leverage Archives - Algorithmic and Mechanical Forex Strategies

One line of code makes all the difference

February 9, 2017 by Shaun Overton 4 Comments

I was really excited about my Pilum strategy two months ago. The research looked great and everything was ready to rock and roll. Demo testing began and then… not much happened.

The Quantilator is (mostly) finished, which finally gave me time to circle back and review what happened with Pilum.

Live demo trading of Pilum. Dec 9, 2016 to Feb 7, 2017

The expected outcome was that I would win 75% of the time. Trades were infrequent, so I thought maybe I’m just having bad luck. But then my win rate remained stuck around 50%. Simple statistical tests told me this was unlikely to be bad luck.

I used the research time to pour over my research code and to compare it with live trades. What I found was that a single line of code (AHHHHHHHHHHHHHHH!) was incorrectly calculating my entry price, dramatically overstating the profits.

The flawed code produced this equity curve from a single combination of settings:

When the actual, correct result looks like this with those same settings:

The accurate backtest of Pilum

I’ll be honest… I like the flawed backtest a lot more!

The new, single-setting backtest isn’t as good, but it’s still trade-worthy. There are some characteristics that I dislike and features that I love. Let’s dig into those.

What I dislike

The frequency of trades is very low. Out of 19 months there were a total of 43 trades. 43 trades to comprise a backtest on 40+ instruments is a very small number.

If it weren’t for the statistical pattern backing up the frequency, I would not consider the test. However, there are 20,000 bars each on the 44 instruments. There are 880,000 total bars used to analyze whether my Pilum pattern offers any predictive value.

The most valuable predictions, however, are also exceptionally rare. That’s why I’m not able to get the trading frequency higher, which would potentially smooth the returns.

What I love

My previous systems like QB Pro and Dominari traded actively for relatively small wins. Trading costs exercised a massive impact on the overall performance.

The accurate backtest of Pilum

Now look again at the correct equity curve (the image to the right). Do you see the final profit of roughly 0.14? That’s a 14% unleveraged return over a 19 month period.

Allocating 2:1 or 3:1 leverage on this strategy could average annual returns of 15-25%.

Detecting hidden risk

A key measure of risk is skewness. You may not use that term yourself, but it’s something most of you already understand. The biggest complaint about people trading Dominari was that the average winner relative to the average loser was heavily skewed towards the losers.

Dominari wins on most months, but when it lost in December it was devastating. I implemented what I thought was a portfolio stop after the December 9th aftermath. Then I had a smaller, but still very painful, loss in January. The portfolio level stop loss of 3% should prevent future blowouts now that I know what goes wrong.

I still believe in Dominari. But, I obviously lost the work of most of the year due to those events.

Knowing that skewness is a good measure of blowout risk (even if you’ve never seen it in a backtest, like happened with Dominari), Pilum looks extremely encouraging.

This is a histogram of profit and loss by days. You should notice a few things.

The tallest bar is to the right of 0. That means that the most frequent outcome is winning.

The biggest winning day is dramatically better than the worst losing day. The worst outcome was a loss of 2%. The best outcome is gains near 10% in a single day (unleveraged!).

This is the statistical profile of an idea that’s much more likely to grab an avalanche of profits than it is to get blown out.

It gets even better

Would you say that the blue and red equity curves are highly or loosely correlated? Look closely.

Writing this blog post made me think carefully about the Pilum strategy. I decided that maybe I should see if all of the profits are coming from different settings at the same time. There’s very little risk of overfitting the data as my strategy only has 1 degree of freedom.

The blue bars are the equity curve of Setting 1.

The red bars are for Setting 2.

Do you think these are tightly or loosely correlated?

If you said loosely correlated, then you are correct. Notice how each equity curve shows large jumps of profit. Did you notice how those profit jumps occur on different days?

The blue setting skyrockets on a single day in November 2016. It leaves the red equity curve choking in its dust.

But then, look what happens as I advance into December. The red curve dramatically catches up to the blue curve and even overtakes it.

The correlation between the 2 strategies is only 57%.

Combine multiple settings into 1 portfolio

This is a much nicer equity curve!

Loose correlations are a GIFT. Combining two bumpy equity curves into a single strategy makes the performance much, much smoother.

The percentages of days that are profitable also increases. Setting 1 is profitable on 58.0% of days. Setting 2 is profitable on 53.5% of days.

But… combining them makes Pilum profitable on 68.2% of days. Awesome!

That also provides more data, which puts me in a stronger position to analyze the strategy’s skewness. Look at the frequency histograms below. They’re the same type of histograms that I showed you in the first section of this blog post. As you’ll notice, they look a lot different.

Pilum most probable daily profit and loss

The most probable outcome for any given day is a small winner

The tall green bar is the most probable trading outcome for any given day with filled orders. The average day is a positive return of 0-1%.

The small red bar is the worst trading day of the combined strategy.

