A system approach

We have heard over and over again that in order to improve our chances of ever becoming a successful traders we at least need to:

1. Develop and document a trading plan
2. Paper trade ad nauseum while following our trading plan to the letter and journaling each trade
3. Improve our plan and execution through lessons learned
4. Finally apply the trading plan to live trading with outmost discipline and journaling
5. Continously improve

Most advanced trading platforms offer the ability to write custom code to develop new indicators and strategies and back-test them on large databases of historical data. In my opinion, our trading systems should maximize these capabilities. I am basing this statement on the assumption that a) most technical analysis-based trading plans can be translated in the form of an algorithm, b) there is more value for the trader in focusing his/her time on trading research and development than in manual trade execution.

Below I provide a simple Plan-Do-Check-Act model to structure the approach.

Plan: Planning is done through the elaboration of a trading strategy. This implies the specification of rules for entering and exiting trade and for risk and money management. This is basically the development of a trading plan as we know it. The plan needs to be comprehensive and specific. The effectiveness of the trading plan will be a direct function of the trader’s experience and expertise in trading the markets. This is by far the most time-consuming, complex and critical step of the process.

Do: This step involves the codification of the trading plan in the form of a software program composed of conditions and logical statements. In other words, this step is the conversion of the trading plan in a machine-readable algorithm.

Check: This step is the verification of the trading strategy against historical data. It implies the verification of test results, an optimization step, and possibly a reiteration of the Plan and Do steps if the results are not satisfactory. Once the results of backtesting and optimization are deemed satisfactory, the trading strategy is then applied to live data via paper trading, what we could also call ‘forward testing’.

Act: This step is the ultimate step of the process. At this point we have a trading strategy that has been a) coded and b) validated both against historical data and live data. We have now built a high degree of confidence in the effectiveness of the strategy and we are ready to unleash it on the market with real dollars at stake. The trading plan is now automated. Instead of manual executing the trading plan, the trader should now focus his/her attention on monitoring the results and fine tuning the system if necessary keeping in mind that the viability of an automated system is inherently limited as market conditions change. At some point the system may indeed have to be updated or even possibly retired.

In any case, the time that has been freed by automation can now be re-invested in the the research and development of new trading systems or the manual execution of more complex systems that did not lend themselves to automation. This is a process of continuous improvement.

Ten Golden Trading Rules

1. Maximize Your Profits, Not the Number of Trades
2. Don’t Risk More Than 1-3% of the Capital on any single trade
3. Be Patient Enough to Wait for Good Trades
4. Be Patient Enough to Avoid Closing a Profitable Position Too Early
5. Don’t Tie Yourself Down with Your First-Blush Opinion About a Position
6. Immediately Close Your Position When the Initial Conditions Are Disrupted
7. Make a Decision About the Stop Level Before Entering a Position
8. Cut Losses Early, Protect Profits with Trailing Stops
9. Return to a Trend if Your Previous Assumptions Turn Out to Be Wrong and the Trend is Progressing
10. Focus on Big Market Moves. Don’t Try to Catch Small, Noisy Fluctuations

FX Paper Trading System

One of the issues that I always faced when I was considering trading equities was the availability of good paper trading systems. At the time the best one that I had found was with eSignal but of course it was limited to a 30-day trial. In Forex it’s a different story and plenty of brokers offer full-featured demo accounts, but still some of them are time limited. The best one that I have found so far is called FXGame by Oanda. FXGame offers unlimited paper trading capabilities in a browser-based system FOR FREE. Of course their platform is not as feature-rich as an eSignal or a MetaTrader but I think that it’s more than enough for a beginner and it has definitely met my paper trading needs. Plus it works through my company’s firewall so I can keep an eye on the market during regular business hours!

The following is a screen print of what you will experience in the FXGame. I particularly appreciate the ability to pass buy/sell orders, and set stop losses and take profit targets directly from the charts (very similar in this sense to Ninja Trader for those of you who are familiar with this tool).

