AT: This year has been pretty rough overall for currency managers, and currencies have been stagnant for a while. Let’s talk about the evolution of online forex brokers. As this market grows, what do you think of the potential profit opportunities? Will the trend moves continue to dissipate and will that make it harder for currency managers to make money? Is a sea change in the market occurring?

PP: I’ve been around long enough to know that it’s not new. But on the other hand, the market is changing with regard to the distribution of prices. We know that market prices are not normally distributed, meaning there are sharp moves that don’t fit the normal distribution pattern — these “fat tails” in a non-Gaussian (bell) curve. This tendency is increasing, in my opinion.

All system trading ultimately relies on near-normal distribution. When this deteriorates, you have less opportunity for systematic trading. Things will be more difficult for system traders, and fundamental traders who have a view about price levels might come to the forefront.

On our Web site there’s a comparison between systematic and discretionary currency managers how they under perform and outperform each other. It shows that, currently, discretionary are ahead of systematic traders. If that will persist, I don’t know. I should like to think not.

AT: If it does, how would it impact your trading?

PP: It’s not going to. But we have to be more careful with the fine-tuning of the parameter spaces and be on the button with regard to monitoring how systems perform in general and how other traders perform.

AT: It wouldn’t lead to shortening your trading horizon, decreasing your size or some other change?

PP: No. We are very happy with the current model. We don’t, generally, reduce the position size if we lose money.

AT: So when you talk about adjusting parameters depending how the market evolves, what are you talking about changing?

PP: The parameters we change are “buffers,” which adjust to market volatility. But we tend not to change them, if we can avoid it.

AT: Are the buffers essentially volatility-based filters that dictate how much a market has to move after an initial signal is triggered before the signal is acted upon?

PP: Yes.

AT: What’s an average trade length?

PP: Two days.

AT: Is forex a unique market, in that trading currencies is different than trading stocks or bonds?

PP: Currencies don’t “scale” like other assets. Stocks, bonds and other asset prices scale logarithmically (i.e., on a percentage basis). What I’m saying is, the daily volatility of, say, soybeans trading at $12 will be higher than it would with beans trading at $3. It moves in percentage terms according to the price level. That’s normal.

I checked the average daily range or volatility of the British pound when it was trading around $1 vs. when it was around $2 or $2.50 and, funnily enough, there was virtually no difference in the daily volatility. It should have been half when the pound was trading at $1 vs. where it was with the pound at $2, but it wasn’t.

This is probably because currencies are reciprocal — you could say there’s a pound/dollar rate and a dollar/pound rate. By contrast, gold bullion is measured in dollars, but you never measure dollars in gold bullion.

One thing’s for sure: Currencies do not fluctuate more when they are at higher prices — at least as much as they should.

The medium of currencies is not comparable to the bond and stock markets, in which you have indices people can buy — a portfolio of bonds or a portfolio of stocks, like buying all the stocks in the S&P 500 — that serves as a benchmark. You can’t do that in currencies.

AT: I read you only trade the three largest currency pairs (EUR/USD, USD/JPY and EUR/JPY),
but you also have a study that discusses the superior trend characteristics of less mature currencies. If some of these less mature markets have better trend characteristics even if they’re less liquid — isn’t there enough price movement to justify doing some trading in them?

PP: The risk is just too big. Everything is fine and dandy on paper, but simulations don’t show everything — you find out there was a 50-point market gap that wasn’t factored in because most people work with hourly data, at best. Even if you had one-minute data, even then you wouldn’t even necessarily spot a “liquidity black hole” (a term created by Prof. Avinash Persaud). We’ve seen liquidity holes occur in time spans less than one minute. So even if you make a one-minute chart, the gap doesn’t show up.

And this is a risk that has increased recently in my opinion — I’ve never seen so many liquidity holes, particularly in the dollar/yen rate.

AT: Are there any currency pairs you are currently not trading but are watching because they are poised to become mature enough to trade?

PP: No.

Peter Panholzer: Currency system architect Part 4

AT: Also, do you think some of the less mature currency pairs are viable for individual traders, who don’t have to worry as much about huge liquidity?

PP: Sure. You can choose between many models when you buy a car.

AT: You seem to feel the Bank of Japan is especially responsible for the liquidity holes you talk about — you’ve even referred to their “manipulative moves” on your Web site. Why is that?

PP: The Bank of Japan simply has more discretionary powers than other central banks.

AT: What basic principles would you advise forex traders adopt given today’s market?

PP: After all my 31 years of trading, I’ve come to say that the best way is to trade systematically — in an unemotional way — and that can only be done using very rigorous system construction and exploitation of data statistics.

You can do this as an individual trader, but it takes a lot of resources. You can’t buy a good trading program, in my opinion. We certainly wouldn’t sell ours. The program has to fit you like your own clothing. In that sense we have a tailor — that is, a programmer who is, ideally, himself a trader — andwe work together with him to develop and monitor the systems. This is Adam Hartley, of SnapDragon Systems in Oxford, England.

I also believe simple rules, amazingly enough, make the best systems; complex rules don’t, necessarily. A complex rule, for example, would be the application of chaos theory. Rocket scientists were given millions of dollars to research and trade using fractals and non-linear dynamics, and they failed. Sophistication is not the solution.

Sometimes the simplest system will be the most useful because it is easy to understand and execute — the Turtle system, for example, or the very similar system I used long before the Turtles. (“Turtle”was the name given to the trend following disciples of trading star Richard Dennis, who made hundreds of millions of dollars in the 1970s and 1980s.) Decades ago I used a four-week breakout system (buy at the four-week high and sell at the four-week low), and that turned out to be the Turtle system, except the Turtle system entered at four weeks and got out at two.

Obviously it was very useful in very trendy markets in the 1970s when there was inflation. That’s another thing: The 1970s were unprecedented inflationary years. If that happens again, we’ll have some tremendous advantages. What you need is movement. Right now, there’s not so much in the currency market.

AT: If a general deterioration of trend moves is inevitable — not just cyclical — doesn’t that eventually spell doom for currency trend followers? Wouldn’t you eventually have to adopt a different approach?

PP: Currently these clouds seem far away. As [Former Canadian Prime Minister] Pierre Trudeau once said to an old lady who asked him about inflation, “The universe will unfold as it must.”

AT: Do you have any feeling about currencies over the next six months or so?

PP: I think 2005 will be a banner year for currencies. I also have a strong feeling the remainder of the year will show a strong improvement in conditions. There seems to be some kind of seasonality that October, November and December tend to be good months. But of course, that could be called witchcraft (laughs). Nevertheless, the statistics are there to show the last quarter is good.

AT: Why is 2005 going to be good?

PP: Because when you come out of a long sideways move, in general, you get a big move. This is natural.

AT: Do you think the high leverage sometimes offered by forex brokers is a good thing for smaller traders to use?

PP: I think it’s irresponsible to trade with only the margin money — in the spot market or in futures. But the exchanges and brokers have an interest to let the little guy trade with as little money as possible the margin. It’s not in the interest of the trader. It’s in the interest of the broker because it creates more commission per customer dollar.

All I can say is, in currency trading leverage is a very important thing. You can use no leverage or 100 to-1 leverage. And in general, you should always use less leverage than you think you should because we always overestimate our tolerance for risk.

We don’t always understand that risk isn’t always a money risk; there’s the risk of regret. Sometimes you regret you haven’t been in the market, sometimes that you got out too early or that you’ve taken a loss when it wasn’t necessary. It’s not only the money we worry about, it’s also our regret we worry about.