Monthly Archives: November 2012

In academic terms, the Disposition Effect is a psychological bias in traders and investors to take profits quickly and let losses run. This is something which has been talked about in the markets for many years. It comes from a combination of risk aversion effects and a bias toward certainty over uncertainty. In other words, we humans generally prefer a sure gain, even when there is the prospect for a bigger one, while at the same time we prefer having the prospect for a smaller (or no) loss, rather than a sure one.

It’s pretty easy to see how these biases can turn into being quick to book a gain, but giving the market a chance to turn around rather than taking a sure loss.

It is to avoid the potential negative outcomes from this bias – not making as much as we should on winning trades, and taking losses which are much bigger than they should be on the bad trades – that we introduce systems and processes in our trading. For some it goes as far as strictly mechanical trading. For others it includes rules about where to place stops and how to move them up with the market. They attempt to enforce a discipline on us to avoid allowing psychological biases like the Disposition Effect to negatively impact our performance.

Keep in mind, however, that this needs to apply to social trading as well.

In most cases, when using an auto-trading or mirror trading system like Trade Leaders you have the ability to make changes to trades that are done in your account. As a result, there may be the temptation to close out or cut-back a winning trade before it is done by the trader you are following. This is not something that is good idea.

Consider the math of trading performance. Expected returns follow this formula:

R = (win% x avg. winner) – (loss% x avg. loser)

If you close out winning trades early you are impacting the size of the avg. winner. That lowers R - the expected return. This could go so far as to produce a negative expectancy in the most sensitive systems.

In other words, as a social investor you need to ensure you abide by very similar discipline as you would if you are trading in your own right. Don’t let the Disposition Effect drag down your performance.

 

Stock prices moved sharply higher during the summer months, as investors speculated that further central bank action might just return the economies of the industrialised world to a more familiar growth-setting in the not too distant future.  The world’s leading monetary policymakers from the Bank of England, the Bank of Japan, the European Central Bank, and the US Federal Reserve, duly delivered on cue, but the notion that the latest round of unconventional measures will do anything more than maintain economic growth not too far below trend, is misguided and virtually certain to disappoint.

Investors continue to cling to their misguided beliefs, even though almost four years of ultra-accommodative monetary policies have already failed to deliver anything like a typical economic recovery in the developed world, and the lacklustre activity in the US has prompted the Federal Reserve to commit to a near-zero interest rate policy through mid-2015 – nearly a full seven years after the global financial crisis reached its climax during the latter months of 2008.

Real economic activity remains below its pre-recession peak throughout most of the developed world despite the extraordinary monetary stimulus provided in recent years, and the reason is clear.  Monetary policy loses its potency in the face of a deep and protracted deleveraging; it can do little but soften the blow, and buy time until balance sheets have been repaired, such that credit expansion can proceed anew.

Milton Friedman, the Nobel Prize-winning monetary economist, warned the American Economic Association, in his 1968 Presidential address, not to expect too much of monetary policy.  Investors need to wake-up and appreciate that the late-economist’s words of caution are particularly true of the developed world today, where most economies are caught in a liquidity trap.

A liquidity trap occurs when the implosion of a joint asset and credit bubble severely harms private sector balance sheets, and leads to a pronounced and prolonged deleveraging that renders conventional monetary policy ineffective.  To quote the late American President, Dwight D. Eisenhower, “Pull the string and it will follow you everywhere. Push it, and it will go nowhere at all.”

Central banks may reduce policy rates to zero, attempt to engineer higher inflation expectations that lead to negative real rates, and manipulate asset prices through quantitative easing measures, but the impact on growth will remain muted, so long as the private sector’s borrowing capacity remains impaired.

The inability to stimulate domestic demand may prompt the monetary authority to resort to the last policy tool – the exchange rate – and attempt to engineer a currency depreciation that prompts a sufficient increase in exports vis-à-vis imports that offsets the weakness in domestic demand arising from the desired increase in private-sector savings relative to investment.  However, a competitive devaluation’s ability to replace demand lost to deleveraging depends not only upon the size of an economy’s exports and imports relative to GDP, but also upon the strength of import demand among its trading partners.

The economic reality suggests that the export sector is not sufficiently large across the majority of industrialised countries to make a meaningful difference, while the dependence of many economies upon the consumer means that higher import costs could depress domestic demand even further.  More importantly, most of the developed world is caught in a liquidity trap, which means that ‘beggar-thy-neighbour’ policies are simply not an option.