The small green bars are the best trading days of the combined strategy.

Look how far to the right the green bars go. The largest winner is more than 3x the biggest loss. And, there are so many more large winners compared to losers.

Giant winners are far more likely than comparable losses.

The Plan

I immediately pushed Pilum into live trading this combination of two strategies. I expect that adding a second degree of freedom and running about 30 different versions of the strategy – all with different settings – will add to the performance and smooth the returns even further.

Dominari hasn’t been working on my FXCM account, which is very difficult to accept because the lacking performance seems to be a buried execution issue. Pilum, however, trades very infrequently. It’s unlikely that execution quality will make a dramatic difference in the long term outcomes.

So, I’m going to convert the FXCM account to trading Pilum exclusively. That will be offered as a strategy on Collective2 within the next few weeks, a company with whom I’ve been working closely. Their users are more investor rather than trading oriented – they’re far more likely to view low trading frequency as a good thing. I suspect that most people here have a different opinion and want to see a lot of market action.

I’ll write an update on Dominari shortly.

Analyze your Trading Algo with 3D Charts

June 28, 2016 by Lior Alkalay Leave a Comment

These days, any mention of the term 3D is associated with entertainment. But in fact, when it comes to charting, and more specifically to charting your trading algo, 3D charting is not only insightful but provides important practical advantages.

The most common chart to measure a trading algo is profit over time. That lets you know how much money the algo is making over a specific duration, usually from a few weeks to several months. As the chart below illustrates, it gives you a good idea how well your trading algo performs over time and it gives an indication of the periods when it was underperforming.

The thing is that, while profit over time are the two most important dimensions, they leave plenty of dimensions out—dimensions that can help you answer important questions. Such as why, during a specific period, was your trading algo under-performing? Or how much risk are you taking in a given time? Often, the answers to such questions can be the difference between profit and loss, between success and failure of a strategy.

Trading Algo in 3D

First things first. Before we start running 3D charts on our algo it’s important to go over a few practicalities and make the 3D chart work for you.

Assuming you’ve already exported the data of your algo Profit and Loss to Excel you’re likely to have two columns of data, e.g. Time and Profit. Adding a third column will allow you to run a 3D chart, whether it’s volatility, risk or whatever additional dimension you deem necessary.

Once you have your three columns you click to generate a chart—you must choose a type called 3D surface chart. As you will notice, almost always, the Time stamp will be the X-Axis, Profit the Y-Axis and our third parameter will be the Z-Axis.

Now comes the important part—making the chart comfortable to work for us.You must remember that our goal in using a 3D chart in the first place was to identify areas of either exceptional profits or exceptional losses to optimize our algo.

As can be seen in the charts below, Excel divides the Y axes into ranges and each range is colored. The best practice is to choose the same color for levels that are not exceptional and select a contrasting color for the highest range and another for the lowest range. This allows us to spot the exceptional.

The Z axes changes the angle of the chart; the steeper the angle, the higher our Z parameter—say risk or whatever else we choose.

And finally, make the 3D chart clearer through formatting the Plot area. Play with the Y rotation angle as well as the Debt Level until you are comfortable working with the chart

Trading Algo Case Studies

Once you are clear as to how to make a 3D chart, it’s time to decide which dimension is relevant. Usually, besides time and profit, the following dimensions are worth considering—risk, volatility and duration.

For example, the chart above shows a profit over time of a specific strategy; let’s call it Strategy A. Suddenly, out of the blue, the profit plunges rapidly. It’s not clear why, yet.

Then we add another dimension—risk. Risk, in this case, will be the Dollar amount risked in a given moment. Now, the reason is apparent; just before the profit collapsed, risk was rising, as well. Maybe leverage jumped, maybe several positions were opened simultaneously; it depends on the strategy. But by using a 3D chart we were able to easily detect where trouble was coming from.

Using 3D charts is not only good to spot weaknesses in a strategy but strengths. Let’s take a look at another strategy, which we’ll call Strategy B.

We will test how Strategy B performs during volatility. In this case, the volatility will be the standard deviation of each pair we trade. What we see is interesting. When volatility is high, Strategy B performs exceptionally well and not so well when volatility is average to low.

In such a case, we should consider using the strategy only during high volatility to optimize returns.

More uses could be to measure duration per trade. If the duration is getting longer at certain areas perhaps the trigger for the entry or exit is not working well. The benefit with using a 3D chart here is that we put the opening time stamp on the X-Axis and the closing time stamp on the Z-Axis so we can actually analyze duration per trade over time. A 3D chart then is much more accurate than a two dimensional chart where duration is a trailing average.

In Conclusion

There are endless samples and ways in which 3D charts can allow you improve your trading algo and identify both weaknesses and strengths within your strategy. Sure, you can manage with a 2-dimensional chart. But the benefit of 3D charting is that, many times, it allows you to zoom in and identify areas of change much easier.

