Forex Trading Strategies: Early or Wrong?

Early or Wrong?

I have a friend who is brilliant stock picker, but she specializes in out of consensus calls. She was in Coinstar last year before anyone even knew the name, short the Amazon earnings and long a bunch of internet gaming stocks just as states and municipalities started to consider online gambling as a source of revenue for their cash starved budgets. But occasionally, because she is ahead of the crowd she places her bets too early and finds herself deep in the hole as the position moves against her.

When the trade “gets up her butt,” as she indelicately puts it, she must make a tough decision – add more at better prices or bail out of the trade? In essence she is faced with that existential question that all investors must confront – am I early or am I wrong? Since she is a classic long/short hedge fund manager and most of her positions comprise no more than 2.5% of the portfolio, she can consider each trade on its own merits. Quite often, staying in proves to be the right decision as her analysis is generally dead on.

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Unfortunately, as speculators rather than investors we do not have the luxury for such contemplation. When the trade goes against us by a predetermined amount we must always assume we are wrong and get out of the way. Many of you may think I am idiot for arguing this point, and I have no doubt that I will get multiple emails telling me how some traders are successful averaging in and out trades. After all, markets are notoriously mean reverting most of the time. Furthermore, currencies unlike stocks are naturally range bound markets - if you wait long enough the price will come back.

Those are all good arguments, but they don’t apply to us. As that great economist and speculator John Maynard Keynes once said, “In the long run we are all dead.” Extrapolating this concept to our trading accounts we can conclude that if we wait and do nothing our equity will disappear long before the position turns itself around. As speculators rather than investors we use a massive amount of leverage. The higher the gearing, the smaller our margin for error.

In that sense speculation is very similar to driving. If we are driving 5 miles per hours in deserted parking lot we may be perfectly comfortable at pulling figures eight’s to our heart’s content with little fear of injury. But if we are speeding at 100 miles per hour down a freeway it would be suicidal if we decided to swerve around an obstacle without first slowing down. A stop in a speculative trading account acts just like anti-lock breaks in a car. It protects you from hitting a wall, so that you may live to trade another day.

I have no doubt that some of you are successful at scale in/scale out strategies that rarely use stops. This approach can be especially tempting if we find ourselves getting repeatedly stopped out only to see the trades reverse in our favor. But in the end such activity may prove fatal to your account. For most of us it is much wiser to quickly accept that we are wrong not early.

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