A magnitude of improvement

I am very excited about the direction my trading has taken in this first week. I've made some simple optimizations to my strategy that help take each currency pair's personality into account. In the month of May, I was putting everything into one box which seemed logical to me at the time. But I soon realized that the currency pairs behave very differently, and they tend to each have their own attitude. It would be better if I could treat the currencies in a more dynamic way, much in the same way one might parent children ;)

For example, I am currently re-testing each pair and incorporating an additional metric that I had not tracked before: the reward ratio of the setup. Reward ratio (aka risk/reward ratio) is expressed as a comparison of a single trade's probability of risk to reward. So if your maximum loss potential on a trade is 50 pips, and your expected target is 150 pips, that would be a 1:3 risk:reward ratio. Risk is always expressed as a 1, so I just call it the "reward ratio" and say that it is 3. This means that for every $1 I commit to risk on this trade, there is a probability I will reap $3 in return (net 200% return). This method of trading allows me to constrain risk to a specific threshold of pain (such as a percentage of account equity) and also target specific profit levels.

If you take the average reward ratio for an entire collection of trades (such as the entire lookback testing period), you get a different figure called expectancy. This figure represents the average expected return on your system for the given pair. In my weekend analysis, I realized that it doesn't make sense to trade pairs that do not have exceptional expectancy. I would rather trade less frequently but with more accuracy. That would be working smarter, not harder.

I'm still performing lookback tests and adding quality pairs to my toolbox. I've decided to set a minimum standard of 3.0 expectancy. Anything less does not make the grade. Here is my list so far:

• Great British Pound / US Dollar: expectancy 4.5 trading with 6:1 profit targets -- WOW!
• Euro / US Dollar: expectancy 4.5 trading with 4:1 profit targets -- awesome!
• New Zealand Dollar / US Dollar: expectancy 3.0 trading with 2:1 profit targets
• US Dollar / Japanese Yen: expectancy 3.0 trading with 2:1 profit targets
• Australian Dollar / US Dollar: expectancy 5.0 trading with 2:1 profit targets -- woohoo!

So in laymen's terms, I would describe it like this: The higher the expectancy, the more likely the pattern is to work and the trade to become a winner. The higher the profit target, the more moolah generated with each trade taken. So in my opinion, the best performer in the group so far would be GBPUSD, but truly all of these are superstars!! There were plenty of currency pairs I tested that failed to make the 2.0 expectancy grade.

One of the biggest frustrations for a trader
One of the biggest frustrations for a calm, collected trader who is waiting patiently on the sidelines for the absolute juiciest and most succulent fruit to come along... that flyball that he hopes to hit right out of the ballpark -- is to miss the trade setup. YIKES!

This exact scenario happened to me this week and I'm bummed. I did not do anything wrong and all of my system procedures worked correctly. The computer informed me at 4am that a prime trade was developing, and that I should get involved to take a look. ARG! For whatever reason ... I did not hear the multiple alerts that were reaching my cellphone. I must have been in REM sleep mode or something :( By the time I awoke at 7am, it was too late. I entered my trade order but the pair never retraced to reach my optimal entry.

Typically on the 4hour timeframe when a pattern forms, it seems that there is only a small window of opportunity to execute. The computer does all the heavy-lifting and math calculations so it is not a big deal to wake up and key the trade entry (I don't have to do any thinking except to evaluate how sexy the pattern looks).

To give some weight to the frustration... this pattern formed on GBPUSD which, as discussed above, is one of the absolute best pairs in my toolbox right now. This single trade would have eclipsed the entire month of May due to optimizations made this past weekend. Trades taken on the Great British Pound are expected to catapult my account into the stratosphere!

Alas, I am not too disappointed. Part of being a good trader, I believe, is rolling with the punches. The lesson learned here for me is that I need to prioritize automating the trade-entry process. I think I will make that my major focus and hope to have a prototype ready next week. I would like to give the computer the freedom to identify and also execute on my trade orders, because I do not want to miss a single RIPE trade.