7 Things You Need To Become A Successful Forex Trader

June 13, 2016 by Nikolai Kuzentsov 1 Comment

If you make the decision to start trading forex to earn extra income it is vital that you set yourself up to succeed. To do so you need to be aware of the 7 things you need to become a successful forex trader.

The desire to succeed

Firstly, it is elementary that you commit fully to the process of becoming a forex trader. That means that you are willing to put the time in to learn all important aspects of currency trading and the global currency market. You will only have the motivation to put the time in to learn, if you truly have the desire to succeed and make money trading currencies.

A genuine interest in forex, economics and the financial markets

Secondly, and this ties in with the first point, if you want to succeed as a currency trader it is vital that you have a genuine interest in the financial markets. If you are doing it just to make a quick buck, without actually putting in the regular work of reading financial news, analyzing charts and reading daily currency market updates, then you will most likely not succeed. Furthermore, you will need to learn about macroeconomics, as economic data and central bank policies are key drivers of the foreign exchange market. Hence, having a genuine interest in what moves the financial markets is a key component to becoming a successful currency trader.

The right online broker

There is a vast choice of online brokers that charge different spreads and commissions and have different product ranges. Hence, it is important to choose an online broker that is right for you. To do so, you need to choose a broker that covers the asset classes and currency pairs you wish to trade, charges you comparatively low fees, offers tight spreads, has a good reputation and is regulated by your country’s financial regulatory body.

It is also important that the online broker you choose offers easy-to-use chart analysis tools, timely market news updates and possesses good customer service. The best way to choose a broker is to check independent broker reviews and comparisons online.

Trading capital (but less than you might think)

To start trading forex you need a certain amount of capital. However, it is must less than you might think if you choose to trade with leverage. Leverage in the foreign exchange market refers to the ability to move, for example, USD 100 dollars worth of a currency using only USD 1. This would be leverage of 100:1, which is a popular leverage amount in the currency market. Other common leverage amounts are 50:1 and 20:1. Using leverage you can move large amounts of a security by only putting down a small initial amount per trade. This small amount is referred to as the initial margin.

The best way to use leverage is by trading so-called CFDs (contracts for difference) as they allow you to set your leverage, as you require it. By adopting a CFDs trading strategy you are able to profit off small moves in the currency pairs you are trading without putting down a large amount of capital on each trade. Hence, this is the best way to trade currencies if you only have a small amount of available trading capital.

The right trading strategy

Once you feel comfortable with the currency market’s terminology and mechanics and you have deposited your trading capital into your online brokerage account, it’s time for you to apply the right trading strategy.

When it comes to trading currencies there are many approaches you can take. For example, you can apply more of a momentum trading strategy and put on trades just after market moving news, such as economic data announcements, or you can use a technical indicators-based trading strategy and follow a set of indicators that give you buy and sell signals for the currency pairs you follow. Of course, there are many more approaches you can take. It is important for you to find a strategy that suits your style of trading and is in line with your risk-return profile.

The discipline to stick to your strategy

Once you have found a trading strategy that works for you, it is important that you have the discipline to stick to your trading strategy. A great way to ensure you don’t let emotions get in the way of you following your strategy is to set target prices and stop-losses, where your broker automatically buys or sells the currency you hold against another, once these trading levels have been hit.

The emotional stability to handle losses

Finally, if you truly want to succeed as a forex trader you need to develop the emotional stability to handle losses. No matter how good your trading strategy is you will have days where you will generate losses. It is important to accept down days and not let your losses affect you emotionally, as this could impair you when you put on further trades.

Big change to Dominari

March 9, 2016 by Shaun Overton 24 Comments

I said it here and here and here. The biggest issue with my Dominari is trading costs. Things aren’t going to really take off until I do one of two things.

Reduce the trading costs
Make more money on each trade

I’ve been working on Dominari since around September or October of last year. After racking my brain for months, I more or less wrote off the idea of improving the trade profitability.

That suddenly changed last week on Friday after the market closed. The best reason to trade my own systems live is that the agony of underperforming forces creativity. The feeling reminds me a lot of Daymond John’s (the guy from Shark Tank) new book the Power of Broke. When life isn’t going your way, it’s the resourceful and creative who are best able to get to the top.

Nobody wants to feel broke or under extreme stress. As much as we hate those feelings, they’re often the strongest drivers of performance. That’s how I feel right now with Dominari. I’m so close to getting there and wasn’t sure how to fix that missing ingredient.

If it weren’t for that stress, I would not have had my simple but very powerful insight last Friday.

And please don’t laugh. The change is so dumb and obvious that you’re going to wonder what’s wrong with me. When you’re in the thick of designing a system, the ugly truth is that sometimes you get lost in the weeds. Or to use another botany metaphor, you only see the trees instead of the forest.

