Social Indicators

Toward the end of 2012 I authored a post that discussed a phenomenon academics in the area of behavioral finance term the Disposition Effect. This is a bias theorized and observed in which traders are prone to hold on to losers too long and close out winners too quickly. Anyone who has been involved in the markets for a decent amount of time while have likely heard the equivalent of cut your losses short and let your winners run, which is advice essentially meant to counter the psychological impact of the Disposition Effect without actually naming it.

In that prior post I talked about how this bias can be just as problematic for those taking part in social trading as trading on their own. The inclination to take sure profits can be very strong.

Of course there are ways one can work to overcome the desire to cut winners short and let losers run. Some traders opt for totally automated trading to take emotion completely out of the picture. Those who don’t go that route face significant challenges.

A recent paper looks at the impact on the inclination toward Disposition Effect influences on trading from the perspective of experience and sophistication. The authors find that higher levels of either measure can reduce the impact considerably, but neither can eliminate it on its own. Even when combined, high experience and sophistication will only eliminate the “hold the losers” side of the equation. It does not completely rid one of the inclination to close winning trades.

To restate the above, you can largely overcome the impact of the Disposition Effect on your trading through education and practice. That will make taking losses tolerable, but there will likely still be some compulsion to want to close out winning trades early. Knowing this, though, should help you overcome that bias.

Following on this subject, there’s another paper which looks at the Disposition Effect somewhat differently than most have to date. It firstly supports the case of the paper I just talked about in that it indicates the larger accounts (suggestive of more sophisticated and/or experienced traders) tend to show less inclination toward exiting winners and holding losers. This, however, is only the case when looking at individual trades. When looking at things from a portfolio perspective (they use forex accounts, so think multiple trades being on at once) the Disposition Effect influences continue.

Basically, the second paper says more experienced and sophisticated traders may be able to overcome the Disposition Effect on any given trade, but they still fall victim to it when managing a group of active positions. This is another thing for you to keep in mind, whether you’re doing your own trading or engaging in social trading. The easy solution is to have a specific plan to stick to it.

The question of whether someone really should not be a Forex trader is one that's not often brought up in discussions between market participants. It's almost as if the baseline assumption is that the sole criterion is that you want to trade. While I'm a believer in the view that just about anyone can learn, there are limits to that. Ignoring the obviously physical and mental disabilities, here are the ones I think are most important.

Lack of Impulse Control
If you cannot keep yourself from acting on impulse - meaning making snap decisions without a plan - then you're likely not going to do well in trading. Successful trading means applying a consistent edge. That, in turn, requires a plan that is being followed, not making random trades when the mood hits.

There is probably some confusion here when the subject of gut instinct comes into play. Here's the deal, though. If you've only just started trading, you have no gut instinct. That comes from long experience. If you're a rookie making gut trades, for your own good you should stop now. Any success you've had to this point is almost certainly a function of luck, not skill.

A Troubled Emotional State
We all go through periods when we're in a mixed up emotional state. It could be relationship issues, family difficulties, the death of a loved one, stress at work, or any number of other things that put you off your game. These are not good times to trade. Granted, trading can be an escape from the emotional strains in some cases, but that's only if the trader can consistently execute their normal work and strategy without it being impacted by what's going on in the rest of their life.

Trading has a way of really exposing emotional problems, even among the most stable of individuals. If you've already got some mental strains going on, trading is likely to either make it worse, or to see you feed on that emotion in destructive ways - like trading angry. It is best to stay clear of the markets when these sorts of things happen if there's any chance of spill-over or distraction.

Looking for a Quick Buck
Trading is not a get rich quick program. Any systems or broker ads that lead you believe otherwise are being deceptive. As any trader who's been around more than a year will tell you, trading is a marathon, not a sprint. If you come into the market looking to make a fast killing you are almost certainly going to blow your trading account up because you'll end up taking much too much risk. Basically, you'll be a gambler rather than a trader.

I could probably toss in "those who think trading is going to be easy", but that might rule out almost every new trader.

That all said, though, the things I've noted above can all be viewed as changeable. Lives can calm down. People can learn to follow a plan rather than just do whatever occurs to them at a given time. The gambling impulse can be replaced by a more long-run view. That means there's hope for just about everyone, so long as they do right by their expectations.

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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.

Some refer to it as a bank holiday, in Canada they call it Victoria Day and in the US we celebrate Memorial Day. Regardless of the name, for traders it is a day away from the trading screens and hopefully a time to celebrate and take a road trip with family and friends. If you were lucky enough to do just that, then undoubtedly you took a peak at the local economies. You almost have to since traders could set their watches by the economic releases from around the world.

How were the local economies doing? Are more small businesses starting to reopen again or are they still closing? Were people spending money or just browsing in the shops?

Where I was at there was little doubt on how the local economy was doing. This is normally a popular 3-day weekend destination but this year it seemed as if all the hotels had vacancy signs, with some even advertising ‘off-season rates’. Even the day-trippers seemed to have been staying home as there was no need for a reservation at restaurants. This is just one example, though, and maybe the places that you visited had just the opposite true with big crowds.

