Tag Archives: risk

A new contributor to the Currensee Blog, Wenjie Tang is the lead trader at Trade Leader Alpha Harvest.

I often hear forex traders, some of them with years of trading experience, talk about what percent of their balance they use to trade. They are thinking about risk management concepts too simply:

How much money do you use to trade? “I use 10% of balance”

On a single trade? “I never put more than 5% on a single trade.”

Well, do you think that position is large? “I think that position is small because it’s less than 5% of balance!”

I believe the majority forex traders (mostly retail traders) don’t really understand the idea of leverage and position size. Let me list some of common questions from retail traders:

  1. What leverage do you use to trade?
  2. Is this leverage the same as margin rate that your broker gives?
  3. How shall we control position size?
  4. Is 5% of balance position is small or big?

To correct the assumptions behind those questions, let's begin with the idea of the "risk" of a trade.

Simple definition: how much money you can to lose or you can afford to lose. Assume that you have 10,000USD in your margin account. If you decide you can afford to lose 500USD on a bad trade, then 5% is the risk for a trade. If overall, you only want to allow 10% loss for several trades, than you can enter more trades, but they should not be allowed to lose more than 1,000USD all together.

Furthermore, when you get 1% margin rate from your broker, how much money do you actually use to trade for a 5% risk trade? Here comes the tricky part. You have to understand the idea of stop loss. If you trade EUR/USD and have 100 pips for SL in mind, then 5% risk on a trade means you can trade 0.5 lot. (1 lot = 100,000).

Here is the calculation:

  • 5% risk on a 10,000 USD account = 500 USD
  • 1 pip EUR/USD / lot = 10 USD
  • 100 pip stop loss / lot needs =1,000 USD
  • To stick to your 500 USD risk limit, you can trade only 0.5 lot with your 100 pip stop.

Wait a minute? What if SL is 200 pips away? And what if SL is just 20 pips? Which way is riskier? As long as you stick to the formula, it’s equally risky, because risk is still 5% of balance, which is 500USD. In case of 200 pips, you can just open 0.25 lot. With 20 pips SL, you can open 2.5 lots.

What are the leverages for above three cases? What if broker gives 200 leverage? I'll leave that math to my readers, but my point is that it doesn’t matter, you should only focus on how much money you can lose.

After all, risk is always the only thing we can control in trading. Once you see an opportunity to trade, calculate the SL and then trading lot size.

In complicated models, pros like to use probability models to evaluate the overall risk when there are a lot of trades. The idea is that if we enter 100 trades with each risking 0.1%, theoretically, the overall risk should be less than 10% because of the correlation or lack of correlation between the 100 trades. Retail traders probably should not attempt this.

So, what then are the correct questions to ask? Answering these questions will allow you to use the formulas above to get a better handle on risk:

  1. Risk in terms of % of balance per trade or on all positions
  2. Pip value and stop loss
  3. Trade lot size

What now? Once your risk is controlled, if you stick to your plan and the market goes your way, you can let your profits run!

As much as I try to do my part to squash it, it seems there is always a group of retail forex traders who, for whatever reason, think “hedging” is a good idea. You’ll notice I put the term in quotes there because the way these folks use it varies from the way most people in the markets do. Hedging, in common usage, is the practice of putting on a position in a different market or security which attempts to minimize the risk of a position in some way. For example, someone holding a long position in the stock market could short the S&P 500 index as a way to protect against a general market decline. This is classic hedging.

But not in retail parlance
In retail forex “hedging” has come to mean putting on a position exactly opposite the one you already have. For example, a hedge of this kind could be putting on a 1 lot short in EUR/USD when you have a 1 lot long already in place. The idea most often cited by those who do this kind of thing is that it neutralizes the risk in a position that’s going against them, giving them a chance to wait it out until the market turns. This, of course, is exactly the same thing as just closing the trade.

There are variations on this hedging idea which actually involve putting on both the long and the short at the same time. It’s a kind of straddle play. Sometimes it’s done in what’s call a grid strategy where trades are layered at different levels. The underlying structure of these trades is actually one based on mean reversion or counter-trend action. They look for the market to reverse its recent move.

