Not even having a system differentiates between both: I’ve seen systems sold by people to make money from Lotto, or on the tables, or horses.”

“So you’re a gambler then?” they all asked.

“Well there is one thing that differentiates us.”

“What’s that?”

I knew they wouldn’t understand the terminology I was going to use as the answer so I used a simple illustration.

“Let’s say that I find a game at the Crown that allows me to make $1 if I can call the flip correctly, but I’ll lose $1 if I call it incorrectly.”

I stopped making sure they understood – they did.

“Now let’s say that I flip away all night and end up tossing the coin 1,000 times. On average, how much do you think I would make at the end of the night?”

“Well,” spoke up one hoping to impress his woman, “you’ll have roughly a 50% chance of calling the correct face each time. Therefore you’ll win about 500 times out of the 1,000 and you’ll lose on the other 500 times.”

“Yep, that’s right, so how much have I made or lost?”

“Well… if you’ve won 500 times that means you’ll win $1 each time, therefore making $500, but you’ve lost 500 times and you’re going to lose $1 each time, meaning you’ve lost $500, resulting in making nothing… and losing nothing.”

“Good!” I was impressed, so I decided to modify the illustration slightly, “Let’s say you find the same type of game but it pays $1.10 on a correct flip, and $1 on an incorrect call. What’s likely to happen after 1,000 flips, now?”

Again the same friend decided to take the new challenge.

“Ok, you’ve won 500 times and you’ve made $1.10 each time, therefore you’ve made $550. The losses are the same as last time, being $500, therefore you’d profit $50.”

“Well done!”

“But I still don’t see the point between forex trading and gambling,” said another frustrated that he wasn’t quick enough to answer yet annoyed that I hadn’t answered the question.

“How many times would you play that first game?” I asked.

No one wanted to play the first game.

“How many times would you want to play the second game?” I asked.

A couple jided on how crap the returns were, but all agreed that they’d play it.

“What you’ve just done is proven that you’re not a gambler. You’ve just calculated your expectancy for both games. In essence expectancy is just the probability of winning multiplied by the amount of your win less the probability of losing multipled by the amount of your loss.”

A joke was made, and the conversation turned to a little less technical matter.

“Yep, he’s a gambler,” they all laughed.

Unfortunately what my friends failed to understand was that all games in the casino have a negative expectancy. You might win at the start, but the more you play the greater your chance of giving it all back and losing it all – which is why the casino does as much as it can to keep you playing.

So, do you know your expectancy?

There’s an interesting article on CNN’s Money site that I think all of you should read especially in light of my last two posts regarding forex simulators: Forex Simulator and Forex Tester.

If you think that you’ll achieve long-term forex trading success within a year I think you’re going to be sorely disappointed – the forex market is one of the fastest markets in the world and what might work for you now, may not work in 3 months time – it’s a constantly moving target. And it’s why I endorse having the mechanisms in place that help you monitor when these changes are happening to your trading model (by doing things such as the self-audit process).

Anyway, I think the article will prove to be quite insightful, perhaps print it out for future reference.

Enjoy.

CNN Money Article