Piptopia

What Does a Trader Do?

2008-05-07T11:29:09Z

What does a trader do?

One thing that I couldn't accept as an attorney (for the five minutes I seriously considered that as a profession) was that I'd be confronted with the temptation to make money from projects and clients with whom I did not want to work. The wealth that is created from doing a law-job is wealth that comes from the support of, allegiance to, and active promotion of a client's business.

How is trading different?

A trader creates wealth from scratch. When you produce income from trading, you are creating wealth from the following ingredients:

Charts
Fundamental information
Price
YOUR MIND

Some would argue that trading is a zero-sum game, and what you win is someone else's loss. I think that's an immature description of trading. It's far more productive to view trading as the opportunity to use your mind, your talents, your discipline, and your friendships to create wealth.

When you produce income in this way, you're not extracting (consuming) a piece of someone else's pie. You're not feeding off the labor of others, or piggybacking on the business interests of some other party. Or earning wages from the support of a cause that you cannot support. Or befriending others for the purpose of winning their business rather than because you have shared goals. The cause is the support of you and your family. Of your ideals. The cause is the charities that you support, the friendships you can foster through trading, and the development and strengthening of your own talents.

In summary, a trader is self-sufficient. The practice of using ingredients like charts, fundamentals, price, a computer, and your mind to produce wealth enhances your ability in the long term to be completely independent.

What is the Purpose of Trading?

2008-05-06T11:20:21Z

What is the purpose of trading?

It seems clear, doesn't it? The purpose of trading is to make money. The trade is planned, entered, and exited with the goal of increasing the size of one's trading account. What other purpose would there be?

The dictionary says this about purpose:

"something set up as an object or end to be attained : intention b: resolution, determination"

What about:

The purpose of trading is to not lose money.
The purpose of trading is to practice discipline.
The purpose of trading is to use my talents.
The purpose of trading is to grow.

Or how about:

The purpose of trading is to express my true nature. I was meant to be a trader.

Maybe the purpose of trading is simply to trade. Because that is what you have been called to do, or what you are meant to do, or it's the highest expression of your nature as a producer rather than a consumer. When you trade successfully, you are disciplined, you are growing, you are using and developing your talents, you are making money, and you are creating wealth from scratch. But most of all, you are trading because it's the right thing to do for you.

Reykjavík Under Seige?

2008-04-17T14:20:18Z

[you can listen to our broadcast about this here]

It has the world’s highest literacy rate. People live longer in Iceland than any other country. They are supposedly some of the happiest people on earth if you believe a new book out. Here is what is happening to the one of the world’s smallest independent economy and its currency:

1. Inflation is out of control. It’s now at 9%.
2. Central bank interest rate: 15%.
3. Performance of the currency (the krona): -20% against the Euro since the start of 2008.

Who’s to blame? The central bank asserts that it’s the fault of hedge funds and international financier Michael Weist, who operates a currency trading empire out of Malaysia. I am not so sure about the hedge funds, but I would keep an eye on the Weist guy. Sounds shifty.

The central bank really is arguing that international financial players are preying upon a difficult situation in the country and wreaking havoc on the economy. You know, doing wild speculative things that you only see in financial documentaries for people over 18.

But is that really the problem here? Let’s go back and see how the country handled its own finances, and we’ll see if we can trace the line of responsibility for the current problems back to anyone else. In the last 5 years, the three major Icelandic banks issued billions of dollars in cod-bonds.

These are bonds that offered really, really attractive interest payments. Who bought these bonds? International financial players like, oh, say, hedge funds. These hedge funds, as we all know now, sold Japanese Yen and bought high-interest bonds in New Zealand, Brazil, Hungary, and yeah, Iceland. Lots of them in Iceland. Billions of dollars of them. Foreign debt, in the last 4 years, quadrupled. And you know what these banks started to do when they realized they were on the hook for these huge interest payments?

They hedged their bets. Sounds smart, right? That’s what intelligent traders do.

These banks sold their own currency, the krona, in futures contracts. They entered crazy derivatives deals with leverage and bet against the value of their own currency. When the krona started to fall, they made huge amounts of money and everyone was happy.

At the same time the banks were doing this, the hedge funds that were playing the carry trade game were buying and selling – and some of you already guessed it – credit default swaps (CDS) to hedge their own risk, just in case the Icelandic banks weren’t able to pay the debt.

