September 2003

Futures Magazine – Special Edition (The Secrets of the Master Traders)

The DNA of the Profitable Trade:

Trading profitably – while never easy - is not an unduly complicated process and can be stripped-down, when properly analyzed, to its component parts - or “DNA“

How can knowing the DNA of a profitable trade help you, the trader? By identifying and enumerating the basic minimums required in your trading market, you can skew the odds of trading success maximally in your favor…

Imagine you were suddenly forced to move to a new country. What minimum fundamental characteristics would you look for in a country to give yourself the greatest chances of success? Presumably, if you're a typical U.S. citizen, you would seek a country that offers:

· A familiar language,

· Acceptable cultural and social mores;

· A free-market capital structure and a robust economy;

· Low taxes;

· A democratic political system.

Without those basic fundamentals, you might feel constrained in your ability to succeed there.

Similarly, when seeking employment, you'd most likely look for a job or vocation that:

· Matches your skills and personality;

· Offers potential for advancement;

· Is challenging and satisfying;

· Offers competitive remuneration.

YOUR FRIEND 'OLIE'

Your choice of trading market and instrument should be given equally serious consideration because the first step toward profitable trading is being able to identify optimal trading conditions for your situation.

All traders, no matter what or how they trade, have only four basic needs:

1. O - Opportunity--Volatility in a market that trends.

2. L - Liquidity--A market must be deep, reliable, accessible.

3. I - Information--Unfettered real-time access to the latest information such as market commentary, research, analysis, analytics, charts, price alerts, price-discovery mechanism, etc.

4. E - Execution--Tight bid/ask spreads, low commissions and reliable trade entries and exits.

Some markets, depending on your choice of broker/dealer, offer just one or maybe two of these four necessary ingredients for profitable trading. But If you don't have all four, if you don't have "OLIE," the bare minimum sustenance you need to trade profitably, then you should reassess your trading strategy and ask yourself these questions:

Am I trading in the right market?
Am I trading the right instruments?
Am I using the right broker?
Am I maximizing profit potential?

THE FOREX ALTERNATIVE

The OLIE approach can lead traders to any number of markets, based on their unique situations. Futures, options and equities all have their advantages. In recent years, though, the forex markets have earned significant respect within the industry. For some, trading the online foreign exchange market, when approached properly, now is a realistic alternative that offers the essentials necessary for maximizing your trading potential. Here are some features of forex trading that illustrate how it compares with other markets using the OLIE criteria.

O - OPPORTUNITY

You can access forex markets 24 hours a day. Forex offers the convenience of being able to trade according to your own schedule, day or night, so that you can react to market developments instantly as they happen in real-time without needing to wait until the next open, as you do with session-traded contracts. Also, if you've traded some futures markets off-hours, for example, you may be aware of the dangerous illiquidity that can prevail.

There's less chance of price gaps and the risk that comes with them. Foreign exchange is a truly international market traded in all major global market centers from New York to London to Tokyo to Sydney. The forex market trades in smooth, continuous weekly sessions rather than daily sessions because the forex market effectively opens Sunday nights at 5 p.m. EST--8 a.m. Monday morning in Sydney--and closes for the weekend on Friday nights at 5 p.m. EST. As a result, there is much less chance of being burned by "gaps" that often occur daily in the futures market from session close to session open the next day (see "Ouch! That hurts!" right).

Trends are prevalent in forex. Unlike some other markets, currencies rarely spend much time in tight trading ranges and tend to trend. A technical trader can identify new trends, breakouts, overshoots and support and resistance points that can provide multiple opportunities to enter and exit positions (see "Sticking with technicals," page 34).

Forex daily price moves aren't artificially limited. Most futures exchanges impose daily price move caps on their contracts, limiting daily volatility. If you are short a futures contract that moves down to a price boundary, this limits your ability to profit.

L - LIQUIDITY

The forex market is the largest in the world. The liquidity of the $1.5 trillion forex market means that positions can usually be liquidated and stop orders executed without slippage. Depending on your broker, trades can usually be executed all at one time, in one clip, in your full amount, all at one price instead of selling "one lot at 9, another at 7, two lots at 5 ..."

I - INFORMATION

News coverage of events and developments that affect forex markets is as close as your television or newspaper, and there are many choices for market commentary, charts, etc., much of it online so you can gain access as quickly as any other trader in the world.

