The Best Currency Pairs To Trade & Times To Trade Them ...

Former investment bank FX trader: Risk management part 3/3

Former investment bank FX trader: Risk management part 3/3
Welcome to the third and final part of this chapter.
Thank you all for the 100s of comments and upvotes - maybe this post will take us above 1,000 for this topic!
Keep any feedback or questions coming in the replies below.
Before you read this note, please start with Part I and then Part II so it hangs together and makes sense.
Part III
  • Squeezes and other risks
  • Market positioning
  • Bet correlation
  • Crap trades, timeouts and monthly limits

Squeezes and other risks

We are going to cover three common risks that traders face: events; squeezes, asymmetric bets.

Events

Economic releases can cause large short-term volatility. The most famous is Non Farm Payrolls, which is the most widely watched measure of US employment levels and affects the price of many instruments.On an NFP announcement currencies like EURUSD might jump (or drop) 100 pips no problem.
This is fine and there are trading strategies that one may employ around this but the key thing is to be aware of these releases.You can find economic calendars all over the internet - including on this site - and you need only check if there are any major releases each day or week.
For example, if you are trading off some intraday chart and scalping a few pips here and there it would be highly sensible to go into a known data release flat as it is pure coin-toss and not the reason for your trading. It only takes five minutes each day to plan for the day ahead so do not get caught out by this. Many retail traders get stopped out on such events when price volatility is at its peak.

Squeezes

Short squeezes bring a lot of danger and perhaps some opportunity.
The story of VW and Porsche is the best short squeeze ever. Throughout these articles we've used FX examples wherever possible but in this one instance the concept (which is also highly relevant in FX) is best illustrated with an historical lesson from a different asset class.
A short squeeze is when a participant ends up in a short position they are forced to cover. Especially when the rest of the market knows that this participant can be bullied into stopping out at terrible levels, provided the market can briefly drive the price into their pain zone.

There's a reason for the car, don't worry
Hedge funds had been shorting VW stock. However the amount of VW stock available to buy in the open market was actually quite limited. The local government owned a chunk and Porsche itself had bought and locked away around 30%. Neither of these would sell to the hedge-funds so a good amount of the stock was un-buyable at any price.
If you sell or short a stock you must be prepared to buy it back to go flat at some point.
To cut a long story short, Porsche bought a lot of call options on VW stock. These options gave them the right to purchase VW stock from banks at slightly above market price.
Eventually the banks who had sold these options realised there was no VW stock to go out and buy since the German government wouldn’t sell its allocation and Porsche wouldn’t either. If Porsche called in the options the banks were in trouble.
Porsche called in the options which forced the shorts to buy stock - at whatever price they could get it.
The price squeezed higher as those that were short got massively squeezed and stopped out. For one brief moment in 2008, VW was the world’s most valuable company. Shorts were burned hard.

Incredible event
Porsche apparently made $11.5 billion on the trade. The BBC described Porsche as “a hedge fund with a carmaker attached.”
If this all seems exotic then know that the same thing happens in FX all the time. If everyone in the market is talking about a key level in EURUSD being 1.2050 then you can bet the market will try to push through 1.2050 just to take out any short stops at that level. Whether it then rallies higher or fails and trades back lower is a different matter entirely.
This brings us on to the matter of crowded trades. We will look at positioning in more detail in the next section. Crowded trades are dangerous for PNL. If everyone believes EURUSD is going down and has already sold EURUSD then you run the risk of a short squeeze.
For additional selling to take place you need a very good reason for people to add to their position whereas a move in the other direction could force mass buying to cover their shorts.
A trading mentor when I worked at the investment bank once advised me:
Always think about which move would cause the maximum people the maximum pain. That move is precisely what you should be watching out for at all times.

Asymmetric losses

Also known as picking up pennies in front of a steamroller. This risk has caught out many a retail trader. Sometimes it is referred to as a "negative skew" strategy.
Ideally what you are looking for is asymmetric risk trade set-ups: that is where the downside is clearly defined and smaller than the upside. What you want to avoid is the opposite.
A famous example of this going wrong was the Swiss National Bank de-peg in 2012.
The Swiss National Bank had said they would defend the price of EURCHF so that it did not go below 1.2. Many people believed it could never go below 1.2 due to this. Many retail traders therefore opted for a strategy that some describe as ‘picking up pennies in front of a steam-roller’.
They would would buy EURCHF above the peg level and hope for a tiny rally of several pips before selling them back and keep doing this repeatedly. Often they were highly leveraged at 100:1 so that they could amplify the profit of the tiny 5-10 pip rally.
Then this happened.

