Third Bite of Parcelled Cross Trading Strategy

How we handle stop losses? When we decided our investment strategy we adopted 2% maximum risk per open trade. This means that, if everything goes wrong, our total loss in this trade wont exceed 2% of our portfolio size. If our portfolio is $10.000 our maximum exposure per trade is $200. In Jaypex we open four crosses for each trading signal. 2 lots of GBPUSD ($100 = 50 pip), 1 lot of USDCHF ($50 = ~60 pip), and 1 lot of CHFJPY (~60 pip). This sets maximum stop loss in pips. However, we need to work inside maximum exposures. So we need to consider checking ATR in combination with timeframe which we want to trade. The longer the timeframe the bigger the stop loss. The shorter the timeframe the bigger the noise.

The True Range is the distance from maximum of yesterday’s range to today’s range. We obtain it from three simple calculations; take the maximum of these numbers.

• The distance from today’s high to today’s low
• The distance from yesterday’s close to today’s high
• The distance from yesterday’s close to today’s low

The Average True Range is a moving average of the True Ranges (The shorter the range, the closer it reflects present).

Average True Range Technical Indicator (ATR) is an indicator that shows volatility of the market.

If 2xATR feets into maximum allowed it is good to start with. As we described in second bite, crosses tend to diverge and eventually one or two will hit the stop loss and go further without us on board. We can forget about them and take great care for the ones in positive territory.

After our cross breaks two resistance levels (if long) or supports (if short) we can do two things:

a) Move stop loss well into plus and wait

b) Double the position and move stop loss for all positions to new entry level (2 pips in positive)

In the example a) we have locked-in some profit and let the position run at the same pace, each 1 pip move bringing in 1 pip of profits. In the example b) we did not lock any profits, but we covered our exposure 100%. From this point further we play “on the house”. Not a penny of our money is at risk and every move for 1 pip in the right direction brings in 2 pips in profits.

Our experience taught us to alternate. First we start with a). If trend goes on our next move is b) and than a )  again and b) and so on as far as it goes.

Sometimes a strong overnight move or a gap over the weekend will allow us to do both, doubling and move deep into positive. When this happens never forget to thank for your luck.

When we are “in the money” we can make bold moves. Once we are closed out we have to forget all the good and wait for another opportunity. Don`t just do something, sit there! Patience comes next!

 

Second Bite of Parcelled Cross Trading Strategy

From strategically background talk straight to the point. When we pick EURJPY cross we actually don’t have to open EURJPY. We get much the same effect if we open EURUSD and at the same time USDJPY. If USD cancels out the result is clear. The sum of EURUSD and USDJPY will be almost the same as EURJPY with small short term deviations. This is the first step. If you look a little bit deeper, you will quickly realise that EURUSD is basically composed of EURGBP and GBPUSD, while USDJPY is a result of USDCHF and CHFJPY. This is the second step.

The third logical step in this strategy is after generating Buy to Open (BTO) signal in EURJPY cross to open long positions in EURGBP, GBPUSD, USDCHF, and CHFJPY.

Because EURGBP and GBPUSD will tend to diverge as well as USDCHF and CHFJPY we have as our fourth logical step to enter breathable but tight stop loss on all the constituent crosses. With a little help from volatility (which at the times of crises abounds), we will have a strong divergence run in all crosses, two will be taken out at stop loss (and continue falling without us) and the other two will continue rising (with us on board). Soon we are able to move stop loss to zero position, which we define as entire trade without a loss.

Our fifth logical step in said strategy is the way we manage a stop loss.

This is not too much text but information contained herein may be revolutionary. Even if it looks a small bite chew on it until we explain how we manage a stop loss and why we did not find trailing stop to be satisfactory.

 

Parcelled Cross Trading Strategy

We maintain three parcelled cross trading strategies on Collective2: Artex, Jaypex and Montex. We’ll talk about them later.

Parcelled cross trading strategy is a forex trading strategy that evolved through the years of trying to follow thousands of qualified and non-qualified forex advisers. Some strategies tried were not suitable for our style of trading. I do not say that they were necessary bad. I am just saying that trading strategy needs to fit chief trader’s personality.

Some traders can bear huge draw downs before the market turns their way. I can’t. I can’t sleep if draw down exceeds my comfort zone which is tight since I wiped-out my entire forex trading account in 1997.