Using the simultaneous long/short example, the idea is to have a target for each side. The expectation is that the market will move to one target, then turn around and move to the other. That would make both legs profitable. In the meantime, though, going long and short at the same time just locks in a spread loss and one never actually has a directional exposure until one of the legs is closed.

A sample system
An example of a “grid” system I recently heard about (though there are many variations) is from a player who starts with simultaneous long and short positions. He used a 100 pip target. If the market moved to that target the profitable leg of his original pair is closed and another matched long/short pair of trades is put on. This goes on every time the market moves to a 100 pip target level.

Let’s think about what this would look like if the market were to rally 100 pips. First of all, by putting on the original matching long/short the trader has lost the spread because he went long at the offer and short at the bid. When the market rallies those 100 pips the long is +100, but the short is -100, so no net gain or loss. The long is closed, so a realized gain is achieved, but an open loss remains in the remaining open short. Now a new long/short combo is added (again, immediately costing the spread). This means 1 unit of long and 2 units of short, so a 1 unit net short position.

From here, if the market turns down then everything is good because the gain on the 2 shorts will exceed the loss on the 1 long. Should the market keep rallying, though, the loss in the 2 shorts exceed the gain on the 1 long, so the trader is losing money. What you have here is a counter-trend or mean-reversion system, as a result.

Confused traders losing money
All strategies like the one mentioned above can be replicated in a non-hedging fashion. In this case, the trader could have just waited until the market rallied 100 pips and put on a 1 unit short. It would have the same net market exposure and would not have cost the spread twice. That’s the thing a lot of these folks don’t realize. This tells me they don’t fully understand just what they’re doing. They think the risk is lower, but it isn’t.

The reason I wanted to bring this up is because I’ve heard tell of people employing these types of strategies who are followed by social traders. This worries me considerably. This “hedging” is nothing more than a method of accounting (and not allowable in the US, though one can get around it by using multiple accounts). As such, it can create a very distorted view of performance. One could, for example, end up with a high win %, which may be attractive to potential investors, but that hides the major blow up risk underlying the approach being used.

So when you’re looking at traders to follow – either from a social perspective or just from a learning angle – avoid those who employ these types of “hedging” strategies. It demonstrates a lack of understanding of trading mechanics and potentially means they don’t realize the sort of risk they are taking.

The global economy began to stabilize following the most severe downturn since the 1930s during the summer of 2009.  The recovery that subsequently materialized outpaced the previous post-1945 recessions of 1975, 1982, and 1991, as relatively lackluster growth in real income-per-capita in developed economies was more than offset by a robust rebound in economic activity across the emerging world.

Three years on, the world’s largest advanced economies continue to struggle, and require ultra-accommodative monetary policies simply to prevent the already sizable output gap from widening further.  Despite the ongoing life support, recent data indicates that activity across virtually the entire developed world has down-shifted close to ‘stall speed.’

Equally troubling, if not more so, is the observation that unlike previous ‘growth scares,’ the emerging world’s primary growth engines have struck a ‘speed bump,’ with a pronounced slowdown in economic activity evident in Brazil, China, and India.  All told, roughly two-thirds of the global economy is slowing, stagnating, or contracting.

Against this disquieting background, it is hardly a surprise that the voracious appetite for risk assets apparent earlier in the year, has all but disappeared.  Indeed, investors’ increasing emphasis on wealth preservation over capital gains has seen global equity indices slip into negative territory year-on-year, and lose virtually the entire advance in prices recorded during the first quarter of the current calendar year.

Few risk assets have escaped investors’ desire for safety, and the unsettling global outlook has precipitated a particularly pronounced decline in commodity prices.  The Thomson Reuters/Jefferies CRB Commodity Index has plunged more than 15 per cent since late-February, and is more than 20 per cent below the highs registered last summer.