So, let me get this straight:

1. The Bank of Iceland set the base interest rate high.
2. This attracted foreign capital on a massive scale.
3. This launched the economy into a frenzy.
4. Icelandic banks sold their own currency to hedge the bet.
5. Hedge funds did the same.
6. Now the krona is cratering.

Does this seem like an international monetary conspiracy to you? Was the central bank angry when foreign capital came in and boosted the economy? Why would they be upset when foreign capital is leaving and causing problems for the economy? The same country whose banks created “cod-bonds” to specially attract international hedge funds is feeling the effects of having created the entire mess in the first place. You can choose to raise interest rates, or allow your banks to trade on leverage and create risky financial instruments. You can’t choose the consequences of those actions.

It’s not so different from any losing trader. We love the system we’re using when, with outrageous leverage and sweet euphoria we make tons of money. And we become disenchanted with trading for a living when it all goes wrong. We start to say things like, “It’s not actually possible to trade for a living,” and “My dealer stopped me out,” and so forth.

Maybe, I suspect, we shouldn’t have fallen for the oldest trick in the book, which it seems that even countries are not immune from: we tend to increase our bets and greedily want to accumulate as much as possible now, without regard or attention to the longer term consequences of our selfishness.

Wal-Mart Dollars and the Next Boom

2008-04-16T14:11:18Z

What does it take to have a strong economy since 1990?

1. Capital: the world has to be awash in money. In 1994, Bill Clinton signed into law a regulation that allowed banks to hold less in reserve. The world became awash in cheaper money. Greenspan lowered rates significantly during the latter part of the decade. In 2001, the Fed aggressively cut rates and kept cutting them into the next year, and we saw 1% for over a year.
2. An asset class that attracts the ordinary investor and institutions alike. In the 1990’s, we had stocks and in particular IPOs. It was the decade of equities. It will forever be known as the tech boom, most likely, but in general, the last 5 years of the decade were simply ruled by a white hot stock market and an institutional appetite to invest in startups. Billions of dollars were poured into new companies who developed technologies – many / most of these companies failed, but the result was a huge influx of advanced technology into society.

In the first five years of 2000, housing ruled the American economy. As investors who were burned by tech stocks looked for the next big thing, many of them felt more comfortable buying real estate than investing in the stock market. They were finally listening to their mothers, who said the stock market was risky (a Great Depression era mentality) and put their money into a hard asset like real estate. I have a friend who says that trading and real estate are different, because when something goes wrong with your trade, you can quickly go broke, but when something goes wrong with real estate, you can simply hold on. Well, if you look at a heat map (www.hotpads.com) of foreclosures in the southwest, we’ll all agree that holding on to underwater real estate isn’t what is happening.

Both the stock market and real estate bubble had something not only for the regular investor, but more importantly, had huge appeal to the institutions and funds who needed to park massive amounts of money. It was easy enough to invest in startups, venture firms, office parks, housing developments, and the returns were great during the good years.

So what’s happening now? It seems we’re due for a contraction, which we’re getting right now, before the next bubble comes along. But issue is: what’s the next bubble? Where’s the next driver of the American economy?

We are, as a world, swimming in a sea of capital. There are trillions – yes, trillions – of Wal-Mart- and Petro-dollars in the world today. “Wal-Mart dollars” is my term for the export dollars created when Asian nations ship us cheaply made products and we send them our hard-earned cash. You know what petrodollars are.

So we’ve got the first element: the world’s got money. And piles of it all around us – to the Far East (Wal-Mart dollars), the South (Mexico has its fair share of Nafta-Flavored Wal-Mart dollars), and the Middle East and North (Islamic Petrodollars, and Canuck petrodollars). There are still billions of private equity and venture capital dollars in the states. We’re not hurting for cash as a world right now, and that’s why it’s so easy for WaMu, Wachovia, Citibank, Morgan Stanley – all of them – to raise more capital very quickly. It begs the question of why Bear Stearns couldn’t be helped at the last minute by a big investment rather than a big bailout, but that’s a question for another time.

Do we have an asset class that fits the bill? I think we not only have one, but we have two potential candidates.

The first is health care. Baby boomers were born between 1946 and 1964. There are 82 million of them. The oldest ones are now 62 years old. And for the next 20 years the oldest ones will reach 82 and the youngest 62. That means we’re going to get about 80 million super-users of health care over the next 20 years. Medical equipment, pharmaceuticals, hospitals, disease prevention and curing, and genetic research are just five areas that could use loads of institutional capital to grow. This is probably the next bubble, and it’s going to be huge. This industry is easy for ordinary investors (through stocks) and institutions to invest in.

