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Mind over emotion, using risk management

Consensus trades have always been those trades that tend to get a bit crowded as traders and investors coalesce around a common position. Who can forget the calls for euro parity against the US dollar which saw the single currency close to within 340 points of 1 earlier this year?

We’ve seen similar calls with respect to the euro against the pound, and a move towards parity, and while they may seem sensible trades at the time, they are fraught with danger, with a number of high profile names having had to backtrack on their predictions in a matter of weeks.

If I’ve learned one thing in almost 30 years of looking at FX markets, or any market for that matter, it’s to try and avoid making calls that have only have a 50/50 potential of being right, and to make calls based on an analysis of the price action, and risk relative to reward.

Technical analysis tends to get a bad rap from some in the mainstream media, not to mention the economics profession, and that’s fine because it tells me they don’t really understand it. The whole point of technical analysis, or charting if you prefer, is to allow the use of risk-management tools to identify potential turning points in the market.

Not everyone gets it right but that is just as true of economists who claim to be able to foresee the future with all their mathematical models and spreadsheets of data. If the study of data were the be all and end all, then most economists would probably be able to coalesce around a common position on almost anything.

That they can’t do that, tells us that for all of their knowledge, economists probably have no more or less idea about how an economy reacts to various stimuli than anyone else. How else can you explain the variety of different predictions on GDP and prices from bodies such as the the Organisation for Economic Cooperation and Development, International Monetary Fund, World Bank, various central banks and independent think-tanks?

We only have to look at the constant hand-wringing as to why the so-called Phillips curve, which describes the historical links between unemployment and inflation, doesn’t appear to be working to know that.

The simplicity of studying price action is the assumption that everything is more or less discounted in the price and the analysis of trend, momentum and human emotion is represented in a single data item. It also gives the trader the ability to identify the important key support or resistance levels, or previous highs and lows.

Another advantage is that charting is less disposed to groupthink in that each different trader will have his own different exit and entry points, while hoping to get the overall direction of the trade right.

This is probably where most economic models fall down in that there is no single mathematical formula that can be encapsulate human emotion into a single calculation in a spreadsheet That makes it a huge intangible, as human beings are by nature unpredictable, and won’t necessarily react in a way that is expected.  

The use of charts allows the implementation of a disciplined approach to trading in an effort to set rules to risk management, but also more importantly to take some of the emotional burden out of trading, but also to help make sense of these intangibles.

This is important as human beings have a tendency to herd in a particular direction and this can have its problems particularly at the end of a trend, but it does also introduce a degree of predictability.

Not for nothing was it reported that Baron Rothschild, an 18th century nobleman coined the phrase “time to buy is when there’s blood on the streets”

Fear can cause a market to overshoot to the downside, something that we saw in 2008 and 2009 in equity markets, when the FTSE100 fell from 6,400 to lows of 3,460 in the space of ten months.

We saw something similar in terms of the oil price in 2014 and 2015 when analysts continually wrote down their targets on an almost daily basis, as Brent crude fell from peaks above $110 to as low as $27, before rebounding.

Sometimes waiting for the market to come to you in terms of an entry into a trade is the wisest course of action, whereas fear of missing out or (FOMO) can be a trait that can cost money.

Ultimately you have to make a judgment and in the case of the oil price, the judgement was this, how much further downside was potentially left, and more importantly what is the risk reward for shorting at levels last seen in 2003? Having seen an $80 decline already how much further did it have to fall, another $5 or $10 to around $20, or could it rebound $15 or $20, back towards $40?

We know the answer to that now, but it wouldn’t have been the consensus trade at the time, and that’s where risk management comes in as it helps to minimise losses and maximise profits. 

The be all and end all for any trade or investor should always be capital preservation first and capital appreciation second. Forget that at your own risk.

CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

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