If it quacks like a duck…

Talking about ‘potential’ scams, here is a little one fresh off the press that I received in my inbox this morning: http://www.secretforexsociety.com/fantaseaone/

Now, a few interesting things about this one:

• The email was sent by ‘Felix Homogratus’, an individual who obviously uses a nickname to run his business.  His real name is Dmitri Chavkerov.  My gut tells me that there is something fishy about running a business under a nickname but maybe that’s just me.
• ‘Felix’ runs a few sites, one of those is www.forexbastards.com.  According to Felix “ForexBastards was founded in January of 2006, after I literally couldn’t handle getting screwed any longer. Learning how to trade forex I went through several forex brokers, a few different trading signals providers and used multiple forex educational training services; some brilliant, some useless and some down right horrible.”.  For some reason I get the feeling that his Yacht Seminar is a typical example of the types of scams his website was meant to expose.
• The speakers include Felix’s partner, Rob Grespinet.  According to the agenda, “If he feels like it, [Rob] will share with the participants the “inner talk” and “big boys outlook” on the forex market over the next year.  Otherwise, we’ll just have to enjoy his profanity and witty humor.”.  Have you ever been to a seminar where one of speakers may or may not participate depending on his mood on that day?  Interesting character…
• Now the piece de resistance is the other two speakers: Skip Atwater and Marty Rosenblatt.  Those guys are supposedly experts in ‘Remote Viewing’.  Now I have to admit that I had to look up ‘Remote Viewing’ because I had no idea what that meant.  I thought that maybe it was the name of a new fancy indicator or strategy but I came to find that remove viewing (RV) is “is a protocol used in consciousness research where a viewer attempts to gather sense impressions and “knowingness”, non-sensorial information, about a target.”  So basically we are talking about telepathy or clairvoyance in trading the Forex?!?!  How desperate are we getting here?  What’s next, opening a ‘channel’ to Jesse Livermore to ask him for tips?
• The last speaker is ‘anonymous’ and I quote “He wants to keep his identity unknown before the seminar”.  Come on…people using nicknames, others using clairvoyance, and this last one the enigmatic speaker who wants to remain incognito.  Is it a trading seminar or a masquerade?  Is there really a difference?  I am starting to wonder.
• As another test, let’s go back to the CFTC warnings and let’s see how many apply to this ‘invitation’:
  • “Stay away from opportunities that seem too good to be true”.  In Felix’s own words: “I can teach you a trading system that in my experience can easily make you into a forex millionaire in 3 years or less”.  Now here note the word ‘EASILY’, ‘MILLIONAIRE’, and ‘3 YEARS’.  Too good to be true?  I also always like when systems promise to make you plenty of money with extremely little effort.  Two beautiful examples in this invitation.  First from Felix himself ” I’ll be honest with you, because of this way of trading, I am starting to become very lazy, and I am actually sleeping through a lot of the news announcements that I used to trade short term.”  Next from Skip Atwater: “The technique takes 1 hour per day, 5 days per week, and it has made this guy millions”.
  • “Be Sure You Get the Company’s Performance Track Record”.  In Felix’s own words again “[Rob Grespinet] is a heavy weight financial giant, and most people will never be able to comprehend the level of connections this guy has.  Just being in this guy’s presence is an honor”….Ok, what is HIS performance track record?  Numbers please!  About Skip Atwater: “he will be teaching a simple technique he has been using over the years.  The technique takes 1 hour per day, 5 days per week, and it has made this guy millions.”  So this guy is going to teach me how to use psychic abilities to make money in the market?  Show me a trading journal here, show me a trading account statement!  Quantify this guy’s trading system’s expectancy!  Last but not least: “this is Felix writing, and if you know me, you should know by now that I don’t throw empty words into thin air”.  Actually Felix I don’t know you, at all!  Actually it’s only by googling ‘Felix Homogratus’ that I was able to find your real name.  Maybe you’ve made millions but for all I know none of it was made through trading, maybe you have made all this money scamming retail traders.

Ok, I have already wasted enough time analyzing this email.  My only point is that there are plenty of emails like this one finding their way in my inbox every single day, making incredible promises, telling me that there is a system out there that could make me millions by just working one hour a day, and to be honest I not only don’t believe any of them but I have to come to find them insulting.  As individuals who are entering the retail trading world, this is what we are exposed to.  We have to be vigilant, extremely vigilant.

Forex Scams

As you embark on a trading journey, you will come across many websites, emails (I should really say spam), and other ads promoting infallible systems, golden indicators, and genius-like advice from self proclaimed gurus. With the growth of retail Forex trading over the last few years, there has also been an incredible increase in the number of scams and fraud associated with it. Reportedly, between 2001 and 2006, the U.S. Commodity Futures Trading Commission has prosecuted more than 80 cases involving the defrauding of more than 23,000 customers who lost $300 million, mostly in managed accounts.