More trouble could well be in store for risk assets, as investors’ ‘dash from trash’ has pushed yields on both short- and long-term debt securities across ‘safe haven’ sovereign bond markets to levels that are simply not consistent with economic expansion.  Indeed, the message emanating from government debt markets that include Canada, Germany, Japan, the Netherlands, the U.K., and the U.S., is one of mounting financial stress and economic turbulence.

Increased investor concern has pushed rates on short-term sovereign notes deemed default-free to near-zero, while the scramble for ‘safe’ assets has seen the yields available on long-term government bonds plunge to historic lows of well below two per cent.

The yield on ten-year U.S. Treasury bonds for example, dropped to below 1.5 per cent in early-June, while ten-year German Bund yields fell below 1.2 per cent.  Meanwhile, the yield offered on U.K. gilts declined to levels never seen before in a data-set that extends back to the first issue of British government debt in 1694.

What has sparked the recent panic and the purchase of ‘safe haven’ sovereign debt at prices that would appear to promise zero real returns, at best, on both short and long maturities?  The seemingly irrational dash for safety can be partially explained by the fact that the current economic slowdown is detectable almost everywhere and virtually assures a ‘growth’ recession or below-trend growth – if not worse – during the second half of this year and beyond.

The U.S. is currently experiencing the weakest economic recovery in the post-1945 era, with growth averaging just 2.4 per cent over the last eleven quarters, as compared with 4.8 and 5.5 per cent respectively over a comparable length of time following the deep recessions of 1975 and 1982.  Economic growth is running at less than half the pace that is typical for this stage in the cycle, and slowed to below two per cent in the first three months of the year.

The slump in payroll additions to a miserable 73,000 per month average in April and May, alongside weaker capital expenditures and government outlays, suggests that further deceleration took place in the second quarter.  More troubling however, is the fact that tax cuts and spending increases amounting to roughly four per cent of GDP are set to expire simultaneously at the end of 2012, and the uncertainty surrounding the ‘fiscal cliff’ is hurting growth.

Much has already been written on the euro-zone, where the economic performance since the ‘great recession’ struck trails the Japanese experience following the deflation of its twin property and stock market bubbles more than two decades ago.  The periphery is mired in recession, and recent data confirm that the loss of confidence and the resulting adverse impact on economic activity has spread to the core, including Germany.  It is safe to conclude that the euro-zone will not provide a boost to global economic growth anytime soon.

Meanwhile, the malaise apparent in advanced economies has been accompanied by a growth slowdown in Brazil, China, and India.  The Brazilian economy slowed to a virtual standstill during the first quarter, and the pace of expansion in China dipped to the slowest rate in almost three years over the same period, while India’s quarterly growth performance deteriorated to its worst level in seven years. A return to above-trend growth may not arrive as soon as optimists believe given over-investment in China, a tapped-out consumer in Brazil, and a disturbing fiscal deficit in India.

Investors have dashed to safety, as data confirmed weakness in economic activity virtually everywhere.  Investors must appreciate that fiscal and monetary policymakers are short of tools with which to combat the latest weakness.  Caution is warranted.






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.

Back in March I penned the post Gold is not glittering so much these days which made the case that gold was not performing very well and had some significant downside risk. With all of the risk aversion we have seen running through the markets of late, the question has come up as to why gold hasn’t been more of a beneficiary and why money isn’t flowing into that market as it had done before when the markets have gotten really nervous. I think there are two ways to address that.

Not as much fear as in prior times
As much as things have gotten crazy in the markets at different points of late, they haven’t been as bad as you might think. Yes, we’ve seen interest rates moving rapidly, especially in the Treasury markets. That, though, can be at least partly explained by Fed ownership there as I discussed last week.  And yes, other risk markets have taken losses. Things haven’t gotten too bad in the stock market, though. If the markets were really fearful, we’d see stocks being sold aggressively as well.

No money printing by the central banks
The big thing that drove gold in its long uptrend was the money being printed by the central banks such as the Fed and Bank of England while doing their quantitative easing programs. We are not seeing that sort of activity anymore (despite some calling for it). It is important to note that programs like Operation Twist where the Fed buys long-dated Treasury securities and sells short-dated ones does not expand money supply. Gold has basically gone sideways since QE 2 ended last year.