With no more tools in the central banker’s toolbox, governments have little option but to run large fiscal deficits and fill the demand gap – even though public-sector debt ratios have already climbed to levels that have been shown empirically to retard growth.  In this regard, central banks need to compromise their hard-won independence by allowing monetary policy to become subservient to fiscal policy in an effort to get the industrialised world growing again.

Financial markets have become used to the tactics employed by the most credible central banks in their efforts to dictate fiscal policy and defeat the inflation demon through the 1980s and 1990s.  Indeed, former Fed Chairman, Paul Volcker, forced President Ronald Reagan’s hand by setting real interest rates above the economy’s real growth rate, which put the fiscal position on an unsustainable path.  The battle was won by the central banker, which underlined the Federal Reserve’s independence as we know it today.

Investors need to appreciate however, that changed circumstances call for different rules.  In the presence of a liquidity trap and the resulting deflation risk, central banks need to set interest rates well below the economy’s growth rate in order to keep public-sector debt ratios in check, while governments exploit the favourable borrowing costs and engage in well-planned fiscal stimulus.

Investors continue to look to central banks for solutions to the developed world’s economic travails, but most of the developed world is caught in a liquidity trap, which has rendered monetary policy ineffective.  Premature fiscal austerity will only prolong the economic misery.

www.charliefell.com

 

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

We had an exciting week here at Currensee. Dave Lemont, our CEO, and Asaf Yigal, our Co-Founder and VP of Product, went to London to attend the first annual Forex Magnates Summit. As if it wasn’t great enough for Dave and Asaf to mix and mingle with over 550 of the executives in the Forex business, we received the award for “Best Social Trading Platform.” Wahoo!

We have been fans of Michael Greenberg and the team over at Forex Magnets since we started our company. Michael and his team do an excellent job of providing in-depth news and research about what’s happening in the Forex industry. They give honest opinions and provide leading news to help those of us in the Forex business stay on top of this face-paced market.

Since we couldn’t pass up the opportunity to be part of an industry event of this magnitude, Asaf Yigal, our co-founder and VP of Product, participated on a panel discussion about emerging financial trends. Also on Asaf's panel were execs from Tradency, FX Bridge, SpotOption, and IG Group. Not too shabby.

Thanks to the Forex Magnates team for a great event, a prestigious award and solidifying our position as a leader in the Forex social trading and investing space.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Not long ago, OANDA posted a blog entry discussing another of the tools they have available for the use of forex traders. This particular tool is a Value-at-Risk (VaR) calculator.

The concept of VaR developed in the 1990s as financial institutions looked for a way to evaluate their unified risks in the wake of the Crash of 1987. It has certainly taken its fair share of lumps and criticism, particularly in the wake of the Financial Crisis, but does have value if used properly.

What the OANDA tool basically does is give you an indication of how a given currency pair traded in terms of price movements over a given recent period of time. How far back that goes depends on your choices of granularity (time frame, number of bars spanned).  You can also choose from different Confidence Levels, which basically means how much of the time the market exhibited price moves of a certain size or smaller.

For example, I plugged in EUR/USD at the 95% Confidence Level looking at 1-day candles and a 1-day trade time frame. The tool gave me the following report:

VaR at 95% Confidence Level = 172 pips.

Over the past 9 months, 3 weeks, 4 days and 12 hours, 95% of 1 day periods, price movement was less than 172 pips.
In other words, there was a 5% chance that price moved more than 172 pips in the last 9 months, 3 weeks, 4 days and 12 hours.

When I change to a 30-minute candle and a 10-period time frame, I get this:

VaR at 95% Confidence Level = 90 pips.

Over the past 6 days and 6 hours, 95% of 5 hour periods, price movement was less than 90 pips.
In other words, there was a 5% chance that price moved more than 90 pips in the last 6 days and 6 hours.

To best use these figures, you should convert them into values relative to your account. For example, if you have a $5000 account and are trading a mini (10,000 unit) lot EUR/USD position, the 90 pips noted in the second example above would represent 1.8% of your account. That’s 90 pips at $1.00 per pip, for $90 in risk, divided by the $5000 account value.

Whether you are doing your own trading, or monitoring your portfolio of positions in an autotrading or social investing account like Trade Leaders, this sort of tool can come in handy to provide you with an idea of the type of risk you have on.

That said, there are a couple things you absolutely must keep in mind.

