Approaching the Markets

I recently received this letter, and thought you might like to see how another currency trader approaches the markets.

"I approach the markets as a game of probabilities. As far as I'm concerned, that's the only way to navigate the currency markets.

"What I mean by a game of probabilities is this: I do as much as I can when figuring my fundamental and technical analysis. I read and study all I can. And I do this with discipline, focus, and consistency. I do this to try to gain an edge.

"But I know there is never such thing as 100% certainty. You can never have enough brain power or computing power to harness the mind of the market. It's not because the computing power isn't available - it is. It's because the players in the market do not make "rational" decisions all the time.

"When push comes to shove, the big moves in the market are driven by good old fear and greed, the base human emotions. The fear and greed and irrationality of millions of players can't be modeled with much degree of certainty. That's a problem for economists and experts who believe they can create some type of Holy Grail model to forecast price action. They simply don't have the mathematics available yet to get their arms around irrationality in a modeling scenario. And there is no reason to think they'll be able to factor in human emotions anytime soon.

"'If you are going to use probability to model a financial market, you had better use the right kind of probability. Real markets are wild. Their price fluctuations can be hair-raising - far greater and more damaging than the mild variations of orthodox finance,'" writes Benoit Mandelbrot, The Misbehavior of Markets.
Note: Benoit Mandelbrot is the person who created fractal mathematics. He is a brilliant man, to say the least. And he has been shunned to a degree because he has never bought into financial orthodoxy that starts out with 'the rational man.'

"Bingo!' Real markets are wild.' The massive volatility we've already witnessed in the currency market, after only the days of trading this year, prove Mandelbrot right once again.

"So, does this mean we should be defeatist and believe we can never win? Absolutely not! But it does mean you need to develop a reliable system to help you recognize when it makes sense to trade. Or in other words, you need a system that pushes the probability of success in your favor. Here's what I do to help make currency trading decisions.

"My methodology is a three-step approach:

"1)  I watch the key macro themes around the world. I continually ask: where is the money flowing around the globe? What countries or regions are hot? What assets are investments flowing into? Is it stocks or bonds or commodities, or some combination of these? Why are assets flowing in those particular investments? Is it interest rates or economic growth, or geopolitics? These are the type of questions you need to ask in order to develop an understanding of the macro themes.

"2)  I look at the technical pictures-charts! First I look at the weekly trends, then daily, then intraday (if it is a very short-term trade). Keep in mind, the tighter the timeframe you analyze on a chart, the more random the movements may be. In other words, these short-term movements you see could be just noise, so you can't always try to match your broad macro themes to the daily charts. Use your weekly charts to confirm your macro view. Charts are especially helpful when you're looking at intermarket relationships. For example, you can see if there's a clear relationship between gold and the U.S. dollar. Often those two move almost as a mirror image of one another. When gold goes up, the dollar goes down, and vice-versa. I continuously compare commodities, bonds, and equities against the move of the dollar to see if there is a relationship. Noticing these relationships can definitely give you an edge in the markets.

"3)  I try to judge what the sentiment is in the markets. I ask myself, are too many players doing the same thing? This is extremely important, because you don't want to be late to the party when investing. When everyone has bought, there is no one left to support prices, and they can fall of their own weight. I also look at surveys, open interest, and volume to gauge sentiment.

"Yes, it's a lot of work. But this is my system that has evolved over the years and suits me well. I'm confident that if I do my homework and apply my system consistently, I'll win over time. And the same system can work for you too."

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