Flagging participation
In my previous gold post I noted that open interest in the front month gold futures contracts had declined, indicating that fewer positions were being held in the market. Also, the volume pattern had changed from surges on up moves to surges on down moves. Both of these patterns have continued in the last few months.

What’s interesting in all this is that gold is clearly sensitive to money supply issues, but hasn’t reacted positively to the talk in the markets recently about central banks doing more policy easing. That suggests two potential conclusions. The first is that the gold market doesn’t really buy the idea that the Fed, BoE, ECB, etc. will be doing big money supply expansions as were done previously. The second is that gold got ahead of itself when it rallied previously, so doesn’t have it at this point to start moving up again. And maybe both factors are part of the story of flat gold.

Looking at the prospects
If anything, I think gold looks worse now than it did when I wrote about it back in March. I said then that the 1500 level was key and that continues to be the case. If the market falls through there we could see a long-term downtrend play out. The interesting thing to watch there is whether the open interest starts rising as the market falls. That might indicate shorts coming in.

In the mean time, the USD Index cup-and-handle pattern I wrote about last month has been broken, creating a strong upside prospect for the greenback. That’s not the sort of thing which tends to be supportive of gold on general principle.

It seems as though Facebook has finally had the chance to regain a bit of its composure over the past few days as the snarling three-headed media monster’s attention has wandered a bit (for now, at least). I, like many others, admittedly do partake in this particular “guilty pleasure” of the investing world by keeping tabs on how the social network is faring in the market. Yesterday, I observed they closed at around $27 a share ($26.96, to be exact). So naturally, what was the first thing to come to mind? Shorting.

If only we could have foreseen the dramatic and untimely demise Facebook's stock would inevitably meet over the course of just two weeks; a sizable gain could have been generated by shorting. For those who aren’t familiar with this practice, it is a strategy based heavily on speculation. Basically, if there is a company who’s stock you feel is grossly overpriced, and you are quite certain that it will in fact depreciate in value, you go ahead and “borrow” shares of that stock from a person or establishment who has purchased them prior. So, let’s say you borrow 100 of company “Xs” shares at $20 a share. Right away, you sell them off at face value for a total of $2,000 - then you wait.

A few weeks later, wouldn’t you know it, Xs stock does end up taking a tumble and is now worth a paltry $10 a share. So, you buy back your 100 borrowed shares and return them to who, or what, you originally obtained them from. You have now made a profit of $1,000. This is clearly an exaggerated layman's version of the practice, but it demonstrates the basic principle.

So, if on Friday, May 18th as I scoffed at Facebook’s $38 opening price, I’d also simultaneously decided to borrow some 1,000 shares of it with plans to short the stock, I would have made a few dollars had I chosen to buy back and return them today (there are various fees that can be tied to shorting stocks that should also be factored in.)

But before you start kicking yourself for not doing this, there was so much hype, who could have really ever known for sure? And, there is always the notion that unlike formal stock investing where you can only lose as much as you put in, theoretically with shorting, you can lose drastic amounts of capital if the stock behaves opposite what you’d predicted and shoots up in value. Shorting is a risky business – is it worth it?


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 sat with our Currensee Trade Leaders and asked them three questions on volatility, trading strategy and the euro. The interviews give a brief glimpse inside the minds of our traders and shines some light on the coming year. The first post in this series starts off with Gabor Asirikuy Trading.

Currensee Trade Leader Gabor Asirikuy Trading (Ticker: GAFLL.B and GAFLL.C) uses a distinctive automated system that leverages the signals of 10 trend-following trading systems, each leveraging different trading tactics. The system leverages the work of an international trading community that analyzes systems using purely statistical methods, and is built to take advantage of the long-term investment horizon. The system is built on the foundation of the Turtle Trading System, with volatility adjusted profit/stop targets and position sizing.

Do you believe 2012 will be as volatile as the end of 2011 has been?