So as a rule, I don’t feel good trading without a stop loss. The first guiding principle of Parcelled cross forex trading strategy is to limit losses and draw downs as much as possible. We never risk more than 2% of portfolio value in one trade. One trade consists of four open positions. This way we can be wrong 5 times in a row and still keep the losses at manageable level. Without such money management one can lose entire investment account in one trade gone badly.

We are not too tight with stop losses as every currency pair needs to “breathe” before succumbing to a long term trend. When volatility is stronger than the trend we elect to stay on the sidelines. We do not take trades even if other indicators show an entry signal. We will have a chance to talk about the importance of patience later on in this series. We want in this place to express our contrairarian opinion to “Idiot-proof” trading strategies like Freedom Rocks.

In stable times Freedom Rocks strategy works well. Basically it consists of long opening of two correlated currency pairs like EURUSD and USDCHF for the long haul. Being inversely correlated and having positive interest rate differential usually one of the crosses will rise when the other is falling. When a cross comes to a top sell 1/10 of a position and at the same time when the other cross is at the bottom buy 1/10 of a position. Depending on the leverage you also multiply interest rate differential. You also make money each time you close a position.

In reality, this strategy depends on the behaviour of EURCHF cross. It works fine when EUR steadily rises against CHF as was the case from April of 2002 to July of 2007. If you traded the same strategy since July 2007 your account would have probably been erased. The wrong thing with described strategy is the omission of stop losses. Because in this strategy you play on crosses going astray and back, you can’t stop the one going down. You actually want it to, because you make money on swings.

But when EURCHF, which is a sum of EURUSD and USDCHF, starts going down, both your open long crosses start losing money. Apart from closing all the positions with a loss you have no remedy. You have no real measure when to close positions. There are no flawless “Idiot-proof” trading strategies. Whenever somebody introduces better “Idiot-proof” strategy somebody else makes a better idiot.

We are still at a stop loss discussion. No stop loss strategy may still be good for gamblers (Gambling trading style). You enter strong and have luck to double your investment in short time. You withdraw your initial investment and gamble with the rest again. Whenever you double your investment withdraw half and gamble some more with the “house money”. This may be good way to make money if it fits your personality. It is gambling, though, not investing.

Just to make sure that everybody is on the same song-sheet: A loss is realised. It moves no more. A draw down is unrealised, still in the open position that can be changed into plus if the market turns your way. Or make the loss bigger.

There is an easy way to avoid huge draw downs and exposure to loss without losing the upside potential. Your market analysis says to buy a cross with 30 pip stop loss. You opened this position. The market turns against you and stops you at minus 30 pips. Market falls 40 pips more before it turns your way. You wait the move to reach your stop loss point and enter the long position again. You did not miss the good thing that is moving up after falling. You escaped the bad thing, the draw down. Namely, if you didn’t exit at 30 pip stop loss, and in the meantime, when you are down 70 pips on your position, adverse information emerges. The market moves instantly 200 more pips against you and your entire investment account is at risk of erasure. You can succeed in making profit after humongous draw downs five or even ten times. Once you fail and all your investment is lost. I have seen many a trading systems reaching 20.000% or more in profit just to lose it all in a draw down, too big to handle.

It is already more info here than bite size. We will cover more in our next post.

 

How I Became a Better Forex Trader?

I considered myself to be an expert on equity markets when I started trading forex in 1997. I made money in stocks since early 1990’s. Yet I lost my entire first investment on forex. I traded longer term. I was hitting it big from the start. All the available leverage put me ahead 70% in just a few months. Without any info out, the market one day started to go against my bets. I added to a position, to lower entry point in an anticipation of market turn. Yeah right, market turned my way, as soon as a margin call wiped-out my entire balance.

I was stunned. My trading pride was badly hurt. I could afford to lose that money it just wasn’t good for my self-consciousness. So I stopped trading for a while and started reading. This way I actually analysed what went wrong. Basically I implemented Murphy’s Law (When all else fails read the Users Manual.).

I found an article describing the need of protecting your gains in leveraged investments. There was an anecdotal description there. You can gain 500% or even 1,000% trading in forex. You can lose no more than 100%. So gaining 500% on $10.000 investment makes it $60.000. Losing 100% on $60.000 brings account to zero. The moral of the story was to protect your gains and never risk too much. I made a rule to risk no more than 2% of my portfolio in one trade.