Something that changed FX markets forever
The SNB suddenly did the unthinkable. They stopped defending the price. CHF jumped and so EURCHF (the number of CHF per 1 EUR) dropped to new lows very fast. Clearly, this trade had horrific risk : reward asymmetry: you risked 30% to make 0.05%.
Other strategies like naively selling options have the same result. You win a small amount of money each day and then spectacularly blow up at some point down the line.

Market positioning

We have talked about short squeezes. But how do you know what the market position is? And should you care?
Let’s start with the first. You should definitely care.
Let’s imagine the entire market is exceptionally long EURUSD and positioning reaches extreme levels. This makes EURUSD very vulnerable.
To keep the price going higher EURUSD needs to attract fresh buy orders. If everyone is already long and has no room to add, what can incentivise people to keep buying? The news flow might be good. They may believe EURUSD goes higher. But they have already bought and have their maximum position on.
On the flip side, if there’s an unexpected event and EURUSD gaps lower you will have the entire market trying to exit the position at the same time. Like a herd of cows running through a single doorway. Messy.
We are going to look at this in more detail in a later chapter, where we discuss ‘carry’ trades. For now this TRYJPY chart might provide some idea of what a rush to the exits of a crowded position looks like.

A carry trade position clear-out in action
Knowing if the market is currently at extreme levels of long or short can therefore be helpful.
The CFTC makes available a weekly report, which details the overall positions of speculative traders “Non Commercial Traders” in some of the major futures products. This includes futures tied to deliverable FX pairs such as EURUSD as well as products such as gold. The report is called “CFTC Commitments of Traders” ("COT").
This is a great benchmark. It is far more representative of the overall market than the proprietary ones offered by retail brokers as it covers a far larger cross-section of the institutional market.
Generally market participants will not pay a lot of attention to commercial hedgers, which are also detailed in the report. This data is worth tracking but these folks are simply hedging real-world transactions rather than speculating so their activity is far less revealing and far more noisy.
You can find the data online for free and download it directly here.

Raw format is kinda hard to work with

However, many websites will chart this for you free of charge and you may find it more convenient to look at it that way. Just google “CFTC positioning charts”.

But you can easily get visualisations
You can visually spot extreme positioning. It is extremely powerful.
Bear in mind the reports come out Friday afternoon US time and the report is a snapshot up to the prior Tuesday. That means it is a lagged report - by the time it is released it is a few days out of date. For longer term trades where you hold positions for weeks this is of course still pretty helpful information.
As well as the absolute level (is the speculative market net long or short) you can also use this to pick up on changes in positioning.
For example if bad news comes out how much does the net short increase? If good news comes out, the market may remain net short but how much did they buy back?
A lot of traders ask themselves “Does the market have this trade on?” The positioning data is a good method for answering this. It provides a good finger on the pulse of the wider market sentiment and activity.
For example you might say: “There was lots of noise about the good employment numbers in the US. However, there wasn’t actually a lot of position change on the back of it. Maybe everyone who wants to buy already has. What would happen now if bad news came out?”
In general traders will be wary of entering a crowded position because it will be hard to attract additional buyers or sellers and there could be an aggressive exit.
If you want to enter a trade that is showing extreme levels of positioning you must think carefully about this dynamic.

Bet correlation

Retail traders often drastically underestimate how correlated their bets are.
Through bitter experience, I have learned that a mistake in position correlation is the root of some of the most serious problems in trading. If you have eight highly correlated positions, then you are really trading one position that is eight times as large.
Bruce Kovner of hedge fund, Caxton Associates
For example, if you are trading a bunch of pairs against the USD you will end up with a simply huge USD exposure. A single USD-trigger can ruin all your bets. Your ideal scenario — and it isn’t always possible — would be to have a highly diversified portfolio of bets that do not move in tandem.
Look at this chart. Inverted USD index (DXY) is green. AUDUSD is orange. EURUSD is blue.