Consistency is key

As with most endeavors, it makes no sense to keep going around in circles if it isn't working (ie, the definition of insanity). But for a trader, consistency is one of the most important accomplishments one can aspire to. We want to realize our "edge," and be able to repeat it over and over in the way that only a dynamic and genius human brain could. We are charged with the task of check-and-balance, of constantly reviewing our execution to see if it can be tweaked or improved. The ultimate goal is consistency. We need a performance metric that can be measured statistically over time, and one that we can use to gauge our market prowess. While discretion is important to a trader, I believe that for review and measurement purposes, we need to extrapolate our execution scorecard in a way that is as objective as possible. In fact, in cases where subjectivity cannot be avoided, I always err on the side of failure, and would rather be pleasantly surprised by reality.

This week marks the end of May, and the first month of a significant new trading strategy for me. I have been very focused on closing efficiency gaps and trying to listen to the tick of the markets. I could argue that this month is not "typical," but then what is typical?? I don't think it is wise to try to define typical or normal -- to put the markets in a one-size-fits-all box. I would rather hone my skills with a strategy that is dynamic and intuitive enough to give me an edge under changing and dramatic conditions. After all, we have not lived through an economy like this yet in our lifetimes, and we certainly cannot assume anything at this point.

A lot of people made bank in the run-up to the Internet bubble bursting circa 2000, but only the smart money managed to live through it (because the rest went bust). I am in this for the long haul so consistency is more important to me than even pips or dollars; I'm not saying they aren't important, just not giving them any focus. I believe that once a trader's strategy becomes second nature (ie, he has mastered his game), then perfect practice will result in a perfect execution. Speculation is an art form, and should be held with such regard. Of course mastery of this art leads to growth, in more ways than one.

So the metric I've chosen to follow, the benchmark by which I will rate my system's success, is called expectancy. In a nutshell, this metric simply gives you a reading of how effective and profitable a strategy is over time. Van Tharp talks extensively about expectancy in his books. This single number gives you a birdseye view of your entire collective strategy. It can help you determine which instruments are worthy to trade your rules with. In my case, I will use expectancy to do these things:

• Identify which currency pairs I can trade with highest success probability before taking any trades;
• Track ongoing system performance and make my own "circuit breakers" to give me advance warning of when a pair goes "out-of-spec" -- because I believe that most strategies do not repeat forever, at least without some degree of morphing. My goal is to be nimble enough stop trading before I can see it visually and obviously in my account equity.

In measuring expectancy from the lookback tests, I can see that some pairs perform exceptionally better than others. For example, I'm finding that the Pound/Dollar and Euro/Dollar have a far better expectancy than Dollar/Swissy. I don't exactly know why, but I'm not sure that I really care either. What matters most is that I have a benchmark to look at, and I know that I need to focus only on pairs that have the highest-probability success patterns.

I'm also currently debating whether it is a good idea to add a leverage weighting to the higher expectancy trades. For example, if I know that Pound/Dollar has twice the expectancy of say NewZealand/Dollar, perhaps I should double the gearing when I place the trade? I think for the upcoming 30 days I will not make this change, but instead will observe what kind of impact that could have. In the back of my mind, I'm trying to justify why NOT to add expectancy weights. In laymens terms, I'm basically arguing: if I know a trade is twice as likely to be successful, then why shouldn't I take twice as much risk, for the opportunity to make twice the reward? It would be an objective way to exponentially grow the account based on a consistent strategy.

Speaking of gearing and leverage, I've started using this different calculator due to some weirdness in lots calculation I noticed for cross currencies like Euro/Swissy. I am now using this calculator which gives me the exact micro lot figure I need to enter into my broker platform. I am still planning to automate this, but the math has me befuddled and as such I have not prioritized it. Once I'm able to consistently work these formulas on paper, I can pretty easily program the computer to calculate them in realtime. There are 3 circumstances requiring 3 different formulas, as I understand:

• direct rate
• indirect rate
• cross rate

Below is an example of how I use this new online calculator to get an exact micro lot calculation prior to entering new trades:

Sitting on hands

Without a doubt, I think the most difficult thing for a trader to do is sit on the sidelines. We have a natural tendency to want to trade trade trade and then trade some more. I think we tend to over-trade by default, with the mistaken assumption that more quantity will equate to more bank. But let us not forget that money is lost as quickly, if not quicker, than it can be made. That a trader could go through all his motions and end up with a gain on the other side -- is a feat in and of itself.

