DISCRETIONARY TRADING

Purely discretionary traders rely on their experience, gut feeling, and reading of the price action to make trading decisions. and for FX traders this means coming to grips with what makes the market tick. Intra-day FX prices are shaped by Haws, and as we know these flows may be the speculative bets of a large hedge fund or they may simply be the hedging activity of an exporter. Either way, supply and demand is what sets short-term prices, which is why we say that in FX there is no such thing as a fair price. Even if the macro backdrop favors a dollar decline, a large buy order will disrupt prices in the short run and drive the dollar higher until the demand is satisfied. For the intra-day trader the thinking behind these flows is not important; price is all that matters.

Getting a proper "feel" for the market comes down to understanding the price action. Price action is that magical thing that scares traders oU{ of their positions and lures them into traps. Watching the bids and the offers get hit is the equivalent of the old-(jme tape reading made famous by Jesse Livermore and other "punters", who used to read the ticker tape attentively in an effort to gauge short-term price trends according to price and volume. Price action reflects the tug-of-war that is constantly going on between the buyers and the sellers in the market, and to the experienced trader it can also be a window into the market's footing.

Since shol1-term price movements are largely dictated by the maneuvering of the "big boys" in the market, it is in the interest of every small speculator to closely rol­low the price action in order 10 find the "footprints" that all large players inevitably leave behind. Needless to say, reading price action is easier in exchange-traded markets, where volume information is available and institutional block orders are more easily detected, but in FX those with no flow information can still glean the market's intentions by looking at the order How information lefl behind in (he form of chart patterns and noting how prices react near important pivot points. Correctly reading price action is not something that can easily be taught. and over lime traders find that it is more of an art form than a science

Approach Forex Dealer

one except the model. that is. People are smart enough to realize when the rules of the game have changed (the bus schedule becomes useless after a certain amount of time has passed), while probability-driven models never take into account the fact that the Illodel itself Illay be wrong and Lhus conti nue to waiL for a bus thaL may. or may not, come. This critical flaw is essentially what makes model-driven trading approaches blow-up spectilcularly, and common sense dictates that the world is simply a lot more complex than any risk-model bui lder would have you believe.

Technical trading proves especially attractive to retail traders because it offers a way to "make sense" oul of a sometimes senseless market. and many find the possibility of discovering the "holy grail" of trading systems simply too good to pass up. Yet those obsessed with trying {Q find Ihe indicator or trad ing system would be beuer served in spending that time trying to understand the market instead of trying to outsmart it, since the only money-making machines that I know of are owned by the central banks of the world.

The clear benefit that systematic trading gives us is order. Having a clear, orga­nized, and coherent strategy is fundamental to trading success. Although in the end your "system" mayor may not prove to be profitable. you should always have a clear understanding as to why you are entering the position, and technicals help us tremendously in this regard. Generally spcaking, the simplcr the model, (he more elegant and useful it becomes, since charts filled with lines, indicators, and all kinds of technical tools only serve to distrac( the trader away from the crucial price action. A( a time when quantitative trading has been finally accepted by the general trading community, the intrinsic virtues of technical analysis are hard to discern since often it is traders' combined actions that turn them into self-fulfilling prophecies. If everyone follows the same indicator. then when it flashes a buy sig­nal everyone will go ahead and buy ... and surprise. the price goes up! A kind of "chicken and egg" scenario has emerged and. 1110re importantly, the retail crowd's love of technical analysis has also turned "obvious" technical levels into a mag­net for stop hunters. Many funds (including ours) actively front-run other people's models by anticipating the trading signals their systems will generate and then positioning themselves for the slight pop created by their execution. If anything. you should make a poi nt to stay away from any clear technical levels. since the price action around these are bound to be full of dealer manipulation. which is why it is never wise to trade breakouts in FX. With the amount of pricc "manage­ment" that goes on in the forex world, false breaks are more often the norm (han the exception. Chances are that Olher traders will have also identified the same important support/resistance levels that you did, and set their stops accordingly. Dealers know this. obviously. and routinely go after them, thus creating the false breaks.