The second is energy. Energy efficiency is the harder of the two to for me to believe in. The drive to wean ourselves from oil in the states is going to go slower and take more political effort than we might have. If we did muster the courage to do this as a nation and a world, we could launch a huge technological boom. Most of this, however, seems like it would have to come from the government and private sector: there are simply not enough areas for the ordinary investor to participate in – there aren’t enough alternative energy stocks to go around just yet. Maybe that can change.

The point to this enormous post is to say that the conditions are right for another boom. Sure, we need a period of cooling off. We need to shake out the bad people from Wall Street, bail out some rich people, save some banks, contain the cost of food and energy, and finish off the mass foreclosure process around the country. That’s going to take 12-18 more months.

And then, let’s bring on the next boom.

List of Things I Do When I Plan a Trade

2008-04-08T23:19:20Z

1. My better trades come when I have found a place to quietly think about the trade idea, before I take the trade. I lay down for a few minutes and let my mind roam. This settles me down at an otherwise tense moment. It also allows me to clearly consider what I like or don't like about the trade.

2. It's important to me to ignore outside influences when I am planning a trade. I'd rather pay attention to my own reasons for the trade, instead of someone else's views of the currency pair that have nothing to do with the indicators and other things that I look at when wanting to buy or sell.

3. It's one thing to have a rule- or principle-based trading methodology. It's another thing to actually trade that system with a clear and rational mind.

4. Sometimes I realize that I have become very anxious about a trade idea, or a trade plan. These are good times to find a quiet place and get away from the computer, until I've sorted out the reason for the anxiety. I take plenty of trades when I'm anxious, of course, but I've at least thought about the reasons behind the anxiety first.

5. How many losses I've taken recently is the last thing on my mind.

Houston Seminar in May

2008-04-08T16:04:17Z

I'm going to do a two day seminar in Houston, Texas, on May 23-24. We'd love to have you join us. Seating is limited for these smaller seminars, and the spots go very quickly, so if you're interested, let me know soon.

What to Do on Your Day Off

2008-04-04T12:38:51Z

What do you do on your day off from trading? I don't mean Saturday. I'm talking about the day you take off from trading, on a weekday, to get away from the screens and the charts and the trading and the stress.

Taking a day off gives you a chance to step back and reclaim some of your personality. Here are two examples:

1. My friend Ariel took a couple days off from trading to go to an Expo, to meet with friends, to visit New York. He didn't even bring his computer. He was rewarded with a fresh perspective, good food, and he even say Erin Burnett at a restaurant in Manhattan. He didn't go to the Expo to learn new things about trading. He went to talk to his friend and recharge his batteries.

2. Another friend took a trip to the Red Sea (he lives in the Near East) to get away from trading during a time when he just did not feel like he was in sync with the market. He reclaimed his sense of place in the markets, felt that he got back his clarity of mind, and resumed making money when he returned.

It makes sense to give yourself a chance to think about something else besides trading. If you do it during the week, you prove that you are not owned by the markets, but that you own your own schedule, that you have the discipline to walk away every once in a while. Give it a try.

Let's Not Spend and Have a Recession Instead

2008-04-03T02:30:28Z

If you think that consumer spending is important to the economy, and, like, you probably do if you live on Earth, then this ought to interest you; it's the XRT index -- the S&P Retail Index:

Consumers in the United States have stopped spending. Consumer spending is 66%+ of total Gross Domestic Product for a country. Recession, anyone?

When Things Go Wrong

2008-04-03T02:01:27Z

So things sometimes don't go the way you wanted.

The trade falls apart. The stop loss gets hit, but your dealer doesn't get you out of the trade. Or the spreads widen. Or you forget you have an order in the system and it triggers, and you're on vacation, and you're just having a great time until you are on the White Knuckler roller coaster ride and you think to yourself:

Holy crap! Did I have an open position on the GBP/JPY when I left the house?

What do to in times like that? What do you do?

Trading is much like holding a fire in your hand.

At the same time, it's beautiful and mesmerizing (for some of you at least). It hurts, too. When you have a bad trade, you are holding fire in your hands, so to speak. What are you going to do with it? Take a picture of it? Hide from it? Close your hand on it? Blow on it? Pour gasoline on top of it?