My key insight was to slightly modify the exit strategy to use limit orders, whereas previously I only exited based on the close of the bar. I noticed two repeated behaviors that finally beat me over the head enough that the point finally sank in.

The number of occasions where my trade closed in the optimal location seemed to be significantly outweighed by the amount of money left on the table. The key insight for me was realizing where to optimally place that limit order. And for those of you on my newsletter, it happens to be closely related to the Auto Take Profit that I’ve been talking about all week.

Backtest assumptions and results

My operating mantra when doing backtests is to minimize the number of assumptions. Spreads for retail traders have changed dramatically from 2008 to today. I remember working as a broker at FXCM when our typical spread on GBPCHF was something like 8-9 pips. I now routinely pay something like 2 pips. It’s impossible to model what happened in the middle without haphazardly guessing.

I find it far more convincing to analyze the raw signal, both on historical and recent market data, then to interpret whether trading costs are likely to be favorable in today’s markets. “Raw signal” is the ideal signal, one which assumes perfect execution, no slippage, no rollover, no spreads and no commissions. The natural result is that you’re overstating historical performance, but the benefit is that you have a very clear idea whether the core idea is a system capable of predicting the market with reasonable risks.

The total leverage employed in the portfolio is 7:1. If I have a $50,000 trading account and held a position in every currency pair in the portfolio, then the notional value of those trades would equal $350,000 (50k * 7).

Another key point is that I used a fixed position size of $12,500 per trade. The size of the trade never increases or decreases during the backtest, which allows me to isolate the impact of the raw signal without adding the variable of money management.

Here are my trade metrics with version 1 of Dominari. Click the images to view them in full size.

The first version of Dominari had a profit factor of 1.26.

After here’s the change with Dominari version 2.0.

My new version of Dominari increases the profit factor to 1.59 with a significantly lower drawdown.

My best case scenario was to hope that the profit factor would jump another 10 points or thereabouts, maybe stretching the profit factor to 1.35 or thereabouts. It’s incredibly exciting to see the edge over breakeven more than double (going from a $0.26 edge to a $0.59 cent edge).

What I’m most excited about is the skew in the returns. Most mean reversion systems look for an edge but are overwhelmed with the impact of losing trades. That was the case with version 1.

The largest losers outweighed the largest winners in version 1.

This new version of Dominari is the very first mean reversion strategy that I’ve ever developed where the winning tails (ie, the biggest winners) nearly equal the losing tails (the biggest losers). It’s almost always the opposite with mean reversion strategies. Said another way, the risk profile of the extreme outcomes significantly improved with version 2.

The impact of the biggest winners is nearly identical to the biggest losers with version 2.

And the metric that most traders care about the most, drawdown, is wildly improved. Version 1 showed a drawdown of 5.72%. The new version is a fraction of that at 1.77%.

Out of sample backtest for Dominari version 2

The out of sample performance is nearly identical to the in sample performance, despite significantly different market conditions.

When I walked my test out of sample onto recent data, covering 2013-2015, the performance characteristics of version 2 are nearly identical to the in-sample test. The profit factor was identical at 1.59, and the max drawdown was 2.01% for 2013-2015.

Translating the theoretical into expected performance parameters

Again, those metrics above are in the ideal world of perfect execution and no trading costs. The real world performance will have lower returns and higher drawdowns. The advantage to having live trade data is that I can now make some kind of intelligent estimate of my expected trade accuracy and profit factor. Just how overstated are the idealized returns likely to be?

The process that I went through to calculate the expected profit factor in the real world is a 5 step process. I don’t think it’s going to make any sense if I try to write out the steps in conversational English. Instead, I’ve chosen to share a spreadsheet where you can view the step by step process for how extrapolating live trading data into expected performance with the new strategy. Click here to view the spreadsheet.

The expected profit factor for my live trading is expected to be between 1.29 to 1.39. The expected percent accuracy for live trades should jump from 62.55% to 70.8%.

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When Your Trading Strategy Stops Working

August 28, 2015 by Lior Alkalay 4 Comments

You had a great strategy, it was working well and it was making you money. The problem? Suddenly, market conditions have changed and your strategy no longer works. Markets are too volatile, too choppy. It’s as though the only thing your strategy can produce is a screen full of red. It seems like your strategy has broken down and is desperately in need of a fixing.

You wonder is it time to ditch your “beloved” strategy, the one that’s always, until now, worked so well. The answer: Not so fast. Your strategy was designed for certain market conditions even if you weren’t aware of them. So what do you do when your strategy gives out? Just like any “doctor” who has to diagnose a sick patient you need to diagnose your ailing strategy. But don’t let the word “diagnostics” scare you; most of the times diagnosing what is not working is simple.

Trading Strategy Failure: Symptoms and Solutions

The key symptom for a trading strategy that has stopped working is a very sharp fall in the win ratio (i.e. profitable trades). This usually means that either your entry or exit conditions are no longer viable or that your leverage is too high. Of course, both can go wrong, too. So how do you know which is which and what has gone wrong? Here are a few tips.