Chart from TradingView
So the whole thing is just one big USD trade! If you are long AUDUSD, long EURUSD, and short DXY you have three anti USD bets that are all likely to work or fail together.
The more diversified your portfolio of bets are, the more risk you can take on each.
There’s a really good video, explaining the benefits of diversification from Ray Dalio.
A systematic fund with access to an investable universe of 10,000 instruments has more opportunity to make a better risk-adjusted return than a trader who only focuses on three symbols. Diversification really is the closest thing to a free lunch in finance.
But let’s be pragmatic and realistic. Human retail traders don’t have capacity to run even one hundred bets at a time. More realistic would be an average of 2-3 trades on simultaneously. So what can be done?
For example:
  • You might diversify across time horizons by having a mix of short-term and long-term trades.
  • You might diversify across asset classes - trading some FX but also crypto and equities.
  • You might diversify your trade generation approach so you are not relying on the same indicators or drivers on each trade.
  • You might diversify your exposure to the market regime by having some trades that assume a trend will continue (momentum) and some that assume we will be range-bound (carry).
And so on. Basically you want to scan your portfolio of trades and make sure you are not putting all your eggs in one basket. If some trades underperform others will perform - assuming the bets are not correlated - and that way you can ensure your overall portfolio takes less risk per unit of return.
The key thing is to start thinking about a portfolio of bets and what each new trade offers to your existing portfolio of risk. Will it diversify or amplify a current exposure?

Crap trades, timeouts and monthly limits

One common mistake is to get bored and restless and put on crap trades. This just means trades in which you have low conviction.
It is perfectly fine not to trade. If you feel like you do not understand the market at a particular point, simply choose not to trade.
Flat is a position.
Do not waste your bullets on rubbish trades. Only enter a trade when you have carefully considered it from all angles and feel good about the risk. This will make it far easier to hold onto the trade if it moves against you at any point. You actually believe in it.
Equally, you need to set monthly limits. A standard limit might be a 10% account balance stop per month. At that point you close all your positions immediately and stop trading till next month.

Be strict with yourself and walk away
Let’s assume you started the year with $100k and made 5% in January so enter Feb with $105k balance. Your stop is therefore 10% of $105k or $10.5k . If your account balance dips to $94.5k ($105k-$10.5k) then you stop yourself out and don’t resume trading till March the first.
Having monthly calendar breaks is nice for another reason. Say you made a load of money in January. You don’t want to start February feeling you are up 5% or it is too tempting to avoid trading all month and protect the existing win. Each month and each year should feel like a clean slate and an independent period.
Everyone has trading slumps. It is perfectly normal. It will definitely happen to you at some stage. The trick is to take a break and refocus. Conserve your capital by not trading a lot whilst you are on a losing streak. This period will be much harder for you emotionally and you’ll end up making suboptimal decisions. An enforced break will help you see the bigger picture.
Put in place a process before you start trading and then it’ll be easy to follow and will feel much less emotional. Remember: the market doesn’t care if you win or lose, it is nothing personal.
When your head has cooled and you feel calm you return the next month and begin the task of building back your account balance.

That's a wrap on risk management

Thanks for taking time to read this three-part chapter on risk management. I hope you enjoyed it. Do comment in the replies if you have any questions or feedback.
Remember: the most important part of trading is not making money. It is not losing money. Always start with that principle. I hope these three notes have provided some food for thought on how you might approach risk management and are of practical use to you when trading. Avoiding mistakes is not a sexy tagline but it is an effective and reliable way to improve results.
Next up I will be writing about an exciting topic I think many traders should look at rather differently: news trading. Please follow on here to receive notifications and the broad outline is below.
News Trading Part I
  • Introduction
  • Why use the economic calendar
  • Reading the economic calendar
  • Knowing what's priced in
  • Surveys
  • Interest rates
  • First order thinking vs second order thinking
News Trading Part II
  • Preparing for quantitative and qualitative releases
  • Data surprise index
  • Using recent events to predict future reactions
  • Buy the rumour, sell the fact
  • The mysterious 'position trim' effect
  • Reversals
  • Some key FX releases
***

Disclaimer:This content is not investment advice and you should not place any reliance on it. The views expressed are the author's own and should not be attributed to any other person, including their employer.
submitted by getmrmarket to Forex [link] [comments]