We don't always react in the best of ways to the unexpected trade. Especially if the trade is a loser, or a mistake, we are likely to try to hide from it first. We flee from the scene of the crime.

If things don't go your way in trading, tackle the situation. Get on top of it. Figure something out, and do it with friends, and do it sooner rather than later. You'll be happy you put out the fire in your hand.

ITC Videos are Up

2008-04-01T18:30:32Z

Dave and I had the pleasure of going to Barcelona for the International Trader's Conference last year. It was hosted by FXstreet.com and it was a great time -- and now you can watch a ton of videos from the event.

Just click here to see the videos.

Walking Away from an Ugly Trade

2008-03-28T14:04:16Z

Over the next 12 months, it's possible that over a million US residential mortgage-holders are going to walk away from their homes. They're going to walk away from all the payments they have made, from the work they've put into making the house look nice, walk away from everything except (probably) their belongings inside. Why would they do that?

They'll do it because they owe more on the mortgage than the house is worth. They bought at the top of the market, they bought with mortgage rates that have climbed as their incomes have fallen, or simply because they have to move for work or other reasons, and can't sell the house.

Thinking about this today brought to mind bad trades. There is a temptation that I've had in my trading career to walk away from a bad trade. Just let it rip. Walk way from it, push it out of my view, put as much distance between me and the bad decision. I call this Possum trading, and you can read about it in my ebook The Woodchuck and the Possum by clicking here.

I think we are tempted to walk away from a bad trade for understandable reasons (like I've described above). Just because the reasons for walking away from a home underwater, I can see why a trader would prefer to close his eyes to the ugliness of a poor trading decision.

This type of behavior has deep, long term negative consequences. When faced with an ugly trade, it is much better to do any or all of the following:

1. Talk to a trading friend and frankly disclose the entire situation;
2. Calculate how close you are to a margin call;
3. As a person who trades for a living what they would do;
4. Immediately admit that you might need to take the loss, but don't necessarily immediately close the trade;
5. Following up on #4, don't panic;
6. Write down or record your thoughts on a regular (daily or hourly) basis about the experience;
7. Stay present in the situation and face it head-on.

The result may be that you close the trade and take a loss. But you do it with integrity, and you learn from the experience. But there is a chance that if you follow some of these steps, you get yourself out of a tight situation -- with help -- and you turn what could otherwise be an unecessary loss (due to panic) into a positive.

The Beginning Trader

2008-03-27T05:53:58Z

Most people who call themselves traders lose money, and you've heard that a thousand times. It's not even interesting to hear people talk about it anymore, although we could all use a dose of that reality more often. It's questionable whether most people who call themselves traders are actually really embarking on a new career as opposed to a hobby. That's a discussion for another time, perhaps.

Tonight, as I was on my flight to Arizona to do a seminar, I thought about some recent "new traders" that I have worked with and known. One is a PhD in organic chemistry. Another is an analyst/researcher at a Wall Street firm. Both are students of mine and I would consider them the best kind of friends in the world.

What impresses me about these "beginning traders" is that they have a fresh, inquisitorial perspective. They are flexible. They are open-minded. They are approaching trading as a new career, with vigor, energy, dedication, responsibility and also generosity (as they share with others that which they have learned). And another thing: neither of them is likely to lose their entire first account. Both of them have been making money, have taken money out of their accounts. Neither of them have had trading experience in the past.

So what makes the difference here? They are beginning traders but they're not psycho-risk-taking crazy gambling currency dudes. Instead, there is something about them that makes a difference.

Right now I can only account for their success (and they are at the beginning, I know) by saying that they are getting the best out of being beginners. This fresh, new, open minded stance they are taking is what creates the very success they are having.

I have a lot more to say about this, and I'd like to hear what you have to say too.

The Wisconsin Cheese Index

2008-03-24T03:38:51Z

Do you like “trading the news?” Then the new-news is any news about the bailout. That’s the big news – look for Fed statements, Treasury speeches, and especially a speech by the President which I would assume has to come in the next month. If it doesn’t it will just mean that we’re putting off a statement by the commander in chief of the economy. These statements and speeches will have huge impacts on the RPP’s – the Risk Proxy Pairs:

USD/JPY, EUR/JPY, GBP/JPY , GBP/CHF, USD/CHF

These are pairs that are prone to move a lot when news hits about the state of the world economy. A lot of risk is bundled up in these pairs: the JPY is all about the carry trade (you think that has gone away, but it hasn't quite yet fully played out); the CHF is about Gold, the world's hedge against inflation (which might not actually be a problem, as we'll be exploring on the radio show this week).