Focus on these things: duration, win ratio and trade frequency. One of the most common symptoms of a non-working strategy is trade duration, which is the average time a trade takes. The key thing to watch for is when duration begins to deviate from its average. This is an indication that the cycles that your strategy had been counting on have now changed. When combined with a win ratio and trade frequency measurement (how many trades are executed per unit of time) it allows you to adequately diagnose the more common mechanisms that tend to go wrong in a strategy. Those mechanisms include leverage, entry and/or exit.

A Leverage Problem

Let’s assume the duration has fallen alongside the win ratio but the frequency of your trades was unchanged. For example, you execute more or less an average of three trades a day and this has not changed then your frequency hasn’t changed. What should you make of this? Simply this; the leverage in your trading strategy is too high for the current market volatility. The fix for this problem is to lower your leverage and take a deeper stop loss. This way your risk does not change because you trade at a smaller position and thus you adjust your strategy to a more volatile market.

An Entry Problem

Now, let’s say your duration has fallen alongside your win ratio but the frequency of your trades has jumped. That means your entry is creating a false signal amid the higher volatility and needs to be adjusted to fit a more volatile market. You do this generally by smoothing the indicators you use.

An Exit Problem

Finally, let’s say the duration of your trades has jumped higher alongside a falling win ratio while the frequency has fallen. That means your cue for disengaging or for closing in your trading strategy is not sensitive enough. Essentially, you leave your trade open for too long until it eventually turns against you. What you need to do is to make your exit trigger more sensitive by running on a shorter period.

Conclusion

Sometimes, as in the cases illustrated above, by simplifying your trading strategy, you can focus on minor tweaks that may go a long way toward stabilizing your returns. As you may have noticed, most of the focus here has been on markets becoming more volatile. Volatility is the main reason that strategies stop working and the reason I focused most of the adjustments and tweaks. But, of course, each case must be to its own merits. If a simple tweak won’t work, then it’s generally prudent to have a strategy in place for each type of market condition.

Why You Trade Irrationally

August 10, 2015 by Lior Alkalay Leave a Comment

Over the years, how many blogs posts have you read that preach, proselytize and lecture you on discipline in trading? I bet if you had a dollar for every one you’d consider early retirement, wouldn’t you? We all realize that discipline is very important in trading; it’s common sense, really. But that doesn’t teach you how to avoid the pitfalls of irrational decision making in trading. For that you must understand what drives you to make an irrational decision when trading. If you dig around for that reason, and all of the trading blogs unanimously concur, that reason is greed. Well, I agree, that that was the way I used to think. But as I will soon explain, the reality is that nothing could be further from truth.

A Moment of Enlightenment

Throughout the many years of my career I have had the opportunity to analyze the performance of at least a thousand traders. Intuitively, I believed that the reason for irrational decisions had to have deeper roots than just greed. The problem was it was hard for me to connect the dots. That is until I stumbled through the works of a Dan Ariely, a professor from Duke University. Ariely, through his numerous books and writings, illustrates time and again how and why we make irrational decisions. Though Ariely doesn’t specifically deal with the trading dilemmas we all face, his insight helped me connect the dots. With a picture now drawn, I hope to enlighten you as to why you do what you do in trading and how you can avoid the pitfalls.

Overly Excited

Ariely concluded that the way we initially feel about a specific matter impacts that particular decision as well as subsequent ones. We can apply his conclusion to trading. Let’s say you’ve just begun to trade and you decide to open your very first trade with high leverage. And, hey! Will you look at that! You’ve gained money! That was exciting and exhilarating, wasn’t it? The problem? It establishes precedence.

Now you’ll expect to be excited and exhilarated every time you trade. As if you’ve got the magic touch; press the buy bottom at just the right second and win a fortune. But in real life? You need an accountant’s state of mind; prudent and suspicious, relying only on data to make a decision. The problem is you’ve already got that blue print in your brain that says trading is exciting. So, almost automatically, you subconsciously push yourself to trade at high risk. Or else you open a trade without good reason, simply because of that imprint of excitement towards trading.

Hack Tip #1: Start with a very small amount (real money, not a demo); enough that you’d only slightly care if you lost it. It should be enough, though, that you’re excited if you profit. That’s the idea behind low leverage. Do that for several months, and you’ll eventually get used to making more rational decisions. That’s because you won’t associate trading with excitement. Although you might lose that sense of “fun,” it’s really the only way to become a rational trader. The bottom line is you’ve become an “adrenaline junkie” trader. You need to give it a few months to wean yourself off of the “excitement.”

X Factor Complex

In the retail trading world we like to believe that every successful trader has something special, a so-called X-factor. That would be some unique character, trait or talent that makes for a great trader. Of course, much as we’d like to believe we all have this X-factor, that’s utter nonsense. Trading is all about statistics and constant analysis. Period.