Therefore, as retail traders who have worked hard for the money that they have, it is important to remember some important warnings from the CFTC:

Stay away from opportunities that seem too good to be true

Always remember that there is no such thing as a “free lunch.” Be especially cautious if you have acquired a large sum of cash recently and are looking for a safe investment vehicle. In particular, retirees with access to their retirement funds may be attractive targets for fraudulent operators. Getting your money back once it is gone can be difficult or impossible.

Avoid any company that predicts or guarantees large profits

Be extremely wary of companies that guarantee profits, or that tout extremely high performance. In many cases, those claims are false.

The following are examples of statements that either are or most likely are fraudulent:

“Whether the market moves up or down, in the currency market you will make a profit.”

“Make $1000 per week, every week”

“We are out-performing domestic investments.”

“The main advantage of the forex markets is that there is no bear market.”

“We guarantee you will make at least a 30-40% rate of return within two months.”

Stay Away From Companies That Promise Little or No Financial Risk

Be suspicious of companies that downplay risks or state that written risk disclosure statements are routine formalities imposed by the government.

The currency futures and options markets are volatile and contain substantial risks for unsophisticated customers. The currency futures and options markets are not the place to put any funds that you cannot afford to lose. For example, retirement funds should not be used for currency trading.

You can lose most or all of those funds very quickly trading foreign currency futures or options contracts. Therefore, beware of companies that make the following types of statements:

“With a $10,000 deposit, the maximum you can lose is $200 to $250 per day.”

“We promise to recover any losses you have.”

“Your investment is secure.”

Don’t Trade on Margin Unless You Understand What It Means

Margin trading can make you responsible for losses that greatly exceed the dollar amount you deposited.

Many currency traders ask customers to give them money, which they sometimes refer to as “margin,” often sums in the range of $1,000 to $5,000. However, those amounts, which are relatively small in the currency markets, actually control far larger dollar amounts of trading, a fact that often is poorly explained to customers.

Don’t trade on margin unless you fully understand what you are doing and are prepared to accept losses that exceed the margin amounts you paid.

Question Firms That Claim To Trade in the “Interbank Market”

Be wary of firms that claim that you can or should trade in the “interbank market,” or that they will do so on your behalf.

Unregulated, fraudulent currency trading firms often tell retail customers that their funds are traded in the “interbank market,” where good prices can be obtained. Firms that trade currencies in the interbank market, however, are most likely to be banks, investment banks and large corporations, since the term “interbank market” refers simply to a loose network of currency transactions negotiated between financial institutions and other large companies.

Be Wary of Sending or Transferring Cash on the Internet, By Mail or Otherwise

Be especially alert to the dangers of trading on-line; it is very easy to transfer funds on-line, but often can be impossible to get a refund.

It costs an Internet advertiser just pennies per day to reach a potential audience of millions of persons, and phony currency trading firms have seized upon the Internet as an inexpensive and effective way of reaching a large pool of potential customers.

Companies offering currency trading on-line will usually be located in different legal jurisdictions to you. Even if they display an address or any other information identifying their nationality on their Web site it may be false. Be aware that if you transfer funds to foreign firms it may be very difficult or impossible to recover your funds.

Currency Scams Often Target Members of Ethnic Minorities

Some currency trading scams target potential customers in ethnic communities, particularly persons in the Russian, Chinese and Indian immigrant communities, through advertisements in ethnic newspapers and television “infomercials.”

Sometimes those advertisements offer so-called “job opportunities” for “account executives” to trade foreign currencies. Be aware that “account executives” that are hired might be expected to use their own money for currency trading, as well as to recruit their family and friends to do likewise. What appears to be a promising job opportunity often is another way many of these companies lure customers into parting with their cash.

Be Sure You Get the Company’s Performance Track Record

Get as much information as possible about the firm’s or individual’s performance record on behalf of other clients. You should be aware, however, that It may be difficult or impossible to do so, or to verify the information you receive. While firms and individuals are not required to provide this information, you should be wary of any person who is not willing to do so or who provides you with incomplete information. However, keep in mind, even if you do receive a glossy brochure or sophisticated-looking charts, that the information they contain might be false.

Don’t Deal With Anyone Who Won’t Give You His Background

Plan to do a lot of checking of any information you receive to be sure that the company is and does exactly what it says.

Get the background of the persons running or promoting the company, if possible. Do not rely solely on oral statements or promises from the firm’s employees. Ask for all information in written form.

If you cannot satisfy yourself that the persons with whom you are dealing are completely legitimate and above-board, the wisest course of action is to avoid trading foreign currencies through those companies.

