Markets. The place for surprises beyond imagination. Anomalies, panics, hysterias, chaos, manias and other extremes that are almost inconceivable. They happen just because humans think that they are in control, or take something for granted, and they lull into a false sense of security. Illusion of control that is.
They think that the probability of the event is too low to be considered. Especially because governments or central banks can control everything, fix market collapses, recessions and deflations; but, as the Wolf sums up in his latest “there is a limit to the power of a central bank.” So, how does one operate in an environment where the almost inconceivable can lead to the risk of ruin? First, some background.
A large number of beginners have jumped into currency trading in recent years under the impression that it is much safer and easier than stocks. Currencies, especially the major pairs, rarely ever move more than 2-3% even in an extreme day, right? Well, how about the Swiss Franc’s 30% move against the euro in under 17 minutes last week?
I have no intention to elaborate more on the CHF story, you can find whatever must know about it in the financial media or on Trader Skillset’s Flipboard magazine edition for mobile devices. It is more important to see that these anomaly events repeat themselves again and again – one century after another. As it has always been: 1637 – the end of the Tulipmania, 1720 – South Sea Bubble collapse, the panic of 1837, the Great Depression/1931 collapse of European debt, 1987 crash, 2000 dotcom bubble, and many in between. Many began overnight when markets are closed or over the weekend like Enron, Lehman and Fannie Mae.
Well, if you plan to own financial instruments for only a year or two, the probability that you get cleaned out on overnight position due to “once in a lifetime anomaly event” is very marginal. But, the risk of a total wipe out is definitely a reality if you consider a full trading career.
Trading for living might mean a few decades – actually I am in my third – which turns the probability of something being “inconceivable” to almost a sure thing. In fact, it is almost 100% that something extreme would pull the rug out from under your feet.
So, be prepared from your very first position.
Back to our original question now, how do you protect yourself? There are two must have items: By betting small relative to your trading capital, and by using stop loss orders. Rather than dwell on these, I would rather reveal my third coping mechanism: I am a day trader; I don’t take overnight positions.
When I wake up in the morning I have the same amount of capital at the start of a new day as I had at the end of the prior day. So every day is a new day, a fresh start without any burden from the day before. There are absolutely no skeletons in the closet. No political force can ruin my work, attempting to manipulate the markets with surprise announcements scheduled for 5 pm EST, or while I am away from my desk.
What makes day trading possible? Many investors or traders insist on using a single time frame and search for patterns there. But come on! Chart patterns are the same on the 5-minute chart as on the weekly or the daily, because of the fractal nature of the markets. They look the same, they work the same way and they have the same attributes. They just repeat themselves on different scale of size.
When you encounter an opportunity on a 10-minute chart, in a liquid instrument during regular market hours, you know that your trade is going to last about 3-8 bars, 30 to 80 minutes maybe a little more and your risk is limited by your stop loss order. When you trade something on the weekly then you are out there in the cold every night, every weekend for two months plus, hoping against the inconceivable happening.
It is easy to walk through a wide open gate, and then get stuck by a trapdoor overnight. Instead, I’d encourage you to make sure you have a more robust exit plan, like I do. Consider the day traders’ game and close your trades by the closing bell, so the inconceivable doesn’t happen to you.
The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.