It’s mildly interesting to watch what happens to the US dollar after the Non Farm Payroll report. But what you will see after Trichet of the ECB announces the full extent of the European Economic Problem in April or May – that will make a Non Farm Payroll report look like the Wisconsin Cheese Index, which is a fake report I made up to prove my point. Actually Max made it up, and it’s the greatest fake report ever.

The Bailout

2008-03-22T21:36:57Z

For those of you who live in the United States:

Let's suppose that a national referendum were held next week. You could vote for or against the following proposed action by the US Government:

The US Government will take control of 20 of the 50 largest US regional banks which have become insolvent due to overextension of credit to subprime borrowers. All shareholders in these banks will lose 100% of their investment. The government will keep these banks' doors open. All deposits up to $200,000 (twice the current amount) will be guaranteed. All other deposits above $200,000 will be wiped out.

Would you vote for that?

How serious do you believe the current economic crisis to be?

Let's add one line to the law, and now think about your answer:

In addition to rescuing these banks through nationalization, the US Government will honor severance packages to bank executives who lose their jobs as part of the process; this includes honoring and paying out as much as $50 million to CEOs of these banks.

Now what?

What is Crazy Risk? Why does Leverage Matter?

2008-03-22T20:49:20Z

Martin Wolf, in his excellent column for Financial Times, points out that a 15.4% annual return for a hedge fund would be "handsome." How many of you that read this blog would be willing to show up at a trading expo and brag that you had achieved a total return of 15.4% over the last 12 months of your trading?

He then goes on to talk about how a mediocre hedge fund manager can produce such handsome returns in seemingly easy fashion by allowing himself to go deep into debt (leverage) at risk of blowing up the fund. What is this excessive risk? Here's a quote:

Hardly a week goes by without the implosion of a hedge fund. Last week it was Carlyle Capital, with an astonishing $31 of debt for each dollar of equity. But we should not be surprised.

I am not making that up. That's what smart financial people believe to be "astonishing" leverage. 31 to 1. Most currency traders trade with 100:1 leverage.

What makes leverage such a big deal? Why does leverage, in and of itself, present such a problem?

First of all, the availability of high leverage encourages a trader to amass a large trading position, even with a small account. Let's take a trader with a $5,000 account. Let's say that his dealer allows 100:1 leverage. This trader puts up $2,000, and in turn is able to command a $200,000 position in the market. Each pip / point that the position moves for him, he makes $20. If the market moves in his favor 50 points, he's made $1,000. That's nearly enough to make a car payment, buy some groceries, perhaps even make a rent payment (at least in West Virginia, where I live -- it could even pay a mortgage).

This all sounds good so far, right? The trader makes a good trading decision, makes a 10% return in one trade, pays some bills, and moves on. Leverage seems to be the friend of the trader. Where else could this person put $5,000 to work so efficiently, so quickly, with such seemingly easy profits? The stock market? Heck no!

In the stock market, this trader would put $2,000 up -- and then be able to command, at most, a position of $4,000 worth of stock (those are the rules -- you can only trade with 2:1 leverage at most in the stock market). If the market moves 50 points, which is unreal in the stock market (can you imagine GE moving 50 dollars in one day?), the trader is likely to make about $50. No wonder so many people are flying out of stock trading and racing into margin currency trading.

This all sounds good so far. The currency market simply allows for a maximization of profits with a small account.

The problems start when this trader begins to have some losses. Instead of making 50 points and $1,000, he loses 50 points and draws his account down to $4,000. If he has a 70/30 trading system that wins on average 7 times for every 3 losses -- he could experience 1, 2, 3, 4 -- or more -- losses in a row and suddenly be looking at a severe reduction in his trading account. Maybe this trader is disciplined in every other way. Maybe the system is tested. Maybe he's a stable person.

But if he loses just 6 times in a row, he's going to have lost $6,000. Um...that's more than he has in the account. He can't even go more than 5 losses in a row.

The problem isn't that leverage exists or that it is available. It's that most of us, when we start trading, don't realize how fast we can run through our entire accounts. We risk more because we can make more and we end up losing more.