Often, we (unknowingly) produce stagnant results that could never dispel the notion that we’re really just run-of-the-mill traders. We’ll always be in the game just enough so that when we profit, even a little, it’s because of our “gift.” If we should lose a little, well, that’s really no big deal. Traders may think like that for prolonged periods because it keeps the illusion alive. So long as they’re not out of the game, they’ll stick with it. They’re not willing to try out a new strategy. Sure, it could produce more gains but it might also mean deeper losses. So they’d rather stay stagnant, and maintain the status quo, such as it is.

For many, this is the perfect scenario to feed their ego. If we gain, we’ll throw a BBQ on Sunday and boast (gloat) about it to our friends. But if we lose? Well, no one has to know about that except you and your broker.

Hack Tip #2: Think of your trading as a business. Find a friend who has some financial background and share your performance with him. Even better, share it with your accountant. With someone looking over your shoulder, you’re forced to acknowledge that there’s a down side to losing. That may give you the incentive you need to avoid stagnation. If trading is a business – and it is – you need a different mindset. Every business is in business to make money. Your friend/accountant is sure to tell you that immutable fact if you should ever forget again.

Free blow up insurance?

January 19, 2015 by Shaun Overton 17 Comments

Last week’s drama with the collapse in the EURCHF peg hammers home an uncomfortable truth: you can lose more in your account than you deposit.

Trading on leverage is inherently dangerous. Although an instant 20% move in a major currency is a once in a lifetime event, it goes to show just how quickly the markets can charge over alleged safety features.

Did placing a stop loss at 1.19 for an open EURCHF trade do any good last week? Not a bit! As soon as the market breached 1.20, it instantly gapped down 10%.

When markets go bidless, it means that there is no liqudity in the market. That’s jargon that means everyone is too scared to do any buying or selling. There literally is no price at the moment where anyone is willing to trade.

It was at 1.20. The next thing you see is 1.08 and the price falling fast.

I was fortunate enough to be awake at 3 a.m. when the proverbial cow-pie hit the fan. Although I’m an alogrithmic trader, I confess that my immediate instinct was to hop on the bandwagon and buy!, Buy!, BUY! all the Swiss francs that I could handle (when you go short EURCHF, you’re selling euros and buying francs).

Every inch of my body wants to go short with the $EURCHF collapse, but I run an algo system and I’m sticking to it.
— OneStepRemoved.com (@_OneStepRemoved) January 15, 2015

The way I coped with the urge was to IM a friend and pass a running commentary on the insanity. Posting on Facebook and Twitter also kept me busy. Basically, it was a strategy to keep myself wholly occupied and distracted so that I wouldn’t be tempted to jump in.

I’ve seen mega moves before and, more importantly, I know from experience how badly people can get hurt. My favorite war story from working as a broker was a wealthy client in Kuwait that opened an account with $250,000 the night before NFP. He went long on 100:1 leverage and of course the report was the complete opposite of expectations. The market gapped instantly and before his trade could close, his account balance was -$20,000.

You don’t read stories like this on the forums because… who on earth wants to go advertise their financial destruction on the internet? It’s embarrassing and, if we’re honest with ourselves, that person is probably doing everything humanly possible to not think about their situation.

Nobody raised their hand to tell me about catastrophic losses in the CHF

Free insurance

The primary reason to trade with maximum leverage is because it’s like free insurance against devastating losses. You never know when a peg will go bust or the next 9/11 is going to happen.

Let’s game this out. You were long USDCHF on Thursday and there was no stop loss in the world that could protect you against an instant 10% gap. Consider two scenarios:

You had a $30,000 account balance and were trading an institutional level of leverage like 5:1. That means your position value was 30k * 5 = $150,000. The instant gap created a loss of 10% * $150,000 = $15,000.
You had a $3,000 account and were trading the “crazy” leverage of 50:1. The position value was also $150,000 and yields a $15,000 loss.

Now let’s talk about what happens in the real world. In the first sceario, the money is on deposit with the broker and you 100% have lost $15,000. It’s a guaranteed fact and you can safely kiss the money goodbye.

In the second scenario, you may legally owe the broker $12,000 (3k-15k=-12k). However, what is the broker’s likelihood of recovering the money? If you’re in the UK and you trade at Pepperstone in Australia, they’d have to sue you in an Australian court. The attorney’s fees alone would be several thousand dollars. And most convincingly, you probably don’t have any assets that the court could award to the broker.

Even if you are in Australia, think about all the bad PR hitting the forums when the big dog starts suing little retail traders. There’s almost no business-case for pursuing the negative balances of retail forex traders.

You’re going to see a lot of hooplah this week about brokers “forgiving negative balances.” It’s great PR and it’s the best way for them to play it. They know darn well that there’s almost no chance of recovering that money. It’s the best way to turn lemons into lemonade because the brokers lost an epic amount of money.