The underlying philosophy here is that we are not in control. Even if we wanted to be, we still could not be in control. The market has a mind of its own, and it's called "crowd behavior." Fortunately for us, crowds are not the smartest beasts on the planet, and they tend to move in very slow and predictable ways. In fact, they move in patterns if you look closely. There are lots of patterns -- maybe even limitless -- and as a trader we only need a few good ones to claim our "edge."

So if we believe that nothing we could do would ever impact the market's behavior (note: believing anything else would be denial) then it should be apparent that our key tasks are:

1. Put our ear to the wire, take an abstract bigger-picture assessment of what's happening, and find those patterns so we have an edge to work with;
2. Utilize correct money management (ie position sizing) so we can always trade tomorrow; and
   
3. Control our human emotions so we do not get sucked into the crowd. The crowd is a moving target and constant temptation.
   

Right now the most difficult challenge for me is #3, because I'm starting to get antsy. I can't wait to jump into a trade but I know that is not a wise feeling to harbor. In a lot of ways, it seems like I'm more tempted to get into a trade than sit still watching the clock tick. With all the unsettling geopolitical news, skyrocketing volatility and stock market computer glitches rattling the regulators... it's no wonder I feel like I'm on a caffeine high waiting for the next opportunity -- any reason at all to grab hold and hang on!

Fortunately my trading rules are pretty strict though. They probably keep me out of the market more than they allow me to be in the market, and that's a good thing. Because the majority of the good cherrypicks happen when the markets are trending. Temptations happen in conditions like we have now when the climate is uncertain at best. We need a catalyst, something to get the crowd moving again. And the movement needs to be slow and tending, which will then become trending. Then it will also be predictable and we'll see those familiar patterns start popping up. That is when I will strike with force.

This week has been an intermission for me so far. Right now, I'm watching the following pairs with interest. I'm looking for patterns, but I haven't seen one that I can trust yet. It could come at any time. And from experience, I also know that when patterns start forming, they tend to come in waves: we could see multiple patterns setup all at once. In that case the challenge will be to go shopping and pick only the plumpest, juiciest cherries.

Aussie/Yen (short) -- RIPE
Euro/Swissy (short) -- RIPE
Euro/Yen (short) -- RIPE
Pound/Yen (short) -- RIPE
Dollar/Swissy (long) -- RIPE

Hang-on for the wild ride!

The EU approved a $1 trillion rescue plan this weekend and looks like most of the pairs are snapping back after last weeks snafu.

Here is a list of pairs I'm watching that are on my "approved to trade" list. I watch new pairs all the time, but I only trade those that have passed my requirements in something I call the "lookback test" -- it is a visual review of the past 6-or-so months studying the patterns I watch. If the pair performs well during this recent market activity, I add it officially to my watchlist. I currently only watch pairs with an average spread of 5 or less.

To identify pairs that I consider tradeable, I look for patterns that work 50% of the time or better. During the lookback test, I record each pattern entry as a win, loss or 1:1 breakeven. All pairs on my list have achieved 2:1 or better expectancy. Some perform exceptionally well and others barely squeak out the 50%. But either way, I feel confident to take every trade signal on a pair when conditions are RIPE for opportunities.

Normally I'm only adding pairs to the RIPE list once per day at the New York close. But a dramatic change of events has occurred since the close on Friday, and as such many pairs have already moved far beyond typical. So for now I'm officially watching these pairs and will make an on-the-fly assessment as to whether or not they are ripe if a pattern should form throughout the day. At 5pm, I'll do my regular review and create a "ripe list" for the upcoming 24 hours.