The global economy is not in a good shape at the moment and probably this will be the situation for the whole year. Usually markets are less volatile when investors are optimistic and central banks gradually increase interest rates. This kind of environment usually starts carry trading in the currency markets.

However, 2012 is probably not about that, especially if Europe does not manage to find a credible solution for the sovereign debt problems. The solution would need the member countries to partly give up their political sovereignty, which is a very hard decision for them and won't happen overnight. If the EU debt crisis extends and the EU finally breaks up, then that might lead to a quite chaotic situation in the financial markets. This would surely increase volatility as investors would escape to safe haven currencies.

Elections in the US and France won't help either, because world leaders will be more concerned with domestic political battles then with the global economy.

On the other hand as a systematic trader I can only say that future is unknown and instead of predictions I keep looking at the statistical numbers of my systems, trade consistently and manage risk properly.

What types of Forex strategies will continue to prevail in 2012?

Well, that's hard to answer, carry trade probably won't for the reasons listed above. However a trader had better not to try to predict market conditions, but to trade strategies that can survive the unfavorable periods, which always come sooner or later. Some markets/periods are better for trend following systems and others for counter-trending (or mean reversion) systems, but that might change over time. Consistency and risk management are the keys.

At Currensee, I trade short-term trend following systems (H1 swing trading) on the major pairs. Major currency pairs tend to build up larger trends, because they are rather moved by global fundamental events than speculation, so for that reason trend following seems to be more apt for these instruments. But this doesn't mean that range bounded periods would not come from time to time even during volatile periods.

What would a breakup of the euro mean for your strategy?

This is an interesting question, indeed. It already occurred at Asirikuy before, and we made experiments to model this problem. The introduction of the euro in 1999 gives us the opportunity to model the impact of an instrument change. We created a few daily trading systems with the help of our genetic algorithm framework, that were optimized on the historical price data of the DEM/USD pair during the 1990 - 1999 period. These systems were then backtested on EUR/USD from 2000-2010. Those systems that were stable during the original optimization period - which means that their performance didn't deteriorate dramatically when we changed slightly their entry/exit parameters or the spread - did well on EUR/USD in the 2000-2010 out-of-sample period, in fact most of them did a bit better.

What that means is that before 2000 it was the Deutsch mark which represented the best the economic performance of the continental Europe, no wonder that Germany is called the economic engine of the EU. After the birth of the euro the characteristics of the market didn't change much: the same traders in the same institutions / banks / corporations in the same time zone speculated or hedged on fundamental events of the same economic conglomerate. In addition the EUR/USD became more liquid than the DEM/USD, which means that technical trading works a bit better in this market.

The same can be assumed in the opposite process when euro ceases to exist. The economic environment won't change dramatically, but the new currency (maybe the euro of a smaller group of countries or the Deutsch mark) will be less liquid, so technicals will work less, and this might mean slightly worse performance.

Of course if the breakup happens in a chaotic manner that might mean that the new currency pair will not be accessible for the retail traders for some time. In that regard we don't have experience - and I personally would be glad not to have one - but time will tell.


Next week: TCM Spencer Beezley (Ticker: SPBJP.A)


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're coming into a kind of silly season for the financial markets. The period around year-end and the start of the new year is one of strong seasonal patterns. We've heard about the Santa Claus rally, and no doubt stock market commentators will be bringing that up quite a bit in the weeks ahead. They may also talk about tax-loss selling, especially given the type of year we've had in the stock market. And of course December sees volumes tend to decline as the big institutions wind down their activity into year-end and folks focus more on gift shopping and holiday parties.

It must be noted, though, that some of the strongest seasonal patterns in the market this time of year are those in the forex market. That's what I want to talk about in this article. As much as I could outline a whole array of year-end patterns among the major pairs, I'm going to focus here on just the yen.

Why the yen?

Well, it's been a pretty tough year where seasonal patterns are concerned. The developments in the Euro Zone in particular have overridden the sorts of trading we otherwise would have expected to see in the euro. The yen has held much more close to form, aside from the Japanese intervention that is.