How to protect yourself

Chris Zimmer, the programmer here at OneStepRemoved, sent me this as soon as the day ended.

I was already on board with it but this recent event makes your method of pulling money out of FX accounts look very obvious.
I just checked and the USDCHF dropped over 1600 pips on that bar. That really hits close to home as we could have easily been Long that pair and something tells me any stop would not have been filled.

Trade on leverage and, for goodness sake, withdraw the money at regular intervals. Nobody can take it away if you don’t keep it in their hands.

Use Maximum Leverage To Grow Profits And Reduce Risks

January 12, 2015 by Eddie Flower 9 Comments

The gains can accumulate quickly when a prop trader is using a strategy based on maximum leverage with limited account size. In order to preserve and build those gains, it’s important to remove them from the trading account according to a good plan.

As described in previous articles in this series, the high-leverage, low-balance strategies used by leading prop traders can be applied to multiple trading accounts using different systems, with each account capitalized by not more than a couple thousand dollars.

The amount in the account typically ranges between $1,000 to several thousand dollars. That way, there’s no psychological obstacle to using the max leverage on each trade.

Reduce the risks from drawdowns

When you have a winning system, profits pile up. It’s tempting to “let it ride” by using the same system to trade ever-bigger position sizes in the growing account.

However, when the entire capital is available in the trading account, it means that the capital is exposed to the inevitable system “blow up,” which typically causes a steep drawdown. Even if the trader escapes financial catastrophe, he or she may become so risk-averse afterward as to become indecisive and ineffective.

Pull money out each month

The smart way to avoid excessive drawdowns due to trading system “blow ups” is to pull money out of the account at the end of each successful month. That way, when a major drawdown occurs, it won’t take all your money, just the couple thousand dollars that you can afford to lose.

Successful prop traders like Shaun sweep the profits out of each winning trading account monthly and move them into a non-trading account, where they remain safe. So, each month the trading accounts open with their individual capitalization set at a given amount.

Pull out at least enough to cover one “blow up”

Once you’ve launched your forex system, you’ll want to think about earmarking enough money to cover at least one trading system failure. After you’ve secured that amount to be used for a recapitalization of your trading account, every subsequent gain is “free money,” at least in a psychological sense.

The first milestone is to pull enough money out of the trading account to cover at least one catastrophe. If you’ve been enjoying mostly winning months, next you should allocate 50% of your profits for high-risk systems.

You can’t lose what’s not at risk

Keep in mind: When a prop trader is using maximum leverage, the only money that’s safe is the money already pulled out of the trading account. Profits should be pulled from each winning trading account, each month.

When a prop trader wins consistently using high leverage with a limited-size account, the gains from relatively small individual trades may compound quickly. Profits gathered from the overflowing small trading accounts can compound into large sums, and it’s important to manage those profits effectively.

If you’d like to learn more about using maximum leverage to pull profits each month, just contact Shaun.

How To Pull Profits Like A Pro

December 16, 2014 by Eddie Flower 4 Comments

As mentioned in a previous article about managing your forex venture like a “prop trading” business, using maximum leverage can truly minimize your at-risk capital. Successful prop traders leverage their accounts and risk every dime of allocated capital each month.

The idea is that a winning trading system will accrue profits quite rapidly, but if the position sizes are increased along with the expanding account size, eventually a “blow up” will intervene to cause a steep drawdown.

The key is to mechanically limit the amount of capital allowed to accumulate in the trading account during winning periods. Prop traders set a par account size, and at the end of each month they “sweep” the overflow from gains into a separate, non-trading account. The account opens each new trading month at the same par size.

By doing so, gains are preserved intact while serious drawdowns are limited to the account’s monthly highwater mark. Profits from winning months are retained, and are protected from risk.

Setting a limit on capital at risk reduces the risk of a trading system “blow up”

By sweeping excess cash from the account, a prop trader reduces the risk from a catastrophic drawdown. The traditional practice of small, independent traders is to treat the entire account as a single unit which they attempt to grow as large as possible. Yet, this can be dangerous.

At some point, every system suffers a “blow up.” When this happens, everything may be lost if the trader hasn’t stashed away some of the previous profits. Prop traders avoid this catastrophic scenario by limiting the trading account size.

As a trading account grows, the savvy prop trader pulls profits out in order to keep them safe. For example, at the end of a given month, assume that a trading account whose par value has been set at $5,000 may now total $6,00. So, the overflow $2,500 is swept into a separate account not accessible for trading or margin.

The trader then begins the new month with the par $5,000 and once again the account should begin to accrue gains at the same consistent rate, by using the same trading system.

Crazy margin for outsize gains

By trading a winning system while using maximum leverage and limiting the amount of capital at risk, an entrepreneurial prop trader can harvest profits from a wide range of forex markets. And, traders who are supported by prop shops have access to highly sophisticated risk-management tools to help them grow even faster.

