The Way of the Dollar

“It’s difficult enough to develop a method that works. It then takes experience to believe what your method is telling you. But the toughest part is turning analysis into money.”

Robert Prechter

Forecasting is one thing: trading is another. Here are four proven rules for turning good forecasts into good profits. They can be used as a sort of checklist for regular consultation.

1) Know your reasons . if we know what we’re doing, we make a trade for a reason or reasons. We must define the reason and keep it in mind; and if it is no longer valid we must get out, no matter what.

2) Know your risk. we win some we lose some. But we must know exactly how much we can lose on any trade. We win by winning, but we get wiped out by losing too much.

3) Know your time-frame. we trade for a reason. But prices fluctuate and adverse fluctuations are the hazard to our position. We must know our own time-horizon so that we can distinguish those fluctuations that are random from those that challenge our rationale.

4) Know your self . do we really want to win? Why are we trading in the first place? Do we tend to be too early or too late? What risk can we handle? Can we cut losses? We cannot win until we know who we are.

Winning in financial markets is a state of mind, or so it seems to judge by the accounts of those who have been successful in building great fortunes, with consistency , over long periods of time. Paradoxically, the man to whom the greatest debt is generally acknowledged by successful traders is Jesse Livermore –the legendary trader who thrived in the early part of this

century. The reason for his fame is the account of his trading experiences that survives in the classic Reminiscences of a Stock Operator by Edwin Lefevre –a book which has perhaps been more influential than any other single book on financial markets. The paradox is that Jesse Livermore, one of the most admired traders that ever lived, failed so utterly in accumulating lasting wealth that he blew his brains out in the men’s room of the Sherry N ether– lands hotel in New York. H e knew it all, except for risk- management.

We get some idea of the mental attitudes required by great traders in anecdote and historical accounts, of men such as Jim Fisk, Jay Could, Bernard Baruch, Richard Wyckoff, Warren Buffet and the odd Rothschild and Rockefeller. One of the most valuable accounts ever assembled – Market Wizards by Jack Schwager –appeared in 1989: a brilliant series of interviews with many of the great traders of today. If you do nothing else, you must read the above two books.

The Big Hitters by Kevin Koy, published by Intermarket is also valuable for two or three chapters. This, and The Alchemy of Finance by the master-investor George Soros, are of interest because they cover trading in currencies as well as securities and commodities.

CHAPTER SEVEN

“I began to realise that the big money must necessarily be in the big swing.”

Reminiscences of a Stock Operator

In forecasting, we try to be right: in trading we try to do right. Your reason for making a trade dictates your time horizon ; your stake is dictated by the risk you yourself can handle. you can take pot- luck in financial markets. or you can decide, once and for all, that you will never, ever, trade without defining your reason, your time-frame and your risk. This is something we can all do just by deciding so. Getting to know ourselves may take time.

Markets fluctuate and their fluctuations subject us to fear – fear of loss or fear of loss of profits. Fear is probably our chief enemy when it comes to translating forecasts into profits. Some would say greed, or hope, is an equally dangerous enemy. Anyway, these emotions of fear and hope are the means by which the market takes our money away.

Of course it is really we who rob ourselves: when I say the market takes our money away, I mean this. The currency markets, remember, are a zero-sum game*: total wins are exactly balanced by total losses. But it quite often happens that a big majority of participants share the same forecasts (in the case of a bullish or bearish consensus). Since the majority cannot win, many of those with the right forecast have to be outwitted. They are outwitted by the market’s price mechanism which ensures that prices are distorted by fear and hope in such a way that losses balance gains. The losses are sustained by those who succumb to their emotions.

Price has to be the ultimate test of our strategies. Hopefully our reason for making a trade will be more often right than wrong. But even when it is right, we shall suffer adverse price fluctuations; and we have constantly to try and ensure that we are not tricked out of the good positions by “random” adverse fluctuations –which is the market’s vocation. We have all been tricked out of good positions by adverse price movements. We probably all have also had the experience of making a calculated currency switch and more or less forgetting about it. As often as not when we remember the

position again months later, we find it has worked out very well. We did the right thing for the right reason: and we were not tricked out for the wrong reason –because we weren’t looking! By not focusing on the adverse fluctuations we did not worry about them. This apparently accidental strategy is something we can emulate intentionally.

It helps to run through the above checklist as soon as we diagnose fear at work. If we do, we shall find out that most often of all, what is wrong is that we have forgotten our time-frame* , or that our time-frame has been twisted out of synch with our reason for holding a position. Having forgotten our time-frame, we have forgotten what we originally knew –namely that we couldn’t rule out quite significant adverse random fluctuations.

For example we might have been long of the Yen in August 1990, on the expectation of massive repatriation of foreign assets by Japanese investors –and then scared out of our position by a set-back (which proved very temporary) on the jump in the price of oil. The jump in oil prices had nothing to do with our reason for holding Yen and did nothing to negate it. Also we must assume that changes in oil prices and the like are instantly discounted in the currency markets; the effects may be unfortunate but they don’t affect the argument for holding our position. Finally, our price horizon for a rise in the Yen was measured in months; it was not based on a temporary perception of the market-place, like the knee-jerk reaction to oil prices, but on a physical event, namely big demand for the Japanese currency by Japanese institutions.

This is one of the distinctions we must always be making –between perceptions and actual physical events. If our position has been taken in the expectation of certain events taking place over time, it doesn’t make sense to abandon it because of a temporary change of mood.

Participants’ time-frames

The principal market-makers in the currencies are the major banks’ dealing desks and the seat-holders in the futures markets: their time frame has to be measured in intra-day terms, if only because they have to close