So what do we expect from the JPY in December? Here's what Opportunities in Forex Calendar Trading Patterns has to say on the subject

First of all, December is a net negative month for the yen overall, though not hugely so. What's interesting, however, is that Fridays in the final month of the year have shown a pretty clear selling pattern. By that I mean about 60% of the time the yen ends the day lower, averaging a loss of about 0.20% against the other major currencies. This may not seem like much, but it does stand out in the statistics as an outlier.

The losses for the JPY tend to be front-loaded toward positions entered early in the month, however. The pattern starts to shift in the latter part of December toward one that is more yen-positive.

Normally, it would be worth looking at EUR/JPY or CHF/JPY as a good play against the yen (and in favor of other patterns) this time of year. With the on-going EZ issues, however, and the defined linkage between the EUR and CHF by the Swiss National Bank, it might be a good idea to avoid those pairs. A good alternative would be AUD/JPY. Long positions in that pair have their strongest positive 1-month hold returns of the year for trades entered in December.

For investors, the AUD/JPY pattern for December is a good set up for carry trade strategies. The cross is one of the strongest among the majors in terms of interest rate differential and the upside bias in the exchange rate has the potential for a nice added kicker to total returns. Just be aware that there could still be considerable volatility in the rate.

For those more trading oriented, a better approach is probably to use the seasonal patterns to bias or shade your positions. For example, you could perhaps take a little more risk when trading with the seasonals and less when trading against them. In other words, integrate seasonals into your existing strategy. Do not just make them a strategy unto themselves. By doing so you could improve your risk-adjusted returns.



The Forex market gets a bad rap in the media and other segments of the financial markets for being risky. It’s not a deserved reputation. In fact, the volatility of currency exchange rates is markedly lower than that of most other markets.

Not surprisingly, in the five year period ending December 2010 the fixed income market represented by 2yr and 10yr Treasury Notes was the least volatile. The major US dollar exchange rates make up the next lowest volatility group. After that come the major stock indices, with small cap stocks (Russell) unsurprisingly more volatile than big cap ones (S&P 500). Oil has been comparably volatile to individual stocks, which have demonstrated the most volatility.

Clearly Forex is no more risky than other markets, and in most cases can be described as less so. In other words, when the media and others portray the foreign exchange market as highly risky they do so on a really faulty basis because the volatility readings just don’t support it. Relatively low volatility, though, does not mean there aren’t any real opportunities to profit in the foreign exchange market.

Clearly there are investment opportunities in the currency market – ones that are no more risky than playing the stock market. It’s a question of finding the way of taking advantage of them that is right for you and your financial objectives. So why do so many folks consider the foreign exchange market highly risky?

The answer is leverage. Those who call the currency market highly risky fail to differentiate between the market and the participants. It’s not that the Forex market itself is risky. It’s that traders and investors are offered the opportunity to play the market with a high degree of leverage. In the stock market leverage is limited to 2:1, meaning you can buy twice as much stock as you have cash in your account by borrowing the difference (day traders often are allowed to use somewhat higher leverage). In Forex it is possible to trade at 50:1 or higher leverage. Successful traders know how to use leverage judiciously and to their advantage – this takes experience, time and diligence. Many traders in the Forex market do not know how to use leverage to properly manage risk. This aspect of risk management is a key consideration as we review new Trade Leaders for our investment program.

Forex gets a bad rap – a big part is due to irresponsible traders who have no experience or risk management strategy. I also believe Forex gets a bad rap because of misinformation. People hear a story here or there and see liquidity and leverage and make assumptions. And, you know what happens when you make assumptions.

Are you a Smartie? Get the facts. Check out our free e-book “The Smarties’ Guide to Alternative Investing in the Foreign Exchange Market”.


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.

Last week I attended my first academic conference. It was held at UCLA and focused on the field of Behavioral Finance. This is the area of academic research which has been challenging the tenets of Efficient Market Theory. As such, it's a field of study that is highly applicable to the way most market participants I've met and talked with over the years think. I look at it as the study of traders, at least in certain sub-set areas.