First, VaR is a backward looking indicator. It will tell you how the market traded in the past, but cannot tell you how the market will trade in the future. Maybe it will be more volatile. Maybe it will be less volatile. As a result, VaR works best if you can integrate it with something which will help you anticipate changes in volatility.

Second, VaR provides no information on how bad things can get beyond the Confidence Level you set. It’s fine to say 95% or 99% of the time the market move X number of pips or fewer. The problem comes in that 5% or 1% of the time when the market moves more than X pips. It could only be a couple of extra pips, or it could be hundreds of extra pips in the case of a black swan type of event. VaR is good for helping anticipate and plan for “normal” market activity, but you need to have something beyond VaR to help you deal with non-normal market situations so you are protected against worst case scenario type moves.

One more item of note. If you are holding positions in multiple different currency pairs in your account, you should look at the VaR of your net exposures, not of the individual positions. For example, if you were to be long EUR/USD and short EUR/GBP, then your net position would be long GBP/USD (or at least mostly so), meaning you would want to look at the VaR of that because that would be your primary risk. The limit to the OANDA tool is that it can only show you one currency pair, so if you have multiple pairs in action which don’t offset and net out like the example here (like being long EUR/USD and short USD/JPY at the same time), you need to factor a correlation adjustment in to come up with a portfolio VaR.

The term “Fiscal Cliff” is being tossed around everywhere since last week’s election. You know it’s a big deal when it hits the New Yorker, known to make political satire out of just about any government-induced malaise.

I came across the article today on NewYorker.com, “The Absolute Moron’s Guide to the Fiscal Cliff,” and it spurred me to write this post. What I think few Americans understand is what the looming doom of the Fiscal Cliff means to our economy and how radically it can change. Some say it will be more like a waterslides, slow and loopy but an eventual drop. Others say it will be more like a cliff, a big drop fast. Regardless of what you believe will happen, the fact is that you need to educate yourself of the basics of what the “Fiscal Cliff” means as there’s an important deadline of January 1, 2013 coming up that could change everything.

First, we need to take a ride in the way back machine to the year of 2001, when, according to the New Yorker post,

“George W. Bush signed a massive round of tax cuts that were supposed to expire ten years later, in 2011. President Obama later extended the expiration date to January 1, 2013. After that, your rates will go back up to the rates you paid in 2001. A bunch of other tax changes, like the expiration of a “payroll tax holiday” and the elimination of some tax credits, will also hit on January 1, meaning that no matter how much you pay now, you’ll probably pay more after the new year unless there's a deal.”

So, your question after reading this might be, “Who the heck do I blame for this crazy freakenomics?” The answer is unclear. Do you blame the Republicans for setting a round of tax cuts in the first place? Or do you blame the Democrats for prolonging the decision on said tax cuts to buy time? Regardless of who you blame, if we don’t have a plan and a deal before the expiration date, experts warn of spending cuts and potentially a recession.

Could this fiscal stalemate be Obama’s way to get what he wants in terms of tax hikes? In the words of Voltare, “A long dispute means that both parties are wrong.” Both parties are wrong because no one is right – that’s what compromise, meeting halfway, and making unbiased decisions for the greater good is about.” Let’s see if the leaders of our countries can turn a fiscal cliff into a fiscal decision that keeps our economy from taking a nosedive.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Equity investors have enjoyed a sustained advance in stock prices for several months, as expectations premised upon the belief that policymakers are miracle-workers, allowed the major market averages to move sharply higher.  An overdue reality-check was sure to arrive at some point, and so it has, as corporate America’s most disappointing quarterly earnings season in many years, reveals that ‘big business’ is not immune to the troubling deterioration in global economic momentum.

The third-quarter reporting season is well underway at this stage, and the latest numbers reveal that corporate America is set to post a year-on-year decline in quarterly earnings-per-share (EPS) for the first time since the autumn of 2009.  Consensus estimates forecast a two per cent drop in quarterly EPS, as a sharp slowdown in revenue growth alongside margin compression, has sent corporate profitability into reverse.

Corporate America has enjoyed an extraordinary earnings boom over the past three years, as an intense focus on costs allowed margins to surge to record levels – more than three percentage points above their long-term mean, while a strong contribution from global operations more than offset tepid revenue growth in the US.

However, the ability to tap further cost efficiencies is largely exploited at this juncture, while the economic malaise in the euro-zone, and a marked slowdown in the pace of economic growth in emerging markets including China, means that foreign operations are no longer bolstering bottom-line performance.