In Search of the Best Yen Pair

This will be a wall of text, but with pictures! I'm going to attempt to analyse USD/JPY, EUJPY, GBP/JPY, AUD/JPY, NZD/JPY, CAD/JPY, CHF/JPY, and ZAJPY. I'm really interested in your feedback, especially from the guys who are good with the supply/demand levels :)
A thought occurred to me while I was regretting eating McDonalds for dinner last night. When there are strong directional moves by one pair, associated pairs and crosses will move in the same way - especially if that move is the result of only one of those currencies strengthening or weakening. Often however, its the associated pairs that will offer a cleaner technical setup.
The purpose of this post is to identify a Yen pair that has the greatest upside potential in the event of the Yen weakening again. It might take a long time to get back up to the highs, so I want a currency with a really good outlook. If you think there is a strong case for a continued move to the downside, I really want to hear it as well.
Likewise on the last big leg up in USD/JPY, when we cracked 100 and then some, I actually lost out a little bit by spreading my trades across EUJPY, USD/JPY and GBP/JPY - the rationale being that if the Yen weakened rapidly, the risk trades would do the best against them rather than the dollar (which normally has quite muted moves whenever the Yen weakens rapidly). Except in that case it was the dollar strengthening, and the Yen fought back against the Euro and Pound.
So I got thinking: one of these pairs must have the cleanest technicals, the simplest fundamentals, and offer the best risk:reward potential for a trade to the upside - especially since it's the BoJ in 2 days.
I'm going to go through the suspects one by one, and just do some basic technical and fundamental analysis. I will only be using trendlines, fibonacci levels and the 50 & 100D SMAs.
For the purpose of simplicity I have ignored price data pre mid-2012, as most of those levels are gone now. Except the one we're at now - in almost all pairs the current level has been a significant pivot, dating back a few years.
Starting with /forex's most hated pair:
USD/JPY
http://i.imgur.com/W8DRrkU.png
Technicals 100 is once again a significant obstacle, and I expect sideways action between here and 96, if the selloff doesn't continue. The Yen might weaken again very sharply, but so also might the dollar. We have a fairly clear and convincing trendline break, and I'm regretting getting in long. We might have a low in place, but we also might not. We are currently supported at a critical level by the 100DMA and the 0.23 fib, as well as a known demand level. A break lower here targets 95 and then 93.50.
Fundamentals We will need a dollar rally as well as a Yen rout to climb quickly, and I'm unwilling to play only one and not the other. Without signs that the US will slow easing and Japan will at least keep it up, we do not have the fundamental driver to push very much higher.
Trades I'm not sure the best trade is to be found here, in either direction. Long seems to be the way forward, but we need some convincing. Otherwise it's sell rallies into 100.
EUJPY
http://i.imgur.com/ETkvc23.png
Technicals If we're looking for the best technical setup for a long, we might have it here. We've spiked through this pair's most significant demand level, bounced off the 100DMA, and closed above the trend line. It's a fairly simple picture.
Fundamentals I am slightly concerned by the Euro's lacklustre performance against everything besides the dollar. EUGBP is down, EUAUD didn't add 200 pips in the last session, etc. That said, I think that the Eurozone is going to start impressing people soon, as long as they can avoid another sovereign debt crisis. Which they won't. It will happen and when it does it will suck this pair down the suck hole faster than USD/JPY ever could.
Trades The problem here is that the bottom of Friday's hammer is 280 fucking pips away. I don't know about you guys but I don't like setting stops 280 pips away, especially with limited upside potential right now. I would look for a higher low to form first before getting in long - maybe around 128.50.
A new Eurozone crisis, continued Yen strength and a break of Friday's low could send this pair screeching to a spike low of 115 in a matter of minutes, in my opinion.
GBP/JPY
http://i.imgur.com/gv5WVy5.png
Technicals Another good long tech setup. A Head and Shoulders pattern was broken and completed on Thursday, with a close above the trend line.
Fundamentals The UK economy is looking better than it has all year, and its recovery is looking set to overtake the Eurozone's. However, Mark Carney comes in next month and we might be staring down the barrel of more dovish MP. This could destroy Cable's fragile recovery, which is showing signs of weakness at a previous pivot level and significant fib.