One of those sub-sets of Behavioral Finance is the field of neurofinance, which attempts to see how our brains impact on how we trade and invest. During the conference there was a presentation by Dr. Paul Zak (Claremont Graduate University) outlining the findings of research he's done on learning and market bubbles.

Bubble experiments
For some time now, researchers have studied the development of market bubbles in laboratory experiments. The version used by Zak in his study is one where the participants are given the opportunity to trade an instrument which has a fairly easily calculable value based on its proscribed cash flows (think dividends or interest payments), one which declines steadily toward zero over the span of the experiment.

One would think in a situation like this that trading would be pretty straightforward, but that doesn't end up being the case. These experiments repeatedly feature the creation of significant bubbles in the price of the asset – meaning it trades well above its fundamental value.

Learning comes into play
It is worth noting, though, that as participants go through the experiment repeated times their behaviors change. The bubbles gradually reduce in size. The implication there is that as people learn they are less likely to act in a manner which drives the market price well above the baseline value of the asset.

Learning is important. Who'd have thunk it?

Bring on the drugs!
To take a closer look at the impact of learning on bubble formation, Zak and his fellow researchers divided the participants into three groups. One was given a drug which impaired learning. A second group received a caffeine pill on the idea that might actually improve learning. The final group was given a placebo. As it turns out, caffeine didn't end up having any real impact above that seen from the placebo.

The impairment drug, however, did act as advertised. Traders on the drug took longer to see their bubble formation reduced, reflecting slower learning. Part of that was from reduced trading activity. They just simply didn't trade as often as their un-drugged peers. Less trading equals less learning.

The conclusions
Dr. Zak presented three conclusions from his research (and that which went before).

1)    Traders who learn market history are less prone to inflating bubbles.

2)    Market/trading learning must be salient, meaning there must be a risk/reward factor (participants in these studies always have monetary rewards at stake as the results are different when there is no real risk/reward element). In other words, to learn you need to trade real money, not paper money.

3)    Infrequently traded markets are more subject to bubbles (real estate being the obvious example).

So basically you would do well to invest considerable time and effort in your trading and markets education and make sure it involves real money, not demo trading. Also, be aware of the markets which are more prone to mispricing (smaller, less actively traded ones) as they may either present opportunities or represent unnecessary risks.

If you've ever watched the 70's sitcom, The Odd Couple, you know that Oscar and Felix had their issues. Oscar, the disheveled, divorced, sportwriter, was the more socially-ept, carefree and witty character, while Felix was uptight, neurotic and of "the sky-is-falling" mentality. The two very different characters combined for a unique type of relationship: in the face of adversity they were somehow able to learn from each other and create opportunity.

The volatility we've seen in the markets over the past few months is what I'm coining: The Finance Odd Couple. On one hand, we have the Dow plunging 500 points in one day, countries in economic ruin and the U.S. credit rating experiencing the first downgrade in history. On the other hand, you have emerging economies rising, bullish analyst opinions on the US Dollar and opportunities to find the silver-lining in the market's volatility.

Because I am a glass-half-full kind of girl, I much prefer to see opportunity where everyone else sees doom and gloom. Case in point - the hot topic of this month's webinar called The Volatility Myth: Uncovering Opportunities in Turbulent Markets. John Forman, senior foreign exchange analyst, has some pretty interesting data to share with us on where the opportunities are for traders and investors alike. John has pulled this data together just for us and we want to share it with you. Wondering how volatile the markets really are? Curious as to where the opportunities lie? Want to ask some questions of your own?

I'll be hosting this month's webinar this coming Wednesday, August 24th at 12pm New York Time. Attendance is free and, by attending, we'll send you an exclusive copy of our nifty new eBook The Smarties' Guide to Alternative Investing in the Foreign Exchange Market. So, bring your questions, your opinions and your friends and join us for what promises to be an informative discussion and unique learning experience you can apply directly to your trading and investing. Register here.

See you at the webinar!


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.