The recent trends are unsettling.  FactSet reports that the percentage of companies reporting earnings above expectations thus far is in-line with historical averages at close to seventy per cent, but the aggressive reduction in earnings estimates during the pre-reporting season means that this figure is not particularly impressive.

Further, the percentage of companies posting revenues above consensus estimates at about 35 per cent, is more than twenty percentage points below recent experience, and as low as the number seen in the first quarter of 2009, when the global economy was deep in the throes of the worst downturn in generations.

The top-line disappointment is almost exclusively an international affair, with a spate of companies including GE, Ingersoll Rand, and Microsoft attributing the shortfall in sales to weak economic conditions in Europe, and others including Caterpillar and Intel, citing soft activity in China.  Currency issues were mentioned in a number of earnings reports, but this was just a minor irritation, with sluggish revenue growth stemming primarily from soft demand.

The fourth-quarter earnings season is unlikely to prove any kinder than the current reporting period, as more than three-quarters of the companies that issued forward guidance, provided an earnings outlook below the Wall Street consensus. This the highest number since FactSet began collating the data in 2006.

The negative guidance appears to have had little impact on the bottom-up analyst community, who forecast a resumption of earnings growth during the fourth quarter, with an eight per cent increase in EPS pencilled in.  The optimism continues for 2013, with a four per cent increase in revenues expected to lead to EPS growth of ten per cent.

The numbers appear fanciful as the US economy continues grow at subpar rates, the euro-zone crisis is ongoing, while structural issues could well see growth rates in emerging markets such as Brazil, China, and India that are well below recent norms.  Further, it is difficult to see how low, single-digit sales growth will propel margins any higher than they already are.

Corporate America’s good fortunes in recent years have been premised upon a concerted effort to control variable costs, with incremental revenue increases dropping straight to the bottom line.  Costs have already been pared to the bone, which means that further margin expansion is not feasible without robust top-line growth.  Indeed, revenue increases in the three to four per cent range, at such an advanced stage of the earnings cycle, have typically been accompanied by margin contraction, and not expansion.

In this regard, it is instructive to observe that current earnings have reached levels – relative to their ten-year average – that have rarely been exceeded during the past half century and typically followed by poor growth outcomes in subsequent years.  Statistical analysis reveals that corporate earnings are roughly 25 per cent above trend, and given the soft global economic picture, it would be unduly optimistic to expect double-digit percentage point gains to continue.

The third-quarter reporting season has been notable for the sluggish revenue growth that has brought an end to corporate America’s winning streak.  Wall Street remains bullish on the outlook for the remainder of this year and beyond, but a more constructive analysis suggests the boom in corporate profits is at an end.

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

I believe it was New Jersey governor Chris Christy I saw saying to his constituents before Hurricane Sandy hit something to the effect of damage was going to happen despite their best efforts because they couldn’t prevent the storm barreling through.  This is a lesson for investors.

Markets do not always do what we want them to do. That’s a fact of life as an investor or trader. We can do all kinds of great analysis, pick just the right market or security or investment vehicle but still get hit by something unexpected or unavoidable. The investors who survive these sorts of events, and even thrive coming out of them, are the ones who are prepared, while those thinking only of how much they stand to make in the markets are the ones swept away.

It all comes down to risk management. And it has become clear in recent years that the old methods of diversification through spreading money around low-correlated markets are no longer sufficient. Markets which are largely uncorrelated during good times have a tendency to becoming strongly correlated during troubled times – exactly what the old diversification systems relied on them not doing. As I shared with my Twitter and Facebook followers, even just looking at stocks we have seen big swings in the correlation of individual securities with the overall market (which interestingly has gotten low recently). This requires a different type of thinking.

And even if we get the diversification side of things right, that doesn’t completely mitigate our big picture risk. There is always something that can come along and put our hard-earned money at risk. That is where worst case scenario type analysis has to take place. This is where many in the financial sector fell flat, leading to the financial crisis. They felt comfortable with the risk of their portfolios as indicated by the Value-at-Risk (VAR) models they were using, forgetting to account for what could happen beyond the 95% confidence level – events virtually inevitable in the long run. It’s the remaining 5% they should have been worried about, as it’s in that area where they lost their business and very nearly locked up the whole financial system.

The same goes for an individual. Identify the worst and prepare of it. The tools Currensee has put in place in the Trade Leaders program definitely help do just that. You won’t be able to avoid taking some losses along the way, but if you prepare properly you can avoid seeing your financial well-being get swept out to sea.