Aussie/Yen short
Euro/Swissy short
Euro/Dollar short
Pound/Yen short
Dollar/Swissy long
NewZealand/Dollar long

The following pairs also showed promise, but they need to be formally tested before I would commit any risk with them:
Aussie/Dollar short
Swissy/Yen short
Euro/Yen short
Pound/Dollar short
Dollar/Loonie long

Lastly, here is a correlation check I've done. Basically it works like this: once I get into the first cherrypick trade, for any subsequent trades I'll check this chart and if the combination is circled, I'll pass on that trade. The goal is to avoid pairs that are too highly correlated, because that could double risk or cancel opportunity on existing trades.

Correct position sizing critical to overall success

As I understand, there are 3 main ingredients that make a successful trader. These are the "secret sauce" that separate the men from the boys. Or maybe it would be more appropriate to say... these keys are what separate the 5% who succeed in this career from the 95% who fail. The 3 ingredients are:

• emotional discipline: a trader must have discipline to sit on the sidelines when conditions are not perfect to take a trade. We want to take trades only when they are as obvious as walking up to a table and picking up the bills. A lot of preparation and training goes into the development of a high-probability trade, and therefore we should not settle for a mediocre setup. My philosophy is to wait patiently for the next one and then strike with force. There is always a "next one".
  
• discipline to follow trade rules: a trader spends many hours in the trenches studying and identifying repeatable patterns. He knows intellectually what works and what doesn't. So why, then, would a trader abandon his rules in the midst of the battle? The only excuse I can think of is the all-powerful fear/greed psychology. These two states of mind can cause a trader to go berserk at exactly the wrong time. So that is why it is critically important to have a written set of trade rules and to discipline oneself not to deviate from them, no matter how sexy the market looks or how scary it may seem.
• correct position sizing: aside from the obvious ingredients above, there is a mathematical requirement as well. In addition to all of the technical analysis that traders are so good at, and the emotional control we hope they can maintain... there is also a statistical probability that must be constrained. No matter what happens in a trade, the trader should ensure one thing above all else: that he will live to trade again the next day. Therefore, a key ingredient to success is that each trade be boxed independently in such a way that it could never destroy more than a measured amount of the trader's account. One way to do this is to pre-identify the maximum risk of each trade setup prior to entering the market (this is also the way I trade). Knowing this certainty allows a trader to control risk, or possibly decide if the trade setup is even worthy of committing funds at all. Sometimes the chart analysis looks great on the surface, but when you crunch the numbers you see that visuals can be illusions. For example, my trade rules dictate that I will not take trades yielding less than a 2:1 Reward Ratio. That means for each dollar I risk, I expect to make $2 or more (otherwise I won't take the trade at all).

It occurred to me this week, during all of the market chaos, that I needed a better and quicker method for properly gearing trades. I need something that is quick and also takes into account the current exchange rates. A slip of my spreadsheet caused me to accidentally enter an order with 10x the amount of risk I intended (misplaced decimal point). Oops. Fortunately I was able to correct this in time before it caused a disaster. But, that experience rattled me enough to begin researching a way to automate that process. Since the computer already helps me identify my patterns, I plan to learn how to fully calculate the leverage and trade lots (there are many formulas on the internet for this). Unfortunately math is not my strong suit and I'm having a hard time with these formulas even on paper! I must be able to solve the problem on paper first before I could ever hope to code it in a program.

In the meantime, I've abandoned my (outdated?) spreadsheet in favor of a more accurate online calculator I found (see link to the right called Free position sizing calculator).

This calculator is great, but does not support the concept of a micro account. Because I trade with conservative risk only (currently 1%), I prefer to take advantage of my broker's micro lot feature, which allows me to gear trades all the way down to pennies. One way I found that this can be accomplished is to multiply the account equity by 100 and then divide the resultant lots by 100. The broker I use allows a minimum micro lot of 0.01 which equals 1 penny USD.

Let the computer do the heavy lifting

Each night at the New York close, I review pairs and classify them in one of three categories:
RIPE
FORMING RIPE
NOT RIPE

The term "ripe" is a word my mentor and I used to describe a "cherrypick" opportunity, because we only wanted to take those trades with the highest probability of success. Anything less would be akin to eating fruit before it had reached its full maturity. The best tasting fruit are the ones where you can sit back and enjoy the succulent juicy flavors exploding in your mouth. Most cherries do reach this level of ripe, and that is when you want to pick them.