I am an economist by education and I know a lot about John Maynard Keynes. But it was years after my forex wipe-out when I found his famous saying: “Markets can behave irrational far longer than you can stay solvent.” That was a trigger to my next rule – don’t try to outsmart the market. Trade with the trend, not against it. If I think that market exaggerates I stay on the sidelines. I actually use this rule ever since in all markets. Even in Real Estate. I pay more in rising market. I sell in falling markets. Wherever I can use stop-loss, I use stop-loss (or some other strategy or combination of instruments to the same effect). Even my Home Insurance is a kind of stop-loss.

I tried that strategy and it works. I switched many trading strategies and styles of trading before I devised cross-majors strategies I use now with a success.

Also, when I first started trading forex I entered with an intention to make big profits. I tried to catch every upswing and every downswing. I overtraded, even if it paid-off at first. Than I picked a story telling that good swing traders catch 1 swing in 10. No one can catch every move. You have a choice to enter a trade or not. When you enter the trade you lose control. After you are in, the market will dictate moves and you can exit only as circumstances allow. My next rule is connected to the mind set. First I need to protect my portfolio; second goal is to make profit.

That is completely different mindset. I do not rush into every opportunity to make money with all the risks of loss associated with every open position. I wait until an opportunity that satisfies preset criteria arises. I limit my loss. I know what I will do whichever way the market turns.

There are more rules I try not to break in my trading, but these three are fundamental: Limit your risk, follow the trend and wait for the right opportunities. If used in every situation they will save you a lot of headaches.

Using stop-loss to limit my potential loss to 2% of my portfolio I can be wrong 5 times in a row and still not lose more than 10% of my portfolio. If I didn’t have stop-loss one big move against me could wipe-out my entire portfolio.

I am rarely wrong five times in a row but I have never been 100% right for more than a week.

 

Why I Like “Trading Systems Authority”?

Two years ago surfing I stumbled upon a website called Collective2, “Trading Systems Authority”. It took me some time to go through it but I am glad I did. Why? To make a long story short:

I used to invest some money in stocks and mutual funds, I tried commodities and options and I enjoyed trading currencies. My problem was, that I could not possibly study each trading market and segment particularities. It is just too huge for a humble human mind to know it all. I tried managed accounts, but all serious money managers required bigger amounts than I could afford.

In C2 I found more than 5000 trading systems, from commodities to stocks to options to currencies. All the systems are audited in real time and their performance scrutinized and analysed. Not all are good, but I was able to pick a few good ones. By good ones I mean systems that bring in more than 10% a month, consistently and with low exposure to loss. And I did not expose my money either. I was given free demo account to learn what to do and how. I started live trading only after I learned how to evaluate trading systems according to their past achievements and their trading style.

The beauty of these systems is a mixing capability. I usually pick 5-7 systems and give them different weights. For example, I give the first system 25%, the second system 20%, 15% to the third, and 10% to next four. If I do not like how they trade (I can check their open positions in real time through my free C2 account) I can easily switch one or more systems off, replace them by another or reinstate them afterwards again.

I do trade currencies successfully. With C2 I can trade all the markets successfully.

 

Ichimoku Kinko Hyo

Ichimoku is a fancy Japanese name for a complex technical indicator. Its main components are still moving averages. Ichimoku looks intimidating but ones we understand its components and the significance of the meaning of their interaction every trader can find it very useful. Let us look at Ichimoku components. Out of respect for its creator Goichi Hosoda, a journalist, we keep naming Ichimoku components by their Japanese names:

• Tenkan-sen shows the average price value during the shorter time interval defined as the sum of maximum and minimum within this time, divided by two (usually from 6 – 10);

• Kijun-sen shows the average price value during the longer time interval defined as the sum of maximum and minimum within this time, divided by two (usually from 18 – 25);

• Senkou Span A shows the middle of the distance between two previous lines shifted forwards by the value of the second time interval;

• Senkou Span B shows the average price value during the longest time interval shifted forwards by the value of the longer (Kijun-sen) time interval (somewhere between 45 and 60 periods).

• Chinkou Span shows the closing price of the current candle shifted backwards by the value of the longer (Kijun-sen) time interval.

1) First part of Ichimoku is a change in trend. Tenkan-sen and Kijun-sen serve as simple moving average crossover. When Tenkan-sen crosses Kijun-sen top-down we get sell indication and we get buy indication when Tenkan-sen crosses Kijun-sen bottom-up.