E - EXECUTION

No matter how many lots you trade, most forex market-makers will never charge any trading commissions or any other typical costs associated with other trading such as exchange fees, clearing fees, "pass-throughs" or other ticket charges. Accordingly, with no ancillary costs of trading, a forex trader's breakeven point can be significantly lower per trade.

With forex trading, you actually have the ability to choose the exact level of leverage that you wish to employ. For traders whose position size (money management) is an important ingredient to their analysis, this flexibility alone can make forex the best market for them. Some forex brokers offer leverage as high as 100 to 1, which is about three times more than futures and 50 times more than stocks. Whether you should assume so much leverage is UP to you, but the option is there.

Trading directly with a forex market-maker doesn't require routing orders through an exchange. Orders usually can be filled immediately.

OTHER DIFFERENCES

What should you do with your September futures if it is the middle of September and you still wish to keep the position? In all likelihood, you'll need to sell September futures and repurchase December futures. With forex, most market-makers will automatically roll forward any open positions on a daily basis to the next settlement date so you never have to worry about standard futures delivery or additional fees.

Also, some forex firms offer you the opportunity to earn "interest rate carry" where you can earn the interest rate differential between the two currency pairs in your position. For example, if you are long GBP/JPY, the British Pound interest rate (which you earn) is much higher than the Japanese yen rate (which you pay). Therefore, you can profit from holding a long GBP/JPY position, even if you sell at the exact same rate at which you bought it or slightly lower. Think of it as earning the "dividend" on stock trading. (Note: Depending on your position, you can also be "charged" the interest rate carry. Check this out with your forex market-maker.)

FOREX VS. EQUITIES

The forex markets are particularly advantageous vs. equities. While they share some of these benefits with futures and other markets, a few of them are unique to forex.

As with futures, you can profit in a rising or declining market with Forex. There are no restrictions on short selling. Profit potential exists in the currency market whether you are long or short a given currency pair or which direction the market is moving. Because forex trading always involves buying one currency and selling another, there is no systemic market bias to be ‘long.’ This means that all trades have equal opportunity to profit in both rising and falling prices.

Liquidity is an area where forex has a significant advantage over stocks. Have you ever had a 2,000 or 5,000 share position, only to see only 100 shares on the bid when you want to sell? It can be a harrowingly frustrating experience for an equity trader. Given the liquidity available in the forex market, this type of scenario is much less likely to occur.

Other traders have experienced something even worse. Have you ever owned a position in a stock that was profitable until, suddenly, trading in the stock was "halted"? Frequently, after a stock re-opens for trading, your profit has become a loss. Trading "halts" do not exist in the forex market and generally never happen in "convertible" currencies as the market is simply too large and there is no physical marketplace to force a stoppage on.

Stocks represent companies, which have extraneous baggage. Stocks can trade erratically and unpredictably when news of a dividend change or a record-date change is announced or when a stock trades cum or ex-dividend. Moreover, when a stock splits or reverse-splits, price action doesn't always move in your favor. These confusing end distracting issues don't apply to forex so you can focus on your most important task: just trading.

Of course, you should never forget the other important factors that can and will determine your degree of trading success, regardless of market traded--discipline/emotion, money/position management, trade timing, entry/exit signals and, of course, plain old luck. But these factors speak to each individual trader's style and are less relevant in the context of the larger, over-arching discussion on the structure of the markets you might want to trade.

Hopefully, you now understand the fundamentals to look for in a market before trading it so you can skew the odds for profit in your favor. Never forget that the objective is to maximize profit, regardless of which market you trade. However, market choice is a decision as important, if not more, than the indicators you use to analyze price. Just as with disciplined trading, you should never "marry" or emotionally stick with the current market you trade without asking whether you are maximizing your profit potential.

Josh Levy is president of CMC Markets USA (www.CMCforex.com) and manages the North American arm of CMC Markets. He previously was an interbank FX trader for Goldman Sachs and was managing director of the forex trading division of the Sungard STN Transaction Network. He co-founded Matchbook FX, the world's first online currency trading ECN.

Document FMCO000020031015dz9f00007

Levy, Josh

1,798 words

15 September 2003

Futures Magazine – Special Edition (Secrets Of The Masters)

32 ISSN: 0746-2468; Volume 32; Issue 12 English