Learn to use technical indicators. but also learn when to ignore them. Find something thilt works for you and stick with it. We know that no strategy is always profitable. so the key for technical traders is to identify and understand. your system 's strengths and weaknesses. This lets you limit your exposure in tradi­ tionally bad times and double-up in the good ones. Does your system work best in high-volatility or slow markets? Does it work best in ranging or trending environ­ments? Does it work best for USD pairs or others? These are the types of questions you should be asking of your system, since just like the blackjack player YOLI want to end up betting only when the odds are in your favor. In isolation all technical tools are essentially the same. and only in their application will you find the true differentiator. This is why I think it is vital 10 keep a discretionary element to your trading, even if it is simply knowing when to turn your system "on" or "off". We know that the only instrument that can consistently beat the market is the human mind, so make sure to use it.

Picking the Right Approach

Ahhough proper money management guidelines are the foundations needed to support any sort of trading strategy, al the core of all trading is the fundamen¬tal reasoning. a model or system used by traders to enter and exit positions. Broadly speaking, FX traders can be divided into the fundame ntalist and the tech¬nical crowd. On the one hand, fundamentalists choose to place their bets based on macroeconomic factors such as interest rates. GDP, inflation, CUf fe nt account imbalances, etc .. and their relation to a currency's intrinsic "value", Much like equity managers who like La buy "undervalued" companies, fu ndamental traders use economic models to forecast theoretical exchange rates a nd trade deviations from these.
The technical crowd, on the other hand, cares less about the underlying economic picture and instead prefers to rely on two things only: time and price. In their think ing, a currency's past behaviour is the best predictor of future exchange rates, so they focus on identifying purely mathematical reasons for entering/exiting trades, such as buying a currency after it moves X % in a one direction or using chart patterns to guide their trading.
Although the fundamentalist approach may seem like the more logical way to go, extensive research into the matter actually indicates that technical trading is a much morc profitable way to trade FX. Although the "value investor" mindsel may pay off in equities, it seems that this line of reasoning is utterly useless in forecasting exchange rates (especially in the short run) because of central bank intervention and other market nuances, and it gets decidedly beaten by using a simple randomizer model. This may explain why economists' forecasts are undeni;:lbly horrible, and to the short-term trader it means that they should focus their attention on the technical
side of trading, if only for the simple reason that it seems to be more profitable. Thai being said, technical trading is no sure road 10 riches either.


Since the advent of trading. the lrad ing community has been obsessed with ways of predicting or forecasting the future through their use of models. As computa¬tional power increased over time, so did the popularity of technical or quantitative trading models and now a wide variety of these are used, ranging from sim¬ple moving-average systems to complex neural network algorithms. Unfortunately most, if not all, models have built-in biases, so an unquestioning belief in them is eXLrcmely dangerous. To prove this point. a famous study was conducted where
thousands of different indicators and technical 100is were tested in an cffort to find the best forecaster of US GDP growth. After an exhaustive search and counlless regressions, one leading indicator was found that seemed to fit the data pertectly: buttermilk production rates in Bangladesh! Yet I still have not figured out how to get that on my Bloomberg.
Most risk models still in use today consider the one-day October 1987 mar¬ket crash to be a one-in-a-billion event, or the statistical equivalenl of getting hit by lightning
In order to understand beuer why all probability-driven models have limitations that will eventually lead them to fail spectacularly. il is useful 10 look at a very simple example. Imagine yourself silting at a stop waiting ror the bus to come. You know the frequency of the bus service (every ten minutes), but not the actual arrival lime. If the buses run according to schedule, then the probability of a bus arriving in the first minute of you getting to

Rest 3ssured that after a sufficient amount of time has passed, there wi ll be no one left at the bus stop no.