It’s fair to say that in trading (Forex or anything else for that matter) the odds are usually against us. We typically do not have the same information, systems, experience, expertise, and support that professional traders have. The advent of PC-based trading platforms and of the Internet has given us ‘access’ to the playground but it still doesn’t mean that we can win a game. As retail traders we have to be extremely careful and keep our guard up. Don’t forget the lessons that you have learned in life and in business up to now.

This being said, if we decide to enter the playground, let’s do so with wide open eyes and let’s watch our backs.

Picking a Broker

Picking a broker and picking a trading platform often come hand in hand but not always. When it comes to selecting a broker, it seems that there are two main categories out there:

• Market Makers
• ECN/No Deal Desks (NDD)

In my earlier post entitled “Pick a Market” I made the incorrect assumption that Tradestation was a NDD, but in fact that is not the case. Tradestation routes the trades to a company called Gain Capital and this company is a market maker, a deal desk if you prefer. The problem is also that Gain Capital doesn’t seem to have a stellar record with the NFA.  The NFA charged them with “with using deficient promotional material and failing to uphold high standards of commercial honor and just and equitable principles of trade; failing to establish and implement an adequate anti-money laundering program; and failing to notify NFA that GCG was carrying customer accounts.”  You can actually get a copy of the charges at http://www.nfa.futures.org/basicnet/CaseDocument.aspx?seqnum=970.   So the bottom line is that Tradestation doesn’t route their trades directly to the interbank network, like a NDD would do. So one could assume that we would still have the inconvenients of dealing with a MM but in addition to this we would also be paying commissions to Tradestation.  Companies like MBTrading and Interactive Brokers however seem to be legitimate ECN/NDD.

So the plot thickens. My guts still tell me that we would be better off dealing with an ECN/NDD although apparently there are also some inconvenients in doing so. Let’s just say that with those we can take full advantage of the free market of supply and demand but we can also suffer its wrath with a few less safeguards than if we were dealing with a MM. Let’s call that the price of freedom.

To read a bit more about the advantages and inconvenients of NDDs, follow this link: http://nondealingdesk.blogspot.com/2006/04/non-dealing-desk-advantages-and_21.html

In any case it seems that my suggestion to go with TS to develop a high level of proficiency on a trading platform, and allow for the transferability of that proficiency to other instruments could still work but I am worried that we would just be dealing with another MM. This brings us to MBTrading and/or IB. These brokers offer very limited trading platforms that are nothing in comparison to some of the better commercial products so even though we may be using their data feed and order system, we may need to select another platform for analysis and charting. Here the better option may be eSignal which if I recall correctly is priced at approximately $175/month with the proper Forex add-ons and offers complete integration with both IB and MBTrading.

So in conclusion I think that the system of choice for Forex trading, assuming that we want to use a ECN/NDD instead of a MM, is eSignal with MBTrading. This should probably be confirmed via a free 30-day trial with these products.

Picking a Market

One of the very first questions that I faced when I embarked on the trading bandwagon was “what will I trade?”.  There are plenty of instruments one can trade on the open market, from equities and options to currencies, futures, and commodities, just to name a few.  The good news if that there is quite a bit of overlap between these instruments at least in terms of the techniques and tools that you use to trade them.  The fundamentals however tend to be different as well as the brokers and services with which you will deal.  On my journey so far I have considered two markets: Equities and Forex.  The table below provides a high level comparison between these two markets.

	Equities	Forex
Leverage	4:1	100:1
Recommended Account Size	> $25,000 (PDT)	Mini: >= $10,000
		Standard: >= $100,000
# Instruments	Thousands	7 major current pairs
Market Hours	9:30am – 4:00pm	24 hours (Tokyo, London, NYC, Sydney)
Platform/Exchange Fees	> $100/month	Free
Commissions/Pip Spread	$14/round-trip trade	$10-$40 (1 to 4 pip spread on $100K trade)

 

Leverage is very significant in the Forex market, usually 100:1 sometimes even 200:1 or 400:1, compared to 4:1 in equities.  Forex requires such high leverage because the gains that you typically make on a currency pair are in the order of 10,000th of a dollar (fourth decimal).  Therefore you need to trade in lots of $10K (mini lot) or usually $100K (standard lot) for your profits to amount to something significant.  High leverage is the way to do that.  Yet leverage is a double edge sword, while it significantly increases your buying power, it can also result in dramatic losses.  So I wouldn’t necessarily see leverage as a valid argument in favor of Forex over equities.  High leverage in Forex is a necessity.