Will I use this information when I trade for the remainder of this week? Absolutely not. My trades in GBPUSD or EURJPY that hit the Currensee Market Watch table will not be persuaded by anecdotal evidence. If that were the case then most US traders who have had the chance to travel internationally would be underperforming as a weaker US Dollar has made travelling exponentially more expensive for us.

Then why do I bring this up? Last week the US GDP report was released and showed that Q1 growth came in at +3.0%. Consumption accounted for 70.7% remaining the heavyweight in the economy but it was off the highs of 72% from a few years ago. This was also the first time since Q1 of 2007 that we saw such strong consumption levels. Despite relying more heavily on productivity companies were still able to turn out strong profits. The graph below compares the performance of corporate profits to the Dow Jones on a yr/yr basis.

From 1999 through the first quarter of 2010 you can see that the Dow Jones has been receiving a premium for profits. Currently that is not the case. If the US and global economies are bouncing back from the 2007/8 credit crises and companies are producing profits again, then why haven’t traders and investors fully embraced the risk-on trade. (This graph is pre-European crises, but the argument remains the same.)

My guess is that the high unemployment rates have caused investors to spend less and save more than they otherwise would. The ‘flash crash’ and the European crises are not helping either, but in days past those events would have served as an opportunity to place risk back-on. To be seen if this is just a temporary phenomenon, or a change in attitude on saving and spending in the US.

As you trade and invest in the weeks ahead, you will certainly hear from those arguing that valuations are cheap and now is the time to reinvest. Others will argue that another correction (right shoulder per technicians) is ahead. In the end judging the US consumption patterns may be your best guide.

This report is for your information only and does not constitute investment or business advice or an offer to buy or sell securities.

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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.

If you were to go out and buy a car right now would it be a Toyota? General Motors and Ford are still making cars. Or how about a Hyundai, Nissan or even a Porsche? Or have you sworn off cars all together? Will you ever place yourself in a car again especially in a Toyota after the safety troubles that they encountered earlier this Spring? The reason that I bring this up is because it seems that equities are in a similar position that Toyota was a few months back.

It was just a few years back in 2007/08 that equity markets lost approximately half their value. Most experts failed to forecast the swift move lower except for the ‘perma-bears’. Retail investors were the ones most hurt as by the time the markets were building a bottom they were switching their investments out of equities and into cash. You almost can’t blame them though as fear and panic were driving the markets back then.

Of course if you swore off equities back then you missed out on a mighty rebound. The negatives of the credit crises gave way to the positives of the underlying economy which led us back to Dow Jones 10,000, once again.

This leads us to today’s market. As everyone is asking where should I put my money right now? With the equity exchanges acting more like casinos investors will surely mount their cash on the sidelines again. In the long run there are two problems with this. First with your investments in cash you are earning approximately 0% in nominal return (except if you live in Australia). Second your real return is in the neighborhood of -2% to -6% depending on inflation levels. Thus it is in our interest for the exchanges to regain our confidence and for you to earn a return on your money.

Back to our original question, have you regained confidence in Toyota or have you gone to a different dealership? Your investments demand the same question and when the dust finally settles and new regulations are in place to better protect investors you will have to reinvest. One way to follow individual sentiment on the markets is to watch the EURUSD positioning on Currensee. EURUSD enjoys being the most highly traded instrument and currency traders do not have a ‘home’ bias but are forced to look at global economic developments. Looking at the current positioning on Currensee traders are Short by net positions but are Long by volume. You can certainly debate on which is better to utilize, net positioning or by volume, but for now it looks as if currency traders are still unsure of whether or not to believe in these exchanges.

That sentiment will change. For an indication of when to get back into these markets please watch how traders on Currensee are positioned on these markets.

This report is for your information only and does not constitute investment or business advice or an offer to buy or sell securities.

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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.

Forex analyst Tim Mazanec posted yesterday on Forex Crunch about risk and reversal in the EUR/USD.  Starting with a dip into commodities (sugar??), Tim quickly moves on to the heart of the matter:

"To me EURUSD is the ultimate gauge of global risk-taking and if stocks are reversing then shouldn’t EURUSD be trading lower as well?"

He points out that the COT (Commitment of Traders) report, while extremely valuable, is also delayed by three days, an eternity in spot Forex.  Mazanec shows us how to use Currensee's Market Watch widget so see investor positioning in real time.

"The beauty of Currensee is that the MarketWatch table shows the positioning of traders and investors in real-time.  If you go from Long to Short you will see the change right away, not 3 days later.  There is also more than one way to view the MarketWatch data.  One way is to view the currency pair and positioning by positioning volume.  For instance, as of writing at midday on Monday (Jan. 25,  2010) 75% of traders had moved to Long in EURUSD.  Another way is to view the nominal amount of traders with a position at stake in a currency pair.  In this case it is almost evenly split with the amount of traders Long EURUSD vs. traders Short EURUSD."

This screenshot of the Market Watch Widget is almost 24 hours after Tim wrote his post and you can see how much things have moved already:

Market Watch Widget

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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.