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Today I would like to talk about “surviving” as a trader. In particular, I would like to talk about how to avoid  Black Swan events. Per definition, a Black Swan event is something you cannot forsee. And yet, they definitely happen more often than any statistical calculation would make you believe.

lehman

Everyone remembers the event that gave birth to the markets as we know them today: the Lehman Brothers collapse in 2008. But that’s not all…

flash crash

In 2010, there was yet another “Black Swan” event…a flash crash that was as brief as it was intense. The term “software glitch” just doesn’t do it justice.

SNB

And for FX traders, the main event of the past years was the SNB’s decision to pull the plug on  the 1.2000 defence in EurChf. The event was so “systemic” that even “twitter traders” – which never lose and especially never have consecutive losses – had to admit defeat.

twit

So Black Swans do happen, but the pointers we’re going to explore today will keep you safe & sound even in normal times. Trading the markets is a daunting task – so it’s a pity that the kind of people who are most attracted to financial betting are exactly the kind that cannot afford to do it in the first place. Why ?

  • Trading is a profession and must be treated as such. It’s not something that can be learned overnight. It’s not a purely intellectual exercize and it requires experience to do well – just like any other profession. Most aspiring traders, however, view it as an alternative to the Lottery. The mindset with which you approach trading is the first piece to the puzzle.
  • Before you can thrive in trading, you need to survive in trading. And surviving, initially, is all about trading small. You need to conserve your capital. I’ve seen too many novice traders dive into the market on the latest piece of analysis they read, overleveraging their account and always looking for “the big one”.  Trading is a game of consistency and longevity – it’s not a sprint.
  • It’s difficult to trade when you need the money. And this comes from personal experience. When I went full time, and trading was my only income generator, I had an unbearable amount of tension, expectation, and pressure to perform. Of  course, it becomes practically impossible to “wait for trades” and not “look for trades” in those conditions. Compare my initial situation to that of a person with a steady income stream. He can trade calmly because he’s not pulling cash out of his account. He can grow his account, patiently. He can affort to wait for the best setups. He has much less pressure and can see the markets more objectively.
  • It takes time and commitment to trade succesfully. It is possible to trade around a day job, but the progress up the learning curve will be slower. A realistic time frame is years – not days or weeks – before becomming consistently successful. But most aspiring traders expect something magical to happen immediately.

So the first thing to do, to put yourself into a position to survive the tough times and always stay afloat, is to approach Trading as the business it is. Now, let’s explore some nitty-gritty details.

Notional Funding

Back in 2015, I was in contact with a relatively new FX manager. He had a small fund but was making small, consistent gains each month and was rolling out a roadshow. Until the SNB Black Swan hit. The manager, along with many other famous hedge funds, was long EurChf on the back of the SNB’s “promise” to defend 1.2000. It’s beyond the scope of this article to discuss the validity of the trade. What’s important is the outcome.

The manager instantly lost all his assets under management (AUM) and also owed the broker more. I was talking to him on January 15th, trying to calm him down, because he was evidently under shock.  What could he have done differently? Use notional funding.

Notional funding essentially means keeping only a small percentage of your risk capital in your trading account. For example, I like to keep 10-20% with the broker, because if something happens in the market or something happens to the broker, I don’t have all my risk capital in one place. Notional Funding is a concept that comes irectly from the world of professional money managers like CTAs: an investor in a CTA program is only required to deposit a small part of the nominal account size used by the CTA to determine the size of trading positions. The amount not on deposit as margin with the broker is retained by the investor and can earn interest outside the trading account. It’s just another variation of diversification: don’t keep all your trading capital in one place. Always make sure a Black Swan can hit, and you will still have resources to fight back and stay in the game.

Capitalization

Our ancestors used to say “repetita iuvant” so here we go again. If you have a $1000 account, don’t expect to make decent money for a number of years. If you focus on the money, and not the process, you will suffer the fate of many: overleveraging, over trading, and essentially making all-or-nothing bets.

One of the best kept secrets in the marketplace is that the successful market participants that have been around for more than a decade, are very well capitalized. Capitalization doesn’t just mean “large trades”. Capitalization means having options. Here are some common traits of the most successful traders I know:

  • they are well diversified (they use the same trading model on multiple asset classes). If you’re only trading one asset on one time frame, your risk is very much concentrated. Diversification (applying your edge to multiple assets) can help your bottom line enourmously because sometimes, our favorite asset classes just aren’t performing.
  • they invest proceeds outside the financial markets (this means real estate and enterpreneurial activities);
  • they never ever push their risk limits. On this note, one trader I spoke to (who had traded for Bruce Kovner’s Caxton Fund) noted how he kept his risk constant over all trades, at 0.5% of his consolidated equity.
  • they take extended breaks from the market to recharge.
  • they use notional funding.
  • their objective is to grow their account  – not pull income from it each month.
  • they usually have over 10 years of market experience or more, usually within the financial industry.

This is why you should respect your day job if you have one. Your day job will initially pay for your trading education and experience. Having a day job allows you to have the same kind of “peace of mind” that well capitalized traders have. You don’t have to pay the bills or support your family with your trading – and you really should never have to. You should seek to diversify your income sources just like you diversify your trades. The less you are dependant on one source of income, the less pressure you’ll have and the more objective you can be when confronting the markets.

Don’t Create Your Own Black Swans

Unfortunately, many traders dig themselves into a hole. They create their own Black Swans. I’ve seen traders put on trades purely out of “boredom”. I’ve seem traders stare at charts for hours, until finally they find an excuse to “get a piece of the action”. I’ve seen traders risk way too much on a trade, simply because they had a string of losses. I’ve seen traders open positions from their smartphone, on the bus, while on their way to work, and then complain about the quality of the charts. But the top three self-generated Black Swans that I’ve seen are:

  • revenge trading Non-Farm Payrolls, or any variation on the theme. Having been a broker, I guarantee that the most active days are NFP fridays. The exact situation that has professionals sitting on their hands or hedging positions playing defence, seems to reel in a flock of retail traders looking for the “big one”. The sheer volatility of NFP, along with lack of liquidity and wide spreads, is a recipe for disaster.
  • scalping GbpNzd for 20 pips (or scalping anything with a spread over 3 pips). If you’re paying your broker 10% or more of your trading profits, then you should have a darn good reason. Active trading, like scalping, usually leads to a slow bleed of your trading account.
  • jumping into a trade just before a central bank announcement (or right before any other high impact announcement). Evidently, checking the macro calendar should be the first thing you do in the morning. yet so many traders fail to do so.
  • overleveraging. We have discussed this above. Don’t focus on the money, focus on the process. Trading is a marathon not a sprint. Seek for consistency in your trading. Trade small and use notional funding. Stay in the game and learn. Success will follow.

Over to You

Survival, in the financial markets, is quite tough. It requires discipline, self-awareness, grit and a fair amount of luck. In the beginning, the quality of your education will determine the degree of your success and also the degree of your challenges. That’s why we talk about the “New Pathway” here at FXRenew. We strongly believe that receiving guidance from experienced market participants is the best way to avoid the common pitfalls that trap so many aspiring traders.

So before investing in the financial markets, invest in yourself.  With proper guidance, you can learn to transform quality education into action. You can then create successful routines that will keep you on the right path.

 

About the Author

Justin Paolini is a Forex trader and member of the team at  www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.