As of Wednesday morning, my quick list looks like this. I'll take any trade opportunities that form on a "ripe" pair right away (after proper human discretion, of course) and I'll just keep my eye on those that are still "forming ripe."

Aussie/Yen (long) -- RIPE
Pound/Yen (long) -- RIPE
NewZealand/Dollar (long) -- RIPE
Euro/Swissie (short) -- RIPE
Euro/Dollar (short) -- FORMING RIPE
Dollar/Yen (long) -- FORMING RIPE
Dollar/Swissie (long) -- FORMING RIPE
Euro/Pound (short) -- FORMING RIPE

Of course it's possible that a "forming ripe" pair will get a worm, and fall off the tree. We want to see certain characteristics that tell us when the trade has fully ripened for the highest probability opportunity.

---
One of the things I do before entering new trades, and sometimes also on the tail-end, is that I journal what is going on in my world. At the very least, I need to record the specifics of the trade I'm entering, and take a few screenshots of what I'm looking at. But it is also helpful to record your emotional state because truly, this is one of the most difficult components to master.

It happens frequently that shifts in global markets cause trading opportunities in multiple currencies all at once. I think of it somewhat like continental plate tectonics: it's a behemoth to get moving, but once it's in motion everything quickly aligns in harmony. (Sidenote: this is one reason I plan to incorporate currency correlation figures in my trade calculations soon. I want to use that information to better understand risk.)

Anyway, my point is that... when multiple cherrypick trades appear all at once, it causes me stress. The stress comes from my desire to grab all of the cherries, but also maintain proper discipline and discretion when putting real funds on the line. I have already evaluated the currency pair and categorized it as "ripe," but I always want to make a final judgment call before committing to the risk. To make matters worse, I don't like to make mistakes in the calculations because one mis-entered figure -- one slip of a decimal point -- could be disastrous. So in addition to the human (visual) discretion, I also have a fair amount of math to properly gear the trade to ensure my risk objectives are maintained.

So yesterday I added some computer assistance to the mix. I've broken down my trading method into some very basic parts, a pattern that I look for in the chart. When this pattern appears, I would normally begin human evaluation of the pattern to determine if it is truly a cherrypick. So I've told the computer that if it sees this pattern... go ahead and assume the trade is happening, and chug out all the math for me. So (hopefully) at my next group of trades, the computer will have already done all the heavy lifting math I need. Of course I will need to double/triple check for awhile, until I can trust the computer program. But man... I'm really looking forward to the day I don't have to stress about the math (I hate math btw).

Another day is on the horizon. This week is full of nasty-looking economic reports. Can't wait to see what kind of chaos they will breed!

Overall this market is exciting to me, lots of great trading opportunities surrounding the chaos on global markets. Price Action observations for the upcoming week:

Aussie/Yen (long) -- RIPE for trade
The Daily trend looks decent (slope could be better). Next major resistance I see is around 90.26. A nice pinbar has formed on the weekly. Slight resistance showing on Daily near 87.34 and a pinbar appeared in the wrong direction at Friday's close.

Pound/Yen (long) -- RIPE for trade
The Daily trend looks decent (slope could be better). Next major resistance I see is around 150.66. A pinbar appeared in the wrong direction at Friday's close.

NewZealand/Dollar (long) -- RIPE for trade
The Daily trend looks great and is accelerating. Next major resistance I see is around 0.7522.

Euro/Swissy (short) -- RIPE for trade
The Daily trend is tight and building pressure. In my lookback study, I can see that this pattern has resulted in explosive moves in the past. Weekly trend looks great and is accelerating. There is a sexy pinbar formation on the Daily and I expect it will retrace soon. Additionally, this pair recently passed through a major support area and I see no further support in sight!

Dollar/Yen (long) -- ALMOST RIPE but we need to touch support around 93.70
If we touch support intraday this pair will be ripe to trade forming patterns. The Daily trend looks good and next area of resistance is around 100.37. A Daily pinbar formed Friday in the wrong direction.