2) Second part of Ichimoku is support and resistance indication combined with volatility measure. Senkou Span A and Senkou Span B form a “Cloud” or Kumo. Besides shoving the support and resistance levels only, comparing to pivot points, the Kumo is also an indicator of volatility.

3) The third part of Ichimoku shows market sentiment. Chinkou Span is a measure of market sentiment. When sellers dominate the market, the Chinkou span will run below the price trend. When a pair remains bid in the market or is bought up, the span will rise above the price action.

The picture above shows Ichimoku (7, 22, 52), with Tenkan-sen in red, Kijun-sen in blue, and Chinkou Span in pearl white. Senkou Span A (Up Kumo) is brown and Senkou Span B (Down Kumo) silver.

How to trade using Ichimoku:

Look at the Kijun-sen / Tenkan-sen Cross - The potential crossover in both lines will act similar to moving average crossover. When short term trend crosses longer term trend it is a significant point in price action and always indicates a change.

Confirm the down or uptrend with Chinkou Span – If the market sentiment is in line with the crossover the probability of the trade going in the right direction will increase.

Price action needs to run out of the Kumo (Cloud) - Anticipated down or uptrend needs to make a clear breakthrough of the cloud of resistance or support because when price hovers inside the Kumo it is caught in a channel. Then the cloud margins form the support and resistance levels.

If the price is above the cloud, its upper margin forms the first support level, and the bottom margin forms the second support level.

If the price is below cloud, the lower margin forms the first resistance level, and the upper one forms the second resistance level.

If the Chinkou Span line traverses the price chart in the bottom-up direction it is signal to buy. If the Chinkou Span line traverses the price chart in the top-down direction it is signal to sell.

If the price is higher than Kijun-sen, the prices will probably continue to increase.

Tenkan-sen is also used as an indicator of the market trend. If this line increases or decreases, the trend exists. When it goes horizontally, it means that the market has come into the channel.

 

MACD – Moving Average Convergence Divergence

MACD is yet another variation on moving averages. MACD is composed of three averages, usualy of exponential moving averages: Fast EMA, Slow EMA and Signal. EMA’s can be (but of course) applied to open, close, high, low or median. It makes a bit of difference. You have to test before going to trade live. MACD is a bastard, because it is an indicator as well as oscilator. Usualy instruments of technical analysis are either indicators or oscilators. Indicators can have any value while oscilators move from one side of imaginary line to another, staying relatively close to median value. From the pattern that MACD makes, traders try to anticipate the direction of the trend. MACD looks (depending on your settings of colours and lines) something like this:

Moving Average Convergence Divergence

Longer term trend (slow ema) is represented by »zero line« and fast ema by magenta coloured line. The length of silver stripes represent the divergence of fast ema from slow ema. Important points are crosses of zero line (cross between slow and fast ema) and some paterns. One pattern I would like to expose here is an arc. An arc forms either at far distance from the zero line or immediatelly after it. An arc represents a top of a former trend and as such the bottom of the new trend. If we have five or more silver lines supporting an arc this usualy means that the trend changed direction and we should follow. At the point of arc meeting starting leg five or seven columns away we open a position in the direction of the trend. In the picture below we circled an arc that gives as buy signal on its way up, crossing zero line from below.

Arc is a perfect sign of trend changing.

There is a separate tread in Forex Factory describing 4 hour MACD trading with all the patterns involved. If you want to learn more, Forex Factory is the place to go.

MACD trading works best with 4 hour or daily charts, because shorter timeframes tend to be to noisy. MACD signals are fairly good opening signals, while they tend to be to late for closing. When trading according to MACD it is advisible to use stop loss and trailing stop functions. Trailing stops should reflect double ATR for the time frame, or they will tend to prematurely close.

 

Will USA default on their debt?

WSJ – Washington Is Quietly Repudiating Its Debts (August 22, 2008; Page A15) was an article that made me sit down and write my personal view of US “debt problem”.

Consecutive USA governments are not by themselves guilty of accumulating more than 9.5 trillion of outstanding treasuries. Japan, Asian Tigers, and later China helped with its build-up. If we take, for example, a case of Japan we quickly find why Japan is the biggest buyer of US denominated assets:

Japan is net exporter. If they want to purchase raw materials and energy for their production, they need to import those using US dollars. When they sell them abroad, they get dollars, many times the value of raw materials and energy. Their homeland suppliers and workers they need to pay in yen. Therefore, they have to sell US dollars to buy yen. If they sell a lot of dollars the price of yen in dollars tends to go up.