How To Create A Winning Trading System

March 11, 2014 by Eddie Flower 2 Comments

Many traders are attracted to forex because of the opportunities for fat gains, especially when compared with stocks. Yet, when trading forex the inherent leverage can affect traders’ emotions, leading to over-trading, loss-chasing and second-guessing. A mechanical trading system can provide the winning solution.

Why build a trading system?

Manual trading works well for many stock traders, especially those using buy-and-hold strategies for a limited number of favorite picks, yet forex traders need better tools and stronger discipline in order to be profitable.

In any industry, a well-built machine is more efficient than any human

A well-built mechanical trading system offers a trader the best of both worlds: technology and math give the trader the ability to spot and take advantage of market inefficiencies and harvest gains in a busy, cluttered environment, while freeing him or her from the emotional roller-coaster ride of trading.

Find your own niche

There are plenty of trading systems available nowadays; the key to forex trading success lies in finding or adapting the “right” system for your own needs and style. Once you’ve decided the parameters for success, including your overall goals and objectives for trading, personal tolerance for risk, and the amount of capital to be devoted to trading, a system can be built to fit you like a glove.

When building a system, there’s plenty of room for specialization and individualization – If everyone were trading the same way, spreads would soon disappear. Like fast-moving mosquitoes buzzing around a lumbering elephant, many traders earn an excellent living by capitalizing on opportunities inevitably created by the movements of much-larger players in the marketplace; the key is to gather an actionable set of patterns and indicators that fits your personal style.

If a pattern is noticeable, then it’s probably actionable

The first step is to search through past trading data in order to identify patterns and conditions which appear to consistently offer profitable trading opportunities. Historical price and volume charts often show patterns which appear to signal upcoming price moves, and technical indicators will help clarify an otherwise-fuzzy picture.

Try looking at different combinations of indicators over different historical time periods to see if they may give predictive power in spotting market turns or changes in trend. A “caveman-style” approach to quickly testing your hunches can be as simple as finding a noticeable pattern on a printed chart, then holding a sheet of paper over the upcoming section and “guessing” what will happen next; when you’re right, you may have found a winning pattern.

Testing & optimization

Once you’ve identified a fairly-predictable pattern by looking at charts, it’s time to think about how to trade it profitably. You should consider how it fits with your personal trading style, including risk management. The patterns and indicators upon which your system is based can be simple or complex, as long as they work in the marketplace and fit your circumstances.

The next step is to translate these patterns and scenarios into mathematical coding, to form a set of trading rules which can be fully tested. You can do this yourself, or you can rely on the services of a coding expert to help accomplish this. After you’ve created the foundation for a system, it can be tested objectively by changing the inputs to find the optimal conditions for trading, such as the best combinations of currency pairs, stops, and other variables.

You can use software to quickly test multiple combinations of indicators. The key is to identify predictable patterns which will give you the confidence to trade when you see them appear, whether long or short, then fine-tune them to maximize your gains. It’s important to realize that more complexity isn’t necessarily better – A super-complex system probably won’t fatten your wallet if it only signals a trade once every ten years and your computer happens to be offline when that finally occurs.

Don’t become married to your system

Most importantly, if your indicators aren’t working out during testing as you had hoped, don’t become emotionally invested in “proving” that they work. Instead, step back and take a broader look – Perhaps it’s time to use a different combination of indicators, or change your approach altogether.

During testing and optimization, it’s important to leave untouched some of your historical market data as untested “out-of-sample” data while you work through testing your system using in-sample data. For statistical purposes during testing, you can only use data once before modifying your system; then of course it becomes part of your in-sample data. If you contaminate your test data, that is, if you rely on a certain date range of data to first develop and test your system, then later re-test your modified system with the same data, the results may be skewed. So, use your out-of-sample data only for final testing and tweaking after you’ve built your system, so you can be sure that such data is “pure” and not already accounted for in the system.

Be sure to back-test any prospective new system over reasonably long periods, so you’ll have an idea how it performs long-term. And, check the results when using different lengths for your moving averages. Also, it’s worthwhile to test your system widely across different forex pairs, even those you don’t typically trade – You may be surprised to find that your system does especially well in a market that you haven’t tried before.

Implementation

Even though testing and minor tweaking should be thought of as an evolutionary process that continues during the life of your trading, at this point you’re ready to implement your system by using it to trade with real money. If you’ve done your homework well, and you stick to the rules that your testing has proved will work under specific conditions, then you’ll be confident in proceeding forward.

Stick to the proven rules and you’ll be successful

Societies rely on laws to govern the behavior of their citizens because they’ve learned over time (tested and optimized) what works. Likewise, in order to be successful with forex you should adhere to the consistent trading rules that you’ve established in a scientific manner. If you stick to the rules, your mechanical trading system can help you win the forex game.