Changing horses

If not trend, then what? One theory is that some traders build systems, and when they do not work as projected from back-tests or early experiences, the traders abandon the systems in favor of other ideas. If the original system was not well thought out, this could be a good management decision, but on the whole, flipping between different systems is a very bad idea.

Adaptiveness is one thing, but the absence of a theory of how things work and how to exploit it is simply incoherence.

And this is what might be happening. Just changing time frames is sufficient to cause the forex industry’s recent bad trading results. Systems designed to have a holding period of, say, three weeks are newly applied with holding periods of only three days — or three hours — after losses in the longer period reach some predetermined level. Professional managers must produce high gains in short periods, and clients complain about a losing day, let alone a losing week or month. One professional manager envies managers with systems that allow the trader to be square (no position) when in doubt about the next price action. His customers, he said, would take one look at a daily statement showing “no position” and yell the house down. And yet these very same clients would agree wholeheartedly that “preserving capital” is the first rule of investing and trading. You can’t play if you’ve lost all your marbles.

Unreasonable clients cause what the shrinks call “performance anxiety” in even the most experienced professionals. The trader becomes paralyzed and indecisive, or overtrades to compensate for losses. We joke that a winning trader becomes too cocky and is due for a fall (after which is the best time to give him some money), but winning traders face as much or more stress than losing traders because they know a winning streak will end.

Finally, it also seems that some traders are using fancy math based systems with no relation to the fundamentals underlying market moves. One manager built a complex system designed to identify a pattern predicting a three-point opportunity, and he tries to get two points of the three. This worked great when he was the employee of a major bank that was the beneficiary of tiny bid-offer spreads, but not so great when he started to trade his own fund, which got less-desirable spreads. Then the three point opportunities stopped coming along, too. His entire “business plan” went up in smoke.

Another fund manager claims to use the “monkey-throwing-darts” technique. A long position is selected arbitrarily. If it loses a pre-set amount, say 5 percent, the trader stops and reverses to a short position. The short position is held until it hits a pre-set profit target or stop-loss, whereupon the monkey throws the dart again, which could land on the same short position just exited.

The trader knows nothing about the underlying fundamentals or market dynamics; risk management is the entire trading “strategy.” This particular manager has been in business for many years and is thriving. If you want to know why a price moves between the top and bottom of its normal average true range twice in a single day — aberrant behavior — this is the guy to blame, a long with all the others copying the technique.

Forex manager losses can’t be blamed for a reduction in trendedness, but what about volatility? There is, in fact, less volatility than there used to be. The top window in charts the Japanese yen’s daily standard error (the variability from the linear regression trendline). The horrible year 1994 had a low average standard error after a single spike in February — and most traders lost money in 1994. The next year, when variability was high — notice there were about 10 spikes — the managers did much better, about 24 percent for systematic traders, according to Parker Global. Conclusion: A trending market with high volatility provides profit opportunities.

A less-trended market still provides opportunities if volatility is high. Logically, the worst of all possible markets is a non-trending, sideways market with low day-to-day volatility, especially if it has high intraday volatility that causes tight stops to get hit, whether they are tight because the trader is small or because the trader is stressed out.