I also provided the minimum recommended account sizes for both equities and Forex.  In equities you have to deal with ‘pattern day trading’ rules (PDT).  The SEC defines a pattern day trader as a trader who executes 4 or more trades per week.  Such traders are required to maintain an equity balance of at least $25,000 in a margin account.  PDT doesn’t apply to Forex so in Forex it’s possible to open a trading account with sometimes as little as $250.  But that doesn’t mean that you should open an account at that level.  Ideally a mini account should be open with at least $10K and a standard account with at least $100K.  If you do not have the required $10K for the mini account, it is recommended to stick with a demo account (i.e. paper trading).

Forex just has a handful of instruments compared to equities.  While the equity exchanges such as NASDAQ and NYSE offer thousands of tradeable stocks (even though only a small percentage of this number is really worth trading), 90% of the Forex action occurs on the following major currency pairs:

• USD/JPY
• EUR/USD
• GBP/USD
• USD/CHF
• USD/CAD
• NZD/USD
• AUD/USD

Market hours are in my view of the strongest arguments in favor of trading the Forex.  Indeed if you are like me and you have a full-time job, being able to trade or at least practice on the Forex after business hours is a must.  If you consider the market hours of Tokyo, Londer, NYC, and Sydney, you pretty much have an opportunity to trade 24 hours a day.  Compare this to the fact that you can only day-trade equities between 9:30 and 4:00 and you see the advantage (unless your boss doesn’t mind if you day-trade on company time).

I have found that Forex brokers usually offer better trading platforms than their equity counterparts and this usually for free.  In a typical equity trading scenario you would need to purchase a trading platform, which along with data feed and exchange fees could amount to anywhere between $100 and $175/month (e.g. Tradestation or eSignal).  Of course you could use the free platform that companies such as Scottrade offer but I think that you will quickly find that their functionality is very limited and the quality of their data feed is usually sub-standard.  In Forex, I have found a number of brokers who offer high quality trading platforms with a high quality Forex data feed at no cost.  Most if not all of these brokers also let you open a free demo account so that you can not only test-drive their platform and service but also practice with a fictitious account (paper trading).  Here I would like to highlight a company in particular, Oanda, who offers a very nice and unlimited demo account (most would expire about 14 or 30 days).

Forex brokers usually advertise the fact that they do not charge commissions, unlike their equity counterparts.  The statement is true BUT in Forex you deal with what is know as the ‘pip spread’ (i..e. the difference between the bid and ask price of a currency pair, expressed in pips).  Note that equities also have a spread (i.e. the difference between the bid and ask price of an equity, expressed in dollars) but the difference is that if you use a direct access broken (e.g. Tradestation or MBTrading for instance), the bid and ask prices are a directly results of the market’s supply and demand, they are not manipulated by market makers.  In Forex, I find that most brokers are market makers as well, therefore the pip spread is not only the result of market forces, but it is also compounded by additional charges coming from the brokers.  Basically you end up with a ’swollen’ pip spread that is greater than the one offered by the market.  So here it seems that we have two choices, we either go with a ‘broker’ where there will be no commissions per se but wider spreads or we go with a straight-through-processing house (STP) that will not affect the spread but that will charge a commission.  Personally I would pick the latter.  Indeed market makers not only doctor the spread but can also you ability to make trades (e.g. during high periods of volatility).  Being able to work directly through an STP provider, with no deal desk, seems to me to be the healthier approach.  This being said this service comes at a price, i.e. a commission, that ranges from $0.00002 (e.g. Tradestation) to $0.00005 (MBTrading) depending on the provider but this commission is partially (or totally) offset by tighter pip spreads.   Another advantage that I see in using a STP provider such as Tradestation for instance is that you can also develop a good level of proficiency with the platform and eventually transfer that proficiency to other instruments such as equities and options which are also supported by Tradestation.  Likewise if you have developed some custom code in EasyLanguage to support your Forex trading (e.g. new indicators or strategies), you could leverage the same code in trading equities.  This transferability is an appreciable advantage.  The same would not be true of Forex trading platforms that tend to only cater to Forex.

So in conclusion ‘picking a Market’ ends up being a personal decision.  There is no wrong choice here.  It all depends on what you like to do, on your style, and on your lifestyle.  Personally, at this stage of my life (having a full time job and all) it seems that Forex is the most practical choice and it is where I will start.  I will keep using this blog as a way to share my experiences learning about the Forex, paper trading, and eventually live trading.  I welcome any feedback that you may have.