If the price of yen in dollars goes up, the price of Japanese exported goods in US dollar terms tend to increase. If they become too expensive, nobody buys. If nobody buys we have a recession.

To keep the dollar price of yen (USD/JPY exchange rate) low, Japanese have to sell yen for dollars and store dollars in their vaults or to lend them. Natural borrower of US dollars is US government. Everybody likes to lend to solvent borrowers. When US government borrows, the US immediate buying power is higher than it should be exactly for the amount borrowed. USA was the engine of growth for the whole Asia for more than 20 years.

USA dutifully paid all of its debts at maturity. National debt in 2008 represents more than 60% of yearly GDP. Is USA financial system in danger?

In my opinion, already the administration of Bill Clinton (the guy that has leaded the nation between Bushes) prepared emergency exit strategy. “In January, the U.S. Treasury finally auctioned the first in a new series of inflation-indexed securities. With their penchant giving new products cute names, Wall Street professionals have started calling these notes TIPS, an acronym for Treasury Inflation-Protected Securities.” Wrote William F. Ford in ABA Banking Journal, Vol. 89, 1997. Today, on August 22^nd 2008 the yield difference on 30 year treasuries is 4.47% for regular bonds against 2.04% for TIPS (Source: Bloomberg).

TIPS are composed of two parts: inflation-connected interest rate and real interest rate. While with regular treasuries yields are fixed regardless of inflation rate, TIPS pay out inflation adjusted amount. The higher the inflation the bigger the payout on coupons at maturity. From cash flow perspective regular bonds are worth less when inflation is high. TIPS do not lose value if inflation rises. I choose TIPS against regular bonds 5 out of 5 times.

In early eighties we have already seen rampant inflation of over 15% in the USA. We can see it coming again. When (I did not say if) inflation picks up, the Fed lets it go until it rises above 10%. All markets rise, except commodities and bonds. Oil prices fall to 50$ a barrel (this is still 500% more than 10 years ago, when it fell to 10$ in December of 1998! – Source: WTRG Economics), and 30 year treasuries’ prices (at 3% coupon to yield 15%) drop to 20% of their nominal value. Source: Bond Yield Calculator.

What does a smart government do? A smart government in a series of auctions issues heavily demanded TIPS for about two trillion US dollars and slowly and quietly buys back regular bonds for 20 cents on a dollar, thus replacing 9.5 trillion in bonds with 2 trillion in outstanding TIPS. And who cares about the guy making a buck out of 50 cents!

Technically, US government would not repudiate the debt, although the effect seems much the same. Some creditors most likely would not be happy. One of the consequences might be a change in structure of foreign reserves. While now about 63% of 6 trillion of global foreign exchange reserves are held in US dollars, 27% in euro and 10% in all other currencies together, after an operation of “Debt wiper” euro would gain to the expense of US dollar. US dollar would fall against all majors (from 75 where it is now to 50 or even below).

Asian economies would have to write of substantial amount of reserves, but the development that they have achieved in the last quarter of a century probably outweighs the costs incurred. We would probably exit the stagflation times stronger than ever, ready to make another inflationary bubble, hopefully something not already seen.

 

Rainbow Moving Average

Rainbow Moving Average

(when using groups of very long, long, medium, short and very short MA’s)

Rainbow MA is more pictorial then the rest. If you colour groups of MA’s differently and each group comprises of five lines, their positioning and wideness tell the story in more details.

For example, if we colour EMA’s 2,5,8,11, and 15 in yellow, 30, 34,38,42, and 47 in orange, 90, 95, 100, 105, and 110 in green, 190, 200, 210, 220, and 230 in blue and 365, 380, 400, 420, and 450 in red, we will have the least waves in red and the most in yellow. When red and blue and green keep following the same direction and yellow jumps on the other side it usually comes back to the good old stable long term trend. When we, therefore, see a strong deviation from red, we execute the opposite. Namely, if yellow lines jump far above the red ones, with no real changes in colour structure, we assume, that the jump was predominantly speculative and that everything will return to the previous levels. By selling high and buying back cheaper we accomplish our first goal.

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