Trades Going long here seems like the obvious choice. A stop would need to be quite wide, but below Thursday's low would probably be sufficient, as we could probably see Friday's low as a bizarre volatility spike that had very little to do with the Pound or the Yen. Mind you that is still 160 pips away, so either wait for a dip or keep your position size very small.
AUD/JPY
http://i.imgur.com/EDZigYP.png
Technicals This is not a chart that screams, "go long", and it makes me worry about the other Yen pairs' upside potential. It could well be that the next significant move lower starts here, as the Aussie continues its collapse. Currently holding at the 50% fib and 200DMA, but any trendlines are long gone and we can expect price consolidation as long as we do not go lower.
Fundamentals China released a lot of bad data this weekend, some neutral data, and no good data. The Aussie and Kiwi underperformed against the USD this week, despite being given a massive head start. There is huge scope for further easing, and this currency is strictly in "sell rallies" mode. A gold and commodities recovery is the only thing that will save the Australian dollar.
Trades I don't like it either way. As has been said on this sub before: what a c*nt of a pair.
NZD/JPY
http://i.imgur.com/5pEnfhq.png
Technicals An even uglier picture than AUD/JPY, but we have spiked off the 0.38 fib and closed above the 200DMA, if that means anything. A break of Friday's low could get extremely bad very quickly, but this pair isn't known to really motor.
Fundamentals The Kiwi actually performed worse than the Aussie this week, closing at the lows and through significant support, while the Aussie staged a late rally. It's hard to be bullish either of these currencies. This is purely due to the commodities slump. Despite tightening MP, the Kiwi looks particularly vulnerable as the entire bloc collapses.
Trades I'm not sure the best trade is here, but if Yen strength continues then selling a rally into 77.50 looks like a good play.
CAD/JPY
http://i.imgur.com/AdcnwkO.png
Technicals 97.50 is the bull/bear line here and we're well through it, so we would need a close above here to be really bullish. Price bounced off the 0.23 fib and 100DMA, and 97.50 once again offers the most serious upside resistance. A break lower here targets 91.50
Fundamentals The Canadian dollar staged a late rally on Friday on the back of ridiculously good employment data. USD/CAD is now at descending channel support and the 50% fib of the recent rally, so I would be careful either way. Otherwise I don't know much about the Canadian fundamental picture, but I believe they're happy to see Carney go.
Trades Not really sure what to do here. If anyone is more familiar with this pair, let's hear it. Otherwise I'm gonna stay out of this one.
CHF/JPY
http://i.imgur.com/4vvoI2o.png
Technicals CHF/JPY was actually the biggest gainer in % terms when Japan first announced its QE program. Since then it hasn't done much. Trendline is gone but we've bounced off the 100DMA, which has provided support before. We need above 105 to get really bullish here. There is a very long broken wedge which technically targets 93.
Fundamentals I expect the Swiss Franc to weaken if the stock market recovers from here. If it doesn't, and we see a continued decline in stocks, the Yen will strengthen more than the Franc, so we'll probably head down some more. Overall it doesn't look good for this pair. If USD/JPY recovers sharply, USD/CHF probably will as well, so gains here will be muted. If on the other hand gains are driven by fundamental Yen weakening in response to more QE, would could see a large move to the upside.
Trades Buy on a break and hold of 105 only.
ZAJPY
http://i.imgur.com/SYiZZpd.png
I just put this up for the lolz. Something has gone horribly wrong for South Africa, so if you think the Aussie's had it bad...
Technicals A break of the 50% fib gives us real cause for concern here. If the Rand continues to weaken as a result of gold weakening, we could see the rally fully retraced. Expect consolidation.
Fundamentals The Rand performed worst of all the commodity currencies, as gold continues to slide (it recently broke out of its consolidation to the upside, only to crash on Friday to confirm a break lower again, targeting $1350). When USD/JPY collapsed on Thursday, USD/ZAR barely blinked. I've been trading it to the upside on dips, but 10.00 seems to be capping moves for now. If gold does not recover sharply, the South African economy is going to suffer very badly.
Trades F that noise. Buy USD/ZAR on a break of 10.25, or sell it on a break out of consolidation.
submitted by NormanConquest to Forex [link] [comments]

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Which Are The Best Forex Pairs To Trade? - YouTube

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