“Foreign Exchange is a very psychological market”
The currency market has evolved greatly since 1992. Dealing and prop trading desks at banks have been reduced to shadows of their former selves.
The markets have gone full bore electronic and now even the smallest retail trader can participate with close to institutional execution speed and spreads.
You might think these changes make the Bill Lipschutz interview published in The New Market Wizards somewhat outdated, but you would be wrong.
Lipschutz’s interview is a testament not only to the timeless nature of markets and human psychology, but also to his great depth of his understanding and insight. You need to remember this was a new thing when he began. There was no veteran for him to learn from, no website for him to join, or market wizards book for him to read (at least not one featuring a Forex trader).
Every day when I trade, Lipschutz’s advice is in my mind. And it works. Time and time again. In fact, until I re-read the interview again (in preparation for this article), I did not realize quite how much my trading approach has been influenced by him.
Let’s summarize the key insights here.
Know market sentiment
“What is important is to assess what the market is focussing on at the given moment”
This quote sums up market sentiment in a nutshell. The Forex market is highly psychological. It is often not the variant perception that drives market – it is the current perception.
Understand what the market is focusing on, and you will go a long way. Think about the bear trend in the Japanese Yen in 2012 – that was because the market was focussed on the Bank of Japan and Abenomics. The bear trend in the EUR in 2014 was because the markets were focussed on the Greek Debt Crisis. In 2016 the GBP sold off for months, as the focus on was BREXIT.
Sentiment is not always big picture either. If you are a day trader, understand what the market is focusing on for that day or week. As Lipschutz says, “one day the market might be focussing on interest rate differentials; the next the market may be looking for capital appreciation, the exact opposite”.
Don’t trade on your “gut”
“For myself, any trade idea must be well thought out and grounded in reason before I take the position”
Currency trades should be carefully planned.
You need to consider the best way to implement the trade to produce the best risk/reward profile.
Additionally, scenario planning should be conducted. We know based on Lipschutz that good traders spend a lot of time thinking about what could possibly happen, what it means for their position(s) and what the correct response would be. They “develop scenarios, re-evaluate scenarios, collect information, and re-evaluate that information.”
These strategies both maximize profits and eliminate mistakes in the fires of battle.
This does not preclude any trades based on “instinct”. Sometimes you need to act quickly, but as a general rule, detailed planning is better than gut feel.
It’s about each situation, not a boiled down set of rules
“Many people think that trading can be reduced to a few rules. Always do this or always do that. To me Trading isn’t about always at all; it’s about each situation”.
While I appreciate a rules-based approach to trading, rules can cause the trader to take the wrong actions for the current situation. Perhaps your rule tells you to take profit, but you can clearly see that the trend is likely to continue.
Rather, I prefer a process-driven approach to trading. In a process-driven approach you look to understand what is happening right now, and then apply the correct approach based on your model of how the market works and your toolbox of methods.
This provides the flexibly to adapt to a changing market while remaining within a strict risk-management framework.
Know your risk inside out
“Always know exactly where you stand”
Lipschutz lists some of the main elements to controlling risk.
- Know exactly your position size and exposure
- Don’t concentrate too much of your money in one big trade or group of highly correlated trades
- Always understand the risk/reward of the trade as it stands now – not only when you put the trade on
These risk management rules are all just as relevant today as they were then. Good traders know exactly what risk they have on, they know which trades are correlated, and they take steps to ensure that their positions remain within their established risk limits.
Having a losing streak?
“Work very hard to restore…confidence”
If things are not going well, your judgement is likely to be impaired due to the lack of confidence that tends to accompany any losing streak.
The key is not to trade more to try and win back your losses. The key is simply to regain your confidence.
This can be done by cutting back on your trade size – get some small wins under your belt, and your judgement will reassert itself.
Don’t rely on being exactly right in your timing
“You have to trade at a size that if you’re not exactly right in your timing, you won’t be blown out of your position”
By employing a scale-in and scale-out approach to trading, you eliminate the common mistake of “all or nothing trading”.
Lipschutz would add to his position as it went in his favoured direction, then once the currency was near his intended target (or when circumstances dictated), he would lighten the position piece by piece.
This means he does not have to be exactly right in his timing to be profitable. In particular, it has enabled him to stay with his winners a lot longer than other traders, who exit in one go.
The benefit of this is an improved risk/reward ratio. Lipschutz believes it’s important to “figure out how to make money being right only 20 to 30% of the time.”
Exit when the fundamentals change
“You don’t want to hold a position when you don’t understand what’s going on”
If you are in a position based on a fundamental reason or story, and the fundamentals change, then it’s time to get out of your position. (At least for now.)
Even if a trade is going for you, once you perceive that the fundamentals have shifted, then it’s best to get out and re-evaluate.
(If you don’t know what’s happening, then any profit you are currently making is based entirely on luck, and that is not a good thing. )
Success arises from hard work and courage
“The best traders I know are quite brilliant, and they all work very hard – much harder than anyone else”
Lipschutz is firm in his belief that the best traders don’t think twice about how many hours they work – “there is no substitute for that level of commitment”.
They ask constantly:
“What am I doing right? What am I doing wrong? How can I do what I am doing better? How can I get more information? It’s obsessive”
Top traders need to fight through the pain. This takes courage.
Sometimes you need to be quite different from the crowd, and have the gumption to act on your views and stay the course.
Focus on the process not the money
“The money never had a major effect on me”
Lipschutz was not bothered by the money he had on the table. Rather, his focus is simply on trading well.
This was apparent at one particular point, when he was stuck with a large losing position that was moving against him. Rather than panicking and selling at the first available opportunity, he followed his processes and let the market dictate when he was to get out, resulting in a much smaller loss.
Trading as a game
“I can’t believe I’m making all this money to essentially play an elaborate game”
Lipschutz trades not for the money, but for the challenge.
He suggested that even without the money, he would still trade as he enjoys it so much. To him, trading is a game – and an easy one to keep score of.
Interestingly, a number of top traders have a similar mindset. By thinking of trading as a game, you divorce yourself from the paralyzing stress of worrying about money, and focus simply on making good decisions from a relaxed state of mind.
The timeless nature of trading
Lipschutz’s words are still as relevant today as they were 24 years ago. While the markets and techniques change, the principles of good trading don’t.
So this is where you should spend your time. If you can truly integrate this level of thinking in your trading, then you will be able to achieve your trading goals.
It’s up to you.
About the Author
Sam Eder is a currency trader and author of the Definitive Guide to Developing a Winning Forex Trading System and the Advanced Forex Course for Smart Traders (get free access). He is the owner of www.fxrenew.com a provider of Forex signals from ex-bank and hedge fund traders (get a free trial). If you like Sam’s writing you can subscribe to his newsletter.